-----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, Ka4gX0aAvXU7fX0CkiN/SEvMCJpyzHLacg4AtmMSJAY1LBvubNoiT9kZ14a/HuPC M7TgAmUA+qaBQuLatknLVg== 0000929624-98-001636.txt : 19981008 0000929624-98-001636.hdr.sgml : 19981008 ACCESSION NUMBER: 0000929624-98-001636 CONFORMED SUBMISSION TYPE: 8-K/A PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19980706 ITEM INFORMATION: FILED AS OF DATE: 19981007 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: 8-K/A SEC ACT: SEC FILE NUMBER: 000-22068 FILM NUMBER: 98722327 BUSINESS ADDRESS: STREET 1: 9750 GOETHE RD CITY: SACRAMENTO STATE: CA ZIP: 95627 BUSINESS PHONE: 9168555000 MAIL ADDRESS: STREET 1: 9750 GOETHE ROAD CITY: SACREMENTO STATE: CA ZIP: 95827 8-K/A 1 AMENDMENT NO. 2 TO FORM 8-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 _________________________ FORM 8-K/A CURRENT REPORT AMENDMENT NO. 2 Pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 Date of Report (Date of earliest event reported) July 6, 1998 ------------------------- LEVEL ONE COMMUNICATIONS, INCORPORATED ------------------------------------------------------------------ (exact name of registrant as specified in charter) California 0-22068 33-0128224 - --------------------------------------------------------------------------- (State or other (Commission File Number) (IRS Employer jurisdiction of Inc.) Identification No.) 9750 Goethe Road, Sacramento,CA 95827 - --------------------------------------------------------------------------- (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code: (916) 855-5000 ------------------------ NOT APPLICABLE - -------------------------------------------------------------------------------- (Former name or former address, if changed since last report) ITEM 5. OTHER EVENTS On September 21, 1998, the Registrant filed Amendment No. 1 to the Registrant's Current Report on Form 8-K dated July 17, 1998 (the "Report") to report certain financial information (the "Financial Information") in connection with the Registrant's acquisition of Acclaim Communications, Inc., a Delaware corporation ("Acclaim"). The purpose of this Amendment No. 2 is to: (i) Provide Management's Discussion and Analysis of Financial Condition and Results of Operations for the fiscal years ended December 28, 1997 and December 29, 1996 to reflect the Registrant's acquisition of Acclaim. This is contained on pages 3 to 6 of this report. (ii) Set forth the audited Financial Information. This is contained on pages 7 to 29 of this report. (iii) Provide certain supplementary unaudited Financial Information for the periods ending March 29, 1998, June 28, 1998, March 30, 1997, and June 29, 1997 to reflect the Registrant's acquisition. This is contained on pages 30 to 42 of this report. 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW On July 6, 1998 the Company merged with Acclaim Communications, Inc. in a transaction accounted for as a pooling of interests. The management discussion and analysis below reflects the pooled entity 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. 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 $156.5 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. 3 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 $155,457 $111,392 $77,417 Cost of product sales 65,582 48,477 33,300 -------- -------- ------- Gross margin $ 89,875 $ 62,915 $44,117 ======== ======== ======= Gross margin % product sales 57.8% 56.5% 57.0%
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 $35.4 million in 1997, $26.8 million in 1996 and $18.0 million in 1995. As a percent of revenues, R&D expenses were 22.6%, 23.9%, and 23.0% 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 21.7% and 22.1% for 1996 and 1995, respectively. As previously stated in the gross margin section, in 1996 the Company began accounting 4 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 $26.2 million in 1997, $17.1 million in 1996 and $11.4 million in 1995. As a percent of revenue, sales and marketing expenses were 16.7%, 15.3% 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 $12.1 million in 1997 from $7.4 million in 1996 and $5.8 million in 1995. As a percentage of revenue, expenses were 7.7% in 1997, compared to 6.6% in 1996 and 7.5% 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, 1996 and 1995 was $1.9 million, $2.3 million and $2.1 million, respectively. 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 49.0% for 1997. In 1996 and 1995, the effective rate was 44.0% and 12.0%, respectively. For a reconciliation of the Company's effective tax rate to the statutory federal tax rate, see Note 7 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 $157.0 million. The Company's principal sources of liquidity as of December 28, 1997, consisted of $138.3 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 obtained $5.9 million from the issuance of notes to a bank and certain shareholders. During 1997, the Company generated $17.9 million of cash from its operating activities as compared to $21.6 million in 1996 and $7.4 million in 1995. In 1997, trade accounts receivable increased by $12.5 million due to increased sales levels. Inventories increased by $16.7 million to $26.7 million at the end of 1997. Days of inventory on hand were 111 days at the end of 1997. Current liabilities increased $32.3 million from year end 1996 to 1997. During 1997, 1996, and 1995, total expenditures for capital equipment were $18.0 million, $10.1 million, and $10.2 million, respectively. The expenditures in each year consisted primarily of 5 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. YEAR 2000 COMPLIANCE The Company provides mixed-signal integrated circuit solutions for high- speed digital signal telecom and networking applications. The Company's products have no specific date functions or date dependencies and will operate according to published specifications through the Year 2000 date rollover and dates in the 21st century. The Company recognizes the need to complete its assessment of its Year 2000 issues to ensure that its operations will not be adversely impacted by Year 2000 software failures. The Company is in the process of determining whether there exist any material relationships on which the Company's Year 2000 readiness is dependent. The Company has initiated a comprehensive project to prepare its computer systems for the Year 2000. Company management believes that the likelihood of a material adverse impact due to problems with internal systems or products sold to customers is remote and anticipates that the cost of these projects over the next two years will not have a material effect on the Company's financial position or overall trends in results of operations. The Company is contacting critical suppliers of products and services to determine that the suppliers' operations and the products and services they provide are Year 2000 capable or to monitor their progress toward Year 2000 capability. There can be no assurance that another company's failure to ensure Year 2000 capability would not have an adverse effect on the Company. SUBSEQUENT EVENTS 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 was settled on September 25, 1998. The terms of the settlement are confidential. 6 The following consolidated financial statements of the Company reflect the pooled operations of the Company and its subsidiaries, including Acclaim Communications, Inc., which was acquired by the Company effective as of July 6, 1998, are filed as part of this report: Reports of Independent Public Accountants. Supplemental Consolidated Balance Sheets as of December 28, 1997 and December 29, 1996. Supplemental Consolidated Statements of Income for the fiscal years ended December 28, 1997, December 29, 1996, and December 30, 1995. Supplemental Consolidated Statement of Shareholders' Equity for the fiscal years of December 28, 1997, December 29, 1996, and December 30, 1995. Supplemental Consolidated Statement of Cash Flows for the fiscal years ended December 28, 1997, December 29, 1996, and December 30, 1995. Supplemental Unaudited Consolidated Balance Sheets as of March 29, 1998, June 28, 1998, and December 28, 1997. Supplemental Unaudited Consolidated Statements of Income for each of the three months ended March 29, 1998, June 28, 1998, March 30, 1997, and June 29, 1997 and the six months ended June 28, 1998 and June 29, 1997. Supplemental Unaudited Consolidated Statement of Cash Flows for the three months ended March 29, 1998 and March 30, 1997, and the six months ended June 28, 1998 and June 29, 1997. 7 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Level One Communications, Incorporated: We have audited the 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 consolidated statements of income, shareholders' equity and cash flows for each of the three fiscal years in the period ended December 28, 1997 and have issued our unqualified report thereon dated March 13, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financials statements based on our audits. We have also made similar audits of the accompanying supplemental consolidated balance sheets of Level One Communications, Incorporated and subsidiaries as of December 28, 1997 and December 29, 1996, and the related supplemental consolidated statements of income, shareholders' equity and cash flows for each of the three fiscal years in the period ended December 28, 1997. The supplemental consolidated statements give retroactive effect to the merger with Acclaim Communications, Incorporated on July 6, 1998, which has been accounted for as a pooling of interests as described in Note 1. These supplemental financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these supplemental financial statements based on our audits. We did not audit the 1996 and 1995 financial statements of Acclaim Communications, Incorporated included in the supplemental consolidated financial statements of Level One Communications, Incorporated, which statements reflect total assets, revenues and net loss constituting 3 percent, 0 percent and 39 percent, respectively, in 1996 and 1 percent, 0 percent and 1 percent, respectively, in 1995, of the related supplemental consolidated totals. These statements were audited by other auditors whose report thereon has been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for Acclaim Communications, Incorporated, is based solely upon the report of the other auditors. 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 and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based upon our audits and the report of the other auditors, the supplemental consolidated financial statements referred to above present fairly, in all material respects, the financial position of Level One Communications, Incorporated and its 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, after giving retroactive effect to the merger with Acclaim Communications, Incorporated as described in Note 1, all in conformity with generally accepted accounting principles. /s/ Arthur Andersen LLP Sacramento, California September 18, 1998 8 INDEPENDENT AUDITOR'S REPORT To the Board of Director and Stockholders' of Acclaim Communications, Inc.: We have audited the balance sheet of Acclaim Communications, Inc. as of December 31, 1996 and the related statements of operations, stockholders' equity and cash flows for each of the two fiscal years in the period ended December 31, 1996, which are not separately included herein. 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 Acclaim Communications, Inc. as of December 31, 1996, and the results of its operations and its cash flows for each of the two fiscal years in the period ended December 31, 1996 in conformity with generally accepted accounting principles. Deloitte & Touche LLP San Jose, California June 18, 1997 9 LEVEL ONE COMMUNICATIONS, INCORPORATED SUPPLEMENTAL CONSOLIDATED BALANCE SHEETS As of December 28, 1997 and December 29, 1996
(in thousands) 1997 1996 ------------- ------------ ASSETS Current Assets: Cash and cash equivalents $ 25,743 $ 23,234 Short-term investments 112,560 10,211 Trade accounts receivable, net of allowance for doubtful accounts of $343 and $156 for 1997 and 1996, respectively 30,191 17,671 Other receivables 2,473 608 Inventories 26,699 9,990 Deferred tax assets, net 4,050 2,504 Other current assets 2,907 2,423 ------------- ------------- Total current assets 204,623 66,641 Property and equipment, net 32,893 24,007 Long-term investments 21,559 12,440 Deferred loan origination costs 3,296 - Foundry deposits 14,000 8,000 Other assets 4,108 4,429 ------------- ------------- Total assets $280,479 $115,517 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Notes payable $ 5,949 $ - Current portion of capital lease obligations 1,201 1,129 Accounts payable 22,687 4,992 Accrued payroll costs 4,719 2,198 Income taxes payable - 1,338 Deferred revenue 5,171 3,039 Other accrued liabilities 7,940 2,621 ------------- ------------- Total current liabilities 47,667 15,317 Convertible subordinated notes 115,000 - Capital lease obligations, less current portion 2,175 3,194 Deferred lease expense 300 612 ------------- ------------- Total liabilities 165,142 19,123 Shareholders' Equity: Common Stock, no par value 96,594 87,330 Authorized - 236,250 shares Outstanding - 33,615 and 32,276 shares for 1997 and 1996, respectively Unrealized gain on investments 18 12 Retained earnings 18,725 9,052 ------------- ------------- Total shareholders' equity 115,337 96,394 ------------- ------------- Total liabilities and shareholders' equity $280,479 $115,517 ============= =============
The accompanying notes are an integral part of these supplemental consolidated financial statements. 10
LEVEL ONE COMMUNICATIONS, INCORPORATED SUPPLEMENTAL CONSOLIDATED STATEMENTS OF INCOME For the Fiscal Years Ended December 28, 1997, December 29, 1996, and December 30, 1995 (in thousands, except per share amounts) 1997 1996 1995 ------------------ ------------------ ------------------ Revenues $156,500 $111,987 $78,018 Cost of revenues 65,582 48,477 33,300 ------------------ ------------------ ------------------ Gross margin 90,918 63,510 44,718 Operating expenses: Research and development * 35,419 26,793 17,963 Sales and marketing 26,163 17,136 11,414 General and administrative 12,098 7,415 5,839 ------------------ ------------------ ------------------ Total operating expenses 73,680 51,344 35,216 Operating income 17,238 12,166 9,502 Interest income 3,998 1,884 2,115 Interest expense (2,223) (352) (157) Other income 110 729 113 ------------------ ------------------ ------------------ Income before provision for income taxes 19,123 14,427 11,573 Provision for income taxes 9,450 6,374 1,442 Net income $ 9,673 $ 8,053 $10,131 ================== ================== ================== Basic earnings per share $0.29 $0.26 $0.35 ================== ================== ================== Diluted earnings per share $0.27 $0.24 $0.33 ================== ================== ================== * 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 supplemental consolidated financial statements. 11 LEVEL ONE COMMUNICATIONS, INCORPORATED SUPPLEMENTAL CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY For the Fiscal Years Ended December 28, 1997, December 29, 1996, and December 30, 1995 ================================================================================
Common Stock Retained ------------------- Deferred Unrealized Earnings (In thousands) Shares Amount Compensation Gain (Loss) (Deficit) Total -------- -------- ------------ ----------- --------- --------- Balance at December 31, 1994 28,083 $ 72,442 $ (1) $ - $ (9,132) $ 63,309 Conversion of Acclaim shares in conjunction with pooling of interest transaction 2,227 720 720 Issuance of common stock under stock option and purchase plans 492 431 431 Issuance of common stock upon exercise of warrants 9 19 19 Tax benefit of stock option exercises 2,418 2,418 Stock issued in connection with acquisitions 305 2,462 2,462 Unrealized gain on available-for-sale investments, net of tax 67 67 Amortization of deferred compensation expense 1 1 Net income 10,131 10,131 -------- -------- ------------ ----------- --------- --------- Balance at December 30, 1995 31,116 78,492 - 67 999 79,558 Conversion of Acclaim shares in conjunction with pooling of interest transaction 537 3,380 3,380 Issuance of common stock under stock option and purchase plans 423 1,243 1,243 Issuance of common stock upon exercise of warrants 5 10 10 Tax benefit of stock option exercises 1,205 1,205 Stock issued in connection with acquisitions 195 3,000 3,000 Unrealized loss on available-for-sale investments, net of tax (55) (55) Net income 8,053 8,053 -------- -------- ------------ ----------- --------- --------- Balance at December 29, 1996 32,276 87,330 - 12 9,052 96,394 Conversion of Acclaim shares in conjunction with pooling of interest transaction 11 597 597 Issuance of common stock under stock option and purchase plans 894 3,538 3,538 Issuance of common stock upon exercise of warrants 434 - - Tax benefit of stock option exercises 5,129 5,129 Unrealized gain on available-for-sale investments, net of tax 6 6 Net income 9,673 9,673 -------- -------- ------------ ----------- --------- --------- Balance at December 28, 1997 33,615 $ 96,594 $ - $ 18 $ 18,725 $ 115,337 ======== ======== ============ =========== ========= =========
The accompanying notes are an integral part of these supplemental consolidated financial statements. 12 LEVEL ONE COMMUNICATIONS, INCORPORATED SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CASH FLOWS For the 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 $ 9,673 $ 8,053 $ 10,131 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 10,282 7,556 5,222 Purchased research and development - 2,500 750 Changes in assets and liabilities, net of effect of acquisition: Trade receivables (12,517) (3,259) (8,832) Other receivables (1,865) 370 (189) Inventories (16,709) 5,782 (9,268) Deferred income tax benefit (1,546) 1,785 (977) Other current assets (466) 236 (1,184) Accounts payable and accrued liabilities 30,863 (3,510) 11,604 Deferred revenue 506 2,175 - Deferred lease expense (312) (133) 97 ---------- --------- ---------- Net cash provided by operating activities 17,909 21,555 7,354 ---------- --------- ---------- Cash flows from investing activities: Purchase of short-term investments (155,195) (12,754) (8,042) Proceeds from sales and maturities of short-term investments 52,852 10,711 31,027 Purchase of long-term investments (42,900) (11,780) (3,681) Proceeds from sales and maturities of long-term investments 33,781 4,035 2,200 Purchase of property and equipment (18,029) (10,142) (10,166) Payments (receipts) for related party notes receivable - 1,225 (1,225) Payments for foundry deposits and other assets (5,998) (6,136) (4,081) ---------- --------- ---------- Net cash provided by (used in) investing activities (135,489) (24,841) 6,032 ---------- --------- ---------- Cash flows from financing activities: Proceeds from issuance of notes 5,948 - - Net principal payments under capital lease obligations (947) (550) (569) Proceeds from issuance of convertible subordinated notes, net of origination costs 111,539 - - Proceeds from issuance of stock, net of repurchases and costs of issuance 3,549 4,566 427 ---------- --------- ---------- Net cash provided by (used in) financing activities 120,089 4,016 (142) ---------- --------- ---------- Net increase in cash and cash equivalents 2,509 730 13,244 Cash and cash equivalents at beginning of year 23,234 22,504 9,260 ---------- --------- ---------- Cash and cash equivalents at end of year $ 25,743 $ 23,234 $ 22,504 ========= ========= ========= Supplementary disclosure of cash and noncash transactions Non-cash investing and financing activities: Issuance of common stock in exchange for marketable securities $ - $ 750 $ - Issuance of warrants 586 - - 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) 134 Cash payments for: Interest 616 351 142 Income taxes 3,861 2,564 1,268
The accompanying notes are an integral part of these supplemental consolidated financial statements. 13 LEVEL ONE COMMUNICATIONS, INCORPORATED NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. ORGANIZATION AND DESCRIPTION OF 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 ("ASSP") 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. On July 6, 1998, the Company completed a business combination with Acclaim Communications Inc. ("Acclaim") which is a provider of Fast Ethernet and Gigabit Ethernet switches and integrated Multi-Service access products. The combination was a stock for stock merger that was accounted for as a "pooling-of-interests." In connection with the merger, the Company issued 3,961,374 shares of common stock, and assumed 780,278 stock options and 256,485 warrants in exchange for all the outstanding stock, options and warrants of Acclaim. The accompanying supplemental consolidated financial statements have been restated to include the accounts of Acclaim as if the companies had combined at the beginning of the first period presented. There were no significant transactions between the Company and Acclaim prior to the combination and no adjustments were necessary to conform Acclaim's accounting policies. The results of operations for the separate companies and the combined amounts presented in the supplemental consolidated statements of income are as follows:
(in thousands) 1997 1996 1995 ------------------ ------------------ ------------------ Revenue The Company $156,262 $111,987 $78,018 Acclaim 238 - - ------------------ ------------------ ------------------ $156,500 $111,987 $78,018 ================== ================== ================== Net Income (Loss) The Company $ 19,191 $ 11,213 $10,258 Acclaim (9,518) (3,160) (127) ------------------ ------------------ ------------------ $ 9,673 $ 8,053 $10,131 ================== ================== ==================
14 NOTE 2. RISK FACTORS 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. 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 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 Note 3. 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 supplemental 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. All share and per share numbers in this Report reflect the effect of a 3-for- 2 stock split effected on March 30, 1998. Cash and Cash Equivalents. For purposes of the supplemental consolidated balance sheets and 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. Cash and cash equivalents consist of cash deposited with financial institutions and securities investment companies. 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"). SFAS 115 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. 16 The amortized cost and market values of the Company's available-for-sale investments 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 securities 122,561 36 30 122,567 ----------------- -------------------- --------------------- ----------------- $134,089 $60 $30 $134,119 ================= ==================== ===================== ================= December 29, 1996 Gross Gross (in thousands) Amortized Unrealized Unrealized Market Cost Gains Losses Value ----------------- -------------------- --------------------- ----------------- Municipal bonds $ 20,531 $29 $ 3 $ 20,557 Corporate debt and equity securities 2,100 - 6 2,094 ----------------- -------------------- --------------------- ----------------- $ 22,631 $29 $ 9 $ 22,651 ================= ==================== ===================== =================
The amortized cost and market values of the Company's available-for-sale investments, by maturity, at December 28, 1997, was as follows:
December 28, 1997 ----------------------------------------- (in thousands) Amortized Cost Market Value Due in one year or less $112,536 $112,560 Due after one year through five years 21,553 21,559 ----------------------------------------- $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, notes 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. 17 Inventories. Inventories are stated at the lower of cost (first in, first out method) or market and include materials, labor and manufacturing overhead costs. Inventories as of December 28, 1997 and December 29, 1996 consisted of:
(in thousands) 1997 1996 ----------------- ----------------- Raw materials $ 9,133 $ 32 Work-in-process 13,412 7,948 Finished goods 4,154 2,010 ----------------- ----------------- Total inventories $26,699 $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 3-10 years Property and equipment, net, is comprised of the following:
(in thousands) 1997 1996 ---------------- -------------------- Machinery and equipment $ 37,067 $ 25,529 Furniture and fixtures 18,632 12,061 Leasehold improvements 3,407 3,485 ---------------- -------------------- 59,106 41,075 Less-Accumulated depreciation (26,213) (17,068) ---------------- -------------------- $ 32,893 $ 24,007 ================ ====================
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. 18 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. In 1996, the Company entered into a four year development and license agreement with a company to develop certain technologies and receive license, development and royalty fees through the term of the agreement. As of December 31, 1997, the Company has received payments totaling $2,675,000 under this development and license agreement. The agreement called for certain performance milestones which have not been met as of December 28, 1997. Disputes among the parties have arisen as to who is responsible for not meeting the required milestones. Development on this project has ceased. The agreement includes certain provisions which could require refunding of all proceeds received to date. The parties are negotiating a settlement of these matters. No revenue is being recognized under this agreement until such time as the dispute is resolved. This matter was settled on September 9, 1998 with a payment of $750,000 by the company and a mutual release. The Company earns royalty income under certain contracts and recognizes that income in the period that income is earned. Revenues are comprised of the following:
(in thousands) 1997 1996 1996 ------------------ ------------------ ------------------ Product sales $155,457 $111,392 $77,417 Royalties, licenses and non-recurring engineering revenue 1,043 595 601 ------------------ ------------------ ------------------ Total revenues $156,500 $111,987 $78,018 ================== ================== ==================
Income Taxes. The Company accounts for income taxes pursuant to Statement of Financial Accounting Standards No. 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"). SFAS 123 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. 19 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 Statement Presentation. Certain prior year amounts in the supplemental consolidated financial statements have been reclassified to conform to the fiscal 1997 presentation. NOTE 4. 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 against this line as of December 28, 1997, and December 29, 1996, was zero. Notes Payable consist of:
(in thousands) Note payable to bank with interest at prime plus 1% (9.5% at December 31, 1997) due July 31, 1998. This note is personally guaranteed by the Chairman of the Board of Directors of Acclaim. In connection with this guarantee, 100,000 warrants to purchase Acclaim Series C preferred stock at $3.00 per share were issued. These warrants were converted into Company warrants in the business combination. $2,000 Notes payable primarily to common and preferred shareholders with interest at 7%, due on demand, and unsecured. In connection with these loans, 231,150 warrants to purchase Acclaim Series C preferred stock at $3.00 per share were issued. These warrants were converted into Company warrants in the business combination. 3,949 --------------- Total $5,949 ===============
NOTE 5. 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 $26.67 per share. Interest on the 20 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. NOTE 6. 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:
Operating (in thousands) Capital Leases Leases ----------------------- ------------------- Year Ending 1998 $ 1,415 $ 13,453 1999 1,252 14,059 2000 974 12,070 2001 74 9,049 2002 - 7,212 Thereafter - 29,852 ----------------------- ------------------- $ 3,715 $ 85,695 =================== 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, respectively. 21 NOTE 7. INCOME TAXES The provision for income taxes consists of:
(in thousands) 1997 1996 1995 ------------------ ------------------- ------------------ Current income taxes: State $ 1,098 $ 282 $ 1,333 Federal 9,603 4,309 2,580 Deferred income taxes: State 245 694 (676) Federal (1,496) 1,089 (1,795) ------------------ ------------------- ------------------ Provision for income taxes $ 9,450 $6,374 $ 1,442 ================== =================== ==================
The tax benefits associated with non-qualified 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 bases 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: Inventory reserves $ 1,893 $ 397 Deferred income 1,822 1,244 Allowance for doubtful accounts 134 93 Deferred lease expense 151 265 Inventory Unicap adjustment 796 345 Accrued vacation 484 273 AMT credit carryforwards 365 365 Research and development credit carryforwards 872 537 Net operating loss carryforwards 3,738 46 Other (4) 346 ------------------- -------------------- Total deferred tax assets 10,251 3,911 Deferred tax liabilities: Accelerated depreciation (356) (393) Unrealized loss on Section 475 securities (681) - ------------------- -------------------- Total deferred tax liabilities (1,037) (393) Valuation allowance (5,164) (1,014) ------------------- -------------------- Deferred tax assets, net $ 4,050 $ 2,504 =================== ====================
22 The reconciliation of the federal statutory tax rate to the effective tax rate is as follows:
1997 1996 1995 --------------- --------------- ---------------- Statutory federal tax rate 35.0% 34.0% 34.0% Valuation allowance 16.0 6.4 - Reversal of valuation allowance - - (21.0) Foreign taxes & foreign sales corporation (2.6) (4.7) (3.0) 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) (5.9) --------------- --------------- ---------------- Effective income tax rate 49.0% 44.0% 12.0% =============== =============== ================
NOTE 8. 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 shareholders 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. All common stock amounts and per share amounts have been adjusted retroactively to reflect the stock split. 23 The Company adopted Statement on Financial Accounting Standards 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.
Per Share (in thousands, except per share amounts) Income Shares Amount ------------------- ------------------- -------------------- YEAR ENDING: Net income: 1997 $ 9,673 1996 8,053 1995 10,131 BASIC EPS: income available to common shareholders 1997 $ 9,673 33,117 $0.29 1996 8,053 31,538 0.26 1995 10,131 29,159 0.35 Options and warrants: 1997 2,485 1996 1,804 1995 1,389 DILUTED EPS: income available to common stockholders plus assumed conversions 1997 $ 9,673 35,602 $0.27 1996 8,053 33,342 0.24 1995 10,131 30,548 0.33
No conversion is assumed for the convertible subordinated notes issued in 1997 because it would have an anti-dilutive effect on earnings per share. Options to purchase approximately 92,000, 147,000, and 192,000 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 anti-dilutive. NOTE 9. STOCK OPTION AND PURCHASE PLANS AND EMPLOYEE BENEFIT PLAN Stock-based Compensation Plans. The Company has four stock option plans: the 1985 Stock Option Plan (the "1985 Plan"), the 1993 Stock Option Plan (the "1993 Plan"), the San Francisco Telecom Stock Option Plan (the "SFT Plan"), the Acclaim Communications 1996 Stock Incentive Plan (the "ACCL Plan") and an employee stock purchase plan (the "ESPP"). No further options may be granted under the 1985 Plan, the SFT Plan, or the ACCL Plan and 1,257,698 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 stock option plans. 24 Had compensation cost for these plans been determined consistent with 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 $ 9,673 $ 8,053 $ 10,131 Pro forma 5,670 6,138 9,422 Earnings per share, as reported Basic 0.29 0.26 0.35 Diluted 0.27 0.24 0.33 Pro-forma earnings per share Basic 0.17 0.19 0.32 Diluted 0.17 0.19 0.32
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 weighted average 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, 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 1,012,500 shares of stock to its full-time employees under the ESPP. The Company has sold 67,487 shares and 49,808 shares as of December 28, 1997 and December 29, 1996, respectively, and has sold a total of 168,650 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 6,862,500 shares under the 1993 Plan. The Company had 1,076,081 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. All options previously granted in fiscal 1997 and 1996 under the ACCL Plan have been converted into options of the Company's common stock. Each Acclaim option was converted into .362859 of the Company's options at exercise prices of $0.69 to $1.38. There were approximately 740,000 shares outstanding and 163,000 exercisable at December 28, 1997. All options were granted at a price equal to the fair value of Acclaim stock at the grant date. 25 The following table presents the aggregate options granted, forfeited, and exercised under the 1985 Plan, 1993 Plan, SFT Plan, and the ACCL 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 --------------------------------------------------------------------------------------------------- (shares in thousands) Shares Wtd. Avg. Shares Wtd. Avg. Shares Wtd. Avg. Exer. Price Exer. Price Exer. Price ------------ ----------- ------------ ------------ ---------- ------------- Outstanding, beginning of year 4,836 $ 6.05 3,342 $5.06 2,454 $2.29 Granted Price = Fair Value 2,552 15.31 1,624 9.56 1,542 7.99 Price less than Fair Value 295 1.38 566 0.88 57 0.30 Exercised (704) 3.70 (391) 2.47 (489) 0.62 Canceled (418) 7.10 (305) 8.96 (222) 3.33 ------------ ------------ ---------- -------- Outstanding, end of year 6,561 $ 9.63 4,836 $6.05 3,342 $5.06 ============ ============ ============ =========== ========== ======== Exercisable, end of year 1,948 1,650 826 ============ ============ ==========
The following table summarizes information about options outstanding under the 1985, Plan, 1993 Plan, SFT Plan, and ACCL Plan at December 28, 1997.
(in thousands) Options Options Outstanding Exercisable ------------------------------------------------------ --------------------------------------------- Range of Exercise Shares Wtd. Avg. Wtd. Avg. Shares Wtd. Avg. Prices Outstanding as Remaining Exercise Price Exercisable as of Exercise Price of 12/31/97 Contractual Life 12/31/97 - ----------------------------------------------------------------------------------------------------------------------------------- $ 0.17 $ 7.17 1,703 7.22 $ 2.09 1,397 $ 1.34 7.33 9.78 1,716 7.70 7.94 395 8.02 10.00 13.22 1,651 8.74 10.95 144 10.87 13.33 27.17 1,491 9.67 18.70 12 15.74 - --------------------- --------- --------- --------- --------- -------- $ 0.17 $27.17 6,561 8.29 $ 9.63 1,948 $ 3.49 ===================== ========== ========= ========= ========= ========
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 contributed $490,000, $420,000, and $315,000, respectively, to the 401(k) Plan. 26 NOTE 10. INCENTIVE PLANS The Company has reserved 202,500 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. NOTE 11. STOCK WARRANTS The Company has issued warrants to independent sales representatives to purchase up to 95,625 shares of its Common Stock with exercise prices ranging from $1.03 to $9.33 per share. As of December 28, 1997, an aggregate of 45,155 shares have been issued upon exercise of warrants. In connection with securing a loan from investors in 1992, the Company issued warrants to purchase 456,179 shares of Common Stock with an exercise price of $0.67 per share. The warrants were exercised January 16, 1997, for 433,697 shares, and the balance was surrendered, on a net appreciation basis, in an amount equal to the exercise price. In connection with the issuance of notes in 1996, warrants were granted by Acclaim to purchase 27,000 shares of Series B convertible preferred stock at $5.00 per share. The warrants became exercisable upon the closing of the Series B convertible preferred stock financing during 1996 and expire in ten years. The fair value of such warrants, aggregating approximately $66,600, was recorded as additional interest expense during 1996. These warrants have been converted into warrants to purchase 21,936 shares of the Company's common stock at $6.16 per share. In connection with the issuance of notes in 1997, warrants were granted by Acclaim to purchase 331,150 shares of Series C convertible preferred stock at $3.00 per share. The warrants became exercisable upon the closing of the Series C convertible preferred stock financing during 1998 and expire in ten years. The fair value of such warrants, approximately $586,000, was recorded as additional paid in capital. The related issuance cost of $585,000 was recorded in other assets and is being amortized to interest expense over the life of the recorded debt. Interest expense includes amortization of these issuance costs totaling $331,000. These warrants have subsequently been converted into warrants to purchase 234,549 shares of the Company's common stock at $6.16 per share. NOTE 12. 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. 27 NOTE 13. 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 in cash. This sale was accounted as a one-time gain recorded as "Other Income" in the accompanying Supplemental 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. NOTE 14. 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 195,143 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 expensed. 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 Supplemental 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 304,560 shares of its common stock to SFT's shareholders, assumed existing SFT stock options, which will be exercisable for a total of 56,139 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 Supplemental Consolidated Statements of Income. NOTE 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 28 quarter of 1998, the Company paid an aggregate $1.3 million in additional deposits as required by its agreements. There are no additional deposits due under the Company's existing foundry agreements. Note 16. Subsequent Events 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 was settled on September 25, 1998. The terms of the settlement are confidential. 29 LEVEL ONE COMMUNICATIONS, INCORPORATED SUPPLEMENTAL UNAUDITED CONSOLIDATED BALANCE SHEETS As of March 29, 1998, June 28, 1998, and December 28, 1997
(in thousands) March 29, 1998 June 28, 1998 December 28, 1997 ------------------- ----------------- ------------------- ASSETS Current Assets: Cash and cash equivalents $ 20,999 $ 16,773 $ 25,743 Short-term investments 103,164 103,017 112,560 Trade accounts receivable, net of allowance for doubtful 32,650 36,042 30,191 accounts of $493, $493, and $343 for March 29, 1998, June 28, 1998, and December 28,1997, respectively Other receivables 1,084 4,778 2,473 Inventories 29,233 24,409 26,699 Deferred tax assets, net - 3,035 4,050 Other current assets 6,961 2,851 2,907 ------------- ------------ ------------ Total current assets 194,091 190,905 204,623 Property and equipment, net 35,953 39,618 32,893 Long-term investments 38,186 49,383 21,559 Foundry deposits 16,781 16,781 14,000 Other assets 5,573 5,144 7,404 ------------- ------------ ------------ Total assets $ 290,584 $ 301,831 $ 280,479 ============= ============= ============= Current Liabilities: Current portion of capital lease obligations $ 1,205 $ 1,209 $ 1,201 Accounts payable 22,334 22,838 22,687 Accrued payroll costs 3,979 6,842 4,719 Deferred revenue 2,758 6,076 5,171 Other accrued liabilities 21,629 18,902 13,889 ------------- ------------ ------------ Total current liabilities 51,905 58,367 47,667 Convertible subordinated notes 115,000 115,000 115,000 Capital lease obligations, less current portion 1,903 1,625 2,175 Deferred lease expense 258 218 300 ------------- ------------ ------------ Total liabilities 169,066 172,711 165,142 Shareholders' Equity: Common Stock, no par value 97,927 102,122 96,594 Authorized - 236,250 shares Outstanding - 33,916, 33,919, and 33,615 shares for March 29, 1998, June 28, 1998, and December 28, 1997, respectively Unrealized gain on investments 19 4 18 Retained earnings 23,571 26,995 18,725 ------------- ------------ ------------ Total shareholders' equity 121,517 129,121 115,337 ------------- ------------ ------------ Total liabilities and shareholders' equity $ 290,584 $ 301,831 $ 280,479 ============= ============ ============
The accompanying notes are an integral part of those supplements unaudited consolidated financial statements 30 LEVEL ONE COMMUNICATIONS, INCORPORATED SUPPLEMENTAL UNAUDITED CONSOLIDATED STATEMENTS OF INCOME March 29, 1998, June 28, 1998, March 30, 1997, and June 29, 1997
Three Months Ended Six Months Ended (in thousands, ------------------------------------------------------------------------ -------------------------------- except per March 29, 1998 March 30, 1997 June 28, 1998 June 29, 1997 June 28, 1998 June 29, 1997 share amounts) --------------- -------------- -------------- ------------- -------------- ------------- Revenues $56,630 $30,138 $60,496 $32,708 $117,126 $62,846 Cost of revenues 23,575 12,900 25,968 14,146 49,543 27,046 ------- ------------ ------------- ------------ ------------ ------------ Gross margin 33,055 17,238 34,528 18,562 67,583 35,800 Operating Expenses: Research & development 11,646 7,381 11,786 7,898 23,432 15,279 Sales & marketing 9,251 4,539 9,264 5,138 18,515 9,677 General & administrative 4,053 2,038 7,295 2,597 11,348 4,635 ------- ------------ ------------- ------------ ------------ ------------ Total operating expenses 24,950 13,958 28,345 15,633 53,295 29,591 Operating income 8,105 3,280 6,183 2,929 14,288 6,209 Interest income 2,124 391 2,486 492 4,236 883 Interest expense (1,705) - (1,788) - (3,115) - Other income 23 - 112 - 132 - ------- ------------ ------------- ------------ ------------ ------------ Income before provision for income taxes 8,547 3,671 6,993 3,421 15,541 7,092 Provision for income taxes 3,700 1,676 3,569 1,932 7,270 3,607 ------- ------------ ------------- ------------ ------------ ------------ Net income $ 4,847 $ 1,995 $ 3,424 $ 1,489 $ 8,271 $ 3,485 ======== ============ ============= ============ ============ ============ Basic earnings per share $0.14 $0.06 $0.10 $0.05 $0.24 $0.11 Diluted earning per share $0.13 $0.06 $0.09 $0.04 $0.22 $0.10
The accompanying notes are an integral part of these supplemental consolidated financial statements. 31 LEVEL ONE COMMUNICATIONS, INCORPORATED SUPPLEMENTAL UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS March 29, 1998, June 28, 1998, March 30, 1997, and June 29, 1997
Six Months Ended Three Months Ended ----------------------------- (In thousands) March 29, 1998 March 30, 1997 June 28, 1998 June 29, 1997 -------------- -------------- ------------- ------------- Cash flows from operating activities: Net income $ 4,847 $ 1,995 $ 8,271 $ 3,485 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 3,543 2,191 6,237 4,590 Changes in assets and liabilities, net of effect of acquisition Trade receivables (2,459) (1,788) (5,850) (2,652) Other receivables 1,389 - - (940) Inventories (2,534) (221) 2,290 (7,486) Deferred income tax benefit - - 1,015 322 Other current assets (83) 331 (3,188) 484 Accounts payable and accrued liabilities 1,757 2,632 4,613 6,313 Deferred revenue 77 500 156 500 Deferred lease expense (41) - (82) (68) -------------- -------------- ------------- ------------- Net cash provided by operating activities 6,496 5,640 13,462 4,548 -------------- -------------- ------------- ------------- Cash flows from investing activities: Purchase of short-term investments (19,726) (19,410) (20,796) (30,341) Proceeds from sales and maturities of short-term investments 29,122 10,948 30,339 21,719 Purchase of long-term investments (20,511) (5,940) (31,609) (7,740) Proceeds from sales and maturities of long-term investments 3,884 7,170 3,785 10,630 Purchase of property and equipment (6,272) (4,168) (12,486) (8,074) Payments for foundry deposits and other assets (604) (31) (2,006) (101) -------------- -------------- ------------- ------------- Net cash used in investing activities (14,107) (11,431) (32,773) (13,907) -------------- -------------- ------------- ------------- Cash flows from financing activities: Proceeds from issuance of notes 1,800 - 5,350 - Net principal payments under capital lease obligations (268) (292) (542) (567) Proceeds from issuance of stock, net of repurchases and costs of issuance 1,335 1,303 5,532 2,266 -------------- -------------- ------------- ------------- Net cash provided by financing activities 2,867 1,011 10,340 1,699 -------------- -------------- ------------- ------------- Decrease in cash and cash equivalents (4,744) (4,780) (8,971) (7,660) Cash and cash equivalents at beginning of period 25,743 23,234 25,744 23,234 -------------- -------------- ------------- ------------- Cash and cash equivalents at end of period $ 20,999 $ 18,454 $ 16,773 $ 15,574 ============== ============== ============= ============= Supplementary disclosure of cash and noncash transactions Cash payments for: Interest $ 70 $ 162 $ 1,687 $ 295 Income taxes 435 905 227 80
The accompanying notes are an integral part of these supplemental consolidated financial statements. 32 LEVEL ONE COMMUNICATIONS, INCORPORATED NOTES TO FINANCIAL STATEMENTS (UNAUDITED) NOTE 1. BASIS OF PRESENTATION The accompanying unaudited financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ended March 29, 1998 and June 28, 1998, are not necessarily indicative of the results that may be expected for the year ending December 27, 1998. The information reported in these financial statements should be read in conjunction with the financial statements and footnotes contained in the Company's Form 10-K filed with the Securities and Exchange Commission for the year ended December 28, 1997, and subsequent filings with the Securities and Exchange Commission. All share and per share numbers in this Report reflect the effect of a 3- for-2 stock split effected on March 30, 1998. NOTE 2. COMPREHENSIVE INCOME On December 29, 1997, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS 130). This statement establishes standards for the reporting and display of comprehensive income and its components in the financial statements. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. For the Company, comprehensive income includes net income reported on the income statement and changes in the fair value of its available-for-sale securities reported as a separate component of shareholders' equity. The Company's total comprehensive income for the periods ended March 29, 1998, March 30, 1997, June 28, 1998 and June 29, 1997 was $4,866 million, $2,007 million, $3,428 million and $1,501 million, respectively. 33 NOTE 3. EARNINGS PER SHARE The following is a reconciliation of the numerator (income) and denominator (shares) of basic and diluted earnings per share for the periods ending March 29, 1998, March 30, 1997, June 28, 1998 and June 29, 1997.
(in thousands, except per share amounts) INCOME SHARES PER SHARE AMOUNT ------------------ --------------- -------------------- QUARTER ENDING: Net income: March 29, 1998 $4,847 March 30, 1997 1,995 June 28, 1998 3,424 June 29, 1997 1,489 BASIC EPS: income available to common shareholders March 29, 1998 $4,847 33,596 $0.14 March 30, 1997 1,995 32,748 0.06 June 28, 1998 3,424 33,771 0.10 June 29, 1997 1,489 33,052 0.05 Options: March 29, 1998 - 3,034 March 30, 1997 - 2,142 June 28, 1998 - 3,160 June 29, 1997 - 2,192 DILUTED EPS: income available to common stockholders plus assumed conversions March 29, 1998 $4,847 36,630 $0.13 March 30, 1997 1,995 34,890 0.06 June 28, 1998 3,424 36,931 0.09 June 29, 1997 1,489 35,244 0.04 - ----------------------------------------------------------------------------------------------------------- YEAR-TO-DATE: Net income: June 28, 1998 8,271 June 29, 1997 3,485 BASIC EPS: income available to common shareholders June 28, 1998 8,271 33,684 0.24 June 29, 1997 3,485 32,900 0.11 Options: June 28, 1998 - 3,097 June 29, 1997 - 2,167 DILUTED EPS: income available to common stockholders plus assumed conversions June 28, 1998 8,271 36,781 0.22 June 29, 1997 3,485 35,067 0.10
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 169,000, 70,000, 7,000 and 89,000 shares of common stock for the quarters ending March 29, 1998, March 30, 1997, June 28, 1998 and June 29, 1997, respectively, were not included in the computation of diluted earnings per share because the options exercise price was greater than the average market price of the common shares, making the shares anti-dilutive. 34 NOTE 4. 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 March 29, 1998 and June 28, 1998 consisted of:
(in thousands) March 29, 1998 June 28, 1998 -------------------- -------------------- Raw materials $15,990 $ 5,910 Work-in-process 7,168 10,472 Finished goods 6,075 8,027 -------------------- -------------------- Total inventories $29,233 $24,409 ==================== ====================
NOTE 5. PROPERTY AND EQUIPMENT Property and equipment are recorded at cost and depreciation is provided on a straight-line basis over their useful lives. Property and equipment consists of:
(in thousands) March 29, 1998 June 28, 1998 -------------------- -------------------- Machinery and equipment $ 38,096 $ 41,205 Furniture and fixtures 23,595 25,725 Leasehold improvements 3,686 4,662 -------------------- -------------------- 65,377 71,592 Less-Accumulated depreciation (29,424) (31,974) -------------------- -------------------- $ 35,953 $ 39,618 ==================== ====================
NOTE 6. SUBSEQUENT EVENTS On July 6, 1998, the Company completed a business combination with Acclaim Communications Inc. ("Acclaim") which is a provider of Fast Ethernet and Gigabit Ethernet switches and integrated Multi- Service access products. The combination was a stock for stock merger that has been accounted for as a "pooling-of-interests." Accordingly, the Company's historical consolidated financial statements have been restated to include the financial position and results of operations of Acclaim. As a result of the merger, the outstanding shares of Acclaim capital stock and options and warrants to purchase Acclaim capital stock were converted into the right to receive an aggregate of 5,000,000 shares of the Company's common stock. The Company's acquisition transactions costs incurred as of June 28, 1998 totaled $2.8 million and are included in general and administrative costs in the accompanying consolidated statements of income. 35 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 was settled on September 25, 1998. The terms of the settlement are confidential. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following information should be read in conjunction with the unaudited interim financial statements and the notes thereto included in Item 1 of this Supplement to the Form 8-K, the Management's Discussion and Analysis of Financial Condition and Results of Operations contained in the Company's Form 10-K for the period ended December 28, 1997 filed with the Securities and Exchange Commission on March 27, 1998, and any subsequent filings with the Securities and Exchange Commission. 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 increased 88% to $56.6 and 85% to $60.5 million in the first and second quarters of 1998 compared to revenues of $30.1 and $32.7 million for the same quarters of 1997. Revenues increased sequentially by 11% and 18% since the fourth quarter 1997 revenues of $51.1 million. No single customer represented 10% of total revenues during the first quarter, sales to D- link, Inc. represented 11% of total revenues during the second quarter. The increased revenues reflect the unit sales growth due to the continued market acceptance of the Company's products in both the networking and transmission markets. International revenues for the first quarter of 1998 and 1997 were $21.2 million or 37.5% of revenues and $10.8 million or 36.0% of revenues, respectively. For the second quarter of 1998 and 1997 international revenues were $23.2 million or 39% of revenues and $10.8 million or 33% of revenues, respectively. All sales are denominated in U.S. dollars, thereby eliminating the impact of foreign currency exchange rate fluctuations on revenues. 36 Gross Margin. 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. At 57.1%, gross product margins for the second quarter of 1998 were down slightly from the 58.4% for the first quarter of 1998 and up from 57.2% and 56.8% for the first and second quarters of 1997, respectively. The gross product margin for the first six months of 1998 was 57.7% versus 57.0% for the first six months of 1997, this increase is due to the impact of cost reductions implemented during the second half of 1997 and the first half of 1998. Research and Development. Research and development expenses were $11.6 million or 20.6% and $11.8 million or 19.5% of revenues in the first and second quarters of 1998, respectively, versus $7.4 million or 24.5% and $7.9 or 24.1% of revenues in the first and second quarters of 1997, respectively. For the first six months of 1998 research and development expenses were $23.4 million or 20.0% of revenues versus $15.3 million or 24.3% of revenues for the first six months of 1997. The dollar increase in research and development expense is due to additions to the Company's design engineering staff and related new product design expenses. Sales and Marketing. Sales and marketing expenses were $9.3 million or 16.3% and $9.3 million or 15.3% of revenues in the first and second quarters of 1998, respectively, versus $4.5 million or 15.1% and $5.1 or 15.7% of revenues in the first and second quarters of 1997, respectively. For the first six months of 1998 sales and marketing expenses were $18.5 million or 15.8% of revenues versus $9.7 million or 15.4% of revenues for the first six months of 1997. The increased expenditures are primarily attributable to the expansion of the Company's sales and marketing staffs and their related costs. General and Administrative. General and administrative expenses for the first and second quarters of 1998 were $4.1 million or 7.2% and $7.3 million or 12.1% of revenues, respectively, versus $2.0 million or 6.8% and $2.6 million or 7.9% of revenues in the first and second quarters of 1997, respectively. For the first six months of 1998 general and administrative expenses were $11.3 million or 9.7% of revenues versus $4.6 million or 7.4% of revenues for the first six months of 1997. During the second quarter of 1998 the Company incurred a $2.8 million one time charge for transactions costs associated with the acquisition of Acclaim Communications, Inc. Liquidity and Capital Resources. The Company's principal sources of liquidity as of March 29, 1998 and June 28, 1998, consisted of $124.2 and $119.8 million of cash, cash equivalents and short-term investments, respectively. Working capital was $142.2 at March 29, 1998 and $135.0 million at June 28, 1998 and $157.0 million at December 28, 1997. During the first quarter of 1998, the Company generated $6.5 million of cash from operating activities, as compared to $5.5 million in the same period in 1997. During the second quarter of 1998, the Company generated $13.4 million of cash from operating activities, as compared to $5.5 million in the same period in 1997. In all periods, net cash generated from operations during the period was primarily due to net income before depreciation and amortization expense. Cash was also 37 impacted by the net changes in inventories, accounts receivable, net plant and equipment, and accounts payable. These changes are due primarily to expansion of the Company's business, and do not reflect material changes in the way the Company conducts operations. The Company spent $12.5 million for capital expenditures during the first six months of 1998 as compared to $8.1 million for the same period in 1997. Management believes that, in addition to current financial resources, adequate capital resources are available to satisfy the Company's investment and capital programs. Management believes that the Company's cash flow is sufficient to maintain its current operations. 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 silicon 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 1994 and 1995, the Company 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, 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. 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 38 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 materially 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 39 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 materially 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 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, Inc. Many of these competitors have longer operating 40 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 erosion, 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 5.4%, at June 29, 1997, to 48.6%, at June 28, 1998. This increased leverage will increase the Company's interest expense 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/or 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 revenues 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 41 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 Company's Notes and the Common Stock. Year 2000 Compliance. The Company has reviewed its exposure to risks that could be caused if internal computer systems do not correctly recognize date information when the year changes to 2000. Management believes that the likelihood of a material adverse impact due to problems with internal systems or products sold to customers is remote and expects that the cost of remedying internal systems that currently cannot process the date change will not have a material effect on the Company's financial position or overall trends in results of operations. The Company is also contacting critical suppliers of products and services to determine that the supplier's operations and the products and services they provide are year 2000 compliant. There can be no assurance that another company's failure to ensure year 2000 capability would not have an adverse effect on the Company. PART II - OTHER INFORMATION ITEM 1. 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 was settled on September 25, 1998. The terms of the settlement are confidential. 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 2. CHANGES IN SECURITIES On March 3, 1998, the Company's Certificate of Incorporation was amended to effect a 3-for-2 stock split to shareholders of record on March 9, 1998. The split was effective March 30, 1998. 42 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. LEVEL ONE COMMUNICATIONS, INCORPORATED Date: October 5, 1998 /s/JOHN KEHOE ----------------------------- John Kehoe Senior Vice President and Chief Financial Officer 43 -----END PRIVACY-ENHANCED MESSAGE-----