-----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, VPLNmDBx6qK6tZQmwCJqPSVZgpoR6JcmAJrVE9R5ymdHLs/xB5yqivN5kZT0+TiU HMJuddSQGo3kEY2pnqOOLg== 0000950005-99-000997.txt : 19991117 0000950005-99-000997.hdr.sgml : 19991117 ACCESSION NUMBER: 0000950005-99-000997 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990930 FILED AS OF DATE: 19991115 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: 99753425 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 September 30, 1999 OR | | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________________ to _______________ Commission File Number: 0-23110 ------- 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 September 30, 1999, was 8,028,741 shares. DIGITAL LINK CORPORATION INDEX TO FORM 10-Q Page PART I - FINANCIAL INFORMATION: ITEM 1 - Financial Statements Consolidated Balance Sheets as of September 30, 1999 3 and December 31, 1998 Consolidated Statements of Operations for the quarters 4 and nine months ended September 30, 1999 and September 30, 1998 Consolidated Statements of Cash Flows for the nine 5 months ended September 30, 1999 and September 30, 1998 Notes to Consolidated Financial Statements 6 ITEM 2 - Management's Discussion and Analysis of 10 Financial Condition and Results of Operations ITEM 3 - Quantitative and Qualitative Disclosure About 19 Market Risk PART II - OTHER INFORMATION ITEM 1 - Legal Proceedings 20 ITEM 2 - Changes in Securities and Use of Proceeds 21 ITEM 3 - Defaults Upon Senior Securities 21 ITEM 4 - Submission of Matters to a Vote of Security Holders 21 ITEM 5 - Other Information 21 ITEM 6 - Exhibits and Reports on Form 8-K 21 SIGNATURE(S) 22 2 PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements DIGITAL LINK CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands, except share amounts) - ----------------------------------------------------------------------------------------------
September 30, December 31, 1999 1998 -------- -------- (Unaudited) ASSETS CURRENT ASSETS: Cash and cash equivalents $ 5,154 $ 296 Short-term marketable securities 4,993 15,738 Accounts receivable, less allowance for doubtful accounts of $337 at 9/30/99 and $540 at 12/31/98 6,343 4,767 Inventories 3,099 4,306 Prepaid and other current assets 1,045 998 Income taxes receivable -- 2,501 Deferred income taxes 3,069 3,069 -------- -------- Total current assets 23,703 31,675 Long-term marketable securities 28,210 18,696 Property and equipment at cost, net 2,173 2,582 Deferred income taxes 1,560 1,560 Other assets 50 393 -------- -------- TOTAL ASSETS $ 55,696 $ 54,906 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 2,781 $ 2,365 Accrued payroll expense 2,611 2,168 Other accrued expenses 4,890 4,764 Income taxes payable 288 243 -------- -------- Total current liabilities 10,570 9,540 -------- -------- CONTINGENCIES (Note 6) 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: 8,028,741 shares at 9/30/99 and 8,490,472 shares at 12/31/98 31,470 33,311 Accumulated other comprehensive income / (loss) (309) 52 Retained earnings 13,965 12,003 -------- -------- Total shareholders' equity 45,126 45,366 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 55,696 $ 54,906 ======== ======== 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 NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998 (Amounts in thousands, except per share amounts) - ------------------------------------------------------------------------------------------------------
Quarter Ended Nine Months Ended September 30, September 30, -------------------- -------------------- 1999 1998 1999 1998 -------- -------- -------- -------- REVENUES: Net sales $ 16,400 $ 13,271 $ 47,254 $ 40,587 Cost of sales 7,057 10,168 21,400 24,203 -------- -------- -------- -------- Gross profit 9,343 3,103 25,854 16,384 -------- -------- -------- -------- EXPENSES: Research and development 2,978 3,856 8,163 10,245 Selling, general and administrative 4,802 4,413 14,646 14,401 Purchased in-process research and development 0 0 0 2,299 Restructuring charges (424) 2,506 (424) 2,506 -------- -------- -------- -------- Total operating expenses 7,356 10,775 22,385 29,451 -------- -------- -------- -------- Operating income / (loss) 1,987 (7,672) 3,469 (13,067) Other income 464 551 1,404 1,619 -------- -------- -------- -------- Income / (loss) before provision / (benefit) for income taxes 2,451 (7,121) 4,873 (11,448) Provision / (benefit) for income taxes 613 (2,848) 1,218 (4,538) -------- -------- -------- -------- NET INCOME / (LOSS) $ 1,838 $ (4,273) $ 3,655 $ (6,910) ======== ======== ======== ======== COMPREHENSIVE INCOME / (LOSS) $ 1,811 $ (4,252) $ 3,294 $ (6,930) ======== ======== ======== ======== EARNINGS PER SHARE (Basic) Net income / (loss) per share $ 0.23 $ (0.47) $ 0.45 $ (0.74) ======== ======== ======== ======== Shares used in computing per share amounts 8,013 9,129 8,122 9,311 ======== ======== ======== ======== EARNINGS PER SHARE (Diluted) Net income / (loss) per share $ 0.22 $ (0.47) $ 0.44 $ (0.74) ======== ======== ======== ======== Shares used in computing per share amounts 8,255 9,129 8,258 9,311 ======== ======== ======== ======== 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 NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998 (Amounts in thousands) - ------------------------------------------------------------------------------------------
Nine Months Ended September 30, -------------------- 1999 1998 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income / (loss) $ 3,655 $ (6,910) Adjustments to reconcile net income / (loss) to net cash flows provided by operating activities: Depreciation and amortization 1,203 2,759 Reduction in allowance for doubtful accounts (165) (76) Provision for excess and obsolete inventories 1,114 2,944 Purchased research and development -- 2,299 Deferred tax on acquisition -- (1,399) Changes in: Accounts receivable (1,411) 613 Inventories 93 256 Prepaid and other assets 296 629 Accounts payable 416 1,898 Accrued payroll and other accrued expenses 569 263 Income taxes payable / (receivable) 2,546 (2,336) -------- -------- Net cash flows provided by operating activities 8,316 940 -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of marketable securities (16,308) (25,664) Maturities of marketable securities 17,178 35,199 Payment in connection with Acquisition of Semaphore Corporation -- 182 Acquisition of property and equipment (794) (1,075) -------- -------- Net cash flows provided by investing activities 76 8,642 -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from exercise of stock options and employee stock purchase plan 451 421 Repurchase of common stock (3,985) (6,402) -------- -------- Net cash flows used in financing activities (3,534) (5,981) -------- -------- Net increase in cash and cash equivalents 4,858 3,601 Cash and cash equivalents at beginning of year 296 2,504 -------- -------- Cash and cash equivalents at end of period $ 5,154 $ 6,105 ======== ======== 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 Company 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 presentation 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, which was filed with the Securities and Exchange Commission on March 29, 1999. The year-end balance sheet at December 31, 1998 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 nine months ended September 30, 1999 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 net income per share is computed in accordance with Statement of Financial Accounting Standards No. 128 ("SFAS No. 128").
Quarter Ended Nine Months Ended September 30, September 30, 1999 1998 1999 1998 ---- ---- ---- ---- Basic (in thousands, except per share data) (in thousands, except per share data) Weighted average common shares outstanding 8,013 9,129 8,122 9,311 for the period Shares used in computing per share amounts 8,013 9,129 8,122 9,311 Net income / (loss) $ 1,838 $ (4,273) $ 3,655 $ (6,910) Net income / (loss) per share $ 0.23 $ (0.47) $ 0.45 $ (0.74)
6
Quarter Ended Nine Months Ended September 30, September 30, 1999 1998 1999 1998 ---- ---- ---- ---- Diluted (in thousands, except per share data) (in thousands, except per share data) Weighted average number of shares outstanding 8,013 9,129 8,122 9,311 for the period Common equivalent shares from conversion of stock 242 -- 136 -- options under treasury stock method Shares used in computing per share amounts 8,255 9,129 8,258 9,311 Net income / (loss) $ 1,838 $ (4,273) $ 3,655 $ (6,910) Net income / (loss) per share $ 0.22 $ (0.47) $ 0.44 $ (0.74)
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): September 30, 1999 December 31, 1998 ------------------ ----------------- (Unaudited) Raw materials $1,002 $1,349 Work-in-process 1,091 1,456 Finished goods 1,006 1,501 ------ ------ $3,099 $4,306 ====== ====== 4. RESTRUCTURING CHARGES During the three and nine months ended September 30, 1999 the Company had an expense recovery of $424,000 due to the reversal of a portion of the restructuring charge that was originally included in the three-month and nine-month periods ended September 30, 1998. The 1998 restructuring charge was originally recorded as a result of the termination of the DL7100 and the Virtual Private Network product lines, including the termination of 25 project employees and the abandonment of a leased facility. The partial reversal in 1999 of the 1998 restructuring charge was due to the favorable resolution of certain legal contingencies that were included in the original charge. 5. OUTSTANDING TENDER OFFER On September 3, 1999 the Company and DLZ Corp., a corporation formed by Vinita Gupta, the founder, chief executive officer and holder of approximately 50% of the outstanding shares of the Company, announced that they had executed a definitive merger agreement. Under the terms of the merger agreement, DLZ made a tender offer for all 7 outstanding shares of the Company's stock not owned by DLZ for $10.30 per share. The tender offer commenced on September 10, 1999 and was set to expire at 12:00 midnight on October 15, 1999. The merger and tender offer were subject to certain conditions, including a minimum condition in the tender offer that DLZ own an aggregate of 90% of the outstanding stock following the tender offer. The original tender offer has been extended several times. As of 12:00 midnight on October 29, 1999, 2,690,031 shares of Digital Link stock had been tendered which, together with shares held by DLZ and its affiliates, constituted approximately 83.5% of the outstanding Company stock. On November 1, 1999, the tender offer price was increased to $10.85 and the offer was extended to 12:00 midnight on November 15, 1999. The merger agreement provides that the offer, if consummated, will be followed by a merger of DLZ Corp. and the Company. In connection with the merger, all remaining outstanding shares of the Company's Common Stock would be converted into the right to receive $10.85 per share in cash. 6. 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 matters 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 approximately $950,000 for these matters deemed probable in prior years, it is currently unable to estimate the ultimate range of loss regarding these matters. Therefore, it is reasonably possible that the ultimate resolution of these matters could result in final settlement that could exceed or be less than the amounts accrued and that the settlement of these matters could be material to the Company's results of operations. Adjustment to amounts accrued will take place in the period in which such matters are resolved. 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. Discovery to date has been limited in the state court action, and the Superior Court has not set a trial date. In the parallel Federal proceedings, the Court on September 11, 1997 granted the Company's motion to dismiss the federal complaint with leave to amend, and plaintiff filed an amended complaint. The Company moved to dismiss the 8 amended complaint, the hearing on which was scheduled to take place in September 1999. Plaintiff has attempted to dismiss the Federal proceedings without prejudice but has maintained his right to pursue the State action. The Company has objected to this procedure and has requested an opportunity to brief the issue in the Federal Court. 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 effect 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. 7. RECENT ACCOUNTING PRONOUNCEMENTS In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This standard requires companies to capitalize qualifying computer software costs which are incurred during the application development stage and amortize them over the software's estimated useful life. SOP 98-1 was effective for the Company's current fiscal year. The adoption of SOP 98-1 had no impact on the Company's financial statements. In April 1998, the AICPA issued Statement of Position 98-5 ("SOP 98-5"), "Reporting on the Costs of Start-Up Activities." This standard requires companies to expense the costs of start-up activities and organization costs as incurred. SOP 98-5 was effective for the Company's current fiscal year. The adoption of SOP 98-5 had no impact on the Company's results of operations. In September 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities." SFAS 133 establishes new standards of accounting and reporting for derivative instruments and hedging activities. SFAS 133 requires that all derivatives be recognized at fair value in the statement of financial position, and that the corresponding gains or losses be reported either in the statement of operations or as a component of comprehensive income, depending on the type of hedging relationship that exists. SFAS 133 will be effective for the first quarter of 2000. The Company does not currently hold derivative instruments or engage in hedging activities. 9 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 ("SEC"), including its Form 10-K for the year ended December 31, 1998 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 SEC that attempt to advise 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 possible, in some future quarters that 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 are primarily derived from the sale of wide-area network access equipment. Net sales increased 24% to $16,400,000 in the third quarter of 1999 compared to $13,271,000 in the third quarter of 1998 and increased 16% to $47,254,000 for the nine months ended September 30, 1999 compared to $40,587,000 for the corresponding period in 1998. The Company has two major products, broadband products (i.e., transmission rates in excess of T1/E1) and narrowband products (i.e., transmission rates up to T1/E1). Increased demand for broadband products continued to generate a very strong increase in sales of these products, particularly in the inverse multiplexer product line. The increase in broadband sales was partially offset by a decline in sales for narrowband products. Narrowband sales decreased due 10 to the anticipated decline in sales of the Company's T1 OEM product and to decreased demand for lower-end narrowband products. During the third quarter of 1999, narrowband sales in absolute dollars decreased by 22% and decreased to 41% of net sales as compared to 65% of net sales in the third quarter of 1998. Broadband sales increased in absolute dollars by 107% and grew to 59% of total sales in the third quarter of 1999 as compared to 35% of net sales in the third quarter of 1998. During the first nine months of 1999, narrowband sales in absolute dollars decreased by 6% and decreased to 50% of total sales as compared to 62% of total sales in the first nine months of 1998. Broadband sales increased in absolute dollars by 52% and increased to 50% of net sales for the first nine months of 1999 as compared to 38% of net sales for the same period in 1998. The changes in narrowband sales and broadband sales as a percentage of net sales were primarily due to higher sales of broadband products to certain domestic carrier customers and the decline in sales of the T1-OEM product. Net sales continued to be impacted by lower average selling prices on certain narrowband and broadband products as a result of price reductions made in 1998 and in the first part half of 1999. The Company anticipates that the pricing pressure will continue during the remainder of 1999. International sales, including Canada, represented 24% of net sales in the third quarter of 1999 and 1998, compared to 20% for the same period of 1998. International sales for the nine months ended September 30, 1999, were 26% as compared to 22% for the same period of the prior year. These increases were primarily due to an increased sales presence in Asia and Europe and increased demand for broadband products. 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, unexpected changes in regulatory requirements and tariffs, and potentially adverse tax consequences, which may in the future contribute to fluctuations in the Company's business and operating results. Gross Profit During the third quarter of 1999, gross profit increased 201% to $9,343,000 from $3,103,000 for the same period of the prior year. Gross margin increased to 57.0% of net sales in the third quarter of 1999 as compared to 23.4% in the third quarter of 1998. The net increase in gross margin from the third quarter 1998 to the third quarter of 1999 was due to a combination of factors. Cost of goods sold for the third quarter of 1998 included a charge amounting to approximately $3.2 million for inventory write-downs and warranty reserves which related to the discontinuance of certain of the Company's products in connection with the Company's restructuring. Also, there was a shift in the mix of products sold in the third quarter of 1999 to include more broadband products, which generally have higher gross margins than narrowband products. In addition, there was a significant reduction in sales of the T1 OEM units, which have relatively low margins. During the nine months ended September 30, 1999, gross profit increased 57.8% to $25,854,000 from $16,384,000 for the same period of the prior year. Gross margins increased to 54.7% of net sales for the first nine months of 1999 as compared to 40.4% for the same period of the prior year. This gross margin increase also reflects the shift in the mix of products sold to include more broadband products as well as the previously mentioned restructuring adjustment. 11 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 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 that 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 expenses are personnel, consulting, prototype materials and professional services. During the third quarter of 1999, R&D expenses decreased 23% to $2,978,000 from $3,856,000 for the third quarter of 1998. For the nine months ended September 30, 1999, R&D expenses decreased 20% to $8,163,000 from $10,245,000 for the same period of the prior year. The decrease in expenses during both the third quarter and first nine months of 1999 is primarily due to a reduction in headcount because of discontinued or de-emphasized products resulting from restructuring activities in September 1998. As a percentage of net sales, R&D expenses decreased to 18.2% for the third quarter of 1999 as compared to 29.1% for the same period of the prior year. R&D expenses were 17.3% of net sales for the nine months ended September 30, 1999 as compared to 25.2% for the same period of 1998. The decrease in R&D expenses as percentage of net sales for the third quarter and the first nine months of 1999 is the result of higher net sales combined with lower costs as a result of discontinued or de-emphasized products. 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 expense increased 9% in the third quarter of 1999 to $4,802,000 from $4,413,000 for the same period of the prior year. This increase in SG&A expense was attributable to an increase in advertising and promotional activities and increased personnel costs due to headcount increases. SG&A expense increased 2% to $14,646,000 for the first nine months of 1999 from $14,401,000 for the comparable period in 1998. This increase in SG&A expense was primarily attributable to increased marketing costs such as advertising offset by reduced travel and bad debt expenses. As a percentage of net sales, SG&A expenses decreased to 29.3% and 31.0% respectively, for the third quarter and first nine months of 1999, compared to 33.3% and 35.5% for the same periods 12 of 1998. The decrease in SG&A expense as a percentage of net sales during both the quarter and nine months ended September 30, 1999 was primarily the result of higher sales volume, offset in part by the increased SG&A expense mentioned above. Purchased In-Process Research and Development In the nine months ended September 30, 1998, the Company incurred an expense of $2.3 million related to purchased research and development for which technological feasibility had not been achieved related to the acquisition of Semaphore. Such in-process technology was valued, along with other acquired assets, in 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". Other Income Other income is derived primarily from interest income. Other income decreased 16% to $464,000 during the third quarter of 1999 as compared to $551,000 during the same period of 1998. Other income decreased 13% to $1,404,000 during the first nine months of 1999 as compared to $1,619,000 for the first nine months of 1998. These decreases were primarily due to lower interest income due to reduced interest rates and lower investment balances. Provision for Income Taxes The Company's effective tax rate decreased to 25.0% for the third quarter and first nine months of 1999 compared to 40% for the same periods in 1998. The 1998 rate assumed a carryback of the then-current year losses compared to the effective tax rate applicable if the Company were profitable. The Company's 1999 tax rate reflects the resolution of prior contingencies. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities was $8.3 million for the first nine months of 1999 and $0.9 million for the same period in 1998. Cash provided by operating activities during the first nine months of 1999 resulted primarily from net income and a refund of income taxes. The major components of cash provided by operating activities for the nine months ended September 30, 1998 were an increase in the provision for excess and obsolete inventories, depreciation and amortization, and purchased research and development, offset by a net loss and an increase in income tax receivable. Net cash provided by investing activities was $76,000 for the nine months ended September 30, 1999, compared to $8.6 million for the same period in 1998. The 1999 provision of cash resulted from the maturity of $17.2 million of marketable securities offset by the purchase of $16.3 million in marketable securities and $794,000 of capital equipment. The net cash provided by investing activities during the nine months ended September 30, 1998 resulted primarily from the maturity of $35.2 million of marketable securities offset by the purchase of $25.7 million of marketable securities and $1,075,000 of capital equipment. 13 Financing activities consumed $3.5 million of cash during the nine months ended September 30, 1999 and $6.0 million during the comparable period of 1998. The use of cash during both periods was primarily due to the Company's repurchase of $4.0 million and $6.4 million, respectively, worth of its Common Stock, offset by the proceeds from the exercise of stock options and the Employee Stock Purchase Plan. During the nine months ended September 30, 1999 working capital decreased 41% to $13,133,000 from $22,135,000 at December 31, 1998. The decrease of $9,002,000 was primarily due to the shift from cash and short-term investments to long-term investments. In October 1996, the Company's Board of Directors announced the authorization for the Company to repurchase up to 500,000 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 block transactions, at which time the stock will be retired. The Board authorized additional repurchases of up to 1,000,000 shares in May 1998, 500,000 shares in December 1998 and 500,000 in April 1999. No time limit was set for completion of the repurchase program. The Company purchased 584,000 shares of common stock during the first nine months of 1999, 1,372,000 shares in 1998, and 142,000 shares in 1997 under this program at a cost of $3,986,000, $9,364,000 and $2,422,000 for 1999, 1998 and 1997, respectively. In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This standard requires companies to capitalize qualifying computer software costs which are incurred during the application development stage and amortize them over the software's estimated useful life. SOP 98-1 was effective for the Company's current fiscal year. The adoption of SOP 98-1 had no impact on the Company's financial statements. In April 1998, the AICPA issued Statement of Position 98-5 ("SOP 98-5"), "Reporting on the Costs of Start-Up Activities." This standard requires companies to expense the costs of start-up activities and organization costs as incurred. SOP 98-5 was effective for the Company's current fiscal year. The adoption of SOP 98-5 had no impact on the Company's results of operations. In September 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities." SFAS 133 establishes new standards of accounting and reporting for derivative instruments and hedging activities. SFAS 133 requires that all derivatives be recognized at fair value in the statement of financial position, and that the corresponding gains or losses be reported either in the statement of operations or as a component of comprehensive income, depending on the type of hedging relationship that exists. SFAS 133 will be effective for the first quarter of 2000. The Company does not currently hold derivative instruments or engage in hedging activities. 14 OTHER FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS In addition to the factors set forth above in this "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 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. 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 third 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. In addition, none of the Company's customers are contractually obligated to purchase any quantity of products in any particular period, and product sales to major customers have varied widely from quarter to quarter and year to year. There can be no assurance that the Company's current customers will continue to place orders with the Company, that orders from existing customers will continue at the levels of previous periods or that the Company will be able to obtain orders from new customers. Other factors that may cause fluctuations in the Company's operating results include, but are not limited to, the timing of new product announcements and introductions by the Company and its competitors, market acceptance of new or enhanced versions of the Company's products, changes in the product mix sold toward narrowband products that yield lower gross margins, seasonal capital spending patterns of large domestic customers, changes in sales volumes through the Company's distribution channels, 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 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 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. This 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. 15 The Company's success and ability to compete are dependent on its ability to develop and maintain the proprietary aspects of its technology. It relies on a combination of trademark, trade secret and copyright law and contractual restrictions to protect these rights. Despite its efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of its products or to obtain and use information that it regards as proprietary. Unauthorized use or misappropriation of the Company's intellectual property could seriously harm its business. To enforce its proprietary rights, the Company may be required to bring legal action against third parties. For example, on June 1, 1999, the Company filed a suit in Santa Clara County Superior Court against Tiara Networks, Inc., its three corporate officers and certain of its personnel, all of whom are former Digital Link employees regarding Tiara's business and products being based on the improper disclosure and use of Digital Link's proprietary and confidential information by its former employees. See Part II, Item 1 of this Form 10-Q for additional information regarding this proceeding. There can be no assurance that the Company will prevail in this or any other legal proceeding. In addition, any legal action that the Company may bring to protect its intellectual property rights, including the suit against Tiara, could be expensive and distract management from day-to-day operations. The Company's future prospects will depend in part on its ability to enhance the functionality of its existing WAN access products in a timely manner. It will also depend on the Company's ability 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. 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. For example, in December 1998, Lana Vaysburd was hired as Vice President, Engineering, in March 1999, Sherman Silverman was hired as Vice President, Sales and Marketing, Worldwide and in June 1999, Naresh C. Kapahi was hired as Vice President, Finance and Operations and Chief Financial Officer. In addition, in March 1998 Vinita Gupta was reappointed as the Company's interim President and Chief Executive Officer, which position she accepted on a full-time basis in January 1999. The current availability of qualified sales and engineering personnel is quite limited, and competition among companies for such personnel is intense. The Company is currently attempting to hire a number of sales and engineering personnel and has experienced delays in filling such positions. There can be no 16 assurance that the Company will be successful in attracting and retaining skilled personnel to hold these important positions. The Company utilizes management information systems and software technology that may be affected by Year 2000 issues throughout its businesses. During 1998, the Company began to implement plans for certain of its internal operating systems to ensure these systems continue to meet its internal and external requirements. The Year 2000 compliance efforts encompassed: o All Digital Link products. The incurred cost of this effort was approximately $250,000 and was financed through working capital and the use of internal engineering resources. o All Digital Link major operational systems (including ASK MANMAN, databases, spreadsheets, word processing, and CAD). The cost of these initiatives is estimated to be $200,000. The Company contracted with a third party to perform the MANMAN compliance work and has used a combination of consultants and internal resources to address the compliance issues with other internal operational systems. In addition, the Company has developed questionnaires and contacted key suppliers and customers regarding their Year 2000 compliance to determine any impact on its operations. The initiatives to address vendor and customer compliance were completed by the end of September 1999. In general, the Company's suppliers and customers have advised it that they have developed or are in the process of developing plans to address Year 2000 issues. The Company will continue to monitor and evaluate the progress of its suppliers and customers on this critical matter. The Company is also reviewing its non-information technology systems to determine the extent of any changes that may be necessary and believes that there will be minimal changes necessary for compliance. To date, the Company has incurred approximately $450,000 in expenses related to Year 2000 compliance of its products and internal operating systems. All current active products meet the Company's Year 2000 compliance requirements. Currently, all critical internal systems are Year 2000 compliant and in excess of 99% of the internal operating systems of the Company are Year 2000 compliant. The Company plans to complete Year 2000 compliance for its internal operating systems by November 1999. Based on the progress the Company has made in addressing its Year 2000 issues and the Company's plan and timeline to complete its compliance program, the Company does not foresee significant risks associated with its Year 2000 compliance at this time. As the Company's plan is to address its significant Year 2000 issues prior to being affected by them, it has not developed a comprehensive contingency plan. However, if the Company identifies significant risks related to its Year 2000 compliance or its progress deviates from the anticipated timeline, the Company will develop contingency plans as deemed necessary at that time. The Company is concerned that many enterprises and carriers will be devoting a substantial portion of their information systems spending to addressing the Year 2000 issue. This expense may result in spending being diverted from networking solutions in the near future. This diversion of information technology spending could have a material adverse impact on the Company's future sales volume. However, to date, no significant impact has been experienced. 17 The foregoing statements regarding the Company's Year 2000 compliance are based upon management's best estimates at the present time, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources, third party modification plans and other factors. There can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, the nature and amount of programming required to upgrade or replace each of the affected programs, the rate and magnitude of related labor and consulting costs and the success of the Company's external customers and suppliers in addressing the Year 2000 issue. The Company's evaluation is on going and it expects that new and different information will become available to it as that evaluation continues. Consequently, there is no guarantee that all material elements will be Year 2000 ready in time. 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. See paragraphs two and three in Note 6 of Notes to Consolidated Financial Statements in Part I of this Form 10-Q. Since the public announcement of the merger agreement on September 3, 1999, a number of lawsuits have been filed in the Superior Court of Santa Clara County, California. See paragraph one in Legal Proceedings in Part II of this Form 10-Q. 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 DSU/CSUs, may infringe upon patents held by it. The third party 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. See paragraph one in 6 of Notes to Consolidated Financial Statements in Part I of this Form 10-Q. 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. 18 On September 3, 1999, the Company announced the execution of a merger agreement with DLZ Corp., a corporation formed by Vinita Gupta, the founder, chief executive officer and holder of approximately 50% of the outstanding shares of Digital link. Pursuant to the merger agreement, DLZ Corp. made a cash tender offer for all of the issued and outstanding shares of the Company's Common Stock, which, if successful, is to be followed by a merger of the Company with DLZ Corp. See Note 6 of Notes to Condensed Consolidated Financial Statements in Item 1 of this Form 10-Q. This intended acquisition by DLZ Corp. may result in the diversion of management's attention from other business concerns, the disruption of the Company's business, the loss of key employees, the loss of orders for the Company's products from its customers and the loss of key distributors, supplier or other business partner relationships. There can be no assurance that the Company will succeed in overcoming these or any other significant risks encountered in connection with the proposed acquisition. 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. ITEM 3. Quantitative and Qualitative Disclosure About Market Risk The Company has limited exposure to financial market risks, including changes in interest rates. The Company does not use derivative financial instruments in its investment portfolio. The Company's investment portfolio is generally comprised of government agency securities that mature within three years. The Company places investments in instruments that meet high credit quality standards. These securities are subject to interest rate risk, and could decline in value if interest rates increase. Due to the duration and conservative nature of the Company's investment portfolio, the Company does not expect any material loss with respect to its investment portfolio. The Company does not have any significant foreign operations and thus is not materially exposed to foreign currency fluctuations. The Company does not currently hedge against foreign currency rate fluctuations. 19 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings On September 3, 1999, the Company and DLZ Corp. commenced that they had executed a definitive merger agreement and DLZ Corp. subsequently issued a tender offer for all outstanding shares of the Company's stock not owned by DLZ Corp. for $10.30 per share. Since the public announcement of the merger agreement on September 3, 1999, a number of purported class actions have been filed in the Superior Court of Santa Clara County, California. The complaints allege that the Company's directors breached their fiduciary duties by failing to maximize the value of the shares of the Company's Common Stock, that the value of the shares of the Company's Common Stock is materially greater than the offer price and, in one action, that the director defendants failed to disclose material non-public information concerning the Company's financial condition and prospects. Each complaint seeks certification of a plaintiff class, declaratory and injunctive relief preventing the offer and the merger, unspecified compensatory damages, and attorneys' fees and costs. The plaintiffs have filed a motion to consolidate these cases, and the hearing on this motion is scheduled to take place on December 2, 1999. On October 13, 1999, the Superior Court denied an application for a temporary restraining order filed by plaintiffs in two purported class actions challenging DLZ's tender offer. The court also denied plaintiffs' application for expedited discovery. The court set a hearing for December 2, 1999 on the plaintiffs' threatened application for a preliminary injunction. If the tender is consummated and the related short-form merger is completed, there will be no hearing on plaintiff's motion for a preliminary injunction. DLZ Corp., the defendant members of the Gupta Family, the Company, and the members of the Special Committee believe that the actions are without merit, and intend to defend them vigorously. The Company and certain of its officers and directors are parties to various lawsuits described in paragraphs two and three in Note 6 of Notes to Consolidated Financial Statements in Part I of this Form 10-Q. See also prior disclosures contained in the Company's reports on Form 10Q filed for the quarters ended March 31, 1999 and June 30, 1999. The Company on June 1, 1999 filed a lawsuit in Santa Clara County Superior Court against San Jose-based Tiara Networks, Inc., its three corporate officers and certain of its personnel, all of whom are former Digital Link employees. The suit charges that Tiara's business and products are based upon the improper disclosure and use of Digital Link's proprietary and confidential information by its former employees. Digital Link's complaint alleges the named defendants are liable for violating confidentiality agreements, fiduciary obligations to the Company and engaging in unfair business practices. The Company is seeking damages and injunctive relief. A demurrer as to the second, third, and fourth causes of action alleging breach of fiduciary duty, conversion and unfair business practice is pending as of November 12, 1999. See also prior disclosure contained n the Company's reports on Form 10-Q filed for the quarter ended June 30, 1999. 20 ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable ITEM 5. OTHER INFORMATION On September 3, 1999 the Company and DLZ Corp., a corporation formed by Vinita Gupta, the founder, chief executive officer and holder of approximately 50% of the outstanding shares of the Company, announced that they had executed a definitive merger agreement. Under the terms of the merger agreement, DLZ made a tender offer for all outstanding shares of the Company's stock not owned by DLZ for $10.30 per share. The tender offer commenced on September 10, 1999 and was set to expire at 12:00 midnight on October 15, 1999. The merger and tender offer were subject to certain conditions, including a minimum condition in the tender offer that DLZ own an aggregate of 90% of the outstanding stock following the tender offer. The original tender offer has been extended several times. As of 12:00 midnight on October 29, 1999, 2,690,031 shares of Digital Link stock had been tendered which, together with shares held by DLZ and its affiliates, constituted approximately 83.5% of the outstanding Company stock. On November 1, 1999, the tender offer price was increased to $10.85 and the offer was extended to 12:00 midnight on November 15, 1999. The merger agreement provides that the offer, if consummated, will be followed by a merger of DLZ Corp. and the Company. In connection with the merger, all remaining outstanding shares of the Company's Common Stock would be converted into the right to receive $10.85 per share in cash. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 2.1 Agreement and Plan of Merger dated as of September 3, 1999 by and among DLZ Corp. and Digital Link Corporation (incorporated by reference to Exhibit 2.1 to the Company's Report on Form 8-K (File No. 0-223110) dated September 7, 1999). 27.01 Financial Data Schedule. (b) The Company filed a report on Form 8-K dated September 3, 1999 in connection with the proposed merger with DLZ Corp. 21 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: November 12, 1999 /s/ N. C. Kapahi --------------------------------------- Naresh C. Kapahi Vice President, Finance and Operations, Chief Financial Officer and Secretary (Duly Authorized Officer and Principal Financial Officer) 22 EX-27 2 FINANCIAL DATA SCHEDULE
5 This schedule contains summary financial information extracted from the consolidated balance sheet, consolidated statement of income and consolidated statement of cash flows included in the Company's Form 10-Q for the period ending September 30, 1999, and is qualified in its entirety by reference to such financial statements. 9-MOS DEC-31-1999 JAN-01-1999 SEP-30-1999 5,154 4,993 6,343 337 3,099 23,703 8,496 6,323 55,696 10,570 0 0 0 31,470 13,656 55,696 47,254 47,254 21,400 43,785 (1,404) 0 0 4,873 1,218 3,655 0 0 0 3,655 0.45 0.44
-----END PRIVACY-ENHANCED MESSAGE-----