-----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, EttA97F7QCrwovPwTWX/YribEkvsQsOzDQU0dYY9erm3ID/pjPG6kfcVVBVV/1mp EYw3/9IiKBaCZVprUZgDIg== 0000950005-98-000703.txt : 19980817 0000950005-98-000703.hdr.sgml : 19980817 ACCESSION NUMBER: 0000950005-98-000703 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19980630 FILED AS OF DATE: 19980814 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: DIGITAL LINK CORP CENTRAL INDEX KEY: 0000810467 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER COMMUNICATIONS EQUIPMENT [3576] IRS NUMBER: 770067742 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-23110 FILM NUMBER: 98690060 BUSINESS ADDRESS: STREET 1: 217 HUMBOLDT COURT CITY: SUNNYVALE STATE: CA ZIP: 94089-1300 BUSINESS PHONE: 4087456200 MAIL ADDRESS: STREET 1: 217 HUMBOLDT COURT CITY: SUNNYVALE STATE: CA ZIP: 94089 10-Q 1 FORM 10-Q FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1998 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______________ to _______________ Commission File Number: 0-23110 ------- DIGITAL LINK CORPORATION (Exact name of registrant as specified in its charter) California 77-0067742 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification Number) 217 Humboldt Court, Sunnyvale, CA 94089 (Address of principal executive offices, including zip code) (408) 745-6200 Registrant's telephone number, including area code Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| The number of shares outstanding of the registrant's Common Stock as of August 14, 1998, was 9,135,178 shares. DIGITAL LINK CORPORATION INDEX TO FORM 10-Q Page PART I - FINANCIAL INFORMATION: ITEM 1 - Financial Statements Consolidated Balance Sheets as of June 30, 1998 3 and December 31, 1997 Consolidated Statements of Operations for the quarters 4 and six months ended June 30, 1998 and 1997 Consolidated Statements of Cash Flows for the six 5 months ended June 30, 1998 and 1997 Notes to Consolidated Financial Statements 6 ITEM 2 - Management's Discussion and Analysis of 11 Financial Condition and Results of Operations ITEM 3 - Quantitative and Qualitative Disclosure About 21 Market Risk PART II- OTHER INFORMATION ITEM 1 - Legal Proceedings 22 ITEM 1 - Legal Proceedings ITEM 2 - Changes in Securities and Use of Proceeds 22 ITEM 3 - Defaults Upon Senior Securities 22 ITEM 4 - Submission of Matters to a Vote of Security Holders 22 ITEM 5 - Other Information 23 ITEM 6 - Exhibits and Reports on Form 8-K 23 2 PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements DIGITAL LINK CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands, except share amounts)
- -------------------------------------------------------------------------------------------------------------------- June 30, December 31, 1998 1997 ---------------- ------------------ (Unaudited) ASSETS - ------ CURRENT ASSETS: Cash and cash equivalents $ 719 $ 2,504 Short-term marketable securities 16,420 18,026 Accounts receivable, less allowance for doubtful accounts of $434 at 6/30/98 and $517 at 12/31/97 4,461 5,193 Inventories 8,292 8,163 Prepaid and other current assets 1,383 1,433 Income taxes receivable 696 - Deferred income taxes 2,304 2,304 ---------------- ---------------- Total current assets 34,275 37,623 Property and equipment at cost, net 4,000 3,325 Long-term marketable securities 20,187 21,899 Deferred income taxes 2,062 2,062 Other assets 969 1,147 ---------------- ---------------- TOTAL ASSETS $ 61,493 $ 66,056 ================ ================ LIABILITIES AND SHAREHOLDERS' EQUITY - ------------------------------------ CURRENT LIABILITIES: Accounts payable $ 3,670 $ 2,407 Accrued payroll expense 2,102 2,344 Other accrued expenses 3,542 3,785 Income taxes payable - 186 ---------------- ---------------- Total current liabilities 9,314 8,722 ---------------- ---------------- CONTINGENCIES (Note 4) SHAREHOLDERS' EQUITY: Preferred stock, no par value: Authorized: 5,000,000 shares; Issued and outstanding: None Common stock, no par value: Authorized: 25,000,000 shares; Issued and outstanding: 9,133,978 shares at 06/30/98 and 9,427,306 shares at 12/31/97 35,855 34,609 Other Comprehensive Income--Unrealized gain on marketable securities 66 107 Retained earnings 16,258 22,618 ---------------- ---------------- Total shareholders' equity 52,179 57,334 ---------------- ---------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 61,493 $ 66,056 ================ ================ The accompanying notes are an integral part of these consolidated financial statements.
3 DIGITAL LINK CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) FOR THE QUARTERS AND SIX MONTHS ENDED JUNE 30, 1998 AND 1997 (Amounts in thousands, except per share amounts)
- --------------------------------------------------------------------------------------------------------------------------- Quarter Ended Six Months Ended June 30, June 30, ------------------------------- ------------------------------- 1998 1997 1998 1997 ---- ---- ---- ---- REVENUES: Net sales $ 12,797 $ 17,033 $ 27,317 $ 33,071 Cost of sales 6,830 6,856 14,036 13,672 ------------- ------------- -------------- ------------- Gross profit 5,967 10,177 13,281 19,399 ------------- ------------- -------------- ------------- EXPENSES: Research and development 3,567 2,594 6,389 5,627 Selling, general and administrative 4,965 5,768 9,988 10,683 Purchased research and development 2,299 - 2,299 - ------------- ------------- -------------- ------------- Total operating expenses 10,831 8,362 18,676 16,310 ------------- ------------- -------------- ------------- Operating income / (loss) (4,864) 1,815 (5,395) 3,089 Other income 466 638 1,068 1,278 ------------- ------------- -------------- ------------- Income / (loss) before provision for (4,398) 2,453 (4,327) 4,367 income taxes Provision / (benefit) for income taxes (1,712) 748 (1,690) 1,331 ------------- ------------- -------------- ------------- NET INCOME / (LOSS) $ (2,686) $ 1,705 $ (2,637) $ 3,036 ============= ============= ============== ============= COMPREHENSIVE INCOME / (LOSS) $ (2,652) $ 1,747 $ (2,678) $ 2,962 EARNINGS PER SHARE (Basic) Net income / (loss) per share $ (0.29) $ 0.19 $ (0.28) $ 0.33 Shares used in computing per share amounts 9,422 9,188 9,403 9,189 ============= ============= ============== ============= EARNINGS PER SHARE (Diluted) Net income / (loss) per share $ (0.29) $ 0.18 $ (0.28) $ 0.32 Shares used in computing per share amounts 9,422 9,506 9,403 9,541 ============= ============= ============== ============= The accompanying notes are an integral part of these consolidated financial statements.
4 DIGITAL LINK CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND 1997 (Amounts in thousands)
- ----------------------------------------------------------------------------------------------------------------- Six Months Ended June 30, -------------------------------------- 1998 1997 ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net income / (loss) $ (2,637) $ 3,036 Adjustments to reconcile net income / (loss) to net cash flows provided by operating activities: Depreciation and amortization 727 577 Amortization of goodwill 62 Purchased research and development 2,299 Changes in: Accounts receivable 933 (411) Inventories 319 (559) Prepaid and other assets 341 (399) Accounts payable 1,263 1,265 Accrued payroll and other accrued expenses (1,105) 51 Income taxes payable (882) (243) ------------- ----------- Net cash flows provided by operating activities 1,320 3,317 ------------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of marketable securities (18,671) (7,020) Maturities of marketable securities 21,948 8,073 Payment in connection with Acquisition of Semaphore Corporation 182 - Acquisition of property and equipment (887) (1,007) ------------- ----------- Net cash flows provided by investing activities 2,572 46 ------------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from exercise of stock options 419 585 Repurchase of common stock (6,096) (1,946) ------------- ----------- Net cash flows used in financing activities (5,677) (1,361) ------------- ----------- Net increase / (decrease) in cash and cash equivalents (1,785) 2,002 Cash and cash equivalents at beginning of year 2,504 2,043 ------------- ----------- Cash and cash equivalents at end of period $ 719 $ 4,045 ============= =========== The accompanying notes are an integral part of these consolidated financial statements.
5 DIGITAL LINK CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying consolidated financial statements have been prepared by the Digital Link Corporation (the "Company" or "Digital Link") without audit in accordance with generally accepted accounting principles for interim financial information and pursuant to rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments (consisting of only normal recurring adjustments) considered necessary for a fair representation have been included. These financial statements should be read in conjunction with the Company's consolidated financial statements and notes thereto contained in the Company's Annual Report on Form 10-K for the year ended December 31, 1997, which was filed with the Securities and Exchange Commission on March 26, 1998. The year-end balance sheet at December 31, 1997 was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. Operating results for the three months and six months ended June 30, 1998 may not necessarily be indicative of the results to be expected for any other interim period or for the full year. 2. COMPUTATION OF NET INCOME / (LOSS) PER SHARE Basic and diluted income / (loss) per share is computed in accordance with Statement of Financial Accounting Standards No. 128 ("SFAS No. 128"). All per share amounts have been restated in accordance with SFAS No. 128.
Quarter Ended Six Months Ended June 30, June 30, 1998 1997 1998 1997 ---- ---- ---- ---- Basic (in thousands, except per share data) (in thousands, except per share data) - ----- Weighted average common shares outstanding for the 9,422 9,188 9,403 9,189 period Shares used in computing per share amounts 9,422 9,188 9,403 9,189 Net income / (loss) $ (2,686) $ 1,705 $ (2,637) $ 3,036 Net income / (loss) per share $ (0.29) $ 0.19 $ (0.28) $ 0.33
6
Quarter Ended Six Months Ended June 30, June 30, 1998 1997 1998 1997 ---- ---- ---- ---- Diluted (in thousands, except per share data) (in thousands, except per share data) - ------- Weighted average number of shares outstanding for 9,422 9,188 9,403 9,189 the period Common equivalent shares from conversion of stock - 318 - 352 options under treasury stock method Shares used in computing per share amounts 9,422 9,506 9,403 9,541 Net income / (loss) $ (2,686) $ 1,705 $ (2,637) $ 3,036 Net income / (loss) per share $ (0.29) $ 0.18 $ (0.28) $ 0.32
In the above computations, common equivalent shares totaling 20,563 and 73,469 for the quarter and six months ended June 30, 1998 respectively are excluded from the diluted calculation as their effect is anti-dilutive. 3. INVENTORIES Inventories are valued at the lower of cost (determined using the first-in, first-out method) or market. Inventories consisted of (in thousands): June 30, 1998 December 31, 1997 ------------- ----------------- (Unaudited) Raw materials $2,649 $2,952 Work-in-process 2,569 2,275 Finished goods 3,074 2,936 ------ ------ $8,292 $8,163 ====== ====== 4. CONTINGENCIES Certain third parties have expressed their belief that certain of the Company's products may infringe patents held by them and have suggested that the Company acquire licenses to such patents. The Company believes that licenses, to the extent required, will be available; however, no assurance can be given that the terms of any offered licenses would be favorable to the Company. Management, after review and consultation with counsel, believes that the ultimate resolution of these allegations is uncertain and there can be no assurance that these assertions will be resolved without costly litigation or in a manner that is not adverse to the Company. While the Company has accrued certain amounts for these matters in prior years, it is currently unable to 7 estimate the possible loss or range of loss regarding these matters. Therefore, the ultimate resolution of these matters could result in payments in excess of the amounts accrued in the accompanying financial statements and require royalty payments in the future which could adversely impact gross margins. In April 1996, a class action complaint was filed against the Company and certain of its officers and directors in the Santa Clara Superior Court of the State of California, alleging violations of the California Corporations Code and California Civil Code. In October 1996, a similar parallel lawsuit against the Company and the same individuals was filed in the United States District Court for the Northern District of California alleging violations of the federal securities laws. The class period in both of these lawsuits runs from September 12, 1994 through December 29, 1995, and both complaints allege that the defendants concealed and/or misrepresented material adverse information about the Company and that the individual defendants sold shares of the Company's stock based upon material nonpublic information. The complaints seek unspecified monetary damages. To date, the Superior Court has dismissed portions of plaintiff's state court complaint without leave to amend. The Superior Court also dismissed five of the individual defendants without the leave to amend. Plaintiff has filed a third amended complaint that names the Company and three individual defendants. Discovery to date has been limited in the state court action, and the Superior Court has not set a trial date. In the federal action, the Court granted the Company's motion to dismiss the federal complaint with leave to amend on September 11, 1997, and plaintiff has filed an amended complaint. The Company has moved to dismiss the amended complaint. A hearing on the motion to dismiss the amended complaint is scheduled for September 4, 1998. There has been no discovery in the federal action, and no trial date has been set. The Company believes that both actions are without merit and intends to defend both actions vigorously. However, litigation is subject to inherent uncertainties and, thus, there can be no assurance that these lawsuits will be resolved favorably to the Company or that they will not have a material adverse affect on the Company's financial condition and results of operations. No provision for any liability that may result upon adjudication has been made in the accompanying financial statements. 5. RECENT ACCOUNTING PRONOUNCEMENT The Company has adopted the provisions of Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income," effective January 1, 1998. This statement requires the disclosure of comprehensive income and its components in a full set of general- 8 purpose financial statements. Comprehensive income is defined as net income plus revenues, expenses, gains and losses that, under generally accepted accounting principles, are excluded from net income. The component of comprehensive income, which is excluded by the Company from net income is the change in the unrealized gain or loss on securities, and this has been included in the computation of comprehensive income. In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and Related Information" ("SFAS 131"), which supersedes Statement of Financial Accounting Standards, "Financial Reporting for Segments of a Business Enterprise" ("SFAS 14"). SFAS 131 changes current practice under SFAS 14 by establishing a new framework on which to base segment reporting and also requires interim reporting of segment information. This statement is effective for fiscal years beginning after December 15, 1997. The statement's interim reporting disclosures are not required until the first quarter immediately subsequent to the fiscal year in which SFAS 131 is effective. 6. ACQUISITION OF ASSETS OF SEMAPHORE COMMUNICATIONS CORPORATION On April 3, 1998, the Company entered into an Asset Sale Agreement (the "Agreement") with Semaphore Communications Corporation, a Delaware corporation ("Semaphore"), to acquire substantially all of Semaphore's non-cash assets (excluding furniture and fixtures) (the "Assets"). This acquisition of assets (the "Asset Acquisition") was consummated as of such date. Semaphore is a supplier of security management and virtual private network solutions for Internet/intranet and Frame relay applications. The Assets acquired pursuant to the Agreement include intellectual property, inventory, trade receivables and rights under certain assumed contracts. Under the terms of the Agreement, the Company issued 291,182 shares of the Company's Common Stock (the "Shares") to Semaphore, valued at approximately $3,200,000, on April 3, 1998 and assumed certain liabilities (the "Liabilities"). The Liabilities include certain obligations under assumed contracts and under various outstanding purchase orders as well as certain warranty obligations. The Company received $182,000 from Semaphore with respect to the assumption of certain of such Liabilities. In addition, in connection with the Asset Acquisition, approximately 20 of Semaphore's employees became employees of the Company. 9 The following unaudited pro forma condensed combined results of operations information has been presented to give effect to the purchase as if such transaction had occurred at the beginning of each of the periods presented. The historical results of operations have been adjusted to reflect additional depreciation and amortization expense based on the value allocated to assets acquired in the purchase. In-process research and development costs in the amount of $2,299,000 which were written off immediately after the purchase was completed, have been included in the results of both periods presented. The pro forma results of operations information is presented for informational purposes only and is not necessarily indicative of the operating results that would have occurred had the acquisition been consummated as of the beginning of the periods presented, nor is it necessarily indicative of future operating results. Unaudited Pro Forma Condensed Combined Results of Operations (amounts in thousands except per share data) Six Months Ended June 30, 1998 1997 ---- ---- Revenue $27,803 $34,072 Net loss (1,729) (2,357) EARNINGS PER SHARE (BASIC) Net loss per share $ (0.18) $ (0.25) Shares used in per share calculation 9,694(1) 9,480(1) EARNINGS PER SHARE (DILUTED) Net loss per share $ (0.18) $ (0.25) Shares used in per share calculation 9,694(1) 9,480(1) (1) Shares used in the per share calculation reflect Digital Link shares issued to Semaphore as if they were outstanding from the beginning of each period presented and existing Digital Link Shares. Shares used in pro forma income (loss) per share basic and diluted calculations for the six months ended June 30,1998 are as follows (in thousands): 10 Digital Link shares issued in asset acquisition 291(2) Existing Digital Link shares 9,403 ----- 9,694 Shares used in pro forma income (loss) per share basic and diluted calculations for the six months ended June 30, 1997 are as follows (in thousands): Digital Link shares issued in asset acquisition 291(2) Existing Digital Link shares 9,189 ----- 9,480 (2) The number of shares issues was determined by dividing $3,200,000 by the volume-weighted average price per share (as reported by Bloomberg Financial Services) at which Digital Link's common stock traded on the five business days immediately preceding the execution of the Asset Sale Agreement by the parties. DIGITAL LINK CORPORATION ITEM 2. Management's Discussion And Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS Except for the historical statements contained herein, this Form 10-Q contains forward looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These forward looking statements involve a number of risks, known and unknown, and uncertainties, such as the loss of, or difference in actual from anticipated levels of purchases from, the Company's major customers, the impact of competitive products and pricing, the ability to retain and attract key personnel and other risks which are described throughout the Company's reports filed with the Securities and Exchange Commission, including its Form 10-K for the year ended December 31, 1997, and within "Management's Discussion and Analysis of Financial Condition and Results of Operations," including under the title "Other Factors That May Affect Future Operating Results." The actual results that the Company achieves may differ materially from any forward looking statements due to such risks and uncertainties. When used in this Form 10-Q words such as "believes," "anticipates," "expects," "intends," and similar expressions are intended to identify forward looking statements, but are not the exclusive means of identifying such statements. Readers are urged to carefully review and consider the various disclosures made by the Company in this report and in the Company's reports filed with the Securities and Exchange Commission that attempt to advise 11 interested parties of the risks and factors that may affect the Company's business. Due to all the foregoing factors, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as an indication of future performance. Similarly, past performances are not necessarily indicative of future results. It is likely that, in some future quarters, the Company's operating results will be below the expectations of stock market analysts and investors. In such event, the price of the Company's Common Stock would likely be materially adversely affected. Consequently, the purchase or holding of the Company's Common Stock involves an extremely high degree of risk. Net Sales Net sales for the second quarter of 1998 decreased 25% to $12,797,000 from $17,033,000 for the same period of the prior year. Net sales for the six months ended June 30, 1998 decreased 17% to $27,317,000 from $33,071,000 for the same period of the prior year. These decreases in net sales were primarily attributable to a decrease in unit sales of broadband (i.e., transmission rates in excess of T1/E1) products, as a result of lower sales to certain domestic carrier customers, including MCI, and a decrease in the average selling prices on certain broadband products as a result of price reductions made in 1997. The Company anticipates that lower sales to certain domestic carrier customers will continue for at least the remainder of 1998. In addition, the Company anticipates that this increased pricing pressure will continue for the foreseeable future. However, actual results could vary from the foregoing forward looking statements in the prior two sentences due to, among other factors set forth or referenced in "Other Factors That May Affect Future Operating Results" below, and as a result of the loss of, or difference in actual from anticipated levels of purchases from, the Company's major customers, the impact of competitive products and pricing and other risks described throughout this Form 10-Q. Narrowband sales in absolute dollars remained flat but increased to 60% of net sales in the second quarter of 1998 as compared to 45% in the second quarter of 1997. Broadband sales decreased in absolute dollars by 45% and decreased as a percentage of net sales to 40% in the second quarter of 1998 as compared to 55% in the second quarter of 1997. Narrowband sales in absolute dollars decreased by 1% but increased to 60% of net sales in the first six months of 1998 as compared to 50% in the first six months of 1997. Broadband sales decreased in absolute dollars by 34% and decreased as a percentage of net sales to 40% in the first six months of 1998 as compared to 50% for the same period in 1997. The changes in narrowband sales and broadband sales as a percentage of net sales were primarily due to lower sales of broadband products to certain domestic carrier customers, including MCI. International sales, including Canada, represented 26% of net sales in the second quarter of 1998 as compared to 19% in the second quarter of 1997, and 22% of net sales for the first six months of 1998 as compared to 17% for the same period of the prior year. These increases were 12 primarily due to sales of the products developed by Semaphore Communications Corporation ("Semaphore") that the Company acquired in connection with the acquisition of Semaphore in April 1998. International sales are subject to inherent risks, including difficulties in homologating products in other countries, difficulties in staffing and managing foreign operations, greater difficulty in accounts receivable collection, and unexpected changes in regulatory requirements and tariffs, which may in the future contribute to fluctuations in the Company's business and results. Gross Profit Gross profit decreased 41% in the second quarter of 1998 to $5,967,000 from $10,177,000 for the same period of the prior year. Gross profit decreased to 46.6% of net sales in the second quarter of 1998 as compared to 59.7% in the second quarter of 1997. Gross profit decreased 32% in the six months ended June 30, 1998 to $13,281,000 from $19,399,000 for the same period of the prior year. Gross profit decreased to 48.6% of net sales for the first six months of 1998 as compared to 58.7% for the same period of the prior year. These decreases in gross profit are primarily a result of decreased sales volumes and the above mentioned price reductions. Gross profits may vary significantly from quarter to quarter depending on many factors including competitive pricing pressures and changes in the mix of products sold. A significant portion of the Company's business is very price competitive, which has in the past and will in the future require the Company to lower its prices, resulting in fluctuations in the Company's business and operating results. The Company anticipates that this increased pricing pressure will continue for the foreseeable future. In addition, the mix of products sold may change to include a higher percentage of narrowband products which generally have lower gross margins and would therefore adversely affect the Company's overall gross profits. Research and Development The primary types of expenses included in research and development ("R&D") expenses are personnel, consulting, prototype materials and professional services. R&D expenses increased 38% to $3,567,000 in the second quarter of 1998 from $2,594,000 in the second quarter of 1997. This increase was due primarily to an increase in personnel-related expenses associated with the acquisition of Semaphore. As a percentage of net sales, R&D expenses were 27.9% in the second quarter of 1998 as compared to 15.2% in the second quarter of 1997. R&D expenses increased 14% to $6,389,000 for the six months ended June 30, 1998 from $5,627,000 for the same period of the prior year. As a percentage of net sales, R&D expenses increased to 23.4% for the first six months of 1998 as compared to 17.0% for the same period of the prior year. The increases in R&D expenses as a percentage of net sales primarily is due to lower sales volumes during the second quarter and first six months of 1998. The absolute dollar increase for the six-month period is attributable to 13 higher personnel-related expenses associated with the acquisition of Semaphore. The Company anticipates that its R&D expenses, excluding purchased R&D, for at least the remainder of 1998 will continue to increase in absolute dollars and as a percentage of sales as a result of the Company's acquisition of Semaphore and the expected on-going development of the Semaphore technology. However, actual results could vary from the foregoing forward looking statement due to, among other factors set forth or referenced in "Other Factors That May Affect Future Operating Results," below, the Company's ability to successfully develop and market its products, and the Company's ability to accelerate or defer operating expenses, achieve revenue levels during such periods and hire new personnel. All of the Company's R&D expenditures to date have been expensed as incurred. In the future, the Company may be required to capitalize a portion of its software development costs pursuant to Statement of Financial Accounting Standards No. 86, "Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed." Selling, General and Administrative The primary types of expenses included in selling, general and administrative (SG&A) expenses are personnel, advertising, other promotional, and travel and entertainment. SG&A expenses decreased 14% in the second quarter of 1998 to $4,965,000 from $5,768,000 for the same period of the prior year. As a percentage of net sales, SG&A expenses increased to 38.8% in the second quarter of 1998 from 33.9% in the second quarter of 1997. SG&A expenses decreased 7% for the six months ended June 30, 1998 to $9,988,000 from $10,683,000 for the same period of the prior year. As a percentage of net sales, SG&A expenses increased to 36.6% for the first six months of 1998 from 32.3% for the same period of the prior year. The decreases in SG&A expenses in absolute dollars were primarily due to lower personnel-related expenses and travel and entertainment, primarily within the sales organization, and an decrease in consulting fees. The increases in SG&A expenses as a percentage of net sales were primarily the result of lower sales volumes during the second quarter and the first six months of 1998. Purchased Research and Development The Company incurred an expense of $2.3 million related to purchased research and development for which technological feasibility had not been achieved in the second quarter of 1998 related to the acquisition of Semaphore. Such in-process technology was valued, along with other acquired assets, in 14 accordance with valuation techniques commonly used in the technology industry and was expensed upon acquisition in accordance with Financial Accounting Standards No. 2, "Accounting for Research and Development Costs". See Notes 6 of Notes to Financial Sections in this Form 10-Q. Other Income Other income primarily includes interest income. Other income decreased 27% in the second quarter of 1998 to $466,000 from $638,000 for the same period of the prior year. For the six months ended June 30, 1998, other income decreased 16% to $1,068,000 from $1,278,000 for the same period of the prior year. These decreases were primarily due to lower interest income due to lower interest rates and lower cash balances. Provision / Benefit for Income Taxes The Company's effective tax rate increased to 39% for the second quarter and first six months of 1998 compared to 30.5% for the same periods in 1997. This increase is due primarily to the higher rate available assuming a carryback of current year losses compared to the effective tax rate applicable if the Company were profitable. LIQUIDITY AND CAPITAL RESOURCES The Company had working capital of $25.0 million and cash, cash equivalents and marketable securities of $37.3 million at June 30, 1998. Net cash provided by operating activities was $1.3 million for the first half of 1998 primarily due to a write-off of purchased R&D, an increase in accounts payable and decrease in accounts receivable, offset to some extent by net loss and a decrease in accrued payroll and other accrued expenses. Net cash provided by operating activities was $3.3 million for the first half of 1997 primarily as a result of a generation of net income and an increase in accounts payable, offset to some extent by an increase in inventories and accounts receivable. Cash provided by investing activities during the first half of 1998 was primarily from the maturity of marketable securities of $21.9 million offset by additional purchases of marketable securities of $18.7 million. Cash provided by investing activities during the first half of 1997 was primarily from the maturity of marketable securities of $8.1 million offset by additional purchases of marketable securities of $7.0 million. Leasehold improvements and capital equipment additions were $887,000 in the first half of 1998 as compared to $1.0 million in the first half of 1997. In May 1998, the Company approved the repurchase of up to an additional 1,000,000 shares of Common Stock for cash from time-to-time at market prices and as market and business conditions warrant, in open market, negotiated, or 15 block transactions. On October 17, 1996, the Company previously announced its initial intentions to repurchase up to 500,000 shares of Common Stock, which shares have been repurchased since that announcement. Net cash used in financing activities was $5.7 million in the first half of 1998, primarily due to the repurchase of common stock offset by the proceeds from the exercise of stock options. Net cash used in financing activities was $1.4 million in the first half of 1997, primarily from the repurchase of common stock offset by the proceeds from the exercise of stock options and employee stock purchases. During the first six months of 1998, the Company repurchased on the open market a total of 646,500 shares of common stock at prices ranging from $6.8125 to $11.50 a share. This stock has subsequently been retired. The Company believes that existing cash and cash flows from operations will be sufficient to meet its anticipated cash requirements for working capital and capital expenditures for at least the next 12 months. OTHER FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS In addition to the factors set forth above in the "Management's Discussion and Analysis of Financial Condition and Results of Operations," there are a number of other factors that may affect the Company's future operating results. Most of the following discussion consists of forward looking statements and accompanying risks. The Company believes that the loss of, or difference in actual from anticipated levels of purchases from, the Company's major customers have in the past adversely affected the Company and could in the future adversely affect operating results. A significant portion of the Company's business is derived from substantial orders placed by large end users and telephone companies, and the timing of such orders, including the completion of the build out of carrier and network service providers infrastructures, could cause material fluctuations in the Company's business and operating results. For example, in the fourth quarter of 1997 and in the second quarter of 1998, the Company had lower operating results than expected due in part to a weaker than expected demand from certain domestic carrier customers including MCI. Other factors that may cause fluctuations in the Company's operating results include, but are not limited to, seasonal capital spending patterns of large domestic customers, changes in the product mix sold toward narrowband products that yield lower gross margins, the timing of new product announcements and introductions by the Company and its competitors, changes in sales volumes through the Company's distribution channels, market acceptance of new or enhanced versions of the Company's products, availability and cost of components from the Company's suppliers and economic conditions generally or in various geographic areas. In addition, the Company's expense levels are based in part on its expectations of future revenue. The Company operates with limited order backlog, and a substantial 16 majority of its revenues in each quarter result from orders booked in that quarter. If revenue levels are below expectations, the Company may be unable to adjust spending in a timely manner which would adversely affect operating results. The Company's industry has in the last several years been characterized by declining prices on existing products, therefore continual improvement of manufacturing efficiencies and enhancements to existing products are required to maintain gross margins. The market for the Company's products is highly competitive. The Company expects competition to increase in the future from existing competitors and from other companies that may enter the Company's existing or future markets. In addition, the Company faces competition from suppliers of internetworking equipment, such as routers, and telephone equipment, such as switches, which are including a direct WAN interface in certain of their products. An increased reliance by customers on such suppliers for WAN access would reduce demand for the Company's products, which would have a material adverse affect on the Company's business and operating results. As discussed above, increased competition has also placed increasing pressures on the pricing of the Company's products, which has resulted in lower operating results. The Company anticipates that this pricing pressure will continue for the foreseeable future. The Company's future prospects will depend in part on its ability to enhance the functionality of its existing WAN access products and DL7100 products (formerly known as the W/ATM GateWay Products) in a timely manner and to identify, develop and achieve market acceptance of new products that address new technologies and meet customer needs in the WAN access market. Any failure by the Company to anticipate or to respond adequately to competitive solutions, technological developments in its industry, changes in customer requirements, or changes in regulatory requirements or industry standards, or any significant delays in the development, introduction or shipment of products, could have a material adverse effect on the Company's business and operating results. There can be no assurance that the Company's product development efforts will result in commercially successful products or that product delays will not result in missed market opportunities. In addition, customers could refrain from purchasing the Company's existing products in anticipation of new product introductions by the Company or its competitors. New products could also render certain of the Company's existing products obsolete. Either of these events could materially adversely affect the Company's business and operating results. 17 The Company is currently developing and may in the future develop products with which the Company has only limited experience and/or that are targeted at emerging market segments, including the Company's DL7100 product. The Company has experienced delays in the development of the DL7100 product, in part related to technical problems that required some software to be redesigned. This became available for revenue shipments in the second half of 1997. The Company has experienced very limited customer interest to date in this product. The Company continues to evaluate the long-term viability of the DL7100 product. Given its complexity, there can be no assurance that this product will not encounter further technical or other difficulties that could significantly delay its deployment or acceptance or could result in the termination of the development program for this product. There can be no assurance that the market for ATM infrastructure products will continue to develop, that the DL7100 will meet the needs of the emerging ATM market or any other market or, that products currently available or under development by competitors will not directly compete with the DL7100 product. The occurrence of any of these events could have a material adverse affect on the Company's business and operating results. The Company believes that its future success will depend in large part upon the continued contributions of members of the Company's senior management and other key personnel, and upon its ability to attract and retain highly skilled managerial, engineering, sales, marketing and operations personnel, the competition for whom is intense. Certain of the Company's key management personnel have only recently joined the Company and certain personnel have only limited experience in the Company's industry. In February 1998, Alan I. Fraser, the Company's President and Chief Executive Officer resigned to pursue other interests. Vinita Gupta, Chairman of the Board, assumed the responsibilities of President and Chief Executive Officer upon Mr. Fraser's departure, and the Company is searching for an individual to succeed Ms. Gupta as President and Chief Executive Officer. In addition, the Company is searching for a Vice President, Sales. The Company is also currently attempting to hire a number of sales and engineering personnel and has experienced delays in filling such positions. The current availability of qualified sales and engineering personnel is quite limited, and competition among companies for such personnel is intense. There can be no assurance that the Company will be successful in attracting and retaining skilled personnel to hold these important positions. The Company completed an acquisition of Performance Telecom in the third quarter of 1997 and an acquisition of substantially all of the assets of Semaphore in the second quarter of 1998 and may complete additional acquisitions in the future. The process of integrating an acquired company's business into the Company's operations may result in unforeseen operating difficulties and expenditures and may absorb significant management attention that would otherwise be available for the ongoing development of the Company's business. Moreover, there can be no assurance that the anticipated benefits of an acquisition will be realized. The Company 18 has experienced declining revenues from the products acquired in the Performance Telecom acquisition. In addition, acquisitions involve numerous risks, including difficulties in managing diverse geographic sales and research and development operations, risks of entering markets in which the Company has no or limited direct prior experience, difficulties in the assimilation of the technologies and products of the acquired companies and the potential loss of key employees of the acquired company. The inability of the Company's management to respond to changing business conditions effectively, including the changes associated with its recent acquisitions, could have a material adverse affect on the Company's business, financial condition and results of operations. The Company has assessed and continues to assess the impact of the Year 2000 issue on its operations, including the development of cost estimates for, and the extent of programming changes required to address, this issue. Although final cost estimates have yet to be determined, it is anticipated that these Year 2000 costs will not be material to the Company's expenses during 1998 and 1999. The Company does not currently have any information concerning the Year 2000 compliance status of its suppliers and customers. In the event that any of the Company's significant suppliers or customers does not successfully and timely achieve Year 2000 compliance, the Company's business or operations could be adversely affected. In April 1996, a class action complaint was filed against the Company and certain of its officers and directors in the Santa Clara Superior Court of the State of California, alleging violations of the California Corporations Code and California Civil Code. In October 1996, a similar parallel lawsuit against the Company and the same individuals was filed in the United States District Court for the Northern District of California alleging violations of the federal securities laws. The class period in both of these lawsuits runs from September 12, 1994 through December 29, 1995, and both complaints allege that the defendants concealed and/or misrepresented material adverse information about the Company and that the individual defendants sold shares of the Company's stock based upon material nonpublic information. The complaints seek unspecified monetary damages. To date, the Superior Court has dismissed portions of plaintiff's state court complaint without leave to amend. The Superior Court also dismissed five of the individual defendants without leave to amend and another individual defendant with leave to amend. The Superior Court also denied motions to dismiss filed by the Company and two other individual defendants with respect to the remaining portions of the complaint. Plaintiff has filed a third amended complaint that names the Company and three individual defendants. Discovery to date has been limited in the state court action, and the Superior Court has not set a trial date. On September 11, 1997, the Court granted the Company's motion to dismiss the federal complaint with leave to amend, and plaintiff has filed an amended complaint. The Company has moved to dismiss the amended complaint. There has been no discovery in the federal action, and no trial date has been set. The Company believes that both actions are without merit and intends to defend 19 both actions vigorously. However, litigation is subject to inherent uncertainties and, thus, there can be no assurance that these lawsuits will be resolved favorably to the Company or that they will not have a material adverse affect on the Company's financial condition and results of operations. No provision for any liability that may result upon adjudication has been made in the accompanying financial statements. The telecommunications industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. For example, a third party has on several occasions expressed its belief that certain of the Company's products, including its CSU/DSUs, may infringe upon patents held by it and has suggested on such occasions that the Company acquire a license to such patents. The Company believes that a license, to the extent required, will be available; however, no assurance can be given that the terms of any offered license would be favorable to the Company. Should a license be unavailable, the Company could be required to discontinue the sale of or to redesign certain of its products. In addition, Larscom, a competitor of the Company, has continued to express its belief that the Company's inverse multiplexer products may infringe a patent jointly owned by Larscom and a third party and has suggested that the Company acquire a license to the patent. The Company does not believe that there is merit to Larscom's claim. Management, after review and consultation with counsel, believes that the ultimate resolution of both these allegations is uncertain and there can be no assurance that these assertions will be resolved without costly litigation or in a manner that is not adverse to the Company. While the Company accrued certain amounts for these matters in prior years, it is currently unable to estimate the possible loss or range of loss regarding these matters. Therefore, the ultimate resolution of these matters could result in payments in excess of the amounts accrued in the accompanying financial statements and require royalty payments in the future which could adversely impact gross margins. There can be no assurance that other third parties will not assert infringement claims against the Company in the future, that any such claims will not result in costly litigation or that the Company will prevail in any such litigation or be able to license any valid and infringed patents from third parties on commercially reasonable terms. The risks outlined herein are difficult for the Company to forecast, and these or other factors can materially affect the Company's operating results and stock price for one quarter or a series of quarters. Further, in recent years the stock market has experienced extreme price and volume fluctuations that have particularly affected the market prices of securities of many high technology companies, for reasons frequently unrelated to the operating performance of the specific companies. These fluctuations, as well as general economic, political and market conditions may materially adversely affect the market price of the Company's common stock. 20 The Company has adopted the provisions of Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income," effective January 1, 1998. This statement requires the disclosure of comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income is defined as net income plus revenues, expenses, gains and losses that, under generally accepted accounting principles, are excluded from net income. The component of comprehensive income, which is excluded from net income, is the change in the unrealized gain or loss on securities and has been included in the computation of comprehensive income. In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and Related Information" ("SFAS 131"), which supersedes Statement of Financial Accounting Standards, "Financial Reporting for Segments of a Business Enterprise" ("SFAS 14"). SFAS 131 changes current practice under SFAS 14 by establishing a new framework on which to base segment reporting and also requires interim reporting of segment information. This statement is effective for fiscal years beginning after December 15, 1997. The statement's interim reporting disclosures are not required until the first quarter immediately subsequent to the fiscal year in which SFAS 131 is effective. ITEM 3. Quantitative and Qualitative Disclosure About Market Risk Not Applicable. 21 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company and certain of its officers and directors are parties to various lawsuits described in paragraphs two and three in Note 4 of Notes to Consolidated Financial Statements in Part I of this Form 10-Q. See also the Company's Form 10-Q for the period ended March 31, 1998 and its Form 10-K for the period ended December 31, 1997 for previous disclosures about such lawsuits. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS On April 3, 1998, the Company entered into an Asset Sale Agreement (the "Agreement") with Semaphore Communications Corporation, a Delaware corporation ("Semaphore"), to acquire substantially all of Semaphore's non-cash assets (excluding furniture and fixtures) (the "Assets"). This acquisition of assets (the "Asset Acquisition") was consummated as of such date. The Assets acquired pursuant to the Agreement include intellectual property, inventory, trade receivables and rights under certain assumed contracts. Under the terms of the Agreement, the Company issued 291,182 shares of the Company's Common Stock (the "Shares"), valued at approximately $3,200,000, to Semaphore on April 3, 1998 and assumed certain liabilities (the "Liabilities"). The Liabilities include certain obligations under assumed contracts and under various outstanding purchase orders as well as certain warranty obligations. The Company received $182,000 from Semaphore with respect to the assumption of certain of such Liabilities. The Shares issued to Semaphore in the Asset Acquisition were issued in a private placement pursuant to the exemption from registration under the Securities Act of 1933, as amended, under Section 4(2) of such Act. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On May 20, 1998, the Company held its annual meeting of shareholders. At that meeting, the Company's six incumbent directors were reelected to office by the following vote: Votes Name Votes for Withheld - ---- --------- -------- Vinita Gupta 8,678,410 12,678 Richard C. Alberding 8,678,560 12,528 Gregory M. Avis 8,678,560 12,528 Lance B. Boxer 8,678,560 12,528 22 Alan I. Fraser 8,641,806 49,282 Narendra K. Gupta 8,676,410 12,678 Also at that meeting, the shareholders ratified the selection of PricewaterhouseCoopers, L.L.P. as independent auditors for the Company's current fiscal year, with 8,658,853 votes for, 2,800 votes against, and 29,435 votes abstaining. ITEM 5. OTHER INFORMATION Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 27.01 Financial Data Schedule. (b) Reports on Form 8-K The Company filed a report on Form 8-K on April 17, 1998 and a report on Form 8-K/A on June 16, 1998 in connection with the acquisition of assets of Semaphore Communications Corporation. The Form 8-K provided information under Items 2 and 7 with respect to the Semaphore acquisition and the Form 8-K/A provided information under Item 7 with respect to such acquisition, including audited financial statements of Semaphore as of December 31, 1996 and 1997 and for the years then ended and unaudited pro forma condensed combined Statements of Operations for the year ended December 31, 1997 and the three months ended March 31, 1998 and an unaudited pro forma condensed combined Balance Sheet as of March 31, 1998. 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. DIGITAL LINK CORPORATION Date: August 14, 1998 /s/ Stanley E. Kazmierczak ------------------------------ Stanley E. Kazmierczak 23 Vice President, Finance and Administration, Chief Financial Officer and Secretary (Duly Authorized Officer and Principal Financial Officer) 24 EX-27.01 2 FINANCIAL DATA SCHEDULE
5 6-MOS DEC-31-1998 JAN-01-1998 JUN-30-1998 719 16,420 4,461 434 8,292 34,275 11,465 7,465 61,493 9,314 0 0 0 35,855 16,324 61,493 27,317 27,317 14,036 32,712 (1,068) 0 0 (4,327) (1,690) (2,637) 0 0 0 (2,637) (0.28) (0.28)
-----END PRIVACY-ENHANCED MESSAGE-----