FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1996 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number: 0-23110 DIGITAL LINK CORPORATION (Exact name of registrant as specified in its charter) California 77-0067742 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 217 Humboldt Court, Sunnyvale, California 94089 (Address of principal executive offices, including zip code) (408) 745-6200 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No The number of shares outstanding of the registrant's common stock at November 13, 1996 was 9,167,905. DIGITAL LINK CORPORATION INDEX TO FORM 10-Q PART I - FINANCIAL INFORMATION: ITEM 1 - Financial Statements Page Consolidated Balance Sheets as of September 30, 1996 3 and December 31, 1995 Consolidated Statements of Income for the quarters 4 and nine months ended September 30, 1996 and September 30, 1995 Consolidated Statements of Cash Flows for 5 the nine months ended September 30, 1996 and September 30, 1995 Notes to Consolidated Financial Statements 6 ITEM 2 - Management's Discussion and 9 Analysis of Financial Condition and Results of Operations PART II - OTHER INFORMATION ITEM 1 - Legal Proceedings 19 ITEM 2 - Changes in Securities 19 ITEM 3 - Defaults Upon Senior Securities 19 ITEM 4 - Submission of Matters to a Vote of 19 Security Holder ITEM 5 - Other Information 19 ITEM 6 - Exhibits and Reports on Form 8-K 19 SIGNATURE(S) 21 PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements DIGITAL LINK CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands, except share amounts) September 30, December 31, 1996 1995 (Unaudited) ASSETS CURRENT ASSETS: Cash and cash equivalents $ 1,644 $ 2,639 Short-term marketable securities 15,243 16,726 Accounts receivable, net 5,901 7,690 Inventories, net 5,604 4,603 Prepaid and other current assets 2,847 2,807 Total current assets 31,239 34,465 Property and equipment at cost, net 1,839 1,608 Long-term marketable securities 25,739 18,244 Other assets 696 438 TOTAL ASSETS $59,513 54,755 LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 1,917 $ 1,371 Accrued payroll expense 1,748 1,433 Other accrued expenses 3,768 2,751 Income taxes payable 1,289 1,427 Total current liabilities 8,722 6,982 SHAREHOLDERS' EQUITY: Common stock, no par value: Authorized: 25,000,000 shares; Issued and outstanding: 9,161,530 shares in 1996 and 9,000,500 shares in 1995 29,778 29,283 Unrealized gain on marketable securities 189 555 Retained earnings 20,824 17,935 Total shareholders' equity 50,791 47,773 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $59,513 $54,755 The accompanying notes are an integral part of these consolidated financial statements. DIGITAL LINK CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited) FOR THE QUARTERS AND NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1995 (Amounts in thousands, except per share amounts) Quarter Ended Nine Months Ended September 30, September 30, 1996 1995 1996 1995 Net sales $14,127 $12,500 $36,355 $34,324 Cost of sales 5,666 4,687 14,869 12,471 Gross profit 8,461 7,813 21,486 21,853 EXPENSES: Research and development 2,749 2,405 7,135 6,923 Selling, general and administrative 4,206 3,550 11,934 10,400 Total expenses 6,955 5,955 19,069 17,323 Operating income 1,506 1,858 2,417 4,530 Other income 625 573 1,832 1,706 Income before provision for income taxes 2,131 2,431 4,249 6,236 Provision for income taxes 650 753 1,359 1,933 NET INCOME $1,481 $1,678 $2,890 $4,303 NET INCOME PER SHARE $ 0.16 $ 0.18 $ 0.31 $ 0.45 Shares used in computing per share amounts 9,451 9,483 9,417 9,470 The accompanying notes are an integral part of these consolidated financial statements. DIGITAL LINK CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1995 (Amounts in thousands) Nine Months Ended September 30, 1996 1995 CASH FLOWS FROM OPERATING ACTIVITIES: Net Income $ 2,890 $4,303 Adjustments to reconcile net income to net cash flows provided by operating activities: Depreciation and amortization 898 1,204 Provision (reduction in provision) for doubtful accounts (282) 130 Provision for excess and obsolete inventories 357 123 Changes in assets and liabilities: Accounts receivable 2,071 (1,286) Inventories (1,357) (1,329) Prepaid and other assets (298) (426) Accounts payable 546 (417) Accrued payroll and other accrued expenses 1,332 176 Income taxes payable (138) 2,004 Net cash flows provided by operating activities 6,019 4,482 CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of marketable securities (31,971) (27,749) Maturities of marketable securities 25,593 21,176 Acquisition of property and equipment (1,131) (1,088) Net cash flows used in investing activities (7,509) (7,661) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from exercise of stock options and employee stock purchases 495 496 Net cash flows provided by financing activities 495 496 Net decrease in cash and cash equivalents (995) (2,683) Cash and cash equivalents at beginning of year 2,639 4,638 Cash and cash equivalents at end of period $ 1,644 $1,955 SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the period for income taxes $ 1,443 $ 405 SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Unrealized gain (loss) on securities carried at market $ (366) $ 515 The accompanying notes are an integral part of these consolidated financial statements. DIGITAL LINK CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying consolidated financial statements have been prepared by the Company without audit in accordance with generally accepted accounting principles for interim financial information and pursuant to rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments (consisting of only normal recurring adjustments) considered necessary for a fair representation have been included. These financial statements should be read in conjunction with the Company's consolidated financial statements and notes thereto contained in the Company's Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 28, 1996. The year-end balance sheet at December 31, 1995 was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. Operating results for the nine months ended September 30, 1996 may not necessarily be indicative of the results to be expected for any other interim period or for the full year. 2. COMPUTATION OF NET INCOME PER SHARE Net income per share is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the period. Dilutive common equivalent shares consist of stock options using the treasury stock method for all periods presented. 3. INVENTORIES Inventories are valued at the lower of cost (determined using the first-in, first-out method) or market. Inventories consisted of (in thousands): September 30, 1996 December 31, 1995 (Unaudited) Raw materials $ 2,210 $1,838 Work-in-process 2,226 1,965 Finished goods 1,168 800 $ 5,604 $4,603 4. CONTINGENCY Certain third parties have expressed their belief that certain of the Company's products may infringe patents held by them and have suggested that the Company acquire licenses to such patents. The Company believes that licenses, to the extent required, will be available; however, no assurance can be given that the terms of any offered licenses would be favorable to the Company. Management, after review and consultation with counsel, believes that the ultimate resolution of these allegations are uncertain and there can be no assurance that these assertions will be resolved without costly litigation or in a manner that is not adverse to the Company. Accordingly, while the Company has accrued certain amounts for these matters, the ultimate resolution of these matters could result in payments in excess of the amounts accrued in the accompanying financial statements and require royalty payments in the future which could adversely impact gross margins. As discussed under "Legal Proceedings" in Part II hereof, in April 1996, a class action complaint was filed against the Company and certain of its officers and directors in the Santa Clara Superior Court of the State of California, alleging violations of the California Corporations Code and California Civil Code. In October 1996, a similar parallel lawsuit against the Company and the same individuals in the State Court action was filed in the United States District Court for the Northern District of California alleging violations of the federal securities laws. The class period in both of these lawsuits runs from September 12, 1994 through December 29, 1995, and both complaints allege that the defendants concealed and/or misrepresented material adverse information about the Company and that the individual defendants sold shares of the Company's stock based upon material nonpublic information. The complaints seek unspecified monetary damages. The Company believes that both actions are without merit and intends to defend both actions vigorously. However, litigation is subject to inherent uncertainties and, thus, there can be no assurance that these lawsuits will be resolved favorably to the Company or that they will not have a material adverse affect on the Company's financial condition and results of operations. Accordingly, no provision for any liability that may result upon adjudication has been made on the accompanying financial statements. 5. CHANGE IN DEPRECIATION METHOD Effective January 1, 1996, the Company adopted the straightline method of depreciation for all property and equipment placed in service after that date. Property and equipment placed in service prior to January 1, 1996 continue to be depreciated using the double-declining balance method. The estimated useful lives under either method ranges from 3 to 5 years. Management believes that the change from the double-declining balance method to the straight-line method provides a better matching of costs and revenues over the lives of its property and equipment and conforms to predominant industry practice. Use of the straight line method of depreciation on assets placed in service in 1996 versus the double-declining balance method resulted in no material difference on the pre-tax income or net income in the nine months ended September 30, 1996. 6. RECENT ACCOUNTING PRONOUNCEMENT During October 1995, the Financial Accounting Standards Board issued Statement No. 123 (SFAS No. 123), "Accounting for Stock-Based Compensation," which establishes a fair value based method of accounting for stock-based compensation plans. The Company intends to continue to account for employee stock options under APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123 is effective for fiscal years beginning after December 15, 1995 and will require certain additional disclosures in the financial statements for the year ending December 31, 1996. DIGITAL LINK CORPORATION ITEM 2. Management's Discussion And Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS Except for the historical statements contained herein, this Form 10-Q contains forward looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These forward looking statements involve a number of risks and uncertainties, such as the impact of competitive products and pricing, the loss of, or differences in actual from anticipated levels of purchases from the Company's major customers, the Company's timely development of new products, including its W/ATM GateWay product, and their acceptance by the market, and other risks which are described throughout the Company's reports filed with the Securities and Exchange Commission, including its Form 10K for the year ended December 31, 1995, and within this "Management's Discussion and Analysis of Financial Condition and Results of Operations," including under the title "Other Factors That May Affect Future Operating Results." The actual results that the Company achieves may differ materially from any forward looking statements due to such risks and uncertainties. The Company has identified by an asterisk (*) various paragraphs within this "Management's Discussion and Analysis of Financial Condition and Results of Operations," which contain such forward looking statements. Actual results could differ materially from such forward looking statements as a result of the factors discussed in such paragraphs and those factors discussed in the sections referenced above and in other sections of this and other documents filed with the Securities and Exchange Commission. In addition, when used in this Form 10-Q, words such as "believes," "anticipates," "expects," "intends" and similar expressions are intended to identify forward looking statements, but are not the exclusive means of identifying such statements. The Company undertakes no obligation to revise any forward looking statements in order to reflect events or circumstances that may arise after the date of this report. Net Sales Net sales for the third quarter of 1996 increased 13% to $14,127,000 from $12,500,000 for the same period of the prior year. Net sales for the nine months ended September 30, 1996 increased 6% to $36,355,000 from $34,324,000 for the same period of the prior year. These increases were primarily attributable to an increase in unit sales of both narrowband (i.e., transmission rates up to T1/E1) products in the Encore product family and domestic broadband (i.e., transmission rates in excess of T1/E1) products. These increases were offset in part by decreased unit sales of the Company's broadband SMDS access products primarily sold in Europe and decreased average selling prices on certain of the Company's narrowband and broadband products. *The Company believes that the decrease in sales of broadband SMDS access products is due in part to the continuing effects of earlier delays in Europe, and in particular in the United Kingdom, in the deployment of SMDS networks due to technical problems within the networks and to earlier market confusion among Frame Relay, SMDS and ATM technologies. The Company anticipates that it will continue to experience the effects of these earlier conditions through at least the remainder of 1996, which would result in lower levels of annual sales of its broadband SMDS access products in 1996 as compared to annual sales in 1995. *Narrowband sales in absolute dollars increased by 13% and remained flat as a percentage of net sales at 53% in the third quarter of 1996, as compared to the third quarter of 1995. Broadband sales increased in absolute dollars by 13% and remained flat as a percentage of net sales at 47% in the third quarter of 1996 as compared to the third quarter of 1995. For the third quarter of 1996, as compared to the same quarter last year, narrowband sales and broadband sales as a percentage of net sales remained flat notwithstanding lower sales in Europe of broadband products which were offset by higher broadband sales to certain domestic carrier customers and Internet Service Providers (ISPs). Narrowband sales in absolute dollars increased by 22% and increased as a percentage of net sales to 59% for the nine months ended September 30, 1996, as compared to 51% for the first nine months of 1995. Broadband sales decreased in absolute dollars by 11% and decreased as a percentage of net sales to 41% for the first nine months of 1996, as compared to 49% for the first nine months of the prior year. For the first nine months of 1996, as compared to the first nine months of 1995, broadband sales as a percentage of net sales decreased as a result of lower SMDS net sales in Europe, which was slightly offset by higher broadband sales to certain domestic carrier customers and ISPs. The Company anticipates that the mix of products sold may change to include a higher percentage of narrowband products which would adversely affect the Company's gross margins. *International sales represented 18% of net sales in the third quarter of 1996 as compared to 21% in the third quarter of 1995, and 15% of net sales for the nine months ended September 30, 1996 as compared to 30% for the same period of the prior year. The decreases for the quarter and nine month periods ending September 30, 1996 were primarily due to a decrease in unit sales of SMDS products in Europe. For the reasons discussed above, the Company anticipates that international sales will remain at similar levels during the remainder of 1996, as compared to 1995, which would result in a decrease in international sales as a percentage of net sales for 1996. International sales are subject to inherent risks, including difficulties in homologating products in other countries, difficulties in staffing and managing foreign operations, greater difficulty in accounts receivable collection, unexpected changes in regulatory requirements and tariffs, and potentially adverse tax consequences, which may in the future contribute to fluctuations in the Company's business and operating results. *During the third quarter of 1996, sales to MCI accounted for 16% of the Company's net sales. During the first nine months of 1996, MCI and BBN Planet Corporation accounted for 16% and 15%, respectively of the Company's net sales. The Company anticipates that sales to BBN Planet Corporation will decrease as a percentage of net sales in the fourth quarter of 1996 as a result of fluctuations in activities associated with the build out of its Internet infrastructure. A significant portion of the Company's business is derived from substantial orders placed by large end users and telephone companies, and the timing of such orders could cause material fluctuations in the Company's business and operating results. For example, in the fourth quarter of 1995, the Company had lower operating results than expected due in part to a weaker than expected demand from certain domestic carrier customers, as well as the slow down of sales of its SMDS access products. During the third quarter of 1996, net sales through direct sales, value added resellers (VARs), and OEMs were 53%, 38%, and 9%, respectively, compared to 55%, 33%, and 12% in the third quarter of 1995. Net sales through direct sales, VARs, and OEMs for the nine months ending September 30, 1996, were 59%, 32%, and 9%, respectively, compared to 48%, 32%, and 20% for the same period of 1995. These increases in the percentage of direct sales were primarily a result of selling directly to BBN Planet Corporation during 1996 compared to 1995 when sales to BBN Planet Corporation were made through a VAR. The decreases in the percentage of OEM sales were primarily a result of decreased sales in SMDS access products primarily sold in Europe. Gross Profit Gross profit increased 8% in the third quarter of 1996 to $8,461,000 from $7,813,000 for the same period of the prior year. Gross margin decreased to 59.9% of net sales in the third quarter of 1996 as compared to 62.5% in the third quarter of 1995. This decrease in gross margin was primarily due to price reductions made since the second half of 1995 with respect to some of the Company's access products. Gross profit decreased 2% in the nine months ended September 30, 1996 to $21,486,000 from $21,853,000 for the same period of the prior year. Gross margin decreased to 59.1% of net sales for the first nine months of 1996 as compared to 63.7% for the same period of the prior year. This decrease in gross margin reflects the above referenced price reductions and a shift in the mix of products sold to include more narrowband products, which generally have lower gross margins than broadband products. The Company anticipates that this increased pricing pressure will continue during at least the remainder of 1996. *Gross margins may vary significantly from quarter to quarter depending on factors such as competitive pricing pressures, changes in the mix of products sold and the channels through which they are distributed, the timing of orders and the timing of new product introductions by the Company. A significant portion of the Company's business is very price competitive, which has in the past and will in the future require the Company to lower its prices, resulting in fluctuations in the Company's business and operating results. For example, periodically throughout 1995, and the first nine months of 1996, the Company reduced the prices on some of its access products to address competitive pricing pressures, which adversely affected the Company's gross margins during 1995 and 1996. In addition, the Company anticipates that the mix of products sold may change to include a higher percentage of narrowband products which generally have lower gross margins and would therefore adversely affect the Company's overall gross margins. Research and Development Research and development ("R&D") expenses increased 14% to $2,749,000 in the third quarter of 1996 from $2,405,000 in the third quarter of 1995. This increase was due primarily to an increase in consulting fees primarily related to the Company's W/ATM GateWay product, offset by a decrease in personnel-related expenses and professional services. As a percentage of net sales, R&D expenses were 19.5% in the third quarter of 1996 as compared to 19.2% in the third quarter of 1995. This slight increase as a percentage of net sales is primarily due to the faster rate of growth in consulting fees during the third quarter of 1996 relative to the rate of growth in net sales during the same period of the prior year. R&D expenses increased 3% to $7,135,000 in the nine months ended September 30, 1996 from $6,923,000 for the same period of the prior year. As a percentage of net sales, R&D expenses were 19.6% for the first nine months of 1996 as compared to 20.2% for the same period of the prior year. The absolute dollar increase for the nine-month period is primarily attributable to higher consulting fees related to the Company's W/ATM GateWay product, offset by a decrease in professional services, material costs for prototype products, and personnel-related expenses. The decrease as a percentage of net sales was primarily the result of operating efficiencies from higher sales volume during the period. *The Company anticipates that its R&D expenses in the fourth quarter of 1996, especially consulting expenses related to its W/ATM GateWay product, will increase in absolute dollars and may increase as a percentage of net sales as compared to the third quarter of 1996, subject to, among other factors set forth or referenced in "Net Sales" above and "Other Factors That May Affect Future Operating Results" below, the Company's ability to accelerate or defer operating expenses, achieve revenue levels and hire new personnel during the remainder of 1996. *All of the Company's R&D expenditures to date have been expensed as incurred. In the future, the Company may be required to capitalize a portion of its software development costs pursuant to Statement of Financial Accounting Standards No. 86, "Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed." Selling, General and Administrative Selling, general and administrative ("SG&A") expenses increased 18% in the third quarter of 1996 to $4,206,000 from $3,550,000 for the same period of the prior year. As a percentage of net sales, SG&A expenses were 29.8% in the third quarter of 1996 as compared to 28.4% in the third quarter of 1995. These increases were primarily due to higher personnel-related expenses, primarily within the sales and marketing organizations, an increase in promotional activities and higher evaluation product expenses. SG&A expenses increased 15% for the nine months ended September 30, 1996 to $11,934,000 from $10,400,000 for the same period of the prior year. As a percentage of net sales, SG&A expenses were 32.8% for the first nine months of 1996 as compared to 30.3% for the same period of the prior year. These increases were primarily a result of higher personnel related expenses, primarily within the sales and marketing organization, and higher evaluation product and promotional expenses. *The Company has in the past hired more of its SG&A personnel and incurred increased expenses related to trade shows and other promotional activities during the first half of the year. Accordingly, SG&A expenses as a percentage of net sales are generally higher during the first half of the year, and the Company anticipates that this will be true for the remainder of 1996. The Company anticipates that its SG&A expenses will increase in absolute dollars during the fourth quarter of 1996 as compared to the third quarter of 1996 as a result, in part, of increases in legal expenses associated with its defense of the recently filed class action lawsuits against the Company. However, any such decrease is subject to, among other factors set forth or referenced in "Net Sales" above and "Other Factors That May Affect Future Operating Results" below, the Company's ability to accelerate or defer operating expenses and achieve revenue levels during such periods. Other Income Net other income increased 9% in the third quarter of 1996 to $625,000 from $573,000 for the same period of the prior year. For the nine months ended September 30, 1996, net other income increased 7% to $1,832,000 from $1,706,000 for the same period of the prior year. These increases were primarily due to higher interest income from higher cash and marketable securities balances. Provision for Income Taxes The Company's effective tax rate decreased to 30.5% for the third quarter of 1996 compared to 31.0% for the same period last year. This decrease is due primarily to the use of the Company's R&D tax credit. The Company's effective tax rate increased to 32.0% for the nine months ended September 30, 1996 compared to 31.0% for the same period last year. This increase is due to lower foreign sales and lower R&D tax credit. The Company anticipates that its effective tax rate during the fourth quarter of 1996 will remain at levels similar to that experienced in the third quarter of 1996. LIQUIDITY AND CAPITAL RESOURCES The Company had working capital of $22.5 million and cash, cash equivalents and marketable securities of $42.6 million at September 30, 1996. Net cash provided by operating activities was $6.0 million for the first nine months of 1996, primarily as a result of a net income before depreciation and amortization, a decrease in accounts receivable and an increase in accrued payroll and other accrued expenses, offset to some extent by an increase in inventories. This compares to net cash provided by operating activities of $4.5 million for the first nine months of 1995, primarily as a result of net income before depreciation and amortization and an increase in income taxes payable, offset by an increase in accounts receivable and inventories. Cash used in investing activities during the first nine months of 1996 was primarily from net purchases of marketable securities and, to a lesser extent, leasehold improvements and capital equipment additions of $1,131,000 in cash flow as compared to $1,088,000 in the first nine months of 1995. In October 1996, the Company approved the repurchase of up to 500,000 shares of common stock for cash from time-to-time at market prices and as market and business conditions warrant, in open market, negotiated, or block transactions. Net cash provided by financing activities was $495,000 in the first nine months of 1996 from the exercise of stock options and issuance under the employee stock purchase plan, as compared to $496,000 in the first nine months of 1995. *The Company believes that existing cash and cash flows from operations will be sufficient to meet its anticipated cash requirements for working capital and capital expenditures for at least the next 12 months. OTHER FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS As indicated above, there are a number of factors that may affect the Company's future operating results. *The Company believes that changes in the product mix sold toward narrowband products that yield lower gross margins have in the past and could in the future affect operating results. Other factors that may cause fluctuations in the Company's operating results include the gain or loss of significant customers, the timing of new product introductions by the Company and its competitors, seasonal capital spending patterns of large domestic customers, completion of the build out of carrier and ISP infrastructures, changes in sales volumes through the Company's distribution channels, market acceptance of new or enhanced versions of the Company's products, availability and cost of components from the Company's suppliers (some of which are in short supply and are key to new product development), and economic conditions generally or in various geographic areas. In addition, the Company's expense levels are based in part on its expectations of future revenue. The Company typically operates with limited order backlog, and a substantial majority of its revenues in each quarter result from orders booked in that quarter. The Company has occasionally recognized a substantial portion of its revenues in a given quarter from sales booked and shipped in the last month of that quarter. If revenue levels are below expectations, the Company may be unable to adjust spending in a timely manner which could adversely affect operating results. *The market for the Company's products is highly competitive. The Company expects competition to increase in the future from existing competitors and from other companies that may enter the Company's existing or future markets. The Company anticipates that it will face competition from internetworking equipment and other telecommunications equipment manufacturers, certain of whom are including a direct WAN interface in their products. For example, in 1995, the Company signed an OEM agreement with Cisco Systems, Inc. ("Cisco") pursuant to which the Company supplies DSU cards for inclusion in one of Cisco's key product lines. Increased sales to Cisco or other internetworking equipment and telecommunications equipment manufacturers could adversely affect the Company's gross margins, as sales to OEMs generally have higher discounts than sales to end users. Further, to the extent that internetworking equipment, such as routers, and telecommunications equipment, such as switches, successfully develop a direct WAN interface for inclusion in their products, overall demand for the Company's products would be reduced, which would have a material adverse affect on the Company's business and operating results. As discussed above, increased competition has also placed increasing pressures on the pricing of the Company's products, which has resulted in lower operating results. The Company anticipates that this increased pricing pressure will continue during at least the remainder of 1996. *The Company's future prospects will depend in part on its ability to enhance the functionality of its existing WAN access products in a timely manner and to identify, develop and achieve market acceptance of new products that address new technologies and meet customer needs in the WAN access market. Any failure by the Company to anticipate or to respond adequately to competitive solutions, technological developments in its industry, changes in customer requirements, or changes in regulatory requirements or industry standards, or any significant delays in the development, introduction or shipment of products, could have a material adverse affect on the Company's business and operating results. For example, the Company has experienced decreased sales of its SMDS and ATM access products, which the Company believes is due in part to delays in the further deployment of SMDS networks due to technical problems within the networks and to market confusion in Europe among Frame Relay, SMDS and ATM technologies. There can be no assurance that the Company's product development efforts will result in commercially successful products or that product delays will not result in missed market opportunities. In addition, customers could refrain from purchasing the Company's existing products in anticipation of new product introductions by the Company or its competitors. New products could also render certain of the Company's existing products obsolete. Either of these events could materially adversely affect the Company's business and operating results. *The Company is currently developing and may in the future develop products with which the Company has only limited experience and/or that are targeted at emerging market segments, including the Company's W/ATM GateWay product. The W/ATM GateWay product has not been deployed to any end user customers, and the Company has experienced delays in the development of this product, in part related to technical problems which required some software to be redesigned. The Company has entered into an agreement with an OEM to market this product once its development has been completed, but such agreement does not obligate the OEM to purchase any minimum number of products. In addition, an agreement with AT&T Network Systems to market the W/ATM GateWay under that company's name expired in September 1995. According to the Company's current plan, this product is not anticipated to be available for customer evaluation before December of 1996. Given its complexity, there can be no assurance that this product will not encounter further technical or other difficulties which could significantly delay its deployment or acceptance or could result in the termination of the development program for this product. If this product becomes available, there can be no assurance that markets for the W/ATM GateWay will continue to develop, that the Company will receive orders for this product, that the W/ATM GateWay will meet the needs of the emerging ATM market or that products currently under development by others will not be introduced that would directly compete with the W/ATM GateWay product, any of which could have a material adverse affect on the Company's business and operating results. *The Company believes that its future success will depend in large part upon the continued contributions of members of the Company's senior management and other key personnel, and upon its ability to attract and retain highly skilled managerial, engineering, sales, marketing and operations personnel, the competition for whom is intense. Certain of the Company's senior management have only recently joined the Company. For example, in September 1996, Alan Fraser joined the Company as President and Chief Executive Officer, replacing Vinita Gupta, who remains as Chairperson of the Board of Directors. There can be no assurance that the Company will be successful in attracting and retaining skilled personnel to hold important management positions. *As discussed under "Legal Proceedings" in Part II hereof, in April 1996, a class action complaint was filed against the Company and certain of its officers and directors in the Santa Clara Superior Court of the State of California, alleging violations of the California Corporations Code and California Civil Code. In October 1996, a similar parallel lawsuit against the Company and the same individuals in the State Court action was filed in the United States District Court for the Northern District of California alleging violations of the federal securities laws. The class period in both of these lawsuits runs from September 12, 1994 through December 29, 1995, and both complaints allege that the defendants concealed and/or misrepresented material adverse information about the Company and that the individual defendants sold shares of the Company's stock based upon material nonpublic information. The complaints seek unspecified monetary damages. The Company believes that both actions are without merit and intends to defend both actions vigorously. However, litigation is subject to inherent uncertainties and, thus, there can be no assurance that these lawsuits will be resolved favorably to the Company or that they will not have a material adverse affect on the Company's financial condition and results of operations. *The telecommunications industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. For example, a third party has expressed its belief on several occasions that certain of the Company's products, including its CSU/DSUs, may infringe upon six patents held by it and has suggested on such occasions that the Company acquire a license to such patents. There can be no assurance that these assertions will be resolved without costly litigation or in a manner that is not adverse to the Company. The Company believes that a license, to the extent required, will be available; however, no assurance can be given that the terms of any offered license would be favorable to the Company. Should a license be unavailable, the Company could be required to discontinue the sale of or to redesign certain of its products. In addition, Larscom, a competitor of the Company, has continued to express its belief that the Company's inverse multiplexer products may infringe a patent jointly owned by Larscom and a third party and has suggested that the Company acquire a license to the patent. There can be no assurance that other third parties will not assert infringement claims against the Company in the future, that any such claims will not result in costly litigation or that the Company will prevail in such litigation or be able to license any valid and infringed patents from third parties on commercially reasonable terms. The Company's management, after review and consultation with counsel, believes that the ultimate resolution of these allegations are uncertain and there can be no assurance that these assertions will be resolved without costly litigation or in a manner that is not adverse to the Company. Accordingly, while the Company has accrued certain amounts for these matters, the ultimate resolution of these matters could result in payments in excess of the amounts accrued in the Company's financial statements and require royalty payments in the future which could adversely impact gross margins. *The risks outlined herein are difficult for the Company to forecast, and these or other factors can materially affect the Company's operating results and stock price for one quarter or a series of quarters. Further, in recent years the stock market has experienced extreme price and volume fluctuations that have particularly affected the market prices of securities of many high technology companies, for reasons frequently unrelated to the operating performance of the specific companies. These fluctuations, as well as general economic, political and market conditions, may materially adversely affect the market price of the Company's common stock. *During October 1995, the Financial Accounting Standards Board issued Statement No. 123 (SFAS No. 123), "Accounting for StockBased Compensation," which establishes a fair value based method of accounting for stock-based compensation plans. The Company intends to continue to account for employee stock options under APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123 is effective for fiscal years beginning after December 15, 1995 and will require certain additional disclosures in the financial statements for the year ending December 31, 1996. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In April 1996, a class action complaint was filed against the Company and certain of its officers and directors in the Santa Clara Superior Court of the State of California, alleging violations of the California Corporations Code and California Civil Code. In October 1996, a similar parallel lawsuit against the Company and the same individuals in the State Court action was filed in the United States District Court for the Northern District of California alleging violations of the federal securities laws. The class period in both of these lawsuits runs from September 12, 1994 through December 29, 1995, and both complaints allege that the defendants concealed and/or misrepresented material adverse information about the Company and that the individual defendants sold shares of the Company's stock based upon material nonpublic information. The complaints seek unspecified monetary damages. The Company believes that both actions are without merit and intends to defend both actions vigorously. However, litigation is subject to inherent uncertainties and, thus, there can be no assurance that these lawsuits will be resolved favorably to the Company or that they will not have a material adverse affect on the Company's financial condition and results of operations. ITEM 2. CHANGES IN SECURITIES Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 5. OTHER INFORMATION In September 1996, Alan Fraser joined the Company as President and Chief Executive Officer, replacing Vinita Gupta, who remains as Chairperson of the Board of Directors. Mr. Fraser is also a member of the Company's Board of Directors. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10.18 Employment Agreement between Registrant and Alan Fraser dated September 5, 1996. 10.19 Security Agreement between Registrant and Alan Fraser dated September 30, 1996. 10.20 Secured Promissory Note from Alan Fraser dated September 30, 1996. 11.01 Statement of Computation of Net Income Per Share. 27.01 Financial Data Schedule (b) Reports on Form 8-K There were no reports on Form 8-K filed during the quarter ended September 30, 1996. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. DIGITAL LINK CORPORATION Date: November 14, 1996 \s\ Alan I. Fraser Alan I. Fraser Chief Executive Officer Date: November 14, 1996 \s\ Stanley E. Kazmierczak Stanley E. Kazmierczak Chief Financial Officer EXHIBIT INDEX Exhibits 10.18 Employment Agreement between Registrant and Alan Fraser dated September 5, 1996. 10.19 Security Agreement between Registrant and Alan Fraser dated September 30, 1996. 10.20 Secured Promissory Note from Alan Fraser dated September 30, 1996. 11.01 Statement of Computation of Net Income Per Share. 27.01 Financial Data Schedule