-----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, LQU5ejDj9AHmxzKGmCdKgxVoa73JHIWA2PZz8oBxtaEdBBEcbw9PMKD8av/totHS jpbOqVIzFY6P6W/O2rZJgA== 0000908985-98-000007.txt : 19980330 0000908985-98-000007.hdr.sgml : 19980330 ACCESSION NUMBER: 0000908985-98-000007 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19971228 FILED AS OF DATE: 19980327 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: LEVEL ONE COMMUNICATIONS INC /CA/ CENTRAL INDEX KEY: 0000908985 STANDARD INDUSTRIAL CLASSIFICATION: SEMICONDUCTORS & RELATED DEVICES [3674] IRS NUMBER: 330128224 STATE OF INCORPORATION: CA FISCAL YEAR END: 0101 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-22068 FILM NUMBER: 98576075 BUSINESS ADDRESS: STREET 1: 9750 GOETHE RD CITY: SACRAMENTO STATE: CA ZIP: 95627 BUSINESS PHONE: 9168541138 MAIL ADDRESS: STREET 1: 9750 GOETHE ROAD CITY: SACREMENTO STATE: CA ZIP: 95827 10-K 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] For the fiscal year ended December 28, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the Transition period from to Commission File Number: 0-22068 Exact name of registrant as specified in its charter: LEVEL ONE COMMUNICATIONS, INCORPORATED STATE OR OTHER JURISDICTION OF IRS EMPLOYER INCORPORATION OR ORGANIZATION: IDENTIFICATION NO. California 33-0128224 ADDRESS OF PRINCIPAL EXECUTIVE OFFICES: 9750 Goethe Road, Sacramento, California 95827 TELEPHONE NO.: (916) 855-5000 SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: TITLE OF EACH CLASS Common Stock, no par value per share Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ___ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of the registrant's common stock held by nonaffiliates as of March 1, 1998, was $885,726,998. The number of shares outstanding of the Registrant's only class of common stock as of March 1, 1998, was 20,576,916 shares of no par value common stock. PART I ITEM 1. BUSINESS Level One Communications, Incorporated (''Level One'' or ''the Company'') was incorporated in 1985 under the laws of the state of California. The Company has operations in the United States, Europe and Asia. Level One designs, develops and markets mixed-signal application specific standard product (''ASSP'') integrated circuits for high-speed digital signal transmission and networking connectivity to systems that transport information, within an office or around the world. Such systems connect to local area networks ("LANs"), wide area networks ("WANs") and public telephone transmission networks. LANs, WANs, and telephone transmission networks make possible such activities as the use of intra-enterprise networking ("intranets") and the use of the Internet and World Wide Web. Level One ASSPs transmit, regenerate and receive digitized voice, data, and video signals using a wide variety of protocols. Because these products both transmit and receive signals, they are called "transceivers". All networks, LAN, WAN, and telephone transmission, require transceivers. Level One combines its strengths in analog and digital circuit design with its communications systems expertise to produce mixed-signal solutions with increased functionality and greater reliability, resulting in lower total system cost. As the volume of transmitted digital information continues to grow, communications original equipment manufacturers (''OEMs'') that supply products and systems to the transmission and networking markets face a fundamental challenge of providing greater data throughput on a cost-effective basis. Level One addresses the needs of leading communications OEMs by providing high performance mixed-signal ASSPs that optimize the allocation of analog and digital signal processing functions. The Company's proprietary simulation software and sophisticated design and testing methodology accelerate the product design cycle to improve time to market. A key challenge for Level One's OEM customers and their end users is the creation of access technologies that maximize the use of the large installed base of twisted-pair copper telephone lines to transport information. With more than 1.3 billion miles in place in the United States, copper telephone wire is expected to remain the primary medium for local connectivity to the ''electronic superhighway'' transport media that handle long-distance data transmissions. Such long-distance transport media include copper telephone lines, coaxial cable, fiber optic cable, wireless and satellite transmission. Copper telephone wire, which was originally designed to transmit relatively slow analog voice signals, requires special signal conditioning circuits to enable transmission of high-speed digital signals. PRODUCTS AND APPLICATIONS Level One develops and sells advanced ASSPs and custom derivatives that provide silicon connectivity solutions and achieve improved integration of functions. The Company's current products address the needs of two primary segments of the communications connectivity market: the networking market and the telecom market. NETWORKING PRODUCTS Level One's networking products address the rapid evolution of the LAN networking connectivity markets. For these markets, Level One produces Ethernet and Fast Ethernet transceivers, single chip quad Ethernet repeaters, managed Ethernet repeaters, and integrated transceiver solutions. Local Area Networks address the need to share information among individuals and workgroups within a building or campus environment. The dominant networking standard in the LAN environment is Ethernet, commonly implemented over a twisted pair copper wire environment utilizing a 10 megabits per second transmission standard. Fast Ethernet products enable transmissions of up to 100 megabits per second over twisted pair copper wiring. Emerging 1- Gigabit per second Ethernet standards are aimed at the same copper infrastructure as the Fast Ethernet products. These high speed LANs are expected to be catalysts for a variety of new graphics, video, multimedia, and network management applications. Level One's transceivers incorporate analog and digital functions into single chip solutions. Level One products in this category are used in computer/workstation, server, portable computing, network printing, and Ethernet switch applications. To provide Level One customers with cost effective, high performance intranet and LAN solutions, these transceivers incorporate features such as patented on-chip transmit filters, full duplex support, multichannels, 3.3 volt performance, and the smallest form factor package available. Level One repeater and network management products include cascadeable quad repeater hub chips, with integrated, filter technology. These chips allow development of low cost, multiport managed and unmanaged Ethernet repeater hub systems. Level One also produces a family of remote network management devices which incorporate a Media Access Controller and support for Simple Network Management Protocol ("SNMP") and Remote Monitoring ("RMON"). The Company also has a single chip solution optimized for hybrid switching systems. During 1997, Level One introduced the LXT970 Fast Ethernet 10/100 transceiver, and shipped in excess of 4 million units. As the LAN market experiences broad based growth, there is increased demand for compatible protocols and standards to allow LAN/WAN interoperability and management as well as for silicon technology addressing the convergence of the two markets. Level One products service these evolving market needs. TELECOM PRODUCTS Level One's telecom products service the growing demand for high-speed digital signal transmission utilizing the industry-wide specifications referred to as ''T1'' in North America, and ''E1'' in Europe, Asia and much of the rest of the world. T1 systems transmit 1.544 million bits per second and E1 systems transmit 2.048 million bits per second. Level One's products also address the transmission service known as ''Fractional T1,'' in which users can access multiple 64kbs sub-channel rates of T1. Level One produces fully integrated single chip T1 and E1 transceivers to meet the requirements of its customers. Short-haul transceivers, which process signals travelling within buildings, are incorporated into customer premise equipment and into products sold to network service providers such as telephone companies. Short-haul transceivers are typically used for transmissions of 600 feet to 700 feet. Long-haul transceivers, which transmit to approximately 6,000 feet, are incorporated into products such as PBXs, channel service units, routers and multiplexers, which provide connectivity between customer premise devices and the telephone company network. Long-haul transceivers are also used in base stations for mobile communication systems. Repeaters are installed along telephone company transmission lines to receive and regenerate signals at intervals of 6,000 feet, preventing the deterioration of the signal. To reduce service costs, telephone companies use ''smart'' repeaters that enable the system operator to quickly locate a faulty repeater. Level One's products are used in these ''smart'' repeater applications. Intranets and WANs connect individuals and workgroups over longer distances than LANs, using telephone company transmission lines rather than intraoffice wiring. WAN system products that incorporate Level One devices include routers, digital modems, multichannel Access Multiplexers, lottery and point-of-sale terminals. The rapid growth of high bandwidth, low cost digital access services has increased the demand for business and consumer use of WANs. Along with the growth of the Internet and on-line services, WAN equipment markets have experienced significant growth in recent years. The Company's transceivers targeted at WAN equipment segments incorporate analog and digital functions into single chip solutions. Level One products are used in routers, digital modems, and a variety of other customer premise equipment applications. Service offerings such as Frame Relay, Switched 56, and DDS have helped drive demand for Level One's products such as the LXT441, a single chip 56kbs digital access modem. High-bit-rate digital subscriber line (''HDSL'') products produced by the Company are designed to transmit up to 12,000 feet at the T1 rate on two sets of twisted-pair copper wire or at the E1 rate on two or three sets of twisted pair wire, reducing or eliminating the need for repeaters in long-haul T1/E1 transmission. HDSL permits the transmission of data at 784 kilobits per second or 1,168 kilobits per second on any twisted-pair copper wire used for subscriber loops. The Company's HDSL solution is a two-chip chipset. The Company expects that HDSL, together with successor and derivative technologies, will continue to play an important role in the communications infrastructure. Emerging DSL technologies ("xDSL") include high speed Internet access and residential broadband. The Company plans to address these markets with current and future DSL products. Since 1996 the Company has shipped Subrate HDSL or Multi-Rate Digital Subscriber Line ("MDSL") chipsets to selected customers, and formally announced the product in February 1997. MDSL is currently used for Internet access and digital pair gain, primarily for commercial customers. In the future MDSL is expected to also be used for wireless base stations and video conferencing. Level One produces fully integrated T1/E1 quad receivers, which are incorporated into telephone company maintenance and performance monitoring equipment. Level One's LXT360, LXT361, LXT350 and LXT351 integrated T1/E1 transceivers are aimed at developers of Sonet/SDH multiplexers, digital loop carriers, and residential broadband access systems. These products permit OEM customers to develop a single board design that meets both T1 and E1 standards. The chips are designed to operate over poor quality or "noisy" lines. Clock rate adapters (CLADs) adapt signals generated at the host system's internal clock rates for T1/E1 transmission. CLADs are used to generate internal timing systems for channel banks, digital loop carriers, multiplexers, timing generators and other E1/T1 equipment, eliminating the need for expensive discrete crystal oscillators. TECHNOLOGY The Company's proprietary technology includes systems simulation and testing software and an extensive circuit cell library. Level One believes that a key competitive factor in its success is its ability to use this technology, in conjunction with industry standard design tools, to rapidly design and introduce new products. The Company continuously reviews new opportunities in emerging technologies such as xDSL, Switched Ethernet, Fast and Gigabit Ethernet, infrared, ATM, wireless, frame relay and cable transmission. STRATEGIC RELATIONSHIPS Level One's relationships and strategic development arrangements with industry leaders help the Company identify and develop new products that meet industry needs. Through the involvement of key customers in alpha stage development, the Company's objective is to bring to market products that are positioned to become market leaders. Level One is an active member of several important standards committees throughout the world. During 1997, Level One and its strategic partners were instrumental in the development of the standards for two new technologies: HDSL-2, which is repeaterless T1 transmission on a single pair of copper wires, and Gigabit Ethernet on copper wire for the networking market. Both standards have received preliminary approval by their respective standards bodies. Level One has from time to time entered into investment, development or license agreements with third parties to broaden the Company's product and technology offerings. Level One has also in the past entered into strategic alliances with consortia of industry leaders to develop communications products, such as the Company's HDSL chipsets. The Company may in the future enter into such arrangements when appropriate opportunities arise. SALES AND MARKETING Level One's sales and marketing strategy is to achieve design wins by developing products with superior mixed-signal processing functions that are designed into equipment offered by industry leaders. Level One has a direct sales force and a worldwide network of independent distributors and sales representatives. These independent sales organizations are selected for their ability to provide effective field sales and technical support to customers. The Company maintains six regional sales offices in the United States. In addition, there are 23 sales representatives or distributors of the Company's products. Internationally, Level One has six sales offices along with 30 sales representatives or distributors operating in 46 countries. RESEARCH AND DEVELOPMENT The Company believes that the continued introduction of new products in its target markets is essential to its growth. As of December 28, 1997, Level One had 124 full-time employees engaged in research and development. The Company currently anticipates that it will increase research and development staffing levels in 1998. Expenditures for research and development in 1997, 1996, and 1995 were approximately $30.4 million, $22.0 million, and $17.1 million, respectively. These expenditures exclude one-time charges for purchased research and development of $2,500,000 and $750,000 related to acquisitions in 1996 and 1995, respectively. The Company released six new products during 1997, consisting of three networking products and three telecom products. A portion of the Company's research and development resources may be used to enhance existing products and to move to smaller geometries on larger wafers to improve product costs. MANUFACTURING FOUNDRIES Level One uses independent silicon foundries to fabricate its wafers. This approach enables the Company to concentrate its resources on design and test and allowing it to eliminate the cost associated with owning and operating a fabrication facility. The Company's primary wafer needs are supplied by six foundries; however, the Company may, from time to time, qualify other foundries. Except where the Company has contracted for long-term wafer supplies, the Company's suppliers generally are not obligated to supply, nor is the Company obligated to purchase, any minimum amount of wafers. Such suppliers generally agree on production schedules based on purchase orders and forecasts. During 1995, the Company entered into five-year agreements with three of its suppliers for committed foundry capacity in consideration of equipment financing or cash deposits. At December 28, 1997, the Company had provided an aggregate of $20.6 million in capital equipment financing and/or cash deposits to these foundries to obtain committed foundry capacity. During the first quarter of 1998, the Company paid an aggregate $1.3 million in additional deposits per its agreements. There are no additional deposits due under the Company's existing foundry agreements. From time to time, foundries supplying the Company may experience wafer yield problems or capacity constraints which can result in wafer delivery delays, and the Company may need to locate an alternative source of supply for wafers. The Company has experienced increased costs and delays in customer shipments as a result of a foundry reducing shipments to the Company without prior notice, forcing the Company to transfer products to a new foundry. Although the Company believes it can meet customer demand, there can be no assurances that unforeseen demand or supply disruptions will not have a material negative impact on the Company's business. ASSEMBLY Once the subcontracted wafers have been tested and accepted by the Company, the die are assembled into packages by subcontractors located worldwide. The Company utilizes multiple assembly subcontractors for its products. While the Company has not experienced any material disruption in supply from assembly subcontractors, there can be no assurance that assembly problems will not occur. QUALITY AND RELIABILITY ASSURANCE The Company qualifies each assembly and foundry subcontractor before that vendor manufactures products for the Company. Such qualification includes an audit and analysis of the subcontractor's quality system and manufacturing capabilities. The Company continuously monitors subcontractors' quality and reliability on an ongoing basis. Level One's objective is to control the quality of finished goods as thoroughly as if it internally operated every step of the manufacturing process. The Company and its customers thereby realize the economic efficiencies of "fabless" production combined with tight quality control. Effective January 30, 1997, Level One was registered by Underwriters Laboratory as complying with the requirements of ISO 9001. BACKLOG As of December 28, 1997, the Company's total backlog scheduled to be shipped was approximately $70.9 million, as compared to backlog of approximately $32.6 million at December 29, 1996. A portion of the orders constituting the Company's backlog are subject to changes in delivery schedules or to cancellation at the option of the purchaser without significant penalty. The Company limits its reported backlog to those orders expected to ship within the next six months. COMPETITION The Company's competition consists of semiconductor companies and semiconductor divisions of vertically integrated companies. In the telecom market, the Company's principal competitors are Brooktree Corporation (a subsidiary of Rockwell International, Inc.), Crystal Semiconductor, Inc. (a subsidiary of Cirrus Logic, Inc.) ("Crystal"), Dallas Semiconductor, Inc., Lucent Technologies Inc. ("Lucent"), PMC-Sierra Inc. and Siemens A.G. In the networking market, the Company's principal competitors are Advanced Micro Devices, Inc., Broadcom Corporation, Crystal, Integrated Circuit Systems, Inc., Lucent, Micro Linear Corp., National Semiconductor Corporation, Quality Semiconductor, Inc., Seeq Technologies, Inc. and Texas Instruments, Incorporated. Level One believes that its competitive strengths include efficient distribution channels, highly experienced digital and mixed-signal circuit designers, proprietary design and development tools, and its library of analog and digital blocks and cells. The ability of the Company to compete successfully in the rapidly evolving area of high performance integrated circuit technology depends on factors both within and outside of its control. Such factors include, without limitation, success in designing and manufacturing new products, implementing new technologies, intellectual property programs, product quality, reliability, price, efficiency of production, and general economic conditions. Although the Company believes that it competes favorably, there is no assurance that the Company will be able to compete successfully in the future. PATENTS AND LICENSES Level One has 28 United States patents that expire from 2009 to 2017, 30 pending U.S. patent applications, 10 pending international patent applications, and two issued international patents. All of Level One's products are covered by at least one Level One patent. The Company has 31 U.S. mask work registrations on its products. Level One owns seven registered trademarks or servicemarks. The Company has initiated a patent infringement suit against one of its competitors relating to two of the Company's patents. See "Legal Proceedings". Level One has entered into various license agreements for product or technology exchanges. In general, these licenses are to provide second sources for standard products or to convey or receive rights to certain proprietary or patented cores, cells or other technology. EMPLOYEES As of December 28, 1997, the Company had 559 employees. The Company's employees are not represented by any collective bargaining agreement, and the Company has never experienced a work stoppage. The Company believes its employee relations are good. FACTORS THAT MAY AFFECT FUTURE RESULTS The following factors may have an impact on the Company's business: MANUFACTURING RISKS The Company does not manufacture the wafers used for its products. The Company's wafers are manufactured by foundries located in the United States, Europe and Asia. The Company depends upon these suppliers to produce wafers at acceptable yields and to deliver them in a timely manner at competitive prices. The Company may sustain an adverse impact on operating results from problems with the cost, timeliness, yield and quality of wafer deliveries from suppliers. From time to time, the available industry-wide foundry capacity can fluctuate significantly. During periods of constrained supply, the Company may experience difficulty in securing an adequate supply of wafers, and/or its suppliers may increase wafer prices. The Company's operating results depend in substantial part on its ability to maintain or increase the capacity available from its existing or new foundries. In prior years, the Company has experienced increased costs and delays in customer shipments as a result of a foundry reducing shipments to the Company without prior notice, requiring the Company to transfer products to a new foundry. Although the Company believes that it has planned to meet customer demand, there can be no assurances that unforeseen demand, current supplier interruptions or other changes will not have a material impact on the Company's business. Manufacturing process technologies are subject to rapid change. Other companies in the industry have experienced difficulty in migrating to new manufacturing processes, and, consequently, have suffered reduced yields, delays in product deliveries and increased expense levels. The Company's business, financial condition and results of operations could be materially adversely affected if any such transition is substantially delayed or inefficiently implemented. The Company is also dependent upon third-party assembly companies that package or test the Company's devices. The Company depends upon these suppliers to produce products in a timely manner and at competitive prices. The Company may sustain an adverse financial impact from problems with the cost, timeliness, yield and quality of product deliveries from these suppliers. FACTORS AFFECTING ANNUAL AND QUARTERLY OPERATING RESULTS The semiconductor industry is characterized by rapid technological change, intense competitive pressure and cyclical market patterns. The Company's results of operations are affected by a wide variety of factors, including general economic conditions, semiconductor industry environment, changes in average selling prices, the timing of new product introductions (by the Company and its customers), use of new technologies, the ability to safeguard patents and intellectual property, and rapid change of demand for products. The level of net revenues in any specific quarter can also be affected by the level of orders placed during that quarter. The Company attempts to respond to changes in market conditions as soon as possible; however, the rapidity of their onset may make prediction of and reaction to such events difficult. Due to the foregoing and other factors, past results, such as those described in this report, may not be predictive of future performance. DEPENDENCE ON NEW PRODUCTS The Company's future success depends on its ability to timely develop and introduce new products which compete effectively. Because of the complexity of its products, the Company may experience delays in completing development and introduction of new products, and, as a result, not achieve the market share anticipated for such products. The Company's strategy is to develop products for the fastest growing segments of the communications market. The Company conducts its own analysis of market trends and reviews forecasts and information provided by industry analysts. Market conditions may change rapidly as technology, economic, or user-preference conditions cause different communications technologies to experience growth other than that forecast by the Company or others. There can be no assurance that the Company will successfully identify new product opportunities and bring new products to market in a timely manner, that products or technologies developed by others will not render the Company's products or technologies obsolete or noncompetitive, or that the Company's products will be selected for design into the products of its targeted customers. In addition, the average selling price for any particular product tends to decrease over the product's life. To offset such price decreases, the Company relies primarily on obtaining yield improvements and corresponding cost reductions in the manufacture of existing products and on introducing new products which incorporate advanced features and other price/performance factors such that higher average selling prices and higher margins are achievable relative to existing product lines. To the extent that cost reductions and new product introductions with higher margins do not occur in a timely manner, or the Company's products do not achieve market acceptance, the Company's operating results could be adversely affected. MANAGEMENT OF GROWTH; DEPENDENCE ON KEY PERSONNEL The Company is currently experiencing a period of significant growth which has placed, and could continue to place, a significant strain on the Company's personnel and other resources. The Company's ability to manage its growth effectively will require continued expansion and refinement of the Company's operational, financial, management and control systems, as well as a significant increase in the Company's development, testing, quality control, marketing, logistics and service capabilities, any of which could place a significant strain on the Company's resources. The Company's success also depends to a significant extent upon its ability to retain and attract key personnel. Competition for such personnel is intense and there can be no assurance that the Company will be able to retain and attract key personnel. If the Company's management is unable to manage growth effectively, maintain the quality and marketability of the Company's products and retain, hire and integrate key personnel, the Company's business, financial condition and results of operations could be materially adversely affected. INTELLECTUAL PROPERTY The Company relies upon patent, trademark, trade secret and copyright law to protect its intellectual property. There can be no assurance that such intellectual property rights can be successfully asserted or will not be invalidated, circumvented or challenged. Litigation, regardless of its outcome, could result in substantial cost and diversion of resources for the Company. Any infringement claim or other litigation against or by the Company could have a material effect on the Company's financial condition and results of operations. In November 1995 the Company commenced infringement litigation against a competitor. See "Legal Proceedings". SEMICONDUCTOR INDUSTRY The semiconductor industry has historically been cyclical and subject to significant economic downturns at various times. The Company may experience substantial period-to-period fluctuations in operating results due to general semiconductor industry conditions, overall economic conditions or other factors. In addition, the securities of many high technology companies have historically been subject to extreme price and volume fluctuations, factors which may affect the market price of the Company's common stock. As is common in the semiconductor industry, the Company frequently ships more product in the third month of a quarter than in the other months. If a disruption in the Company's production or shipping occurs near the end of a quarter, the Company's revenues for that quarter could be adversely affected. The Company must order wafers and build inventory in advance of product shipments. There is risk that the Company could produce excess or insufficient inventories of particular products because the Company's markets are volatile and subject to rapid technology and price changes. This inventory risk is heightened because certain of the Company's customers place orders with long lead times which may be subject to cancellation or rescheduling by that customer. To the extent the Company produces excess or insufficient inventories of particular products, the Company's revenues and earnings could be adversely affected. Increased demand for semiconductor products may result in a reduction in the availability of wafers from foundries. Such capacity limitations may adversely affect the Company's ability to deliver products on a timely basis and affect the Company's margins. Additionally, the Company believes that during periods of strong demand and/or restricted semiconductor capacity, customers will over- order to assure an adequate supply. Certain of the Company's customers may cancel or postpone orders without notice if product becomes available elsewhere. Shortages of components from other suppliers could cause the Company's customers to cancel or delay programs incorporating the Company's products, resulting in the cancellation or delay of orders for the Company's products. INTENSE COMPETITION The semiconductor industry is intensely competitive. The Company's competition consists of semiconductor companies and semiconductor divisions of vertically integrated companies. In the telecom market, the Company's principal competitors are Brooktree Corporation (a subsidiary of Rockwell International, Inc.), Crystal Semiconductor, Inc. (a subsidiary of Cirrus Logic, Inc.) ("Crystal"), Dallas Semiconductor, Inc., Lucent Technologies Inc. ("Lucent"), PMC-Sierra Inc. and Siemens A.G. In the networking market, the Company's principal competitors are Advanced Micro Devices, Inc., Broadcom Corporation, Crystal, Integrated Circuit Systems, Inc., Lucent, Micro Linear Corp., National Semiconductor Corporation, Quality Semiconductor, Inc., Seeq Technologies, Inc. and Texas Instruments, Incorporated. Many of these competitors have longer operating histories, greater name recognition, access to larger customer bases and significantly greater financial and other resources than the Company with which to pursue engineering, manufacturing, marketing and distribution of products. The ability of the Company to compete successfully in the rapidly evolving area of high performance integrated circuit technology depends on factors both within and outside of the Company's control. Such factors include, without limitation, success in designing and manufacturing new products, implementing new technologies, intellectual property programs, product quality, reliability, price, efficiency of production, and general economic conditions. There is no assurance that the Company will be able to compete successfully against current and future competitors. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which may have a material adverse effect on the Company's business, financial condition and results of operations. INTERNATIONAL OPERATIONS Due to its reliance on international sales and foreign third-party manufacturing and assembly operations, the Company is subject to the risks of conducting business outside of the United States including government regulatory risks, political, social and economic instability, potential hostilities and changes in diplomatic and trade relationships. There can be no assurance that one or more of the foregoing factors will not have a material adverse effect on the Company's business, financial condition or operating results. The recent economic downturn in several Asian countries has not affected the Company in a material way, but there can be no assurances that continued economic problems in Asia or any other region of the world will not affect the Company. INCREASED LEVERAGE As a result of the Company's sale in August and September 1997 of its 4% Convertible Subordinated Notes due 2004 (the "Notes"), the Company has incurred approximately $115.0 million in additional indebtedness which increases the ratio of its long-term debt to its total capitalization from 3.0%, at June 29, 1997, to 48.8%, at December 28, 1997. As a result of this increased leverage, the Company's interest obligations will increase substantially. The degree to which the Company will be leveraged could adversely affect the Company's ability to obtain additional financing for working capital, acquisitions or other purposes and could make it more vulnerable to economic downturns and competitive pressures. The Company's increased leverage could also adversely affect its liquidity, as a substantial portion of available cash from operations may have to be applied to meet debt service requirements and, in the event of a cash shortfall, the Company could be forced to reduce other expenditures and forego potential acquisitions to be able to meet such requirements. VOLATILITY OF NOTES AND STOCK PRICE Economic and other external factors, many of which are beyond the control of the Company, may have a significant impact on the Company's business and on the market price of its Notes and the Common Stock. Such factors include, without limitation, fluctuations in product revenue and net income of the Company or its competitors, shortfalls in the Company's operating results from levels forecast by securities analysts, announcements concerning the Company, its competitors or customers, announcements of technological innovations by the Company, its competitors or its customers, the introduction of new products or changes in product pricing policies by the Company, its competitors or its customers, market conditions in the industry and the general state of the securities market. In addition, the stock prices of many technology companies fluctuate significantly for reasons that may be unrelated or disproportionate to operating results. These fluctuations, as well as general economic, political and market conditions such as recession or international instability, may adversely affect the market price of the Notes and the Common Stock. ITEM 2. PROPERTIES The Company's principal facilities are in two separately leased buildings in an office park in Sacramento, California. The two leases relate to buildings with 87,000 square feet of space and 51,000 square feet of space, and expire in 2008 and 2006, respectively. The Company has entered into leases for additional space currently under construction. These leases relate to buildings with 24,100 square feet of space and 139,500 square feet of space, respectively, and terminate in 2013. The Company also leases approximately 11,000 square feet for the operations of San Francisco Telecom under a lease that is scheduled to expire in 2000. The Company also leases small office facilities for the operation of its design centers and for its domestic and international sales offices. The Company believes these facilities are adequate for its current and immediately foreseeable level of operations. ITEM 3. LEGAL PROCEEDINGS On November 28, 1995, the Company initiated a patent infringement suit against Seeq Technologies, Inc. in United States District Court for the Northern District of California. The suit relates to two Level One patents, No. 5,267,269 and No. 5,249,183, and to certain Seeq products used in Ethernet system products. The suit seeks damages and injunctive relief. Seeq has denied the allegations. On January 21, 1998, the Court denied Seeq's motion to declare claims of the Level One patents invalid. The Court also permitted Seeq to amend its counterclaim to include a claim that certain of the Company's products infringe Seeq's U.S. Patent 5,504,738; the Company has denied these allegations. Trial is set for August 1998. Although the Company does not believe such litigation will have a material impact on the Company, litigation, regardless of its outcome, could result in substantial cost and diversion of resources of the Company. There are no other material pending legal proceedings, other than routine litigation incidental to the Company's business, to which the Company is a party or of which any of its property is the subject. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of the 1997 fiscal year to a vote of security holders, through the solicitation of proxies or otherwise. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS PRICE RANGE OF COMMON STOCK The Company's Common Stock has been traded on the NASDAQ National Market System under the symbol LEVL since its initial public offering on August 19, 1993 at $7{9}/{16} per share (rounded to the nearest {1}/{16}). The following table sets forth, for the fiscal quarters indicated, the high and low closing sale prices of the Common Stock as reported by NASDAQ National Market System (rounded to the nearest {1}/{16}). The Company's fiscal year ends on the Sunday nearest to the calendar year end in each year. In July 1997, the Board of Directors authorized a 3 for 2 stock split, which was effective on August 26, 1997. All common stock amounts and per share amounts have been retroactively adjusted to reflect the stock split. On February 23, 1998, the Company announced that it had approved a 3-for-2 stock split effective March 30, 1998, to shareholders of record on March 9, 1998. Common stock amounts and per share data included in the Company's reports filed prior to March 30, 1998 do not reflect the effect of this split.
Year High Low 1997 Fourth Quarter $47 $25{7}/{8} Third Quarter $39{3}/{8} $24 1/2 Second Quarter $26{11}/{16} $14{11}/{16} First Quarter $24 1/2 $19 1996 Fourth Quarter $25 $17{7}/{8} Third Quarter $19{ 11}/{16} $10{13}/{16} Second Quarter $20{5}/{16} $12{13}/{16} First Quarter $24{3}/{16} $11{3}/{16}
On March 1, 1998, the closing sale price for the Company's Common Stock was $44{15}/{16} per share. As of March 1, 1998, there were approximately 178 holders of record of the Company's Common Stock. The Company has never paid dividends on its Common Stock and does not anticipate paying any dividends in the foreseeable future. The Company's bank line of credit agreement prohibits the payment of dividends on its capital stock (other than dividends payable solely in the Company's stock) without the prior written consent of the bank. The Company intends to retain its earnings for the operation of its business. ITEM 6. SELECTED FINANCIAL DATA
AS OF FISCAL YEAR END (IN THOUSANDS) 1997 1996 1995 1994 1993 BALANCE SHEET DATA: Cash and cash equivalents $ 25,234 $ 20,251 $ 21,628 $ 9,260 $15,141 Working capital 166,239 50,871 50,834 48,231 21,605 Total assets 277,697 112,102 100,801 71,628 33,060 Long-term obligations (less current portion) 117,475 3,806 4,463 361 2,431 Shareholders' equity 123,445 95,581 78,965 63,309 23,910
FISCAL YEAR (IN THOUSANDS, EXCEPT PER SHARE 1997 1996 1995 1994 1993 DATA) Statement of Income Data: Revenues $156,262 $111,987 $ 78,018 $ 46,825 $ 25,984 Cost of sales 65,299 48,477 33,300 18,785 9,782 Gross margin 90,963 63,510 44,718 28,040 16,202 Operating expenses: Research and development (1) 30,398 24,505 17,857 9,956 5,934 Sales and marketing 23,978 16,589 11,372 6,772 4,102 General and administrative 10,212 6,741 5,752 3,424 1,936 Total operating expenses 64,588 47,835 34,981 20,152 11,972 Operating income 26,375 15,675 9,737 7,888 4,230 Net interest and other income (2) 2,263 2,293 2,064 1,440 12 Provision for income taxes 9,447 6,755 1,543 1,323 503 Net income $ 19,191 $11,213 $10,258 $ 8,005 $ 3,739 Basic earnings per share $ 0.95 $ 0.58 $ 0.54 $ 0.43 $ 0.25 Diluted earnings per share $ 0.89 $ 0.55 $ 0.51 $ 0.40 $ 0.23
(1)Includes one-time charges for research and development relating to the acquisitions of Silicon Design Experts, Inc., in 1996 of $2,500,000, and San Francisco Telecom, Inc., in 1995 of $750,000. (2)A one-time gain relating to the sale of a portion of a minority interest in Maker Communications, Inc., of $675,000, is included in 1996. SELECTED QUARTERLY FINANCIAL DATA
Fiscal 1997 Quarters Fiscal 1996 Quarters (IN THOUSANDS EXCEPT PER SHARE DATA) STATEMENT OF INCOME DATA: FIRST SECOND THIRD FOURTH FIRST SECOND THIRD FOURTH Revenues $30,107 $32,642 $42,438 $51,075 $27,542 $27,479 $27,363 $29,603 Cost of sales 12,900 13,566 17,653 21,180 11,588 11,521 11,756 13,612 Gross margin 17,207 19,076 24,785 29,895 15,954 15,958 15,607 15,991 Operating expenses: Research and development 6,341 6,738 8,135 9,184 5,675 5,739 5,249 7,842 Sales and marketing 4,299 4,754 6,470 8,455 4,001 3,989 4,219 4,380 General and administrative 1,802 2,221 2,826 3,363 1,766 1,765 1,595 1,615 Total operating expenses 12,442 13,713 17,431 21,002 11,442 11,493 11,063 13,837 Operating income 4,765 5,363 7,354 8,893 4,512 4,465 4,544 2,154 Net interest and other income 366 492 708 697 392 349 1,084 468 Provision for income taxes 1,674 1,932 2,661 3,180 1,618 1,590 1,857 1,690 Net income $ 3,457 $ 3,923 $ 5,401 $ 6,410 $3,286 $3,224 $3,771 $ 932 Basic earnings per share $ 0.17 $ 0.19 $ 0.27 $ 0.31 $ 0.17 $ 0.17 $ 0.19 $ 0.05 Diluted earnings per share $ 0.17 $ 0.18 $ 0.25 $ 0.29 $ 0.16 $ 0.16 $ 0.18 $ 0.05
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Since its inception, the Company has designed, developed and marketed application specific standard product ("ASSP") integrated circuits and custom derivatives for the telecom and networking markets. Volume shipments of its initial ASSPs began in 1989. Since that time, the Company has experienced significant increases in sales as its mixed- signal integrated circuits have gained market acceptance. The Company's annual revenue compound growth rate has been 101% since 1990. The Company first achieved profitable operations in the quarter ended March 28, 1992 and has been profitable in each subsequent quarter. The Company derives revenues principally from product sales. In addition, the Company has received non-recurring engineering and licensing revenue from strategic partners and customers in connection with product development projects. As a result of those and other transactions, the Company receives royalties and license fees. The Company's cost of sales includes the costs of wafer fabrication and assembly performed by third party vendors, and costs associated with the procurement, scheduling, testing and quality assurance functions performed by the Company. Research and development expenses associated with non-recurring engineering contracts are expensed as incurred, while the related revenue is recognized only as contract milestones are completed. This report contains forward-looking statements that involve risks and uncertainties. The statements contained in this report that are not purely historical are forward- looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including without limitation statements regarding the Company's expectations, beliefs, intentions or strategies regarding the future. All forward- looking statements included in this document are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward-looking statements. The Company's actual results could differ materially from those anticipated in these forward-looking statements. See "Factors that May Affect Future Results". RESULTS OF OPERATIONS REVENUES: Revenues for 1997 increased to $156.3 million from $112.0 million in 1996 and $78.0 million in 1995. The continued growth in revenues is due to the successful introduction of new products and increased sales of existing products to customers in the Company's two target market segments - telecom and networking. In 1997 and 1995, no single customer accounted for more than 10% of revenues. In 1996, sales to Hewlett-Packard were 11.2% of total sales. Export sales, primarily consisting of sales to Canada, Europe, and Asia, were 35% of revenues in 1997, 39% in 1996 and 33% in 1995. All sales were in U.S. dollars, thereby eliminating any foreign currency impact on revenues and net income. The dollar increase in international sales is attributable to increased sales to foreign manufacturing facilities and subcontractors of domestic customers and the Company's increased international marketing and sales efforts. ROYALTIES, LICENSES AND NON-RECURRING ENGINEERING REVENUE: The Company has entered into development agreements with certain customers relating to customer- specific applications, as well as license agreements with certain semiconductor manufacturers. Revenue is not recognized for non-recurring engineering ("NRE") contracts until contract milestones are met, although expenditures associated with the contract are expensed as incurred. During 1997, the Company had $56,000 in revenues from NRE contracts versus $398,000 in 1996 and $289,000 in 1995. In 1997, the Company received royalties of $987,000. In 1996 and 1995, royalties were $197,000 and $312,000, respectively. The Company believes future revenue growth will depend on the success and timing of new products along with continued sales growth of existing products. New products are generally incorporated into a customer's product or system at the design stage. However, design wins may precede volume sales by six months or more. No assurance can be given that any design win will result in future revenues. GROSS MARGIN: The following table sets forth the Company's product sales and product gross margin:
(DOLLARS IN THOUSANDS) 1997 1996 1995 Product Sales $155,219 $111,392 $77,417 . Cost of product sales 65,299 48,477 33,300 . Gross margin $ 89,920 $ 62,915 $44,117 Gross margin % product 57.9% 56.5% 57.0% sales..
Product gross margin is affected by several factors, including average selling prices, the mix between older and newer products, test equipment utilization, manufacturing yields, timing of cost reductions and the mix between direct and distributor sales. Margins on domestic and international sales are similar. Beginning in 1996, certain engineering costs associated with product cost reduction efforts were more appropriately allocated to cost of product sales rather than research and development. This caused margins to decline by approximately 2.0 percentage points in 1996, while reducing research and development expense a similar amount. There was no net impact on operating profit. RESEARCH AND DEVELOPMENT: Research and development ("R&D") expenses were $30.4 million in 1997, $24.5 million in 1996 and $17.9 million in 1995. As a percent of revenues, R&D expenses were 19.5%, 21.9%, and 22.9% in 1997, 1996 and 1995, respectively. In 1996, R&D expense included a one-time charge for purchased research and development of $2.5 million related to the acquisition of Silicon Design Experts, Inc. In 1995, R&D expense included a one-time charge for purchased research and development of $750,000 associated with the acquisition of San Francisco Telecom, Inc. Excluding one time charges, R&D expense as percent of revenues was 19.6% and 21.9% for 1996 and 1995, respectively. As previously stated in the gross margin section, in 1996 the Company began accounting for engineering costs associated with product cost reduction efforts in cost of product sales, rather than R&D. SALES AND MARKETING: Sales and marketing expenses were $24.0 million in 1997, $16.6 million in 1996 and $11.4 million in 1995. As a percent of revenue, sales and marketing expenses were 15.3%, 14.8% and 14.6% in 1997, 1996 and 1995, respectively. The increases in sales and marketing expenses are largely due to increased sales, sales support and application engineering headcount and associated expense increases. The Company has also increased its international sales offices and support staff. GENERAL AND ADMINISTRATIVE: General and administrative expenses increased to $10.2 million in 1997 from $6.7 million in 1996 and $5.8 million in 1995. As a percentage of revenue, expenses were 6.5% in 1997, compared to 6.0% in 1996 and 7.4% in 1995. The expense increases in dollars are primarily attributable to additional headcount and associated expenses due to the Company's growth. NET INTEREST AND OTHER INCOME: The Company earns interest on its cash and investments and incurs interest expense on its convertible subordinated notes and on lease obligations used to finance certain capital equipment. Net interest and other income for 1997 and 1996 was $2.3 million versus $2.1 million in 1995. In 1996, other income included a one-time gain of $675,000 from the sale of a portion of the Company's investment in Maker Communications. PROVISION FOR INCOME TAXES: The Company's effective income tax rate was 33.0% for 1997. In 1996 and 1995, the effective rate was 37.6% and 13.1%. For a reconciliation of the Company's effective tax rate to the statutory federal tax rate, see Note 6 of Notes to Financial Statements. LIQUIDITY AND CAPITAL RESOURCES During the years ended 1997, 1996 and 1995, the Company financed its operations primarily through cash flows from operations and existing cash and investment balances. During the third quarter of 1997 the Company raised $115 million (less discounts, commissions and expenses of approximately $3.5 million) from a private placement to qualified investors of subordinated convertible notes due 2004 with a 4% coupon. Working capital as of December 28, 1997, was $166.2 million. The Company's principal sources of liquidity as of December 28, 1997, consisted of $137.8 million in cash and short-term investments and $10.0 million available under the Company's line of credit. As of December 28, 1997, the Company had no outstanding balance under this line of credit. During 1997, the Company generated $25.3 million of cash from its operating activities as compared to $22.5 million in 1996 and $7.5 million in 1995. In 1997, trade accounts receivable increased by $12.4 million due to increased sales levels. Inventories increased by $16.1 million to $26.1 million at the end of 1997. Days of inventory on hand were 111 days at the end of 1997. Current liabilities increased $24.1 million from year end 1996 to 1997. During 1997, 1996, and 1995, total expenditures for capital equipment were $17.0 million, $9.8 million, and $10.0 million, respectively. The expenditures in each year consisted primarily of equipment used for designing and testing products. Included in the total capital expenditures were amounts of $0.7 million in 1996 and $4.8 million in 1995 for equipment financed by capital leases. The Company's current wafer requirements are supplied primarily by six foundries. During 1995, the Company entered into five-year agreements with three of its suppliers for committed foundry capacity in consideration of equipment financing or cash deposits. At December 28, 1997, the Company had provided an aggregate of $20.6 million in capital equipment financing and/or cash deposits to these foundries to obtain committed foundry capacity. During the first quarter of 1998, the Company paid an aggregate $1.3 million in additional deposits per its agreements. There are no additional deposits due under the Company's existing foundry agreements. The Company expects to finance its 1998 capital equipment requirements using a combination of cash and equipment leasing. The Company believes that its existing cash resources, combined with cash generated from operations, equipment lease management, and its line of credit will be sufficient to meet the Company's cash requirements through the end of 1998. However, the Company may from time to time seek additional equity or debt financing as a result of the capital intensive nature of the semiconductor industry. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA The Company's financial statements included with this Form 10-K are set forth under Item 14 hereof. ITEM 9.DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has been no change of accountants nor any disagreements with accountants on any matter of accounting principles or practices or financial statement disclosure required to be reported under this Item. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT EXECUTIVE OFFICERS AND DIRECTORS The executive officers and directors of the Company and their ages as of March 1, 1998, are as follows:
NAME AGE POSITION WITH THE COMPANY Robert S. Pepper, Ph.D. 62 President, Chief Executive Officer and Chairman of the Board of Directors John Kehoe 52 Senior Vice President and Chief Financial Officer Daniel S. Koellen 40 Vice President, Quality and Reliability George A. Papa 49 Vice President, Worldwide Sales Michael A. Ricci 42 Vice President, Telecom Michael R. Wodopian 45 Vice President, Business Development and Strategic Planning Manuel D. Yuen 57 Vice President, Operations Thomas J. Connors(1)(2) 68 Director Paul Gray, Ph.D. 55 Director Martin Jurick (2) 60 Director Henry Kressel, Ph.D.(2) 64 Director Joseph P. Landy(1) 36 Director
(1) Member of the Audit Committee (2) Member of the Compensation Committee Dr. Pepper joined the Company in July 1986 as President, Chief Executive Officer and a director. He became Chairman of the Board of Directors in January 1993. From 1979 until 1984, Dr. Pepper was Vice President and General Manager of the Solid State division of RCA Corporation. Prior to joining RCA, Dr. Pepper had spent over 15 years in the semiconductor industry, including positions as Vice President and General Manager of the Semiconductor Division at Analog Devices, Inc. Dr. Pepper holds B.S., M.S. and Ph.D. degrees in Electrical Engineering from the University of California at Berkeley. Mr. Kehoe joined the Company in October 1995 as Vice President and Chief Financial Officer. In November 1997, Mr. Kehoe was elected Senior Vice President. Immediately prior to joining the Company Mr. Kehoe served as Senior Vice President and Chief Financial Officer for Focus Surgery, Inc., a medical device manufacturer. From 1992 to 1993 he served as Vice President, Finance and Chief Financial Officer for Celeritek, Inc., a microwave systems company. From 1989 to 1992 he served as Vice President, Finance and Chief Financial Officer of Poqet Computer Corp., a computer manufacturer. Prior to 1989 he worked in various financial and CFO positions for approximately 14 years with high technology companies, including Texas Instruments. Mr. Kehoe holds an MBA from Fordham University and a BBA from Manhattan College. Mr. Koellen has been responsible for the Quality and Reliability function since he joined the Company in January 1989, serving as Manager until January 1992, then as Director until January 1993 when he was promoted to Vice President of Quality and Reliability. From 1985 to 1989, Mr. Koellen was Lead Failure Analysis Engineer for the Denver Aerospace Division of Martin Marietta Corp. Prior to joining Martin Marietta, Mr. Koellen managed the surface analysis laboratory for Mostek Corporation, a supplier of dynamic random access memory integrated circuits. Mr. Koellen holds an M.S. in Engineering and Applied Science from Southern Methodist University and a B.S. in Applied Mathematics, Engineering and Physics from the University of Wisconsin. Mr. Papa joined the Company in February 1997 as Vice President, Worldwide Sales. Prior to joining the Company, he had been employed since 1991 as Vice President of Sales for North America by Siemens Components Corporation, a division of Siemens. Previously Mr. Papa was employed in other management and sales positions with Siemens Components Corporation, LSI Logic Corporation, Intel Corporation, and Tektronix. Mr. Papa holds a B.S.E.E. from Northeastern University Mr. Ricci joined the Company in August 1997. Prior to joining the Company, Mr. Ricci was Director of Wireless Communication at Advanced Micro Devices. Prior to this role, Mr. Ricci held the position of Director, Desktop Networking, at AMD. Mr. Ricci worked at AMD for 17 years. Prior to AMD Mr. Ricci worked at Siliconix, Inc. in the communications area for two years. Mr. Wodopian joined the Company in January 1998. Prior to joining Level One, Mr. Wodopian spent over 16 years at Advanced Micro Devices, most recently as the Director of Marketing for the Communications Products Division. Prior to that, he spent four years at AMD's European headquarters as Director of Marketing for Europe. During the balance of his tenure at AMD, he served in a variety of program management and field applications roles. Prior to working at AMD, Mr. Wodopian was responsible for microprocessor based system level designs for the process control and aerospace industries. Mr. Yuen was Director of Operations from the time he joined the Company in February 1991 until January 1992, when he was promoted to Vice President of Operations. Prior to joining the Company, Mr. Yuen spent over 20 years at National Semiconductor Corporation, a semiconductor manufacturer, as Director of its Santa Clara foundry from 1986 to 1987 and as Vice President-Military Aerospace Division from 1987 to 1989. Mr. Yuen holds a B.S. and an M.S. in Electrical Engineering from the University of California at Berkeley. Mr. Connors has been a director of the Company since April 1991. Since 1980, Mr. Connors has been the principal of TJC Investments, an independent consulting firm that works with companies in the semiconductor and related industries. Previously, Mr. Connors was employed by Motorola, Inc., where he last served as Vice President and General Manager of the Semiconductor Division. Mr. Connors is also a member of the Board of Directors of SGS-Thomson Microelectronics, Inc., a wholly-owned subsidiary of SGS-N.V. Dr. Gray has been a director since April 1994. Dr. Gray is the Dean of the College of Engineering at the University of California, Berkeley. From 1990 to 1993, he served as Chairman of the Electrical Engineering and Computer Sciences Department, and as Vice Chairman of the Department from 1988 to 1990. He served as a director of Microlinear Corporation from 1988 to 1991. He has published more than 100 papers in the electrical engineering field, has served on numerous industry committees, and holds 10 patents. Mr. Jurick has been a director of the Company since April 1991. Since 1984, Mr. Jurick has been a Senior Vice President of Silicon Systems, Inc. ("SSI"), a semiconductor manufacturing company, which until 1996 was a wholly owned subsidiary of TDK Corporation, and in 1996 became a division of Texas Instruments Inc. Mr. Jurick also serves as a director of Microsemi Corp. Dr. Kressel has been a director of the Company since August 1987. Since 1985, Dr. Kressel has been a Managing Director at E.M. Warburg, Pincus & Co., LLC (''EMW''), an investment firm, where he has been employed since 1983. Prior to joining EMW, Dr. Kressel spent 20 years at RCA Laboratories, where he became a Staff Vice President. Dr. Kressel is also a member of the Board of Directors of IA Corporation, Nova Corporation, Maxis, Inc., and Trescom International. Mr. Landy has been a director of the Company since January 1991. Since January 1994, Mr. Landy has served as a Managing Director at EMW, where he has been employed since 1985. Prior to joining EMW, Mr. Landy was employed by Dean Witter Realty, Inc., the real estate investment banking affiliate of Dean Witter Reynolds, Inc., as a financial analyst. He also serves as a director of NOVA Corporation, Indus International, Inc., and CN Biosciences, Inc. Directors are elected by the shareholders at each annual meeting to serve until the next annual meeting of shareholders or until their successors are duly elected and qualified. Officers are elected to serve, subject to the discretion of the Board of Directors, until their successors are appointed. There are no family relationships between any directors or executive officers. There are no agreements or other arrangements or understandings pursuant to which any director of the Company will be selected as a director or nominee. Non-employee, non-affiliated Directors of the Company receive $1,800 per day for each day devoted to Company Board or committee meetings. The Company reimburses each director for reasonable expenses of attending meetings of the Board of Directors and any committees thereof. Non-affiliated non-employee directors receive an annual automatic option grant of 3,000 shares at the end of each year. In 1997, Warburg Pincus Capital Co., an affiliate of EMW, distributed substantially all of its shares of Company stock. Dr. Kressel and Mr. Landy each then became entitled to automatic grants of options to purchase an aggregate of 15,000 shares vesting over five years. SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE To the Company's knowledge, based solely on its review of the copies of such reports furnished to the Company and written representations that no other reports were required, all Section 16(a) filing requirements applicable to its officers, directors and greater than ten percent beneficial owners were complied with during the fiscal year ended December 28, 1997. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth the compensation earned by the Company's Chief Executive Officer and the four other highest paid executive officers whose compensation for the 1997 fiscal year was in excess of $100,000 (collectively the "Named Officers"). SUMMARY COMPENSATION TABLE
LONG-TERM COMPENSATION ALL ANNUAL SECURITIES OTHER COMPENSATION (1) UNDERLYING COMPENSATION NAME AND PRINCIPAL POSITION YEAR SALARY ($) BONUS ($) OPTIONS (#) ($)(2) Robert S. Pepper, Ph.D. 1997 325,846 583,554 390,000 2,794 President, Chief 1996 296,923 185,382 90,000 6,276 Executive Officer and Chairman of 1995 220,000 97,172 --- 4,280 the Board John Kehoe 1997 186,056 201,859 80,000 1,617 Senior Vice President and 1996 153,182 81,508 30,000 1,800 Chief Financial Officer 1995 27,115 12,500 105,000 --- George Papa 1997 142,697 142,350 105,000 17,116 Vice President, Worldwide Sales Manuel D. Yuen 1997 158,711 81,741 22,050 1,376 Vice President, 1996 142,654 28,028 37,950 2,811 Operations 1995 119,674 16,846 49,500 2,443 Daniel S. Koellen 1997 135,740 61,434 6,000 1,253 Vice President, Quality & 1996 120,042 30,726 47,250 3,283 Reliability 1995 106,292 15,227 34,650 3,120
(1) Annual compensation amounts include amounts deferred at the election of the Named Officer pursuant to the Company's 401(k) plan. (2) Other compensation represents the Company's 401(k) matching contributions, and, in the case of Mr. Papa, an automobile allowance. OPTION GRANTS IN LAST FISCAL YEAR AND YEAR- END OPTION VALUES The following table sets forth certain information concerning grants of stock options to each of the Named Officers during the fiscal year ended December 28, 1997. The options listed were granted under the 1993 Option Plan. In accordance with the rules of the Securities and Exchange Commission, also shown is the potential realizable value based on the assumed rates of stock price appreciation of 5% and 10%, compounded annually, from the date the option was granted over the full option term. These amounts represent certain assumed rates of appreciation only and do not represent the Company's estimate of future stock price. Actual gains, if any, on stock option exercises are dependent on the future performance of the Common Stock. OPTION GRANTS IN LAST FISCAL YEAR
INDIVIDUAL GRANTS Potential Realizable Value at Assumed Number of % of Total Annual Rates of Securities Options Stock Price Underlying Granted to Exercise Appreciation for Options Employees in Price Expiration OPTION TERM (1) NAME GRANTED (#) FISCAL YEAR ($/SHARE) DATE 5% ($) 10% ($) Robert S. Pepper, Ph.D. 225,000 13.9 15.54 4/4/07 2,199,932 5,575,498 165,000 10.2 28.13 12/18/07 2,918,464 7.392,961 John Kehoe 45,000 2.8 15.54 4/4/07 439,986 1,115,099 35,000 2.2 28.13 12/18/07 619,068 1,568,840 Manuel D. Yuen 22,050 1.4 15.54 4/4/07 215,593 546,398 Daniel S. Koellen 6,000 .4 15.54 4/4/07 58,664 148,679 George Papa 105,000 6.5 19.00 2/11/07 1,255.079 3,180,867
(1) There is no assurance provided to any executive officer or any other holder of the Company's securities that the actual stock price appreciation over the 5-year option term will be at the assumed 5% and 10% levels or at any other defined level. Unless the market price of the Common Stock appreciates over the option term, no value will be realized from the option grants made to the executive officers. The following table provides information with respect to the Named Officers concerning the exercise of options during the last fiscal year and unexercised options held as of December 28, 1997: AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES
NUMBER OF SECURITIES VALUE OF UNEXERCISED SHARES UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS ACQUIRED VALUE OPTIONS AT FISCAL YEAR END At Fiscal Year End ($)(1) (#) ON EXERCISE (#) REALIZED($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE Robert S. Pepper, Ph.D. 85,000 2,950,397 208,034 577,500 4,907,108 6,008,744 John Kehoe 7,500 92,624 42,000 165,500 528,498 1,692,745 Manuel D. Yuen 56,250 2,510,218 45,487 97,763 1,047,062 1,591,577 Daniel S. Koellen 0 0 65,362 75,188 1,588,245 1,264,282 George Papa 0 0 0 105,000 0 918,750
(1) Based upon the market price of $28.00 per share, which was the closing price per share on the NASDAQ National Market System on the last day of the 1997 fiscal year, less the option exercise price payable per share. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth certain information regarding beneficial ownership of the Company's Common Stock as of March 1, 1998, by (i) each person (or group of affiliated persons) known by the Company to own beneficially more than 5% of the Company's Common Stock, (ii) each of the Company's directors, (iii) each Named Officer, and (iv) the Company's directors and executive officers as a group. Except as indicated in the footnotes to this table, the persons named herein, based on information provided by such persons, have sole voting and investment power with respect to all shares of Common Stock shown as beneficially owned by them, subject to community property laws, where applicable.
SHARES BENEFICIALLY DIRECTORS, NAMED OFFICERS AND 5% SHAREHOLDERS OWNED NUMBER PERCENT (1) Kopp Investment Advisors, Inc. (2) 2,999,181 14.6% 6600 France Avenue South, Suite 672 Edina, Minnesota 55435 Robert S. Pepper, Ph.D. (3) 427,283 2.0% Thomas J. Connors (4) 70,125 * Paul Gray (5) 34,500 * Martin Jurick (6) 24,000 * Henry Kressel, Ph.D. (7) 18,780 * Joseph P. Landy (8) 32,368 * John Kehoe (9) 57,750 * Daniel S. Koellen (10) 106,735 * George Papa (11) 23,527 * Manuel D. Yuen (12) 96,274 * All Named Officers and Directors as a group (10 persons) 891,342 4.3%
(1) Percent ownership is based on 20,576,916 shares of Common Stock outstanding as of March 1, 1998, plus shares issuable pursuant to options or warrants held by the person or class in question that are exercisable within 60 days after March 1, 1998. (2) Includes 2,873,181 shares over which Kopp Investment Advisors, Inc. exercises investment discretion, but for which it is not the record holder; 15,000 shares which Kopp Investment Advisors, Inc., owns directly; 6,000 shares owned by Kopp Investment Advisors, Inc., Profit Sharing Plan; 75,000 shares owned by LeRoy C. Kopp Individual Retirement Plan; and 30,000 shares owned by Kopp Family Foundation. (3) Includes 306,784 shares issuable under stock options held by Dr. Pepper exercisable within 60 days of March 1, 1998. (4) Includes 43,125 shares issuable under stock options held by Mr. Connors exercisable within 60 days of March 1, 1998. (5) Includes 34,500 shares issuable under stock options held by Dr. Gray exercisable within 60 days of March 1, 1998. (6) Includes 9,000 shares issuable under stock options held by Mr. Jurick exercisable within 60 days of March 1, 1998. (7) Includes 993 shares held of record by Warburg Pincus Capital Co. ("Warburg"). Dr. Kressel is a managing director of a Warburg affiliate, and disclaims beneficial ownership of such shares. (8) Includes 993 shares held of record by Warburg. Mr. Landy is a managing director of a Warburg affiliate, and disclaims beneficial ownership of such shares. (9) Includes 57,750 shares issuable under stock options held by Mr. Kehoe exercisable within 60 days of March 1, 1998. (10) Includes 89,924 shares issuable under stock options held by Mr. Koellen exercisable within 60 days of March 1, 1998. (11) Includes 21,000 shares issuable under stock options held by Mr. Papa exercisable within 60 days of March 1, 1998. (12) Includes 76,236 shares issuable under stock options held by Mr. Yuen exercisable within 60 days of March 1, 1998. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In connection with securing a loan from Warburg in 1992, the Company issued a warrant to purchase 304,119 shares of its common stock at an exercise price of $1.03 per share. The warrant was exercised January 16, 1997, for 289,131 shares, and the balance was surrendered, on a net appreciation basis, in an amount equal to the exercise price. Directors Kressel and Landy, each of whom is an affiliate of the entity controlling Warburg, disclaims beneficial ownership, for purposes of Section 16 of the Act and otherwise, of such common stock. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Company's Compensation Committee currently consists of directors Connors, Jurick and Kressel. The Compensation Committee reviews and approves the compensation of the Company's executive officers. The compensation of the Chief Executive Officer is subject to approval by the Board of Directors. Mr. Connors was paid $77,400 during 1997 for consulting services rendered under an agreement with the Company, and was granted options to purchase 22,500 shares at a price of $15.54 per share, the market price on the grant date. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS REPORT:
FORM 10-K PAGE NO. 1. Financial Statements: Report of Independent Public Accountants __ Consolidated Balance Sheets as of December 28, 1997 and December 29, 1996 __ Consolidated Statements of Income for fiscal years ended December 28, 1997, December 29, 1996, and December 30, 1995 __ Consolidated Statements of Shareholders' Equity for fiscal years ended December 28, 1997, December 29, 1996, and December 30, 1995 __ Consolidated Statements of Cash Flows for fiscal years ended December 28, 1997, December 29, 1996, and December 30, 1995 __ Notes to Financial Statements __ 2. FINANCIAL STATEMENT SCHEDULES: II-Valuation and Qualifying Accounts __
ALL OTHER SCHEDULES ARE OMITTED BECAUSE THEY ARE NOT APPLICABLE OR THE REQUIRED INFORMATION IS SHOWN IN THE FINANCIAL STATEMENTS OR NOTES THERETO. 3. EXHIBITS:
EXHIBIT NUMBER 3.1* Amended and Restated Articles of Incorporation of the Company, as amended. 3.2(1) Bylaws of the Company, as amended. 4.1(10) Indenture dated as of August 15, 1997 between the Company and State Street Bank and Trust Company of California (National Association) as Trustee. 4.2(10) Form of 4% Convertible Subordinated Note due 2004. 10.1(1) 1985 Incentive Stock Option, Nonqualified Stock Option and Restricted Stock Purchase Plan, as amended. 10.2(9) 1993 Stock Option Plan, as amended and restated. 10.3(1) Amended and Restated Employee Stock Purchase Plan. 10.4(1) Form of Directors' Indemnification Agreement. 10.5(2) Consulting Agreement with Thomas J. Connors, as amended. 10.6(3) Consulting Agreement with Paul Gray 10.7(4) Agreement and Plan of Reorganization (San Francisco Telecom, Inc.) 10.8(5) Foundry Agreement 10.9(6) Deposit Agreement 10.10(7) Agreement and Plan of Reorganization (Silicon Design Experts, Inc.) 10.11(8) Amendment to Deposit Agreement 22.1* Subsidiaries of Registrant. (see page S-3) 24.1* Consent of Arthur Andersen LLP (see page S-4) 25.1* Powers of Attorney (see page S-1) 27.1* Financial Data Schedule, December 28, 1997
(1) Incorporated by reference to Registration Statement No. 33-65810, August 19, 1994. (2) Incorporated by reference to No. 33- 74088, February 8, 1995. (3) Incorporated by reference to Report on Form 10-K for the Fiscal Year Ended December 31, 1994. (4) Incorporated by reference to Report on Form 10-Q for the Period Ended July 1, 1995. (5) Incorporated by reference to Report on Form 10-Q for the Period Ended September 29, 1995. (6) Incorporated by reference to Report on Form 10-K for the Fiscal Year Ended December 30, 1995. (7) Incorporated by reference to Report on Form 10-K for the Fiscal Year Ended December 29, 1996. (8) Incorporated by reference to Report on Form 10-Q for the Period Ended June 29, 1997 (9) Incorporated by reference to Registration Statement No. 333-06300, September 23, 1996. (10) Incorporated by reference to Registration Statement No. 333-37957, October 21, 1997. * Filed herewith. Confidential treatment granted. Indicates management contract or compensatory plan or arrangement. (B) REPORTS ON FORM 8-K. No reports on Form 8-K were filed during the fourth quarter of 1997. ARTHUR ANDERSEN LLP Report of Independent Public Accountants To the Shareholders and Board of Directors of Level One Communications, Incorporated: We have audited the accompanying consolidated balance sheets of LEVEL ONE COMMUNICATIONS, INCORPORATED (a California corporation) and subsidiaries as of December 28, 1997 and December 29, 1996, and the related statements of income, shareholders' equity and cash flows for each of the three fiscal years in the period ended December 28, 1997, December 29, 1996 and December 30, 1995. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Level One Communications, Incorporated and subsidiaries, as of December 28, 1997 and December 29, 1996, and the results of their operations and their cash flows for each of the three fiscal years in the period ended December 28, 1997, in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index of financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /S/ ARTHUR ANDERSEN LLP Sacramento, California March 13, 1998 LEVEL ONE COMMUNICATIONS, INCORPORATED CONSOLIDATED BALANCE SHEETS December 28, 1997, and December 29, 1996
(IN THOUSANDS, EXCEPT SHARE AMOUNTS) 1997 1996 ASSETS Current Assets: Cash and cash equivalents $ 25,234 $ 20,251 Short-term investments 112,560 10,211 Trade accounts receivable, net of allowance for doubtful accounts of $343 and $156 for 1997 30,079 17,671 and 1996, respectively Other receivables 2,473 608 Inventories 26,118 9,990 Deferred income tax benefit 4,050 2,504 Prepaid expenses 2,502 2,351 Total current assets 203,016 63,586 Property and equipment, net 31,795 23,676 Long-term investments 21,559 12,440 Note acquisition costs 3,296 - Foundry deposits 14,000 8,000 Other assets 4,031 4,400 Total assets $ 277,697 $ 112,102 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Current portion of capital lease obligations $1,201 $1,129 Accounts payable 20,614 4,778 Accrued payroll costs 4,591 1,985 Income taxes payable - 1,338 Deferred distributor revenues 2,490 864 Other accrued liabilities 7,881 2,621 Total current liabilities 36,777 12,715 Convertible subordinated notes 115,000 - Capital lease obligations, less current portion 2,175 3,194 Deferred lease expense 300 612 Total liabilities 154,252 16,521 Shareholders' Equity: Common Stock, no par value 91,897 83,230 Authorized - 157,500,000 shares Outstanding - 20,559,374 and 19,674,341 shares for 1997 and 1996, respectively Unrealized gain on available-for-sale 18 12 securities, net of tax Retained earnings 31,530 12,339 Total shareholders' equity 123,445 95,581 Total liabilities and shareholders' equity $ 277,697 $ 112,102
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS. LEVEL ONE COMMUNICATIONS, INCORPORATED CONSOLIDATED STATEMENTS OF INCOME For Fiscal Years Ended December 28, 1997, December 29, 1996, and December 30, 1995
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1997 1996 1995 Revenues $ 156,262 $ 111,987 $ 78,018 Cost of sales 65,299 48,477 33,300 Gross margin 90,963 63,510 44,718 Research and development* 30,398 24,505 17,857 Sales and marketing 23,978 16,589 11,372 General and administrative 10,212 6,741 5,752 Total operating expenses 64,588 47,835 34,981 Operating income 26,375 15,675 9,737 Interest income 3,959 1,916 2,108 Interest (expense) (1,806) (352) (157) Other income 110 729 113 Income before provision for income taxes 28,638 17,968 11,801 Provision for income taxes 9,447 6,755 1,543 Net income $ 19,191 $ 11,213 $ 10,258 Basic earnings per share $ 0.95 $ 0.58 $ 0.54 Diluted earnings per share $ 0.89 $ 0.55 $ 0.51
*Includes one-time charges for acquisitions of $2,500 and $750 for 1996 and 1995, respectively. THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS. LEVEL ONE COMMUNICATIONS, INCORPORATED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY For the Fiscal Years Ended December 28, 1997, December 29, 1996, and December 30, 1995
Deferred Retained Common Stock Compen- Unrealized Earnings (IN THOUSANDS) Shares Amount sation Gain(Loss) (Deficit) Total Balance at December 31, 1994 18,722 $72,442 $ $ $(9,132) $63,309 (1) - Issuance of common stock under stock option and purchase plans 328 431 - - - 431 Issuance of common stock upon exercise of warrants 6 19 - - - 19 Tax benefit of stock option 2,418 - - - 2,418 exercises Stock issued in connection with acquisitions 203 2,462 - - - 2,462 Unrealized gain on available- for-sale securitiess, net of tax - - - 67 - 67 Amortization of deferred compensation expense - - 1 - - 1 Net income - - - - 10,258 10,258 Balance at December 30, 1995 19,259 77,772 - 67 1,126 78,965 Issuance of common stock under stock option and purchase plans 282 1,243 - - - 1,243 Issuance of common stock upon exercise of warrants 3 10 - - - 10 Tax benefit of stock option - 1,205 - - - 1,205 exercises Stock issued in connection with acquisitions 130 3,000 - - - 3,000 Unrealized loss on available- for-sale securitiess, net of tax - - - (55) - (55) Net income - - - - 11,213 11,213 Balance at December 29, 1996 19,674 83,230 - 12 12,339 95,581 Issuance of common stock under stock option and purchase 596 3,538 3,538 plans Issuance of common stock under cashless exercise of 289 - - warrants Tax benefit of stock option 5,129 5,129 exercises Unrealized gain on available- for-sale securities, net of tax 6 6 Net income 19,191 19,191 Balance at December 28, 1997 20,559 $91,897 $ - $ 18 $ 31,530 $123,445
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS. LEVEL ONE COMMUNICATIONS, INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS For Fiscal Years Ended December 28, 1997, December 29, 1996, and December 30, 1995
(IN THOUSANDS) 1997 1996 1995 Cash flows from operating activities: Net income $ 19,191 $ 11,213 $ 10,258 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 9,714 7,389 5,214 Purchased research & development expenses - 2,500 750 Changes in assets and liabilities, net of effect of acquisitions: Trade receivables (12,408) (3,259) (8,832) Other receivables (1,865) 370 (189) Inventories (16,128) 5,782 (9,268) Deferred income tax benefit (1,546) 1,785 (977) Prepaid expenses (466) 236 (1,192) Accounts payable and accrued liabilities 29,119 (3,427) 11,684 Deferred lease expense (312) (133) 97 Net cash provided by operating activities 25,299 22,456 7,545 Cash flows from investing activities: Purchase of short-term investments (155,195) (12,754) (8,042) Proceeds from sales and maturities of short-term 52,852 10,711 31,027 investments Purchase of long-term investments (42,900) (11,780) (3,681) Proceeds from sales and maturities of long-term 33,781 4,035 1,000 investments Net capital expenditures (17,033) (9,837) (10,033) Payments (receipts) for related party notes - 1,225 (1,225) receivable Payments for foundry deposits and other assets (5,951) (6,136) (4,081) Net cash provided by (used in) investing (134,446) (24,536) 4,965 activities Cash flows from financing activities: Net principal payments under capital lease (947) (550) (569) obligations Proceeds from issuance of convertible subordinated notes, net of acquisition costs 111,539 - - Proceeds from issuance of stock, net of repurchases and costs of issuance 3,538 1,253 427 Net cash provided by (used in) financing 114,130 703 (142) activities Net increase (decrease) in cash and cash equivalents 4,983 (1,377) 12,368 Cash and cash equivalents at beginning of year 20,251 21,628 9,260 Cash and cash equivalents at end of year $ 25,234 $ 20,251 $ 21,628 SUPPLEMENTARY DISCLOSURE OF CASH AND NON-CASH TRANSACTIONS Non-cash and investing and financing activities: Equipment purchased under capital leases $ - $ 726 $ 4,770 Tax benefit related to stock options 5,129 1,205 2,418 Unrealized gain (loss) on available-for-sale securities, net of tax 6 (55) 67 Cash payments for: Interest 199 351 142 Income taxes 3,861 2,564 1,268
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS. LEVEL ONE COMMUNICATIONS, INCORPORATED NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION AND DESCRIPTION OF THE BUSINESS Level One Communications, Incorporated (the "Company") was incorporated in California on November 26, 1985. The Company designs, develops and markets application specific standard product ("ASPP") integrated circuits and custom derivatives for high-speed digital signal transmission and networking connectivity to systems that transport information, within an office or around the world. Such systems connect to local area networks ("LANs"), wide area networks ("WANs") and public telephone transmission networks. LANs, WANs, and telephone transmission networks make possible such activities as the use of intra- enterprise networking ("intranets") and the use of the Internet and World Wide Web. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION. The Company prepares financial statements on a 52-53 week year. During the 3{rd} Quarter of Fiscal 1996, the Company changed its fiscal year end from the last Saturday nearest to the calendar year end to the last Sunday nearest the calendar year end. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS. For purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. INVESTMENTS. The Company accounts for investments pursuant to Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). This statement requires that investments be classified into one of three categories: held-to- maturity, available-for-sale, or trading. It requires that investments classified as held-to- maturity be reported at amortized cost, that investments classified as available-for-sale be reported at fair value with unrealized gains and losses, net of related tax, reported as a separate component of shareholders' equity, and that investments classified as trading be reported at fair value with unrealized gains and losses included in earnings. As of December 28, 1997 and December 29, 1996, all of the Company's investments are classified as available-for-sale and are carried at fair value. As of December 28, 1997, and December 29, 1996, the Company's stockholders' equity reflected an unrealized gain, net of applicable taxes of $18,000 and $12,000, respectively. The amortized cost and market value of the Company's investments available-for-sale as of December 28, 1997 and December 29, 1996, were as follows:
DECEMBER 28, 1997 GROSS GROSS (IN THOUSANDS) AMORTIZED UNREALIZED UNREALIZED MARKET COST GAINS LOSSES VALUE Municipal bonds $ 11,528 $ 24 $ $ 11,552 - Corporate debt and equity 122,561 36 30 122,567 securities $ 134,089 $ 60 $ $ 134,119 30
DECEMBER 29, 1996 GROSS GROSS (IN THOUSANDS) AMORTIZED UNREALIZED UNREALIZED MARKET COST GAINS LOSSES VALUE Municipal bonds $ 20,531 $ 29 $ $ 20,557 3 Corporate debt and equity 2,100 - 6 2,094 securities $ 22,631 $ 29 $ $ 22,651 9
The amortized cost and market value of the Company's investments available-for-sale, by maturity, at December 28, 1997, were as follows:
DECEMBER 28, 1997 AMORTIZED MARKET (IN THOUSANDS) COST VALUE Due in one year or less $ 112,536 $ 112,560 Due after one year through five 21,553 21,559 years $ 134,089 $ 134,119
Proceeds from the sale of available-for-sale investments during fiscal 1997 and 1996 were $86.6 million and $14.7 million, respectively. The cost basis used in determining realized gains and losses is specific identification. During 1997, gross gains of $20,000 with no losses were realized, and gross gains of $1,000 and gross losses of $32,000 were realized in 1996. FINANCIAL INSTRUMENTS. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: For cash and cash equivalents, accounts receivable, trade accounts payable, and convertible subordinated notes, the carrying value is a reasonable estimate of fair value. For investments, fair values are based on quoted market prices or dealer quotes. INVENTORIES. Inventories are stated at the lower of cost (first- in, first-out) or market and include materials, labor and manufacturing overhead costs. Inventories as of December 28, 1997, and December 29, 1996, consisted of the following:
(IN THOUSANDS) 1997 1996 Raw materials $ 8,829 $ 32 Work-in-process 13,135 7,948 Finished goods 4,154 2,010 Total inventories $ 26,118 $ 9,990
PROPERTY AND EQUIPMENT. Property and equipment are recorded at cost. Depreciation is provided on a straight-line basis over the following estimated useful lives:
Machinery and equipment 3-5 years Furniture and fixtures 3-5 years Leasehold improvements 6-10 years
Property and equipment, net, is comprised of the following:
(IN THOUSANDS) 1997 1996 Machinery and equipment $ 36,222 $ 25,254 Furniture and fixtures 18,066 11,899 Leasehold improvements 3,383 3,485 57,671 40,638 Less accumulated depreciation (25,876) (16,962) $ 31,795 $ 23,676
Deferred Lease Expense. Lease payments for certain equipment are recognized as expense on a straight line basis over the term of the lease. PATENT COSTS. Patent costs include direct costs of obtaining the patents. Upon patent approval, patent costs are amortized over the estimated useful life of the patent using the straight-line method. REVENUE RECOGNITION. Product sales are generally recognized upon shipment of product. However, the Company defers recognition of revenues and gross margin from sales to stocking distributors until such distributors resell the related products to their customers. The Company has deferred recognition of gross margin amounting to $2,490,000, $864,000, and $1,300,000 as of December 28, 1997, December 29, 1996, and December 30, 1995, respectively. During 1997 and 1995 no single customer accounted for more than 10% of revenues. In 1996, sales to Hewlett-Packard were 11.2% of total sales. Export sales as a percentage of revenues were 35%, 39%, and 33% for 1997, 1996, and 1995, respectively. The Company from time to time enters into development and license agreements with certain customers related to customer-specific applications. Related costs are expensed as incurred and are included in research and development expenses, while revenue for non- recurring engineering contracts is deferred until contract milestones are met. During 1997, 1996, and 1995, the Company recognized revenues of $56,000, $398,000, and $289,000, respectively, in accordance with the contract milestones in the Company's agreements. The Company earns royalty income under certain contracts and recognizes that income in the period that income is earned. During 1997, 1996, and 1995 the Company recognized revenues of $987,000, $197,000, and $312,000, respectively. Revenues are comprised of the following:
(IN THOUSANDS) 1997 1996 1995 Product sales $ 155,219 $ 111,392 $ 77,417 Royalties, licenses and non- recurring engineering revenue 1,043 595 601 Total revenues $ 156,262 $ 111,987 $ 78,018
INCOME TAXES. The Company accounts for income taxes pursuant to Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." This statement provides for a liability approach under which deferred income taxes are provided based upon enacted tax laws and rates applicable to the periods in which the taxes become payable. STOCK BASED COMPENSATION. As of December 31, 1995, the Company adopted Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). This statement defines a fair-value-based method of accounting for stock-based compensation. As permitted by SFAS 123, the Company has not changed its method of accounting for stock options but has provided the additional required disclosures. The Company recognized no compensation expense related to stock options in 1997. EARNINGS PER SHARE. In February 1997, the Financial Accounting Standards Board (the "FASB") issued SFAS 128, "Earnings Per Share," which establishes standards for computing and presenting earnings per share ("EPS"). It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic and diluted EPS on the face of the income statement for all entities with complex capital structures and requires reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. The statement is effective for financial statements issued for periods ending after December 15, 1997, and requires restatement for all periods presented. FINANCIAL PRESENTATION. Certain prior year amounts in the Consolidated Financial Statements have been reclassified to conform to the fiscal 1997 presentation. 3. SHORT-TERM BORROWINGS The Company has a $10 million revolving line of credit with a bank. The Company compensates the bank for credit facilities by paying annual administrative fees. The balance of the Company's short-term borrowings as of December 28, 1997, and December 29, 1996, was zero. 4. LONG-TERM DEBT The Company sold $115 million of 4% convertible subordinated notes during 1997. The notes will mature on September 1, 2004. Unless previously redeemed or repurchased, the notes are convertible at any time through the close of business on the final maturity date of the notes, into common stock of the Company, at a conversion price of $40 per share. Interest on the notes is payable semi-annually, commencing March 1, 1998. Total interest accrued on the convertible subordinated notes at December 28, 1997 was approximately $1,550,000. After September 2000, the notes are redeemable at the option of the Company, in whole or in part. The notes may be redeemed for either cash or common stock at a repurchase price of 105% of the principal amount of the notes to be repurchased plus accrued and unpaid interest to the repurchase date. The notes are unsecured obligations of the Company and are subordinated to all existing and future senior indebtedness of the Company. The indenture contains no limitations on the incurrence of additional indebtedness or other liabilities by the Company. 5. LEASES The Company conducts its operations using leased facilities and equipment under both capital and operating leases. Minimum future lease payments as of December 28, 1997, are as follows:
(IN THOUSANDS) Capital Operating Leases Leases Year Ending 1998 $ 1,415 $ 12,747 1999 1,252 13,481 2000 974 12,070 2001 74 9,049 2002 - 7,212 Thereafter - 29,852 $ 3,715 $ 84,411
Less - Interest portion (7.38% to 12%) (339) Capital lease obligations 3,376 Less - Current portion (1,201) Long-term portion $2,175
Rent expense for operating leases was approximately $9.0 million, $7.4 million, and $3.5 million for the years ended December 28, 1997, December 29, 1996, and December 30, 1995. 6. INCOME TAXES The provision for income taxes consists of:
(IN THOUSANDS) 1997 1996 1995 Current provision for income taxes: State $ 1,098 $ 361 $ 1,353 Federal 9,603 4,609 2,660 Deferred provision (benefit): State 242 696 (675) Federal (1,496) 1,089 (1,795) Total tax provision $ 9,447 $ 6,755 $ 1,543
The tax benefits associated with nonqualified stock options reduced taxes currently payable by $5,129,000, $1,205,000, and $2,418,000 in 1997, 1996, and 1995, respectively. Such benefits were recorded as an increase to common stock. Deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax basis of assets and liabilities. They are measured by applying the enacted tax rates and laws in effect for the years in which such differences are expected to reverse. The significant components of the Company's deferred tax assets and liabilities as of December 28, 1997, and December 29, 1996, are as follows:
(IN THOUSANDS) 1997 1996 Deferred tax assets (liabilities): Inventory reserves $ 1,893 $ 397 Deferred income on shipments to 750 374 distributors Accounts receivable reserve 114 83 Deferred lease expense 151 265 Inventory Unicap adjustment 796 345 Accrued vacation 445 256 AMT credit carryforwards 365 365 R&D credit carryforwards 573 537 Other - 275 Accelerated depreciation (356) (393) Unrealized loss on Section 475 securities (681) - Net deferred income tax benefit $ 4,050 $ 2,504
The reconciliation of the federal tax rate to the effective tax rate is as follows:
1997 1996 1995 Statutory federal tax rate 35.0% 34.0% 34.0% Reversal of valuation allowance - - (21.0%) Foreign taxes & foreign sales (2.6%) (4.7%) (3.0%) corporation State taxes 4.9% 3.3% 5.7% Non-deductible acquisition costs 0.6% 5.5% 2.2% Research and development credits (3.7%) - - Other (1.2%) (0.5%) (4.8%) Effective income tax rate 33.0% 37.6% 13.1%
7. SHAREHOLDERS' EQUITY AND EARNINGS PER SHARE In July 1997, the Board of Directors authorized a 3 for 2 stock split, which was effective on August 26, 1997. The stock split was declared on July 7, 1997, to holders of record on August 5, 1997. All common stock amounts and per share amounts have been retroactively adjusted to reflect the stock split. On February 23, 1998, the Board of Directors authorized a 3 for 2 stock split effective on March 30, 1998 to shareholders of record on March 9, 1998. Common stock amounts and per share amounts have not been adjusted to reflect the stock split. The Company adopted SFAS No. 128, "Earnings per Share," effective December 15, 1997. As a result, the Company's earnings per share for all prior periods have been restated. The following table reconciles the numerator and denominator of the basic and diluted earnings per share computations.
(IN THOUSANDS, EXCEPT EARNINGS PER EARNINGS SHARE) PER-SHARE NET INCOME SHARES AMOUNT Net income 1997 $ 19,191 1996 11,213 1995 10,258 BASIC EPS: income available to common shareholders 1997 $ 19,191 20,233 $ 0.95 1996 11,213 19,439 0.58 1995 10,258 19,068 0.54 Effect of dilutive securities: Options: 1997 - 1,361 1996 - 1,066 1995 - 910 DILUTED EPS: income available to common stockholders plus assumed conversions 1997 $ 19,191 21,594 $ 0.89 1996 11,213 20,505 0.55 1995 10,258 19,978 0.51
No conversion is assumed for the convertible subordinated notes issued in 1997 because it would have an antidilutive effect on earnings per share. Options to purchase approximately 61,000, 98,000, and 128,000 shares of common stock in 1997, 1996, and 1995, respectively, were not included in the computation of diluted EPS because the options' exercise price was greater than the average market price of the common shares, making the shares antidilutive. 8. STOCK OPTION AND PURCHASE PLANS AND EMPLOYEE BENEFIT PLAN STOCK-BASED COMPENSATION PLANS. The Company has three stock option plans, the 1985 Stock Option Plan (the "1985 Plan"), the 1993 Stock Option Plan (the "1993 Plan"), and the San Francisco Telecom Stock Option Plan (the "SFT Plan"), and an employee stock purchase plan (the "ESPP"). No further options may be granted under either the 1985 Plan or the SFT Plan, and 345,132 options previously granted under these plans remain outstanding. The Company applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its fixed stock option plans. Had compensation cost for these plans been determined consistent with Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), the Company's net income and net income per common share would have been reduced to the following pro forma amounts:
(IN THOUSANDS, EXCEPT SHARE DATA) 1997 1996 1995 Net income As reported $ 19,191 $ 11,213 $ 10,258 Pro forma 15,401 9,325 9,549 Earnings per share, as reported Basic $ 0.95 $ 0.58 $ 0.54 Diluted 0.89 0.55 0.51 Pro-forma earnings per share Basic $ 0.76 $ 0.48 $ 0.50 Diluted 0.76 0.48 0.50
The fair value of each option grant has been estimated on the date of the grant using the Black-Scholes option-pricing model with the following assumptions used for grants in 1997, 1996, and 1995. In calculating compensation cost: risk-free interest rates of 6.12, 6.15, and 5.90 percent, respectively, and expected stock price volatility of 70%, an expected life of six years and no dividend payments for 1997, 1996, and 1995, respectively. Because the SFAS 123 method of accounting has not been applied to options granted prior to January 1, 1995, and due to the nature and timing of option grants, the resulting pro forma compensation cost may not be representative of that to be expected in future years. The Company has authorized the issuance of up to 675,000 shares of stock to its full-time employees under the ESPP. The Company has sold 44,991 shares and 33,205 shares as of December 28, 1997 and December 29, 1996, respectively, and has sold a total of 112,433 shares through December 28, 1997. The Company sells shares at 85% of the stock's market price, which is either the market price at the beginning or at the end of offering period, whichever is lower. The Company may grant options for up to 4,575,000 shares under the 1993 Plan. The Company had 717,387 shares available for grant at December 28, 1997. Under the 1993 Option Plan the option exercise price equals the market price on date of grant. The following table presents the aggregate options granted, forfeited, and exercised under the 1985 Plan, 1993 Plan and SFT Plan for the years ended December 28, 1997, December 29, 1996, and December 30, 1995, at their respective weighted average exercise prices.
1997 1996 1995 Wtd.Avg. Wtd.Avg. Wtd.Avg. (SHARES IN THOUSANDS) Shares Exer.Price Shares Exer.Price Shares Exer.Price Outstanding beginning of 2,855 $ 10.10 2,235 $ 7.60 1,635 $ 3.44 year Granted Price = Fair Value 1,698 22.94 1,084 14.34 1,035 11.98 Price < Fair Value - - 38 0.45 Exercised (464) 5.59 (261) 3.70 (325) 0.94 Cancelled (221) 12.58 (203) 13.44 (148) 5.00 Outstanding end of year 3,868 $16.13 2,855 $10.10 2,235 $7.60 Exercisable, end of period 785 723 551
The following table summarizes information about options outstanding under the 1985 Plan, 1993 Plan, and the SFT Plan at December 28, 1997.
OPTIONS OUTSTANDING OPTIONS EXERCISABLE (SHARES IN THOUSANDS) Shares Wtd. Avg. Shares Outstanding Remaining Exercisable as of Contractual Wtd. Avg. as of 12/28/97 Wtd. Avg. Range of Exercise Prices 12/28/97 Life Exercise Price Exercise Price $ 0.26 $ 11.00 968 6.29 $ 6.81 505 $ 4.05 11.17 15.17 1,019 8.00 12.90 236 13.21 15.54 24.00 985 9.08 17.26 44 19.24 24.50 40.75 896 9.72 28.65 - 25.08 $ 0.26 $ 40.75 3,868 8.24 $16.13 785 $ 7.66
Options for all plans are exercisable in installments at intervals determined by the Board of Directors, not to exceed ten years and one day. 401(K) TAX DEFERRED SAVINGS PLAN. The Company has a 401(k) Tax Deferred Savings Plan (the "401(k) Plan") under which eligible employees may elect to have a portion of their salary deferred and contributed to their accounts under the 401(k) Plan. Under the 401(k) Plan, the Company will contribute at least 1% (and up to a maximum of 3%) of an eligible employee's annual gross salary to the employee's account under the 401(k) Plan. For the fiscal years ended December 28, 1997, December 29, 1996, and December 30, 1995, the Company has contributed $490,000, $420,000, and $315,000, respectively, to the 401(k) Plan. 9. INCENTIVE PLANS The Company has reserved 135,000 shares of Common Stock for issuance to employees pursuant to a stock bonus plan to be agreed upon by the Board of Directors. As of December 28, 1997, no shares had been issued. Beginning in January 1994, the Company implemented an incentive compensation plan. The Company's incentive compensation plan provides for incentive compensation for substantially all employees of the Company based upon the achievement of specified operating and performance results. Incentive compensation totaled $3,739,000, $1,791,000, and $833,000 for 1997, 1996 and 1995, respectively. 10. STOCK WARRANTS The Company has issued warrants to independent sales representatives to purchase up to 63,750 shares of its Common Stock with exercise prices ranging from $1.55 to $14.00 per share. As of December 28, 1997, an aggregate of 30,103 shares has been issued upon exercise of warrants. In connection with securing a loan from investors in 1992, the Company issued warrants to purchase 304,119 shares of Common Stock with an exercise price of $1.03 per share. The warrants were exercised January 16, 1997, for 289,131 shares, and the balance was surrendered, on a net appreciation basis, in an amount equal to the exercise price. 11. PREFERRED STOCK No shares of Preferred Stock are currently outstanding. The Company's Board of Directors is authorized to issue up to 10,000,000 shares of Preferred Stock. 12. RELATED PARTY TRANSACTIONS During 1997, 1996 and 1995, the Company paid consulting and/or directors' fees of approximately $117,000, $129,600, and $130,000 respectively, to three members of the Board of Directors. During the third quarter of 1996, in connection with a third-party financing for Maker Communications, Inc. ("Maker"), the Company sold a portion of its minority interest in Maker for an aggregate of approximately $675,000. This sale was accounted as a one- time gain recorded as "Other Income" in the accompanying Consolidated Statements of Income. The Company continues to hold a minority interest in Maker and license certain Maker technology. Other contractual rights and obligations, including the Company's obligation to provide certain loan financing to Maker, were terminated in the transaction. Following the transaction, Maker repaid the Company approximately $2.9 million, the total balance under an outstanding note. 13. BUSINESS AND TECHNOLOGY ACQUISITIONS During December 1996, the Company acquired Silicon Design Experts, Inc. (SDE). In connection with the transaction, the Company issued an aggregate of 130,095 shares of its common stock valued at $3,000,000 to SDE's shareholders, and agreed to issue additional shares of Common Stock in the future to SDE's shareholders and employees, with the amount to be contingent upon the extent of sales of products developed by SDE and Level One's stock price. The total purchase price of $3,000,000 was allocated as follows: $500,000 to goodwill , and $2,500,000 for purchased research and development. The purchased research and development of $2,500,000 was reported as a one-time charge. The transaction was accounted for under the purchase method of accounting. Accordingly, SDE's operating results after the date of acquisition are included in the Consolidated Statements of Income. On June 6, 1995, the Company acquired San Francisco Telecom, Inc. ("SFT"). SFT operates as a wholly- owned subsidiary of the Company. In connection with the transaction, the Company issued an aggregate 203,040 shares of its common stock to SFT's shareholders, assumed existing SFT stock options, which will be exercisable for a total of 37,426 shares of Common Stock, and agreed to issue additional shares of Common Stock in the future to SFT's shareholders and employees, with the amount to be contingent upon the extent of sales of products developed by SFT. The transaction was accounted for under the purchase method of accounting. Accordingly, SFT's operating results after the date of the acquisition are included in the Consolidated Statements of Operations. 14. RISK FACTORS The Company does not manufacture the wafers used for its products. The Company's wafers are manufactured by foundries located in the United States, Europe and Asia. The Company depends upon these suppliers to produce wafers at acceptable yields and to deliver them in a timely manner at competitive prices. The Company may sustain an adverse impact on operating results from problems with the cost, timeliness, yield and quality of wafer deliveries from suppliers. From time to time, the available industry-wide foundry capacity can fluctuate significantly. During periods of constrained supply, the Company may experience difficulty in securing an adequate supply of wafers, and/or its suppliers may increase wafer prices. The Company's operating results depend in substantial part on its ability to maintain or increase the capacity available from its existing or new foundries. In prior years, the Company has experienced increased costs and delays in customer shipments as a result of a foundry reducing shipments to the Company without prior notice, requiring the Company to transfer products to a new foundry. Although the Company believes that it has planned to meet customer demand, there can be no assurances that unforeseen demand, current supplier interruptions or other changes will not have a material impact on the Company's business. The Company is also dependent upon third-party assembly companies that package or test the Company's devices. The Company depends upon these suppliers to produce products in a timely manner and at competitive prices. The Company may sustain an adverse financial impact from problems with the cost, timeliness, yield and quality of product deliveries from these suppliers. The Company relies upon patent, trademark, trade secret and copyright law to protect its intellectual property. There can be no assurance that such intellectual property rights can be successfully asserted or will not be invalidated, circumvented or challenged. Litigation, regardless of its outcome, could result in substantial cost and diversion of resources for the Company. Any infringement claim or other litigation against or by the Company could have a material effect on the Company's financial condition and results of operations. In November 1995 the Company commenced infringement litigation against a competitor. There are no other material pending legal proceedings, other than routine litigation incidental to the Company's business, to which the Company is a party or of which any of its property is subject. 15. FOUNDRY COMMITMENTS The Company's current wafer requirements are supplied primarily by six foundries. During 1995, the Company entered into five-year agreements with three of its suppliers for committed foundry capacity in consideration of equipment financing or cash deposits. At December 28, 1997, the Company had provided an aggregate of $20.6 million in capital equipment financing and/or cash deposits to these foundries to obtain committed foundry capacity. During the first quarter of 1998, the Company paid an aggregate $1.3 million in additional deposits per its agreements. There are no additional deposits due under the Company's existing foundry agreements. SCHEDULE II LEVEL ONE COMMUNICATIONS, INC. VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS OF DOLLARS) Balance at Charged to Balance at Beginning Costs and End of Classification of Period Expenses Deductions Period YEAR ENDED DECEMBER 28, 1997: Allowance for doubtful 156 - 343 accounts 187 YEAR ENDED DECEMBER 29, 1996: Allowance for doubtful 300 - 144 156 accounts YEAR ENDED DECEMBER 30, 1995: Allowance for doubtful 90 210 - 300 accounts
SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN THE COUNTY OF SACRAMENTO, STATE OF CALIFORNIA, ON THE _________ DAY OF MARCH, 1998. LEVEL ONE COMMUNICATIONS, INCORPORATED By: /S/ ROBERT S. PEPPER Robert S. Pepper PRESIDENT AND CHIEF EXECUTIVE OFFICER Each of the officers and directors of Level One Communications, Incorporated whose signature appears below hereby constitutes and appoints Robert S. Pepper and John Kehoe, and each of them, their true and lawful attorneys-in-fact and agents, with full power of substitution, each with power to act alone, to sign and execute on behalf of the undersigned any amendment or amendments to this Annual Report, and does hereby ratify and confirm all that said attorneys-in-fact and agents shall do or cause to be done by virtue hereof. PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. Dated: March 27, 1998 /S/ ROBERT S. PEPPER Robert S. Pepper, PRESIDENT, CHIEF EXECUTIVE OFFICER (PRINCIPAL EXECUTIVE OFFICER) AND CHAIRMAN OF THE BOARD OF DIRECTORS Dated: March 27, 1998 /S/ THOMAS J. CONNORS Thomas J. Connors, DIRECTOR Dated: March 27, 1998 /S/ PAUL GRAY Paul Gray DIRECTOR Dated: March 27 , 1998 /S/ MARTIN JURICk Martin Jurick, DIRECTOR Dated: March 271998 /S/ HENRY KRESSEL Henry Kressel, DIRECTOR Dated: March 27, 1998 /S/ JOSEPH P. LANDY Joseph P. Landy, DIRECTOR Dated: March 27, 1998 /S/ JOHN KEHOE John Kehoe, SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER (PRINCIPAL FINANCIAL OFFICER) (PRINCIPAL ACCOUNTING OFFICER) EXHIBIT 22.1 SUBSIDIARIES OF REGISTRANT Registrant has five wholly- owned subsidiaries, Level One Communications International, Incorporated, which is incorporated in Barbados, and which does business under the name Level One Communications International, Incorporated; San Francisco Telecom, Inc., which is incorporated in California, and which does business under the name San Francisco Telecom, Inc.; Silicon Design Experts, Inc. California, which is incorporated in California and does business under the name Level One Communications, Incorporated; Level One Communications Europe SARL, which is incorporated in France and does business under the name Level One Communications Europe; and LOCSWEDE, A.B., which is incorporated in Sweden and does business under the name Level One Communications. EXHIBIT 24.1 LEVEL ONE COMMUNICATIONS, INCORPORATED CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K, into the Company's previously filed Registration Statements File Nos. 33-65810, 33- 72398, 33-93360, 33-95590, 333- 06300 and 333- 48333. /S/ ARTHUR ANDERSEN LLP Sacramento, California March 27, 1998 EX-3.1 CERTIFICATE OF AMENDMENT OF RESTATED ARTICLES OF INCORPORATION OF LEVEL ONE COMMUNICATIONS, INCORPORATED ROBERT S. PEPPER and JOHN KEHOE certify that: 1. They are the President and the Secretary, respectively, of Level One Communications, Incorporated. 2. Subsection A of Article Third of the Restated Articles of Incorporation of Level One Communications, Incorporated is amended to read in its entirety as follows: "A. This Corporation is authorized to issue two classes of shares to be designated respectively Preferred Stock ("Preferred Stock") and Common Stock ("Common Stock"). The total number of shares of Common Stock this Corporation shall have authority to issue is Two Hundred Thirty-six Million, Two Hundred Fifty Thousand (236,250,000). The total number of shares of Preferred Stock this Corporation shall have authority to issue is Ten Million (10,000,000). The Board of Directors of this Corporation is authorized to determine or alter the rights, privileges, preferences and restrictions granted to or imposed upon any wholly unissued shares or series of shares of Preferred Stock, and within the limitations or restrictions stated in any resolution or resolutions of the Board of Directors originally fixing the number of shares constituting any series, to increase or decrease (but not below the number of shares of any series then outstanding) the number of shares of any such series subsequent to the issue of shares of that series, to determine the designation of any series, and to fix the number of shares of any series. "B. Upon the effective date of this Amendment to the Restated Articles of Incorporation, each outstanding share of Common Stock of the Corporation is split and converted to 1.5 shares of Common Stock." 3. The foregoing amendment of the Articles of Incorporation was duly approved by the Board of Directors by unanimous written consent on February 13, 1998. 4. The change which has been made hereby to the Articles of Incorporation is to effect a three-for-two stock split (including a proportionate increase in the authorized number of Common Shares). No shares of Preferred Stock are outstanding. Pursuant to Section 902(c) of the California Corporations Code, shareholder approval is not required for this action. 5. The foregoing amendment of the Articles of Incorporation of Level One Communications, Incorporated, shall become effective at the close of business on March 9, 1998. The undersigned declare under penalty of perjury that the matters set forth in the foregoing certificate are true of their own knowledge. Executed at Sacramento, California on March 3, 1998. /S/ ROBERT S. PEPPER Robert S. Pepper, President /S/ JOHN KEHOE John Kehoe, Secretary - 2 - CERTIFICATE OF AMENDMENT OF RESTATED ARTICLES OF INCORPORATION OF LEVEL ONE COMMUNICATIONS, INCORPORATED ROBERT S. PEPPER and JOHN KEHOE certify that: 1. They are the President and the Secretary, respectively, of Level One Communications, Incorporated. 2. Subsection A of Article Third of the Restated Articles of Incorporation of Level One Communications, Incorporated is amended to read in its entirety as follows: "A. This Corporation is authorized to issue two classes of shares to be designated respectively Preferred Stock ("Preferred Stock") and Common Stock ("Common Stock"). The total number of shares of Common Stock this Corporation shall have authority to issue is One Hundred and Fifty-seven Million Five Hundred Thousand (157,500,000). The total number of shares of Preferred Stock this Corporation shall have authority to issue is Ten Million (10,000,000). The Board of Directors of this Corporation is authorized to determine or alter the rights, privileges, preferences and restrictions granted to or imposed upon any wholly unissued shares or series of shares of Preferred Stock, and within the limitations or restrictions stated in any resolution or resolutions of the Board of Directors originally fixing the number of shares constituting any series, to increase or decrease (but not below the number of shares of any series then outstanding) the number of shares of any such series subsequent to the issue of shares of that series, to determine the designation of any series, and to fix the number of shares of any series. "B. Upon the effective date of this Amendment to the Restated Articles of Incorporation, each outstanding share of Common Stock of the Corporation is split and converted to 1.5 shares of Common Stock." 3. The foregoing amendment of the Articles of Incorporation was duly approved by the Board of Directors at its duly held meeting on July 17, 1997, at which a quorum was present and acting throughout. 4. The change which has been made hereby to the Articles of Incorporation is to effect a three-for-two stock split (including a proportionate increase in the authorized number of Common Shares). No shares of Preferred Stock are outstanding. Pursuant to Section 902(c) of the California Corporations Code, shareholder approval is not required for this action. 5. The foregoing amendment of the Articles of Incorporation of Level One Communications, Incorporated, shall become effective at the close of business on August 5, 1997. The undersigned declare under penalty of perjury that the matters set forth in the foregoing certificate are true of their own knowledge. Executed at Sacramento, California on August 4, 1997. /S/ ROBERT S. PEPPER Robert S. Pepper, President /S/ JOHN KEHOE John Kehoe, Secretary - 3 - CERTIFICATE OF AMENDMENT OF RESTATED ARTICLES OF INCORPORATION OF LEVEL ONE COMMUNICATIONS, INCORPORATED ROBERT S. PEPPER and JOHN ZIMMERMAN certify that: 1. They are the President and the Assistant Secretary, respectively, of Level One Communications, Incorporated. 2. Subsection A of Article Third of the Restated Articles of Incorporation of Level One Communications, Incorporated is amended to read in its entirety as follows: "A. This Corporation is authorized to issue two classes of shares to be designated respectively Preferred Stock ("Preferred Stock") and Common Stock ("Common Stock"). The total number of shares of Common Stock this Corporation shall have authority to issue is One Hundred and Five Million (105,000,000). The total number of shares of Preferred Stock this Corporation shall have authority to issue is Ten Million (10,000,000). The Board of Directors of this Corporation is authorized to determine or alter the rights, privileges, preferences and restrictions granted to or imposed upon any wholly unissued shares or series of shares of Preferred Stock, and within the limitations or restrictions stated in any resolution or resolutions of the Board of Directors originally fixing the number of shares constituting any series, to increase or decrease (but not below the number of shares of any series then outstanding) the number of shares of any such series subsequent to the issue of shares of that series, to determine the designation of any series, and to fix the number of shares of any series. "B. Upon the effective date of this Amendment to the Restated Articles of Incorporation, each outstanding share of Common Stock of the Corporation is split and converted to 1.5 shares of Common Stock." 3. The foregoing amendment of the Articles of Incorporation was duly approved by the Board of Directors at its duly held meeting on December 13, 1993, at which a quorum was present and acting throughout. 4. The change which has been made hereby to the Articles of Incorporation is to effect a three-for-two stock split (including a proportionate increase in the authorized number of Common Shares). No shares of Preferred Stock are outstanding. Pursuant to Section 902(c) of the California Corporations Code, shareholder approval is not required for this action. 5. The foregoing amendment of the Articles of Incorporation of Level One Communications, Incorporated, shall become effective at the close of business on December 30, 1993. The undersigned declare under penalty of perjury that the matters set forth in the foregoing certificate are true of their own knowledge. Executed at Sacramento, California on December 15, 1993. /S/ ROBERT S. PEPPER Robert S. Pepper, President /S/ JOHN ZIMMERMAN John Zimmerman, Assistant Secretary - 4 - AMENDED AND RESTATED ARTICLES OF INCORPORATION OF LEVEL ONE COMMUNICATIONS, INCORPORATED Robert Pepper and Joseph Landy hereby certify as follows: 1. That they are the President and Secretary, respectively, of Level One Communications, Incorporated, a California corporation. 2. That the Articles of Incorporation of the corporation are hereby amended and restated to read in full as follows: "FIRST: The name of the corporation (hereinafter called the "Corporation") is Level One Communications, Incorporated. SECOND: The purpose of the corporation is to engage in any lawful act or activity for which a corporation may be organized under the General Corporation Law of the State of California other than the banking business, the trust company business or the practice of a profession permitted to be incorporated by the California Corporations Code. THIRD: A. This Corporation is authorized to issue two classes of shares to be designated respectively Preferred Stock ("Preferred Stock") and Common Stock ("Common Stock"). The total number of shares of Common Stock this Corporation shall have authority to issue is Seventy Million (70,000,000). The total number of shares of Preferred Stock this Corporation shall have authority to issue is Seventeen Million Five Hundred Seventy Thousand (17,570,000), of which Five Million Nine Hundred Seventy Thousand (5,970,000) shares are designated "Series D Preferred Stock," and One Million Six Hundred Thousand (1,600,000) shares are designated "Series E Preferred Stock." The Board of Directors of this corporation is authorized to determine or alter the rights, privileges, preferences and restrictions granted to or imposed upon any wholly unissued shares or series of shares of Preferred Stock, and within the limitations or restrictions stated in any resolution or resolutions of the Board of Directors originally fixing the number of shares constituting any series, to increase or decrease (but not below the number of shares of any series then outstanding) the number of shares of any such series subsequent to the issue of shares of that series, to determine the designation of any series, and to fix the number of shares of any series. Upon the filing of these Amended and Restated Articles of Incorporation, each ten (10) shares of Common Stock then outstanding ("Old Common Stock") shall be combined into one (1) share of Common Stock. In lieu of fractional shares, the corporation will distribute one whole share of Common Stock. B. The rights, preferences, privileges, restrictions and other matters relating to the Series D and E Preferred Stock are as follows: 1. DIVIDENDS. (a) The holders of the Series D and E Preferred Stock shall be entitled to receive, when and as declared by the Corporation's Board of Directors (the "Board of Directors"), and out of any funds legally available therefor, cumulative dividends on each share at the rate of $0.125 per share per annum, payable in cash annually as the Board of Directors may from time to time determine. Such dividends shall accrue on each share from the date of its original issue and shall accrue from day to day, whether or not earned or declared. Such dividends shall be cumulative so that if such dividends in respect of any previous or current annual dividend period, at the annual rate specified above, shall not have been paid or declared and a sum sufficient for the payment thereof set apart, the deficiency shall first be fully paid before any dividend (other than those payable solely in the Common Stock of the Corporation) or other distribution shall be paid on or declared and set apart for the Common Stock. Except as limited by the provisions of California Corporations Code Sections 500 et. seq., in the event the Corporation conducts an initial public offering of its Common Stock which would cause an automatic conversion of the Series D and E Preferred Stock to Common Stock (as provided below), the Board of Directors, prior to such conversion, shall declare a dividend of accumulated and unpaid dividends, PROVIDED, HOWEVER, that the Board of Directors in its sole discretion may declare such dividend to holders of the Series D and E Preferred Stock as of a record date determined by the Board of Directors (the "Dividend Record Date"), and payment of such dividend may be made in shares of Common Stock in lieu of cash (the "Share Dividend"). The number of shares of Common Stock to be paid in the Share Dividend shall be calculated by dividing the cumulative dividend payable as of the Dividend Record Date by the price at which shares of Common Stock are offered to the public in the initial public offering, net of underwriting discounts. The Share Dividend shall be payable upon, and shall be contingent upon, the closing of such initial public offering. Upon payment of the Share Dividend, the Corporation shall have no further obligation to pay dividends with respect to the Series D and E Preferred Stock. (b) In the event the Corporation shall declare a distribution (OTHER THAN any distribution described in Section 2) payable in securities of other persons, evidences of indebtedness issued by the Corporation or other persons, assets (excluding cash dividends) or options or rights to purchase any such securities or evidences of indebtedness, then, in each such case the holders of the Series D and E Preferred Stock shall be entitled to a proportionate share of any such distribution as though the holders of the Series D and E Preferred Stock were the holders of the number of shares of Common Stock of the Corporation into which their respective shares of Series D and E Preferred Stock are convertible as of the record date fixed for the determination of the holders of Common Stock of the Corporation entitled to receive such distribution. (c) Each holder of shares of Series D and E Preferred Stock shall be deemed to have consented, for purposes of Sections 502, 503 and 506 of the General Corporation Law of the State of California, to distributions made by the Corporation in connection with the repurchase of shares of Common Stock issued to or held by employees or consultants upon termination of their employment or services pursuant to agreements providing for such repurchase. 2. LIQUIDATION PREFERENCE. (a) In the event of any liquidation, dissolution or winding up of the Corporation, either voluntary or involuntary, the holders of the Series D and E Preferred Stock shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Corporation to the holders of the Common Stock by reason of their ownership thereof, the amount of $1.25 per share (as adjusted for any stock dividends, combinations or splits with respect to such shares) plus all declared or accumulated but unpaid dividends on such share for each share of Series D and E Preferred Stock then held by them and no more. If upon the occurrence of such event, the assets and funds thus distributed among the holders of the Series D and E Preferred Stock shall be insufficient to permit the payment to such holders of the full aforesaid preferential amount, then the entire assets and funds of the Corporation legally available for distribution shall be distributed ratably among the holders of the Series D and E Preferred Stock in proportion to the preferential amount each such holder is otherwise entitled to receive. (b) After payment to the holders of the Series D and E Preferred Stock of the amounts set forth in subparagraph (a) above, the entire remaining assets and funds of the Corporation legally available for distribution, if any, shall be distributed among the holders of the Common Stock and the Series D and E Preferred Stock in proportion to the shares of Common Stock then held by them and the shares of Common Stock which they then have the right to acquire upon conversion of the shares of Series D and E Preferred Stock then held by them. (c) For purposes of this Section 2, (i) any acquisition of the Corporation by means of merger or other form of corporate reorganization in which outstanding shares of the Corporation are exchanged for securities or other consideration issued, or caused to be issued, by the acquiring corporation, or its subsidiary (other than a mere reincorporation transaction), (ii) any transaction or series of transactions within any three-month period pursuant to an agreement to which the Corporation is a party (other than a registered public offering pursuant to which the Series D and E Preferred Stock are automatically converted into Common Stock pursuant to Section 4(b) below) in which greater than fifty percent (50%) of the Corporation's voting securities (on an as-converted-to-Common Stock basis) shall be transferred, or (iii) a sale of all or substantially all of the assets of the Corporation, shall be treated as a liquidation, dissolution or winding up of the Corporation and shall entitle the holders of Series D and E Preferred Stock to receive at the closing in cash or securities (valued as provided in (d) below) amounts as specified in subparagraphs (a) and (b) above. (d) Whenever the distribution provided for in this Section 2 shall be payable in property other than cash, the value of such distribution shall be the fair market value of such property as determined in good faith by the Board of Directors. 3. VOTING RIGHTS; DIRECTORS. (a) The holder of each share of the Series D and E Preferred Stock shall be entitled to the number of votes equal to the number of shares of Common Stock into which such share of Series D and E Preferred Stock could be converted and shall have voting rights and powers equal to the voting rights and powers of the Common Stock (except as otherwise expressly provided herein or as required by law, voting together with the Common Stock as a single class) and shall be entitled to notice of any shareholders' meeting in accordance with the Bylaws of the Corporation. Fractional votes shall not, however, be permitted and any fractional voting rights resulting from the above formula (after aggregating all shares into which shares of Series D and E Preferred Stock held by each holder could be converted) shall be rounded to the nearest whole number (with one-half being rounded upward). Each holder of Common Stock shall be entitled to one vote for each share of Common Stock held. (b) Prior to the conversion of the Series D and Series E Preferred Stock to Common Stock, the Board of Directors shall consist of seven (7) members. The holders of Series D Preferred Stock, as a class, shall be entitled to designate five (5) members of the Board of Directors. The holders of the Common Stock, as a class, shall be entitled to designate the remaining two (2) members of the Board of Directors. So long as any shares of Series D Preferred Stock remain outstanding, the Corporation shall not, without the vote or written consent of the holders of more than eighty percent (80%) of the then outstanding shares of Series D Preferred Stock, change the authorized number of directors of the Corporation or the terms of this Section 3(b). The Corporation shall not take any of the actions described in Sections 5 or 6 below without the approval of a majority of the Board of Directors. (c) In the case of any vacancy in the office of a director occurring among the directors elected by the holders of the Series D Preferred Stock or Common Stock pursuant to the second and third sentences of Section 3(b) hereof, the remaining director or directors so elected by the holders of the Series D Preferred Stock or Common Stock may elect a successor or successors to hold the office for the unexpired term of the director or directors whose place or places shall be vacant. Any director who shall have been elected by the holders of the Series D Preferred Stock or Common Stock or any director so elected as provided in the preceding sentence hereof, shall be removed during the aforesaid term of office, whether with or without cause, only by the affirmative vote of the holders of a majority of the Series D Preferred Stock or Common Stock, as the case may be. 4. CONVERSION. The holders of the Preferred Stock shall have respective conversion rights as follows (the "Conversion Rights"): (a) RIGHT TO CONVERT. Each share of Series D Preferred Stock shall be convertible, at the option of the holder thereof, at any time after the date of issuance of such share, at the office of the Corporation or any transfer agent for such stock, into such number of fully paid and non-assessable shares of Old Common Stock as is determined by dividing $1.25 by the Series D Conversion Price applicable to such share, determined as hereinafter provided, in effect on the date the certificate is surrendered for conversion. The price at which shares of Old Common Stock shall be deliverable upon conversion of shares of the Series D Preferred Stock (the "Series D Conversion Price") shall initially be $.16848 per share of Old Common Stock. Such initial Series D Conversion Price shall be adjusted as hereinafter provided. Each share of Series E Preferred Stock shall be convertible, at the option of the holder thereof, at any time after the date of issuance of such share, at the office of the Corporation or any transfer agent for such stock, into such number of fully paid and non-assessable shares of Old Common Stock as is determined by dividing $1.25 by the Series E Conversion Price applicable to such share, determined as hereinafter provided, in effect on the date the certificate is surrendered for conversion. The price at which shares of Old Common Stock shall be deliverable upon conversion of shares of the Series E Preferred Stock (the "Series E Conversion Price") shall initially be $.34 per share of Old Common Stock. Such initial Series E Conversion Price shall be adjusted as hereinafter provided. (b) AUTOMATIC CONVERSION. Each share of Series D Preferred Stock shall automatically be converted into shares of Old Common Stock at the then-effective Series D Conversion Price upon the earlier of (i) the date specified by written agreement of at least eighty percent (80%) of the Series D Preferred Stock then outstanding, or (ii) immediately upon the closing of the sale of the Corporation's Common Stock in a firm commitment, underwritten public offering registered under the Securities Act of 1933, as amended (other then a registration relating solely to a transaction under Rule 145 under such Act (or any successor thereto) or to an employee benefit plan of the Company), at a public offer price (prior to underwriter commissions and expenses) equal to or exceeding $6.00 per share of Common Stock (as adjusted for any stock dividends, combinations or splits with respect to such shares) and the aggregate proceeds to the Corporation (after deduction for underwriter commissions and expenses relating to the issuance, including without limitation fees of the Corporation's counsel) of which equal or exceed $7,500,000. Each share of Series E Preferred Stock shall automatically be converted into shares of Old Common Stock at the then-effective Series E Conversion Price upon the earlier of (i) the date specified by written agreement of at least eighty percent (80%) of the Series E Preferred Stock then outstanding, or (ii) immediately upon the closing of the sale of the Corporation's Common Stock in a firm commitment, underwritten public offering registered under the Securities Act of 1933, as amended (other then a registration relating solely to a transaction under Rule 145 under such Act (or any successor thereto) or to an employee benefit plan of the Company), at a public offer price (prior to underwriter commissions and expenses) equal to or exceeding $6.00 per share of Common Stock (as adjusted for any stock dividends, combinations or splits with respect to such shares) and the aggregate proceeds to the Corporation (after deduction for underwriter commissions and expenses relating to the issuance, including without limitation fees of the Corporation's counsel) of which equal or exceed $7,500,000. (c) MECHANICS OF CONVERSION. (i) Before any holder of Series D or E Preferred Stock shall be entitled to convert the same into shares of Old Common Stock, he shall surrender the certificate or certificates thereof, duly endorsed, at the office of the Corporation or of any transfer agent for such stock, and shall give written notice to the Corporation at such office that he elects to convert the same and shall state therein the name or names in which he wishes the certificate or certificates for shares of to be issued. The Corporation shall, as soon as practicable thereafter, issue and deliver at such office to such holder of Series D or E Preferred Stock, a certificate or certificates for the number of shares of Common Stock to which he shall be entitled , after taking into account the reverse stock split as provided in Article Third, Section A of these Amended and Restated Articles of Incorporation. Such conversion shall be deemed to have been made immediately prior to the close of business on the date of surrender of the shares of Series D or E Preferred Stock to be converted, and the person or persons entitled to receive the shares of Common Stock issuable upon such conversion shall be treated for all purposes as the record holder or holders of such shares of Common Stock on such date. (ii) If the conversion is in connection with an underwritten offering of securities pursuant to the Securities Act, the conversion may, at the option of any holder tendering shares of Series D or E Preferred Stock for conversion, be conditioned upon the closing with the underwriters of the sale of securities pursuant to such offering, in which event the person(s) entitled to receive the Common Stock upon conversion of the Series D or E Preferred Stock shall not be deemed to have converted such Series D or E Preferred Stock until immediately prior to the closing of such sale of securities. (d) ADJUSTMENTS TO SERIES D AND SERIES E CONVERSION PRICE FOR CERTAIN DILUTING ISSUES. (i) SPECIAL DEFINITIONS. For purposes of this Section 4(d), the following definitions apply: (1) 'OPTIONS' shall mean rights, options, or warrants to subscribe for, purchase or otherwise acquire either Common Stock or Convertible Securities. (2) 'ORIGINAL ISSUE DATE' shall mean the date on which a share of Series D or E Preferred Stock was first issued. (3) 'CONVERTIBLE SECURITIES' shall mean any evidences of indebtedness, shares (other than the Common Stock and Series D and E Preferred Stock) or other securities convertible into or exchangeable for Common Stock. (4) 'ADDITIONAL SHARES OF COMMON STOCK ' shall mean all shares of Common Stock issued (or, pursuant to Section 4(d)(iii), deemed to be issued) by the Corporation after the Original Issue Date, other than shares of Common Stock issued or issuable: (A) upon conversion of shares of Series D or E Preferred Stock; (B) to officers, directors or bona fide employees of, or consultants to, the Corporation pursuant to stock option or stock purchase plans, on terms approved by the Board of Directors, but not exceeding 9,652,067 shares of Old Common Stock (including for purposes of calculating said 9,652,067 shares, 2,207,768 shares outstanding on the Original Issue Date and net of any repurchases of such 9,652,067 shares), subject to adjustment for all subdivisions and combinations; (C) in connection with lease or working capital financing on terms approved by the Board of Directors, but not exceeding 2,418,950 shares of Old Common Stock (including shares issuable upon exercise of any warrants issued in connection with such lease or working capital financings), subject to adjustment for all subdivisions and combinations; (D) as a dividend or distribution on Series D or E Preferred Stock; or (E) for which adjustment of the Series D or Series E Conversion Price is made pursuant to Section 4(e). (ii) NO ADJUSTMENT OF CONVERSION PRICE. No adjustment in the Conversion Price for a series of Preferred Stock shall be made in respect of the issuance of Additional Shares of Common Stock unless the consideration per share (determined pursuant to Section 4(d)(v) hereof) for an Additional Share of Common Stock issued or deemed to be issued by the Corporation is less than the respective Series D or Series E Conversion Price in effect on the date of, and immediately prior to such issue. (iii) DEEMED ISSUE OF ADDITIONAL SHARES OF COMMON STOCK. In the event the Corporation at any time or from time to time after the Original Issue Date shall issue any Options or Convertible Securities or shall fix a record date for the determination of holders of any class of securities then entitled to receive any such Options or Convertible Securities, then the maximum number of shares (as set forth in the instrument relating thereto without regard to any provisions contained therein designed to protect against dilution) of Common Stock issuable upon the exercise of such Options or in the case of Convertible Securities and Options therefor, the conversion or exchange of such Convertible Securities, shall be deemed to be Additional Shares of Common Stock issued as of the time of such issue or, in case such a record date shall have been fixed, as of the close of business on such record date, provided that Additional Shares of Common Stock shall not be deemed to have been issued unless the consideration per share (determined pursuant to Section 4(d)(v) hereof) of such Additional Shares of Common Stock would be less than the Series D or E Conversion Price in effect on the date of and immediately prior to such issue, or such record date, as the case may be, and provided further that in any such case in which Additional Shares of Common Stock are deemed to be issued: (1) no further adjustments in the Series D or E Conversion Price shall be made upon the subsequent issue of Convertible Securities or shares of Common Stock upon the exercise of such Options or conversion or exchange of such Convertible Securities; (2) if such Options or Convertible Securities by their terms provide, with the passage of time or otherwise, for any increase in the consideration payable to the Corporation, or decrease in the number of shares of Common Stock issuable, upon the exercise, conversion or exchange thereof, the Series D or E Conversion Price computed upon the original issue thereof (or upon the occurrence of a record date with respect thereto), and any subsequent adjustments based thereon, shall, upon any such increase or decrease becoming effective, be recomputed to reflect such increase or decrease insofar as it affects such Options or the rights of conversion or exchange under such Convertible Securities (provided, however, that no such adjustment of the Series D or E Conversion Price shall effect Common Stock previously issued upon conversion of the Series D or E Preferred Stock); (3) upon the expiration of any such Options or any rights of conversion or exchange under such Convertible Securities which shall not have been exercised, the Series D or E Conversion Price computed upon the original issue thereof (or upon the occurrence of a record date with respect thereto), and any subsequent adjustments based thereon, shall, upon such expiration, be recomputed as if: (A) in the case of Convertible Securities or Options for Common Stock the only Additional Shares of Common Stock issued were the shares of Common Stock, if any, actually issued upon the exercise of such Options or the conversion or exchange of such Convertible Securities and the consideration received therefor was the consideration actually received by the Corporation for the issue of all such Options, whether or not exercised, plus the consideration actually received by the Corporation upon such exercise, or for the issue of all such Convertible Securities which were actually converted or exchanged, plus the additional consideration, if any, actually received by the Corporation upon such conversion or exchange; and (B) in the case of Options for Convertible Securities only the Convertible Securities, if any, actually issued upon the exercise thereof were issued at the time of issue of such Options, and the consideration received by the Corporation for the issue of all such Options, whether or not exercised, plus the consideration deemed to have been received by the Corporation (determined pursuant to Section 4(d)(v) upon the issue of the Convertible Securities with respect to which such Options were actually exercised; (4) no readjustment pursuant to clause (2) or (3) above shall have the effect of increasing the Series D or E Conversion Price to an amount which exceeds the lower of (A) the Series D or E Conversion Price on the original adjustment date, or (B) the Series D or E Conversion Price that would have resulted from any issuance of Additional Shares of Common Stock between the original adjustment date and such readjustment date; and (5) in the case of any Options which expire by their terms not more than 30 days after the date of issue thereof, no adjustment of the Series D or E Conversion Price shall be made until the expiration or exercise of all such Options, whereupon such adjustment shall be made in the same manner provided in clause (3) above. (iv) ADJUSTMENT OF CONVERSION PRICE UPON ISSUANCE OF ADDITIONAL SHARES OF COMMON STOCK. In the event this Corporation, at any time after the Original Issue Date shall issue Additional Shares of Common Stock (including Additional Shares of Common Stock deemed to be issued pursuant to Section 4(d)(iii)) without consideration or for a consideration per share less than the Conversion Price with respect to any series of Preferred Stock in effect on the date of and immediately prior to such issue, then and in such event, the Conversion Price for such series of Preferred Stock shall be reduced, concurrently with such issue, to a price calculated to the nearest one-tenth of a cent) determined by multiplying such Conversion Price by a fraction, the numerator of which shall be the number of shares of Common Stock outstanding immediately prior to such issue plus the number of shares of Common Stock which the aggregate consideration received by the Corporation for the total number of Additional Shares of Common Stock so issued would purchase at such Conversion Price in effect immediately prior to such issuance, and the denominator of which shall be the number of shares of Common Stock outstanding immediately prior to such issue plus the number of such Additional Shares of Common Stock so issued. For the purpose of the above calculation, the number of shares of Common Stock outstanding immediately prior to such issue shall be calculated on a fully diluted basis, as if all shares of Series D or E Preferred Stock and all Convertible Securities had been fully converted into shares of Common Stock and any outstanding Options for the purchase of shares of stock or Convertible Securities had been fully exercised (and the resulting securities fully converted into shares of Common Stock, if so convertible) as of such date, but not including in any such calculation any additional shares of Common Stock issuable with respect to shares of Series D or E Preferred Stock, Convertible Securities, or outstanding Options for the purchase of shares of stock or Convertible Securities, solely as a result of the adjustment of the respective Conversion Prices (or other conversion ratios) resulting from the issuances of Additional Shares of Common Stock causing such adjustment. (v) DETERMINATION OF CONSIDERATION. For purposes of this Section 4(d), the consideration received by the Corporation for the issue of any Additional Shares of Common Stock shall be computed as follows: (1) CASH AND PROPERTY: Such consideration shall: (A) insofar as it consists of cash, be computed at the aggregate amount of cash received by the Corporation excluding amounts paid or payable for accrued interest or accrued dividends; (B) insofar as it consists of property other than cash, be computed at the fair value thereof at the time of such issue, as determined in good faith by the Board; and (C) in the event Additional Shares of Common Stock are issued together with other shares or securities or other assets of the Corporation for consideration which covers both, be the proportion of such consideration so received, computed as provided in clauses (A) and (B) above, as determined in good faith by the Board. (2) OPTIONS AND CONVERTIBLE SECURITIES . The consideration per share received by the Corporation for Additional Shares of Common Stock deemed to have been issued pursuant to Section 4(d)(iii), relating to Options and Convertible Securities, shall be determined by dividing (A) the total amount, if any, received or receivable by the Corporation as consideration for the issue of such Options or Convertible Securities, plus the minimum aggregate amount of additional consideration (as set forth in the instruments relating thereto, without regard to any provision contained therein designed to protect against dilution) payable to the Corporation upon the exercise of such Securities, or in the case of Options for Convertible Securities, the exercise of such Options for Convertible Securities and the conversion or exchange of such Convertible Securities by (B) the maximum number of shares of Common Stock (as set forth in the instruments relating thereto, without regard to any provision contained therein designed to protect against the dilution) issuable upon the exercise of such Options or conversion or exchange of such Convertible Securities. (e) ADJUSTMENTS TO CONVERSION PRICES FOR STOCK DIVIDENDS AND FOR COMBINATIONS OR SUBDIVISIONS OF COMMON STOCK. In the event that this Corporation at any time or from time to time after the Original Issue Date shall declare or pay any dividend on the Common Stock payable in Common Stock or in any right to acquire Common Stock, or shall effect a subdivision of the outstanding shares of Common Stock into a greater number of shares of Common Stock (by stock split, reclassification or otherwise than by payment of a dividend in Common Stock or in any right to acquire Common Stock), or in the event the outstanding shares of Common stock shall be combined or consolidated, by reclassification or otherwise, into a lesser number of shares of Common Stock, then the Conversion Price in effect immediately prior to such event shall, concurrently with the effectiveness of such event, be proportionately decreased or increased, as appropriate. In the event that this Corporation shall declare or pay, without consideration, any dividend on the Common Stock payable in any right to acquire Common Stock for no consideration then the Corporation shall be deemed to have made a dividend payable in Common Stock in an amount of shares equal to the maximum number of shares issuable upon exercises of such rights to acquire Common Stock. (f) ADJUSTMENTS FOR RECLASSIFICATION AND REORGANIZATION. If the Common Stock issuable upon conversion of the Series D and E Preferred Stock shall be changed into the same or a different number of shares of any other class or class of stock, whether by capital reorganization, reclassification or otherwise (other than a subdivision or combination of shares provided for in Section 4(e) above or a merger or other reorganization referred to in Section 2(c) above), the Series D and E Conversion Price then in effect shall, concurrently with the effectiveness of such reorganization or reclassification, be proportionately adjusted so that the Series D and E Preferred Stock shall be convertible into, in lieu of the number of shares of Common Stock which the holders would otherwise have been entitled to receive, a number of shares of such other class or classes of stock equivalent to the number of shares of Common Stock that would have been subject to receipt by the holders upon conversion of the Series D and E Preferred Stock immediately before that change. (g) NO IMPAIRMENT. The Corporation will not, by amendment of its Articles of Incorporation or through any reorganization, transfer of assets, consolidation, merger, dissolution, issue or sale of securities or any other voluntary action, avoid or seek to avoid the observance or performance of any of the terms to be observed or performed hereunder by the Corporation, but will at all times in good faith assist in the carrying out of all the provisions of this Section 4 and in the taking of all such action as may be necessary or appropriate in order to protect the Conversion Rights of the holders of the Series D and E Preferred Stock against impairment. (h) CERTIFICATES AS TO ADJUSTMENTS. Upon the occurrence of each adjustment or readjustment of the Conversion Price pursuant to this Section 4, the Corporation at its expense shall promptly compute such adjustment or readjustment in accordance with the terms hereof and cause independent public accountants selected by the corporation to verify such computation and prepare and furnish to each holder of Series D or E Preferred Stock, within ten (10) days following the occurrence of the event causing such adjustment or readjustment and showing in detail the facts upon which such adjustment or readjustment is based. The Corporation shall, upon the written request at any time of any holder of Series D or E Preferred Stock, furnish or cause to be furnished to such holder a like certificate setting forth (i) such adjustments and readjustments, (ii) the Conversion Price at the time in effect, and (iii) the number of shares of Common Stock and the amount, if any, of other property which at the time would be received upon the conversion of Series D or E Preferred Stock. (i) NOTICES OF RECORD DATE. In the event that the Corporation shall propose at any time: (i) to declare any dividend or distribution upon its Common Stock, whether in cash, property, stock or other securities, whether or not a regular cash dividend and whether or not out of earnings or earned surplus; (ii) to offer for subscription pro rata to the holders of any class or series of its stock any additional shares of stock of any class or series or other rights; (iii) to effect any reclassification or recapitalization of its common Stock outstanding involving a change in the common Stock; (iv) to merge or consolidate with or into any other corporation, or sell, lease or convey all or substantially all of its assets, or to liquidate, dissolve or wind up; or (v) to enter into any transaction or series of transactions within any three-month period pursuant to any agreement to which the corporation is a party (other than a registered public offering pursuant to which the Series D and E Preferred Stock is automatically converted into Common Stock pursuant to Section 4(b) above) in which greater than fifty percent (50%)of the Corporation's voting securities (on an as-converted-to-Common Stock basis) shall be transferred; Then, in connection with each such event, the Corporation shall send to holders of Series D and E Preferred Stock: (1) at least twenty (20) days' prior written notice of the date on which a record shall be taken for such dividend, distribution or subscription rights (and specifying the date on which the holders of Common Stock shall be entitled thereto) or for determining rights to vote, if any, in respect of the matters referred to in (iii), (iv) and (v) above; and (2) in the case of the matters referred to in (iii), (iv) and (v) above, at least twenty (20) days' prior written notice of that date when the same shall take place (and specifying the date on which the holders of Common Stock shall be entitled to exchange their Common Stock for securities or other property deliverable upon the occurrence of such event). (j) ISSUE TAXES. The Corporation shall pay any and all issue and other taxes that may be payable in respect of any issue or delivery of shares of common Stock on conversion of shares of Series D or E Preferred Stock pursuant hereto; provided, however, that the corporation shall not be obligated to pay any transfer taxes resulting from any transfer requested by any holder in connection with any such conversion. (k) RESERVATION OF STOCK ISSUABLE UPON CONVERSION . The Corporation shall at all times reserve and keep available out of its authorized but unissued shares of Common Stock, solely for the purpose of effecting the conversion of the shares of the Series D and E Preferred Stock, such number of its shares of Common Stock as shall from time to time be sufficient to effect the conversion of all outstanding shares of the Series D and E Preferred Stock; and if at any time the number of authorized but unissued shares of Common Stock shall not be sufficient to effect the conversion of all then outstanding shares of the Series D and E Preferred Stock, the Corporation will take such corporate action as may, in the opinion of its counsel, be necessary to increase its authorized but unissued shares of Common Stock to such number of shares as shall be sufficient for such purpose, including, without limitation, engaging in best efforts to obtain the requisite shareholder approval of any necessary amendment to this Certificate. (l) FRACTIONAL SHARES. No fractional share shall be issued upon the conversion of any share or shares of Series D or E Preferred Stock. All shares of Common Stock (including fractions thereof) issuable upon conversion of more than one share of Series D or E Preferred Stock by a holder thereof shall be aggregated for purposes of determining whether the conversion would result in the issuance of any fractional share. If, after the aforementioned aggregation, the conversion would result in the issuance of a fraction of a share of Common Stock, the Corporation shall, in lieu of issuing any fractional share, pay the holder otherwise entitled to such fraction a sum in cash equal to the fair market value of such fraction on the date of conversion (as determined in good faith by the Board of Directors of the Corporation). (m) NOTICES. Any notice required by the provisions of this section 4 to be given to the holders of shares of Series D or E Preferred Stock shall be deemed given if deposited in the United States mail, postage prepaid, certified and return receipt requested, and addressed to each holder of record at the address appearing on the books of the Corporation provided that any notice to be given to a holder of shares of Series D or E Preferred Stock residing outside of the United States shall be given by facsimile and second day courier service to the address of such holder as it appears on the books of the Corporation. 5. AMENDMENT. Except as provided in Section 3(b) herein, any term relating to the Series D or E Preferred Stock may be amended and the observance of any term relating to any shares of that series of Preferred Stock may be waived (either generally or in a particular instance and either retroactively or prospectively) only with the vote or written consent of holders of more that fifty percent (50%) of that series of Preferred Stock then outstanding. Any amendment or waiver so effected shall be binding upon the Corporation and all holders of such series of Preferred Stock. 6. RESTRICTIONS AND LIMITATIONS. Except as provided in Section 3(b) herein, so long as any shares of Series D or E Preferred Stock remain outstanding, the Corporation shall not, without the vote or written consent by the holders of more than fifty percent (50%) of the then outstanding share of Series D and E Preferred Stock: (i) Redeem, purchase or otherwise acquire for value (or pay into or set aside for a sinking fund for such purpose) any share or shares of Series D or E Preferred Stock otherwise than by conversion in accordance with Section 4 hereof, or (ii) Pay any dividends on, or purchase, redeem or otherwise acquire (or pay into or set aside for a sinking fund for such purpose), any of the Common Stock of the Corporation, provided, however, that this restriction shall not apply to the repurchase of shares of Common Stock from directors, officers, consultants or employees of the corporation or any subsidiary pursuant to agreements approved by the corporations's Board of Directors under which the Corporation has the option to repurchase such shares at the repurchase price set forth in such agreements, not to exceed original or the most recent issuance price of such stock, upon the occurrence of certain events, such as the termination of employment, or (iii) Effect any sale, lease, assignment, transfer or other conveyance of all or substantially all of the assets of the Corporation or any of its subsidiaries, or any consolidation or merger involving the Corporation or any of its subsidiaries, or (iv) Permit any subsidiary to issue or sell, or obligate itself to issue or sell, except to the Corporation or any wholly owned subsidiary, any stock of such subsidiary, or (v) Effect any reclassification, recapitalization or other change with respect to any outstanding shares of stock which results in the issuance of shares of stock having any preference or priority as to dividend or redemption rights, liquidation preferences, conversion rights, voting rights or otherwise, superior to any such preference or priority of the Series D or E Preferred Stock, or (vi) Increase of decrease (other than by redemption or conversion) the total number of authorized shares of Preferred Stock of the Corporation or the total number of such shares of Preferred Stock designated Series D or E Preferred Stock, or (vii) Authorize or issue, or obligate itself to issue, any other equity security senior to the Series D or E Preferred Stock as to dividend or redemption rights, liquidation preferences, conversion rights, voting rights or otherwise, or create any obligation or security convertible into or exchangeable for, or having any option rights to purchase, any such equity security which is senior to the Series D or E Preferred Stock, or (viii) Reduce the dividend rate on the Series D or E Preferred Stock provided for herein, or make such dividends noncumulative, or defer the date from which dividend will accrue, or cancel accrued and unpaid dividends, or change the relative seniority rights of the holders of the Series D or E Preferred Stock as to the payment of dividends in relation to the holders of any other capital stock of the Corporation, or (ix) Reduce the amount payable to the holders of the Series D or E Preferred Stock upon the voluntary or involuntary liquidation, dissolution, or winding up of the Corporation, or change the relative seniority of the liquidation preferences of the holders of the Series D or E Preferred Stock to the rights upon liquidation of the holders of any other capital stock of the Corporation, or (x) Make the Series D or E Preferred Stock redeemable at the option of the Corporation; or (xi) Cancel or modify the Conversion Rights provided for in Section 4 hereof. 7. NO REISSUANCE OF SERIES D OR E PREFERRED STOCK. No share of shares of Series D or E Preferred Stock acquired by the Corporation by reason of redemption, purchase, conversion or otherwise shall be reissued, and all such shares shall be canceled, retired and eliminated from the shares which the Corporation shall be authorized to issue. FOURTH: A. The liability of the directors of the Corporation for monetary damages shall be eliminated to the fullest extent permissible under California law. B. The Corporation is authorized to indemnify the directors and officers of the Corporation to the fullest extent permissible under California law. C. Any repeal or modification of the foregoing provisions of this Article FOURTH by the shareholders of this Corporation shall not adversely affect any right or protection of an agent of this Corporation existing at the time of such appeal or modification. FIFTH: That, effective upon conversion of the Series D and Series E Preferred Stock to Common Stock, the number of Directors of the Corporation shall be no fewer than five (5) nor more than nine (9). 3. That the foregoing Amendment and Restatement of the Articles of Incorporation has been duly approved by the Board of Directors of this Corporation. 4. That the foregoing Amendment and Restatement of Articles of Incorporation set forth herein has been duly approved by the required vote of shareholders in accordance with Section 902 of the Corporations Code. The total number of shares entitled to vote on or consent to the Amendment and Restatement is 8,411,768 shares of Old Common Stock , 5,970,000 shares of Series D Preferred Stock and 1,600,000 shares of Series E Preferred Stock. The percentage of shares required to effect the amendment was (i) a majority of the outstanding shares of Old Common Stock Preferred Stock, (ii) 50% of the outstanding shares of the Series D Preferred Stock and (iii) 50% of the outstanding Series E Preferred Stock. The number of shares voting in favor of this amendment exceeded the vote required. /S/ROBERT PEPPER Robert Pepper, President /S/JOSEPH LANDY Joseph Landy, Secretary We further declare under penalty of perjury under the laws of the State of California that the matters set forth in this certificate are true and correct of our own knowledge. Executed at SACRAMENTO, California, on July 30, 1993. /S/ROBERT PEPPER Robert Pepper, President Joseph Landy, Secretary - 5 - THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL STATEMENTS FOR THE PERIOD ENDED DECEMBER 28, 1997, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. EX-27.1 FINANCIAL DATA SCHEDULE [MULTIPLIER] 1,000 [PERIOD-TYPE] YEAR [FISCAL-YEAR-END] DEC-28-1997 [PERIOD-END] DEC-28-1997 [CASH] 25234 [SECURITIES] 112560 [RECEIVABLES] 30422 [ALLOWANCES] 343 [INVENTORY] 26118 [CURRENT-ASSETS] 203016 [PP&E] 57671 [DEPRECIATION] 25876 [TOTAL-ASSETS] 277697 [CURRENT-LIABILITIES] 36777 [BONDS] 115000 [PREFERRED-MANDATORY] 0 [PREFERRED] 0 [COMMON] 91897 [OTHER-SE] 31548 [TOTAL-LIABILITY-AND-EQUITY] 277697 [SALES] 155219 [TOTAL-REVENUES] 156262 [CGS] 65299 [TOTAL-COSTS] 65299 [OTHER-EXPENSES] 64588 [LOSS-PROVISION] 0 [INTEREST-EXPENSE] 1806 [INCOME-PRETAX] 28638 [INCOME-TAX] 9447 [INCOME-CONTINUING] 19191 [DISCONTINUED] 0 [EXTRAORDINARY] 0 [CHANGES] 0 [NET-INCOME] 19191 [EPS-PRIMARY] .95 [EPS-DILUTED] .89 -----END PRIVACY-ENHANCED MESSAGE-----