-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, G4CDzgmaodSxYP2nRgHHqL+ayOYppvj+ZiS3CLGNsNEwVBYPw3NQBkPVFyTDp7Hw LhRm2TnyGOW6DywN9zL4Kg== 0000950005-99-000962.txt : 19991115 0000950005-99-000962.hdr.sgml : 19991115 ACCESSION NUMBER: 0000950005-99-000962 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990926 FILED AS OF DATE: 19991110 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CYLINK CORP /CA/ CENTRAL INDEX KEY: 0001005230 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER PERIPHERAL EQUIPMENT, NEC [3577] IRS NUMBER: 953891600 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-27742 FILM NUMBER: 99746338 BUSINESS ADDRESS: STREET 1: 910 HERMOSA COURT CITY: SUNNYVALE STATE: CA ZIP: 94086-4103 BUSINESS PHONE: 4087355822 MAIL ADDRESS: STREET 1: 910 HERMOSA CT CITY: SUNNYVALE STATE: CA ZIP: 94086-4103 10-Q 1 FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 26, 1999 Commission File No. 0-27742 CYLINK CORPORATION (Exact name of registrant as specified in its charter) California 95-3891600 State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 3131 Jay Street Santa Clara, CA 95054 (Address of principal executive offices) (408) 855-6100 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- As of November 8, 1999, there were 29,730,000 shares of the Registrant's common stock outstanding. 1 CYLINK CORPORATION FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 26, 1999 INDEX Page ---- Facing Sheet 1 Index 2 Part I Financial information Item 1 Financial Statements and Supplementary Data a) Condensed Consolidated Balance Sheets at September 26, 1999 and December 31, 1998 3 b) Condensed Consolidated Statements of Operations for the three and nine months ended September 26, 1999 and September 27, 1998 4 c) Condensed Consolidated Statement of Cashflows for the nine months ended September 26, 1999 and September 27, 1998 5 d) Notes to Condensed Consolidated Financial Statements 6 Item 2 Management's discussion and analysis of financial condition and results of operations 9 Part II Other Information 21 Signature 22 Exhibit Exhibit 27.1, Financial data schedule 23 2 PART I. FINANCIAL INFORMATION Item 1. Financial Statements -------------------- CYLINK CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share data; unaudited)
September 26, December 31, 1999 1998 --------- --------- Assets Current assets: Cash and cash equivalents $ 38,180 $ 46,575 Accounts receivable, net of allowances of $1,425 and $1,251 14,974 7,958 Note receivable -- 3,545 Inventories 5,102 10,289 Deferred income taxes 4,504 4,495 Other current assets 2,971 6,675 --------- --------- Total current assets 65,731 79,537 Restricted cash 1,400 -- Property and equipment, net 8,336 5,731 Acquired technology, goodwill and other intangibles 3,873 5,341 Notes receivable from employees or former employees 3,282 2,558 Other assets 1,203 1,151 --------- --------- $ 83,825 $ 94,318 ========= ========= Liabilities and Shareholders' Equity Current liabilities: Current portion of lease obligations and long-term debt $ 29 $ 120 Accounts payable 6,381 3,656 Accrued liabilities 6,616 8,230 Accrued liabilities related to discontinued operations -- 3,878 Income taxes payable 1,045 1,091 Deferred revenue 2,175 1,975 --------- --------- Total current liabilities 16,246 18,950 --------- --------- Capital lease obligations and long-term debt 114 147 --------- --------- Commitments and Contingencies (Note 9) Shareholders' equity: Preferred stock, $.01 par value; 5,000,000 shares authorized none issued or outstanding -- -- Common stock, $.01 par value; 40,000,000 shares authorized 29,573,000 and 29,115,000 shares issued and outstanding . 296 291 Additional paid-in capital 126,237 123,929 Deferred compensation (1,989) (167) Accumulated other comprehensive loss (197) (61) Accumulated deficit (56,882) (48,771) --------- --------- Total shareholders' equity 67,465 75,221 --------- --------- $ 83,825 $ 94,318 ========= ========= See accompanying notes to Condensed Consolidated Financial Statements.
3 CYLINK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except per share data; unaudited)
Three Months Ended Nine Months Ended ------------------------ ------------------------ September 26, September 27, September 26, September 27, 1999 1998 1999 1998 -------- -------- -------- -------- Revenue $ 15,092 $ 12,130 $ 42,186 $ 32,555 Cost of revenue 4,157 5,924 13,038 12,545 -------- -------- -------- -------- Gross profit 10,935 6,206 29,148 20,010 -------- -------- -------- -------- Operating expenses: Research and development, net 3,783 6,222 11,276 12,037 Selling and marketing 6,424 6,170 18,061 17,950 General and administrative 3,800 2,452 9,716 5,782 Amortization of purchased intangibles 724 679 2,084 2,038 -------- -------- -------- -------- Total operating expenses 14,731 15,523 41,137 37,807 -------- -------- -------- -------- Loss from operations (3,796) (9,317) (11,989) (17,797) Other income (expense): Interest income, net 420 542 1,356 1,381 Royalty and other income (expense), net 138 32 276 (83) -------- -------- -------- -------- 558 574 1,632 1,298 -------- -------- -------- -------- Loss from continuing operations before income taxes (3,238) (8,743) (10,357) (16,499) Benefit for income taxes -- (3,060) -- (5,774) -------- -------- -------- -------- Loss from continuing operations (3,238) (5,683) (10,357) (10,725) Loss from discontinued operations, net of tax (Note 2) -- -- -- (259) Gain on disposal of discontinued operations, net of tax (Note 2) 2,246 -- 2,246 22,776 -------- -------- -------- -------- Net income (loss) $ (992) $ (5,683) $ (8,111) $ 11,792 ======== ======== ======== ======== Earnings (loss) per share - basic: Continuing operations $ (0.11) $ (0.20) $ (0.36) $ (0.37) Discontinued operations 0.08 -- 0.08 0.78 -------- -------- -------- -------- Net income (loss) $ (0.03) $ (0.20) $ (0.28) $ 0.41 ======== ======== ======== ======== Earnings (loss) per share - diluted: Continuing operations $ (0.11) $ (0.20) $ (0.36) $ (0.37) Discontinued operations 0.08 -- 0.08 0.78 -------- -------- -------- -------- Net income (loss) $ (0.03) $ (0.20) $ (0.28) $ 0.41 ======== ======== ======== ======== Shares used in per share calculation - basic 29,180 29,082 29,144 28,971 ======== ======== ======== ======== Shares used in per share calculation - diluted 29,180 29,082 29,144 28,971 ======== ======== ======== ======== See accompanying notes to Condensed Consolidated Financial Statements.
4 CYLINK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands; unaudited)
Nine Months Ended -------------------------- September 26, September 27, 1999 1998 -------- -------- Cash flows from operating activities: Net income (loss) $ (8,111) $ 11,792 Adjustments to reconcile net income (loss) to net cash used in operating activities: Write-off of minority investment in unaffiliated company -- 3,000 Gain on disposal of discontinued operations (2,246) (22,776) Loss on disposition of property and equipment 190 -- Depreciation & amortization 4,169 3,695 Deferred income taxes (9) (96) Amortization of imputed interest on Note receivable (184) -- Amortization of deferred compensation related to stock options 212 62 Changes in assets and liabilities (net of effects of acquisitions): Accounts receivable (6,883) 431 Inventories 5,187 (3,602) Other assets 2,650 472 Accounts payable 2,717 925 Accrued liabilities (1,551) (10,971) Income taxes payable (46) -- Deferred revenue 200 1,172 -------- -------- Net cash used in continuing operations (3,705) (15,896) Net cash used in discontinued operations (529) (7,173) -------- -------- Net cash used in operating activities (4,234) (23,069) -------- -------- Cash flows from investing activities: Investment in restricted cash (1,400) -- Acquisition of property and equipment (4,927) (2,157) Loans to employees in exchange for notes receivable (565) (2,289) Proceeds from sale of discontinued operations -- 54,879 Collection of Note Receivable (Note 2) 3,250 -- Acquisition of S.D.I. (Note 8) (538) -- Acquisition of preferred stock of unaffiliated company -- (3,000) -------- -------- Net cash provided by (used in) investing activities (4,180) 47,433 -------- -------- Cash flows from financing activities: Proceeds from issuance of common stock, net 279 1,751 Other (124) (146) -------- -------- Net cash provided by financing activities 155 1,605 -------- -------- Effect of exchange rate changes on cash and cash equivalents (136) 36 -------- -------- Net increase (decrease) in cash and cash equivalents (8,395) 26,005 Cash and cash equivalents at beginning of year 46,575 22,977 -------- -------- Cash and cash equivalents at end of year $ 38,180 $ 48,982 ======== ======== Supplemental disclosures: Cash paid for income taxes $ -- $ 8,215 Cash paid for interest 3 55 See accompanying notes to Condensed Consolidated Financial Statements.
5 CYLINK CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) 1. Basis of Presentation The unaudited condensed consolidated financial statements included herein contain all adjustments, consisting only of normal recurring adjustments which, in the opinion of management, are necessary to fairly state the consolidated financial position, results of operations and cash flows of Cylink Corporation ("Cylink" or the "Company") for the periods presented. These interim condensed consolidated financial statements and notes thereto should be read in conjunction with Cylink's audited consolidated financial statements and notes thereto included in Cylink's Annual Report on Form 10-K for the year ended December 31, 1998. Interim results of operations are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 1999. 2. Discontinued Operations On March 27, 1998, Cylink sold its Wireless Communications Group ("Wireless") to P-Com, Inc. for $60.5 million ($46.0 million in cash and an unsecured promissory note in the amount of $14.5 million due 100 days after closing, subject to closing adjustments). The sale resulted in an after tax gain of approximately $22.8 million. As a result, the operations of Wireless have been classified as discontinued operations in the accompanying Condensed Consolidated Financial Statements and related Notes. Accrued expenses in the amount of approximately $6.8 million, primarily for professional services, anticipated excess facilities expenses, and certain other transaction-related accruals were charged to discontinued operations and reduced the gain on disposal. Pursuant to the restatement of revenues and operating results referred to in Form 10-K for the year ended December 31, 1998, certain revenues of Wireless previously recognized in the fourth quarter of 1997 and the first quarter of 1998 were adjusted. Wireless revenues were $4.4 million in the first quarter of 1998 through the date of disposal. On July 14, 1998, P-Com made a partial payment on its promissory note, which along with other credits, totaled $8.9 million. On August 23, 1999, Cylink accepted as a complete settlement of all outstanding claims and counter-claims a total of $3.25 million of the outstanding balance. After the elimination of other claims by Cylink against P-Com and offsetting certain reserves against those assets, Cylink recorded an additional net gain on disposal of discontinued operations, net of tax, of $2.2 million. 3. Inventories September 26, December 31, ------------------------------------- (in thousands) Raw materials $ 2,003 $ 2,813 Work in process and subassemblies 615 1,877 Finished goods 2,484 5,599 ------- ------- $ 5,102 $10,289 ======= ======= 4. Earnings (Loss) Per Share Basic earnings (loss) per share is based on the weighted-average number of common shares outstanding excluding 306,302 shares escrowed pursuant to the acquisition of S.D.I. disclosed in Note 8 below. Diluted earnings (loss) per share is based on the weighted-average number of shares outstanding and dilutive potential common shares outstanding. Cylink's only potentially dilutive securities are shares exercisable pursuant to currently outstanding stock options and escrowed shares. All potentially dilutive securities have been excluded from the computation of 6 diluted earnings (loss) per share as their effect is anti-dilutive on the loss from continuing operations for the periods presented. As of September 26, 1999 and September 27, 1998, Cylink had 6,699,000 and 6,081,000 stock options outstanding with a weighted average exercise price of $4.82 and $9.01, respectively. 5. Comprehensive Loss The components of comprehensive loss are as follows (in thousands):
Three Months Ended Nine Months Ended ------------------------------- ------------------------------- September 26, September 27 September 26, September 27 1999 1998 1999 1998 -------- -------- -------- -------- (in thousands) (in thousands) Net income (loss) $ (992) $ (5,683) $ (8,111) $ 11,792 Other comprehensive income (loss) (88) 35 (136) (27) -------- -------- -------- -------- Total comprehensive income (loss) $ (1,080) $ (5,648) $ (8,247) $ 11,765 ======== ======== ======== ========
6. New Lease On May 10, 1999, Cylink reached an agreement to lease approximately 96,000 square feet of office and manufacturing space located in Santa Clara, California for use as its principal office and manufacturing facility. The lease term is for 120 months and commenced on September 1, 1999, and includes an option to extend the lease for an additional 5 years on commercially reasonable terms. The lease agreement provides for the payment of rent on a net industrial lease basis commencing at $174,000 per month for the first year and escalating to $228,000 per month in the tenth year of the lease. It is Cylink's intention to sublease its former manufacturing facility, occupying 34,500 square feet, under its lease that expires in June 2001, which carries a minimum monthly lease obligation of $32,775. Cylink's lease on its former headquarters facility expired on September 17, 1999. On August 5, 1999, Cylink amended its lease for the Santa Clara premises to add an additional 46,000 square feet directly adjacent to this facility for use as expansion space. The lease term on the additional space is 119 months commencing approximately October 1, 1999, and includes an option to extend the lease for an additional 5 years on commercially reasonable terms. The amended lease provides for the payment of additional rent on a net industrial lease basis commencing at $47,513 per month for the first year and escalating to $57,457 per month in the tenth year of the lease for approximately 22,000 square feet of the newly added space. The remaining 24,000 square feet of the facility is currently leased to an outside tenant for a term not exceeding 5 years, after which the leasehold interest will revert to Cylink on similar terms and conditions to the initial 22,000 square feet, with rent for this additional space escalating from $59,100 in the sixth year to $64,025 per month in the tenth year of the lease. 7. Restricted Cash As part of the lease agreement referenced in Note 6, the Company posted a cash deposit in the amount of $1.4 million with its bank to secure a Standby Letter of Credit in favor of the landlord which serves as an additional security deposit. The lease agreement provides for the release of all of this portion of the security deposit after four years upon the achievement of certain financial profitability goals. Accordingly, Cylink has classified this as a long-term asset. 8. Business Acquisition On July 21, 1999, Cylink acquired Virginia-based Security Design International, Inc. (S.D.I.), a security consulting and professional services company which provides network vulnerability assessments. Concurrent with the acquisition, Cylink entered into employment contracts with four S.D.I. shareholders. In connection with the acquisition and employment agreements, Cylink (1) paid $450,000 cash, (2) issued 306,302 shares of Cylink common shares into escrow, to be released in annual installments as the shares vest over a three-year employment 7 period, (3) issued options to purchase 150,000 Cylink common shares which vest over four years, and (4) agreed to pay bonuses of up to $1.925 million contingent upon continued employment and the achievement of specified revenue and profitability goals over three years. Transaction costs totaled approximately $132,000. Deferred compensation resulting from the issuance of the escrowed common shares and the stock options totaled approximately $2,034,000 and is reported as a reduction to shareholders equity, to be amortized over the applicable vesting period. The goodwill resulting from the acquisition (approximately $436,000) will be amortized over three years. The purchase price allocation is preliminary and subject to adjustment based on additional information concerning the fair value of assets acquired and liabilities assumed. The pro forma results of operations of S.D.I., assuming the acquisition had occurred as of January 1, 1999, would not be material to Cylink's consolidated financial statements. 9. Contingencies Cylink is currently engaged in litigation. See Part II, Item 1. "Legal Proceedings." 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations This Report on Form 10-Q includes statements that reflect Cylink's belief concerning future events and financial performance. Statements which are not purely historical in nature 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. We sometimes identify forward-looking statements with such words as "expects", "anticipates", "intends", "believes" or similar words concerning future events. You should not rely too heavily on these forward-looking statements. They are subject to certain risks and uncertainties that may cause actual results to differ materially from past results or Cylink's predictions. For a description of these risks see Item 2. "Risk Factors That May Affect Future Results," and other sections of this Report on Form 10-Q. You should also consult the risk factors listed from time to time in Cylink's other Exchange Act Reports. All forward-looking statements included in this document are based on information available to Cylink as of the date of this Report on Form 10-Q, and Cylink assumes no obligation to update any such forward-looking statements, or to update the reasons why actual results could differ from those projected in the forward-looking statements. DISCONTINUED OPERATIONS Pursuant to an asset purchase agreement dated March 27, 1998, Cylink sold its Wireless business to P-Com, Inc. See Note 2 of Notes to Condensed Consolidated Financial Statements. The sale resulted in an overall after-tax gain of approximately $25.0 million. Except where noted, the following comments are associated with the continuing network security business. RESULTS OF OPERATIONS The following table sets forth certain consolidated statement of operations data as a percentage of revenue for the periods indicated:
Three Months Ended Nine Months Ended ------------------ ----------------- Sep 26, Sep 27, Sep 26, Sep 27, 1999 1998 1999 1998 ----- ----- ----- ----- Revenue 100.0% 100.0% 100.0% 100.0% Cost of revenue 27.5% 48.8% 30.9% 38.5% ----- ----- ----- ----- Gross profit 72.5% 51.2% 69.1% 61.5% Operating expenses: Research and development, net 25.1% 51.3% 26.7% 37.0% Selling and marketing 42.6% 50.9% 42.8% 55.1% General and administrative 25.2% 20.2% 23.0% 17.8% Amortization of purchased intangibles 4.8% 5.6% 4.9% 6.3% ----- ----- ----- ----- Total operating expenses 97.6% 128.0% 97.5% 116.1% ----- ----- ----- ----- Loss from operations -25.2% -76.8% -28.4% -54.7% Other income 3.7% 4.7% 3.9% 4.0% ----- ----- ----- ----- Loss from continuing operations before income taxes -21.5% -72.1% -24.6% -50.7% ===== ===== ===== =====
9 Revenue. Revenue increased 24% from $12.1 million for the three months ended September 27, 1998 to $15.1 million for the three months ended September 26, 1999, and increased 30% from $32.6 million for the nine months ended September 27, 1998 to $42.2 million for the nine months ended September 26, 1999. These increases were attributable to increases in unit shipments of existing products, shipments of products with higher average selling prices, and increased revenues associated with software maintenance and support services. International revenue was 38% and 52% of total revenue for the third quarter of 1998 and 1999, respectively. Cylink's revenue is derived primarily from sales of its family of commercial network security products, and to a lesser extent, from the license of software products. Fees for software maintenance and support services are charged separately. Revenue arising from sales of hardware products is recognized upon shipment to customers. Concurrently, a provision is made for estimated cost to repair or replace products under warranty arrangements. Revenue from sales to distributors is recognized upon shipment; no right of return, stock rotation or price protection is given. Revenue from sales to value added resellers is recognized upon shipment and concurrently a provision for estimated returns is recorded based on historical and anticipated experience. Cylink also derives revenue from the license of its software products as well as fees for software maintenance and support. Cylink's revenue recognition policy is consistent with Statement of Position 97-2, Software Revenue Recognition, and the related amendment SOP 98-4. Software license revenue is recognized when a written purchase order, license agreement or contract has been executed; delivery of software has occurred; no significant Company obligations remain; the fee is fixed and determinable; collectibility is probable and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. Vendor-specific objective evidence is based on the price generally charged when an element is sold separately. Allowances for estimated future returns, which to date have been immaterial, are provided upon shipment and adjusted periodically by management based on historical and anticipated experience. Maintenance and support revenue consists of ongoing support and product updates and is deferred and recognized ratably over the term of the maintenance contract, which is typically twelve months. Software revenue, including related maintenance and support fees, was not material in any period presented. Since its acquisition of S.D.I. in July 1999, Cylink also derives revenues from network security consulting services. These include vulnerability assessment, incident response assessment, design review and training, as well as general consulting services. Services are delivered on either a firm fixed price or time & materials basis, depending upon customer preference and availability of required estimating information. Revenue on fixed price services is recognized on a percentage of completion basis. Some services are rendered on a time-and-materials basis, and revenue for those services is recognized as the services are performed. For the quarter ended September 26, 1999, revenue from professional services was not material. Gross Profit. Gross profit increased 76.2% from $6.2 million for the three months ended September 27, 1998 to $10.9 million for the three months ended September 26, 1999, and increased 46% from $20.0 million for the nine months ended September 27, 1998 to $29.1 million for the nine months ended September 26, 1999. The increase in dollars was primarily a result of the increase in revenue. As a percentage of sales, gross profit increased to 72% in the third quarter of 1999 from 51% for the third quarter of 1998. This increase resulted primarily from improved manufacturing utilization generating increased overhead absorbtion and a product mix of higher profit margin products. Research and Development. Research and development expenses consist primarily of salaries and other personnel-related expenses, depreciation of development equipment, facilities and supplies. Research and development expenses for the third quarter of 1998 included a one-time charge of $3.0 million related to the write off of a minority investment in an unaffiliated company. Ignoring this one-time charge, gross research and development expenses increased 7% from $3.9 million for the three months ended September 27, 1998 to $4.1 million for the three months ended September 26, 1999, and increased 25% from $10.1 million for the nine months ended September 27, 1998 to $12.5 million for the nine months ended September 26, 1999. Gross research and development expenses as a percentage of revenue, ignoring the one-time write off, were 32% for the third quarter of 1998 compared to 27% for the third quarter of 1999, and 31% for the first nine months of 1998 compared to 30% for the first nine months of 1999. The dollar increase resulted from increased spending on externally funded contracts, increased personnel, and development costs of new products, particularly in Israel. The decrease in expense as a percentage of revenue was due to an increase in revenue growth at a rate of faster than the growth rate of spending on new products. 10 From time to time Cylink receives engineering funding for development of projects to apply or enhance Cylink's technology to a particular customer's need. The amounts recognized under these research and development contracts are offset against research and development expenses. Amounts recognized under non-recurring engineering contracts totaled $0.6 million for the third quarter of 1998 and $0.3 million for the third quarter of 1999, and $1.0 million and $1.3 million for the first nine months of 1998 and 1999, respectively. Selling and Marketing. Selling and marketing expenses consist primarily of personnel expenses, including sales commissions, and expenses for advertising, public relations, seminars and trade shows. Selling and marketing expenses increased 4% from $6.2 million for the three months ended September 27, 1998 to $6.4 million for the three months ended September 26, 1999, and increased 1% from $18.0 million for the nine months ended September 27, 1998 to $18.1 million for the nine months ended September 26, 1999. Selling and marketing expenses as a percentage of revenue were 51% for the third quarter of 1998 compared to 43% for the third quarter of 1999, and 55% for the first nine months of 1998 compared to 43% for the first nine months of 1999. These modest spending increases were primarily due to increased travel related costs attributable to further development of Cylink's US channels organization and higher occupancy costs. Selling and marketing expenses, expressed as a percentage of revenue, decreased as a result of the increased revenue base. General and Administrative. General and administrative expenses consist primarily of personnel and related costs, recruitment expenses, information systems costs, and audit, legal and other professional service fees. General and administrative expenses increased 55% from $2.5 million for the three months ended September 27, 1998 to $3.8 million for the three months ended September 26, 1999, and increased 68% from $5.8 million for the nine months ended September 26, 1998 to $9.7 million for the nine months ended September 26, 1999. General and administrative expenses as a percentage of revenue were 20% for the third quarter of 1998 compared to 25% for the third quarter of 1999, and 18% for the first nine months of 1998 compared to 23% for the first nine months of 1999. The dollar and percentage of revenue increases in the third quarter of 1999 were primarily due to non-capitalized training and supply costs associated with Cylink's new Enterprise Resource Planning system, relocation and excess facilities costs, an additional provision for doubtful accounts of $.2 million and additional professional services costs. Amortization of Purchased Intangibles. Amortization relating to goodwill and other intangibles was $0.7 million in each period presented and relates to the acquisition of Algorithmic Research, Ltd and Algart Holdings, Ltd. (collectively "ARL") in September 1997, and the acquisition of S.D.I. in the third quarter of 1999. Benefit from Income Taxes. No provision for, or benefit from, income taxes was recognized in the quarter ended September 26, 1999 as Cylink incurred a net operating loss for income tax purposes and had no additional loss carryback potential. Other Income (Expense), Net. Other income (expense), net, consists primarily of interest income, interest expense and, to a lesser extent, royalty income. Interest income, net, decreased from $0.5 million for the third quarter of 1998 to $0.4 million for the third quarter of 1999, principally due to lower cash and cash equivalent balances between periods. LIQUIDITY AND CAPITAL RESOURCES At September 26, 1999, Cylink had cash and cash equivalents of $38.2 million, working capital of $49.5 million and minimal long-term obligations. For the nine months ended September 26, 1999, Cylink recorded a net loss of $8.1 million. Operating activities used $4.2 million in the nine months ended September 26, 1999. This consisted primarily of the loss from continuing operations and an increase in accounts receivable of $6.9 million, offset in part by a decrease in inventories of $5.2 million Both the increase in accounts receivable and the decrease in inventories were the result of increased sales. For the nine months ended September 27, 1998, Cylink recorded net income of $11.8 million, principally due to the $22.8 million gain on sale of Wireless, offset by a loss from continuing operations of $10.7 million and a loss from discontinued operations of $.3 million. For the first nine months of 1998 continuing operations used $15.9 million. This consisted primarily of the loss from continuing operations of $10.7 million, increases in inventories in anticipation of increased sales and payment of estimated income taxes related to the gain on sale of Wireless. Investing activities for the nine months ended September 26, 1999 used $4.2 million in cash. These expenditures consisted primarily of investments in fixed assets totaling $4.9 million, the investment of $1.4 million in restricted 11 cash to secure a standby letter of credit, long-term loans to employees of $.6 million, and a $.5 million cash investment in S.D.I., offset in part by the collection of a note receivable of $3.25 million. The investments in fixed assets consisted primarily of the license and implementation costs of an Oracle Enterprise Resource Planning system, the acquisition of related computer hardware, and tenant improvements and furniture in connection with Cylink's new lease. Cash provided by investing activities for the nine months ended September 27, 1998 was $47.4 million, of which $54.9 million was attributed to the sale of Wireless. The funds attributable to the Wireless sale were partially offset by expenditures for property and equipment of $2.2 million, long-term loans to employees of $2.2 million, and a $3.0 million minority investment in the preferred stock of an unaffiliated company. Cylink is currently engaged in litigation. See Part II, Item 1. "Legal Proceedings." Management believes that the ultimate resolution of these matters will not have a material adverse effect on Cylink's financial position or results of operations. On July 21, 1999, Cylink acquired Virginia-based Security Design International, Inc.("S.D.I."), for a $450,000 cash payment, issuance of approximately 306,000 shares of Cylink's common stock, and a deferred cash bonus of up to $1.925 million. In connection with the terms of the acquisition, Cylink recorded a non-cash, deferred compensation charge of $1.8 million resulting from the issuance of the 306,000 shares, which will be amortized over the life of the underlying employment agreements, and a non-cash, deferred compensation charge predicated on the difference between market value of the underlying shares and the option exercise price on the date of the grant applied to 150,000 options granted in connection with the employment by the Company of the selling shareholders of S.D.I., to be amortized over the vesting period of those options. Cylink recorded as goodwill approximately $.5 million excess of the purchase consideration over the identifiable fair value of the net assets obtained, to be amortized over three years. In addition to the acquisition cost, S.D.I. is expected to utilize approximately $0.5 million in capital equipment and operating loss requirements over the next 12 months. Cylink believes that existing cash balances and cash generated from operations, if any, will be sufficient to fund necessary purchases of capital equipment and to provide working capital through at least the next twelve months. However, Cylink may require additional funds to support its continuing operating losses, working capital requirements or for other purposes and may seek to raise such additional funds through public or private equity financing or from other sources. This additional financing may not be available on terms favorable to Cylink or its shareholders, if at all. Year 2000 Compliance "Year 2000 Compliance" refers generally to the problems that some software, including firmware embedded in Cylink's products, may have in determining the correct century for the year. For example, software with date-sensitive functions that is not Year 2000 compliant may not be able to distinguish whether "00" means 1900 or 2000, which may result in failures or the creation of erroneous results. Cylink has defined "Year 2000 Compliant" as the ability to: (i) correctly handle date information needed for the December 31, 1999 to January 1, 2000 date change; (ii) function according to the product documentation provided for this date change, without changes in operation resulting from the advent of a new century, assuming correct configuration; (iii) where appropriate, respond to two-digit date input in a way that resolves the ambiguity as to century in a disclosed, defined, and predetermined manner, such as in certificate based products, or in accordance with Cylink's Year 2000 Compliant test plan; and (iv) recognize year 2000 as a leap year. Cylink has developed a Year 2000 readiness plan for the current versions of its products. Cylink has largely completed all phases of its plan, except for contingency planning, with respect to the current versions of all of its products. As a result, the current versions of each of its products currently offered for sale are believed to be "Year 2000 Compliant." In some cases, Cylink's products require an upgrade provided by Cylink which is either sold as a complete substitute or as a kit sold with the product in order to be Year 2000 Compliant. Cylink has completed a review of its mission critical internal information systems (including the third-party software for its management information systems, networks and desktop applications, and its hardware telecommunications technology) and believes it has addressed all critical concerns. When deficiencies have been identified in critical components, Cylink is purchasing new or upgraded versions which have been certified by their vendors as compliant. 12 Cylink has funded its Year 2000 plan from operating cash. While Cylink does not expect such costs to be material, Cylink will incur additional amounts related to the Year 2000 plan for administrative personnel to manage Cylink's readiness plans, technical support for its product engineering and customer satisfaction. Cylink has completed its plans to address Year 2000 readiness of its critical operations based on its perception of the known risks involved. Despite testing by Cylink and current and potential customers, and any assurances from developers of products incorporated into Cylink's products or in use in Cylink's business operations, Cylink's products may contain undetected errors or defects associated with Year 2000 date functions. Further, Cylink may be using products in its business operations which are not Year 2000 compliant. An unanticipated Year 2000 interruption could have material adverse financial consequences to Cylink or seriously impair business operations for an indefinite period of time. For a more comprehensive discussion of Cylink's Year 2000 plans and exposures, see the "Year 2000" topic under Part I, Item 2. "Risk Factors That May Affect Future Results." 13 RISK FACTORS THAT MAY AFFECT FUTURE RESULTS Recent Losses; Potential Fluctuations in Operating Results, Future Operating Results Uncertain Cylink incurred losses from continuing operations in 1998 and for each of the prior four years. Cylink expects to continue to incur net losses through at least the balance of 1999. Cylink may not increase or maintain its revenue or be profitable on a quarterly or an annual basis in the future. Cylink has historically experienced significant fluctuations in its operating results on a quarterly basis and could experience such fluctuations in the future. Cylink's operating results are affected by a number of factors, many of which are outside of Cylink's control, including the following: o the timing of the introduction of new or enhanced products by Cylink or its competitors o market acceptance of new products of Cylink, new products of its customers, and new product introductions by its competitors o the timing, cancellation or delay of customer orders, including cancellation or delay in anticipation of new product introduction or enhancement or resulting from uncertainty relating to intellectual property claims o competitive factors, including pricing pressures o changes in operating expenses, including those resulting from changes in available production capacity of independent foundries and other suppliers and the availability of raw materials o delays in manufacturing due to shortages in components or unanticipated revisions in product design o expenses incurred in seeking to obtain, enforce and defend claims with respect to intellectual property rights o the mix of products sold o changes in the percentage of products sold through Cylink's direct sales force o personnel changes o general economic conditions, and, o fluctuations in foreign currency exchange rates. Cylink expects to introduce a number of new products during the remainder of 1999 and 2000. The failure of any such products to achieve market acceptance when anticipated, or at all, would materially and adversely affect Cylink's financial condition and results of operations. In connection with the acquisition of ARL in September 1997, Cylink allocated $63.9 million of the purchase price to in-process research and development ("IPR&D"), and in accordance with generally accepted accounting principles recorded an immediate charge off of that amount on the date of acquisition. The amount allocated to IPR&D was determined in a manner consistent with widely recognized appraisal practices. In a letter dated September 15, 1998, to the American Institute of Certified Public Accountants, the Chief Accountant of the Securities and Exchange Commission ("SEC") indicated the SEC Staff's concerns related to certain appraisal practices generally employed in determining the fair value of IPR&D. As a result, it is possible that the SEC staff may require that any enterprise that recorded an IPR&D charge revise its estimate of the value of the IPR&D. To the extent Cylink is required by the SEC Staff to retroactively revise its estimate of the value of IPR&D, such revision could result in the capitalization of additional goodwill, the amortization of which would reduce future operating results. Lengthy Sales Cycle Sales of Cylink's products generally involve a significant commitment of capital by customers, with the attendant delays frequently associated with large capital expenditures. For these and other reasons, the sales cycle associated with Cylink's products is typically lengthy and subject to a number of significant risks over which Cylink has little or no control. Cylink is often required to ship products shortly after it receives orders and, consequently, order backlog at the beginning of any period has in the past represented only a small portion of that period's expected revenue. As a result, product revenue in any period is substantially dependent on orders booked and shipped in that period. Cylink typically plans its production and inventory levels based on internal forecasts of customer demand, which are highly unpredictable and can fluctuate substantially. In addition, Cylink's current or future customers may curtail or suspend investments in securing their existing networks as the Year 2000 approaches, or divert technology expenditures reserved for enterprise security products in order to address Year 2000 compliance problems (see further discussion 14 under Year 2000 below). If revenue falls significantly below anticipated levels, as it has at times in the past, Cylink's financial condition and results of operations would be materially and adversely affected. In addition, Cylink's operating expenses are based on anticipated revenue levels and a high percentage of Cylink's expenses are generally fixed in the short term. Based on these factors, a small fluctuation in the timing of sales can cause operating results to vary significantly from period to period. For example, on September 14, 1998, Cylink announced that its earnings for the third quarter of 1998 would be below consensus estimates. It is possible that in the future Cylink's operating results will again be below the expectations of securities analysts and investors. In such an event, or in the event that adverse conditions prevail or are perceived to prevail generally or with respect to Cylink's business, the price of Cylink's Common Stock would likely be materially adversely affected. Pending Litigation See Part II, Item 1. "Legal Proceedings." Dependence on Key Personnel On November 4, 1998, Mr. William C. Crowell, formerly Vice President of Product Strategy, was promoted to President and Chief Executive Officer, and on November 16, 1998, Mr. Roger A. Barnes became Cylink's Chief Financial Officer. Cylink's future success will depend on the abilities of Mr. Crowell and the contributions by its other executive officers, key management and technical personnel. The loss of the services of one or more of Cylink's executive officers or key personnel, or the inability to continue to attract and retain qualified personnel, could delay product development cycles or otherwise have a material adverse effect on Cylink's business and operating results. Dependence on Recently Introduced and New Information Security Products Cylink's future results of operations will be highly dependent on the successful completion of the design, development, introduction, marketing and manufacture of Cylink's virtual private networking ("VPN") hardware product and commercial versions of its public key infrastructure ("PKI") products, as well as successful marketing and manufacture of the Cylink Link Encryptors, PrivaCy Manager, PrivateWire and Cylink Frame Encryptor products. To date, Cylink has made only limited, and, in some cases, no commercial shipments of certain versions of such products. These products may require additional development work, enhancement, testing or further refinement before they can achieve or in order to maintain market acceptance. In this regard, Cylink relies on a third party original equipment manufacturer to supply Cylink's ATM Encryptor product, and Cylink is dependent on this supplier for continued development, manufacture and support. If any of Cylink's products have performance, reliability, quality or other shortcomings, then such products could fail to achieve or maintain market acceptance. The failure by Cylink's new or existing products to achieve or enjoy market acceptance, whether for these or other reasons, could cause Cylink to experience reduced orders, higher manufacturing costs, delays in collecting accounts receivable and additional warranty and service expenses, which in each case could have a material adverse effect on Cylink's business, financial condition and results of operations. Competition Competition is intense among providers of network security systems, and Cylink expects such competition to increase in the future. Significant competitive factors in these markets include: o the development of new products and features o product quality and performance o the quality and experience of sales, marketing and service organizations o product price o name recognition, and, o perception of Company stability and long-term viability. Many of these factors are beyond Cylink's control. In addition, some factors, such as the perception of Cylink's stability and viability over the long term may have been adversely affected by the December 1998 restatement of Cylink's 1997 and first and second quarter 1998 financial statements, which could materially adversely impact Cylink's ability to compete. 15 Cylink's competitors in the information security markets, including companies that offer products similar to or as an alternative to Cylink's products, include Axent Technologies, Inc., Checkpoint Software Technologies, Ltd., Network Associates, Inc., Secure Computing Corporation, RSA Security, Inc., Racal-Guardata, Inc., and Information Resource Engineering, Inc. Cylink's OEM supplier of its ATM Encryptor product also competes with Cylink, through distribution channels, for sales of this product. In addition, Northern Telecom Limited, AT&T, Motorola Corporation, and Sun Microsystems, Inc. offer certain information security products as part of their overall networking solutions. A number of significant vendors, including Microsoft Corporation, Netscape Communications Corporation and Cisco Systems, Inc., have embedded security solutions in their software. To the extent that these embedded or optional security capabilities provide all or a portion of the functionality provided by Cylink's products, Cylink's products may no longer be required by customers to attain network security. Certicom Corporation and RSA Security, Inc. ("RSASI"), license various methods of implementing public key cryptography, including some that are different from (and incompatible with) the method of implementing public key cryptography currently used by Cylink in most of its products. Although Cylink has a license to use all of the public key methods promoted by Certicom and RSASI, to the extent significant segments of the network security market adopt technical standards different from those currently used by Cylink, to the exclusion of Cylink's methods, sales of Cylink's existing and planned products in that market segment may be adversely impacted, which could have a material adverse effect on Cylink's financial condition and results of operations. Many of Cylink's competitors have substantially greater financial, technical, marketing, distribution and other resources, greater name recognition and longer standing relationships with customers than Cylink. Competitors with greater financial resources are better able to engage in sustained price reductions in order to gain market share. Any period of sustained price reductions would have a material adverse effect on Cylink's financial condition and results of operations. Cylink may not be able to compete successfully in the future and competitive pressures may result in price reductions, loss of market share or otherwise have a material adverse effect on Cylink's financial condition and results of operations. Product Liability Risks Customers rely on Cylink's network security products to prevent unauthorized access to their networks and data transmissions. A malfunction or the inadequate design of Cylink's products could result in tort or warranty claims. Although Cylink attempts to reduce the risk of such losses through warranty disclaimers and liability limitation clauses in its sales and license agreements and by maintaining product liability insurance, there can be no assurance that such measures will be effective in limiting Cylink's liability for any such damages. Any liability for damages resulting from security breaches could be substantial and could have a material adverse effect on Cylink's business, financial condition and results of operations. In addition, a well-publicized actual or perceived security breach could adversely affect the market's perception of security products in general, or Cylink's products in particular, regardless of whether such breach is attributable to Cylink's products. This could result in a decline in demand for Cylink's products, which would have a material adverse effect on Cylink's business, financial condition and results of operations. Year 2000 The "Year 2000 Issue" refers generally to the problems that some software, including firmware embedded in Cylink's products, may have in determining the correct century for the year. For example, software with date-sensitive functions that is not Year 2000 compliant may not be able to distinguish whether "00" means 1900 or 2000, which may result in failures or the creation of erroneous results. Cylink has developed a Year 2000 readiness plan for the current versions of its products. The plan includes development of corporate awareness, assessment, implementation (including remediation, upgrading and replacement of certain product versions), validation testing, and contingency planning. Cylink continues to respond to customer concerns about prior versions of its products on a case-by-case basis. Cylink has largely completed all phases of its plan, except for contingency planning, with respect to the current versions of all of its products. As a result, the current versions of each of its products currently offered for sale are believed to be "Year 2000 Compliant" as defined below when configured and used in accordance with the related 16 documentation, and provided that the underlying operating system of the host machine and any other software used with or in the host machine or Cylink's products are also Year 2000 Compliant. In some cases, Cylink's products require an upgrade provided by Cylink which is either sold as a complete substitute or as a kit sold with the product in order to be Year 2000 Compliant. Cylink has defined "Year 2000 Compliant" as the ability to: (i) correctly handle date information needed for the December 31, 1999 to January 1, 2000 date change; (ii) function according to the product documentation provided for this date change, without changes in operation resulting from the advent of a new century, assuming correct configuration; (iii) where appropriate, respond to two-digit date input in a way that resolves the ambiguity as to century in a disclosed, defined, and predetermined manner, such as in certificate based products, or in accordance with Cylink's Year 2000 Compliant test plan; and (iv) recognize year 2000 as a leap year. Cylink has not tested its products on all platforms or all versions of operating systems that it currently supports and has advised its customers to verify that their platforms and operating systems support the transition to the year 2000. Cylink has not specifically tested software obtained from third parties (licensed software, shareware, and freeware) that is incorporated into its products, but Cylink's test plan was designed to reveal Year 2000 deficiencies with third party software incorporated in Cylink's products. Despite testing by Cylink and current and potential customers, and any assurances from developers of products incorporated into Cylink's products, Cylink's products may contain undetected errors or defects associated with Year 2000 date functions. Also, certain prior versions of Cylink's products are not fully Year 2000 Compliant, and Cylink is working to address these issues by offering for sale upgrades to compliant versions. Known or unknown errors or defects in Cylink's products could result in delay or loss of revenue, diversion of development resources, damage to Cylink's reputation, or increased service and warranty costs, any of which could materially adversely affect Cylink's business, operating results, or financial condition. Cylink does not currently have any information concerning the Year 2000 compliance status of its customers. If Cylink's current or future customers suspend investments in securing their existing networks while they achieve Year 2000 compliance, or if they divert technology expenditures (especially technology expenditures that are reserved for enterprise security products) to address Year 2000 compliance problems, Cylink's business, results of operations, or financial condition could be materially adversely affected. Some commentators have predicted significant litigation regarding Year 2000 compliance issues. Because this type of litigation lacks precedent, it is uncertain whether or to what extent Cylink may be affected by it. Cylink has completed a review of its mission critical internal information systems (including the third-party software for its management information systems, networks and desktop applications, and its hardware telecommunications technology) and believes it has addressed all critical concerns. To the extent that Cylink is not been able to test the technology provided by third-party vendors, Cylink will purchase upgrades for versions which have been certified by their vendors as compliant. Although Cylink is not currently aware of any material operational issues or costs associated with preparing its internal information systems for the Year 2000, Cylink may experience material unanticipated problems and costs caused by undetected errors or defects in the technology used in its information systems. Cylink has funded its Year 2000 plan from operating cash. While Cylink does not expect such costs to be material, Cylink will incur additional amounts related to the Year 2000 plan for administrative personnel to manage Cylink's readiness plans, technical support for its product engineering and customer satisfaction. Cylink may experience material problems and costs with Year 2000 compliance that could adversely affect Cylink's business, results of operations, and financial condition. Finally, Cylink is also subject to external forces that might generally affect industry and commerce, such as utility or transportation company Year 2000 compliance failures and related service interruptions. Cylink has completed its plans to address Year 2000 readiness of its critical operations based on its perception of the known risks involved. However, were Cylink to experience an unanticipated Year 2000 interruption, business operations could be seriously impaired for an indefinite period of time until remedial efforts could be achieved. 17 Management of Growth In Employees Cylink has recently and may continue to experience substantial fluctuations in the number of employees and the scope of its operations in the network security business, resulting in increased responsibilities for management. To manage its business effectively, Cylink will need to continue to improve its operational, financial and management information systems and to hire, train, motivate and manage its employees. Competition is intense for qualified technical, marketing and management personnel, particularly highly skilled engineers. In particular, the current availability of qualified engineers is quite limited, and competition among companies, academic institutions, government entities and other organizations for skilled and experienced engineering personnel is very intense. Cylink has experienced delays in filling positions for engineering personnel and Cylink expects to experience continued difficulty in filling its needs for qualified engineers and other personnel. There can be no assurance that Cylink will be able to effectively achieve or manage any future growth, and its failure to do so could delay product development cycles or otherwise have a material adverse effect on Cylink's financial condition and results of operations. In September 1997, Cylink acquired Algorithmic Research, Ltd. ("ARL") and assumed responsibility for management of its worldwide operations which currently consists of approximately eighty-four employees. Cylink is heavily dependent on ARL's success in continuing to develop marketable technology and products, such as the PrivateWire family, including PrivateSafe and PrivateCard, toolkits and other components, as well as Cylink's next generation hardware VPN product. Key factors which will determine ARL's success include whether Cylink can adequately fund ARL's development objectives, whether Cylink can provide accurate information for ARL to focus its technology on significant market opportunities, and whether Cylink can predict the most attractive features and functions for ARL's products. Cylink's success in realizing the anticipated return from its investment in ARL also will be determined by Cylink's ability to position and introduce ARL's products into Cylink's markets and channels, and Cylink's ability to provide adequate sales and customer support for ARL's products. To date, Cylink's efforts to market ARL's products through Cylink's direct sales channel have not met Cylink's expectations due to differences between the sales expertise required for selling the ARL products and that required for Cylink's other products. Consequently, Cylink has recently reorganized the management of ARL to strengthen ARL's responsibility for marketing and sales of its products. In addition, ARL's improvements and development of new products have been delayed by inadequate coordination between engineering departments located in Santa Clara, CA and Petach Tikva, Israel. This inadequate coordination to date is due to differing engineering practices concerning development planning and restrictions imposed by U.S. export control laws governing the transfer of cryptographic expertise. Cylink and ARL's successful working relationship may be hindered significantly by differences between the two organizations created by time, distance, language and culture. ARL operates from its principal offices in Israel, a country which is vulnerable to disruption due to the sudden outbreak of hostilities with its neighbors and various indigenous factions. Many of ARL's employees have extensive commitments to the country's military organizations which may require a loss of their services on the Company's behalf in times of political instability. Cylink's recent acquisition of S.D.I. requires management of their professional services in a market where Cylink has limited experience. S.D.I.'s employee morale and reputation for providing objective assessments on its clients' network security may be adversely affected by this acquisition, particularly if S.D.I.'s prospective clients believe S.D.I.'s recommendations are biased in favor of Cylink's products and services. The success of S.D.I.'s business is critically dependent on S.D.I.'s ability to attract and retain qualified employees, and S.D.I.'s present employees may not accept the influence of Cylink's management and loss of autonomy they once enjoyed. Intellectual Property and Other Proprietary Rights Cylink relies on patents, trademarks, copyrights, licenses and trade secret law to establish and preserve its intellectual property rights. Cylink owns a number of U.S. patents covering certain aspects of its network security product designs, and has additional U.S. patent applications pending. There can be no assurance that any patent, trademark, copyright or license owned or held by Cylink will not be invalidated, circumvented or challenged, that the rights granted thereunder will provide competitive advantages to Cylink or that any of Cylink's pending or future patent applications will be issued with the scope of the claims sought by Cylink, if at all. Further, there can be no assurance that others will not develop technologies that are similar or superior to Cylink's technology, duplicate Cylink's technology or design around the patents owned by Cylink. Cylink may be subject to or may initiate interference proceedings in the U.S. Patent Office, which can require significant financial and management 18 resources. In addition, the laws of certain countries in which Cylink's products are or may be developed, manufactured or sold may not protect Cylink's products and intellectual property rights to the same extent as the laws of the United States. The inability of Cylink to protect its intellectual property adequately could have a material adverse effect on its financial condition and results of operations. The computer, communications, software and network security industries are characterized by substantial litigation regarding patent and other intellectual property rights. From time to time, Cylink has received communications from third parties asserting that Cylink's patents, features or content of certain of Cylink's products infringe upon the intellectual property rights held by third parties, and Cylink may receive such communications in the future. There can be no assurance that third parties will not assert claims against Cylink that result in litigation. Any litigation, whether or not determined in favor of Cylink, could result in significant expense to Cylink and could divert management and other resources. In the event of an adverse ruling in any litigation involving intellectual property, Cylink might be required to discontinue the use of certain processes, cease the manufacture, use and sale of infringing products, expend significant resources to develop non-infringing technology or obtain licenses to the infringing technology and may suffer significant monetary damages, which could include treble damages. There can be no assurance that under such circumstances a license would be available to Cylink on reasonable terms or at all. In the event of a successful claim against Cylink and Cylink's failure to develop or license a substitute technology on commercially reasonable terms, Cylink's financial condition and results of operations would be adversely affected. There can be no assurance that existing claims or any other assertions (or claims for indemnity from customers resulting from infringement claims) will not materially and adversely affect Cylink's financial condition and results of operations. Evolving Network Security Market; Market Acceptance Risks The market for Cylink's network security products is relatively new and is still evolving. This market is characterized by rapidly changing technology, emerging industry standards, new product introductions and changes in customer requirements and preferences. Cylink's future success will depend in part upon end users' demand for network security products in general, and upon Cylink's ability to enhance its existing products and to develop and introduce new products and technologies that meet customer requirements. Cylink faces continuing challenges to educate customers as to the value of its security products. Cylink believes that many potential customers do not appreciate the need for high-end security products unless and until they have faced a major security breach. If Cylink is unable to successfully educate potential customers as to the value of, and thereby obtain broad market acceptance for, its products, it will continue to rely primarily on selling new and existing products to its base of existing customers, which will significantly limit any opportunity for growth. In addition, any significant advance in technologies for attacking cryptographic systems could render some or all of Cylink's existing and new products obsolete or unmarketable. To the extent that a specific method other than Cylink's is adopted as the standard for implementing network security in any segment of the network security market, sales of Cylink's existing and planned products in that market segment may be adversely impacted, which could have a material adverse effect on Cylink's business, financial condition and results of operations. See "Competition." Network security-related products or technologies developed by others may adversely affect Cylink's competitive position or render its products or technologies noncompetitive or obsolete. Rapid Technological Change The markets for Cylink's products are characterized by rapidly changing technologies, extensive research and new product introductions. Cylink believes that its future success will depend in part upon its ability to continue to enhance its existing products and to develop, manufacture and market new products. As a result, Cylink expects to continue to make a significant investment in engineering, research and development. Cylink may not be able to develop and introduce new products or enhancements to its existing products in a timely manner which satisfy customer needs, achieve market acceptance or address technological changes in its target markets. The failure of Cylink to develop products and introduce them successfully and in a timely manner could adversely affect Cylink's competitive position, financial condition and results of operations. Risks Associated with International Sales; Reliance Upon Local Partners; Restrictions on Export Cylink plans to continue to expand its foreign sales channels and to enter additional international markets, both of which will require significant management attention and financial resources. International sales are subject to a 19 number of risks, including unexpected changes in regulatory requirements, export control laws, tariffs and other trade barriers, political and economic instability in foreign markets, difficulties in the staffing, management and integration of foreign operations, longer payment cycles, greater difficulty in collecting accounts receivable, currency fluctuations and potentially adverse tax consequences. Since most of Cylink's foreign sales are denominated in U.S. dollars, Cylink's products become less price competitive in countries in which local currencies decline in value relative to the U.S. dollar. The uncertainty of monetary exchange values has caused, and may in the future cause, some foreign customers to delay new orders or delay payment for existing orders. The long-term impact of such devaluation, including any possible effect on the business outlook in other developing countries, cannot be predicted. Cylink's ability to compete successfully in foreign countries is dependent in part on Cylink's ability to obtain and retain reliable and experienced in-country distributors and other strategic partners. Cylink does not have long-term relationships with any of its value added resellers and distributors and, therefore, has no assurance of a continuing relationship within a given market. Due to U.S. and Israeli government regulations restricting the export of cryptographic devices and software, including certain of Cylink's network security products, Cylink is often at a disadvantage in competing for international sales compared to companies located outside the United States and Israel that are not subject to such restrictions. Cylink is unable to offer its products to certain types of foreign customers and, on occasion, has lost sales due to uncertainty over whether Cylink will be permitted to sell its products. The regulatory environment in the United States for export of encryption products is particularly unsettled, with various pending legislative initiatives and conflicting judicial decisions, all causing substantial uncertainty in Cylink's international market. This confusion is often exacerbated by U.S. vendors' incomplete or inaccurate press releases concerning export licenses for their products, and foreign competitors marketing campaigns which stress the restrictions on purchasing encryption products from U.S. vendors. There is no assurance that this disruption will end anytime within the near future. Dependence on Component Availability, Subcontractor Performance and Key Suppliers Cylink's ability to deliver its products in a timely manner is dependent upon the availability of quality components and subsystems used in these products. Cylink depends in part upon subcontractors to manufacture, assemble and deliver certain items in a timely and satisfactory manner. Cylink obtains certain components and subsystems from single, or a limited number of, sources. In particular, Cylink relies on a single OEM supplier for Cylink's ATM product, which Cylink offers to its customers with its own management solution. A significant interruption in the delivery of such items could have a material adverse effect on Cylink's financial condition and results of operations. Item 3. Quantitative and Qualitative Disclosures about Market Risk Cylink's market risk exposures are set forth in its Annual Report on Form 10-K for the year ended December 31, 1998 and have not changed significantly. 20 PART II. OTHER INFORMATION Item 1. Legal Proceedings On September 14, 1998, Cylink announced that its earnings for the third quarter of 1998 would be below consensus estimates. On November 5, 1998, Cylink announced that, with the assistance of its independent accountants, it was reviewing its revenue recognition practices, and Cylink announced that its first and second quarter earnings of 1998 would have to be restated and that it would have operating losses for each of the three quarters for the period ended September 27, 1998. During the review, certain facts became known indicating errors had been made in the application of revenue recognition policies which also impacted the fourth quarter of 1997, and as a result, 1997 full-year results have been restated along with first and second quarter 1998 results. Cylink has filed amended Forms 10-Q for the first and second quarters of 1998 and an amended Form 10-K for 1997. Between November 6 and November 25, 1998, several securities class action complaints were filed against Cylink and certain of its current and former directors and officers in federal courts in California. These complaints allege, among other things, that Cylink's previously issued financial statements were materially false and misleading and that the defendants knew or should have known that these financial statements caused Cylink's common stock price to rise artificially. The actions variously allege violations of Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), as amended, and SEC Rule 10b-5 promulgated thereunder, and Section 20 of the Exchange Act. Cylink believes it has meritorious defenses to these actions and intends to defend itself vigorously. However, it is not feasible to predict or determine the final outcome of these proceedings, and if the outcome were to be unfavorable, Cylink's business, financial condition, cash flows and results of operations could be materially adversely affected. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits. Exhibit Number Description of Exhibit ------ ---------------------- 27.1 Financial Data Schedule for the fiscal quarter ended September 26, 1999 (b) Reports on Form 8-K. Cylink filed a report on Form 8-K on July 19, 1999 as required by Item 4 of Form 8-K with respect to a change in accountants. On July 12, 1999, Cylink retained Deloitte & Touche LLP as its independent accounting firm and dismissed PricewaterhouseCoopers LLP. The change in the independent accountants was approved by the Audit Committee of Cylink's Board of Directors and does not reflect any disagreements with PricewaterhouseCoopers LLP over matters of accounting principles or practices, financial statement disclosure, or auditing scope or procedure. Items 2, 3, 4 and 5 are not applicable and have been omitted. 21 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. Date: November 9, 1999 CYLINK CORPORATION By: /s/ ROGER A. BARNES ------------------------------ Roger A. Barnes Vice President of Finance and Administration and Chief Financial Officer (Duly Authorized Officer and Principal Financial Officer) EX-27.1 2 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE 9/26/99 CONDENSED CONSOLIDATED BALANCE SHEET AND THE STATEMENT OF OPERATIONS FOR THE THREE MONTHS THEN ENDED AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1000 9-MOS DEC-31-1999 JAN-01-1999 SEP-26-1999 37509 0 17070 1425 5102 65731 16867 8531 83825 16246 0 296 0 0 67169 83825 42186 42186 13038 13038 41137 2946 0 (10357) 0 (10357) 2246 0 0 (8111) (0.28) (0.28)
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