SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (X) Quarterly report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended October 3, 1998 or ( ) Transition report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from __________ to __________. Commission file number: 0-15627 SEQUENT COMPUTER SYSTEMS, INC. (Exact name of registrant as specified in its charter) Oregon 93-0826369 (State or other jurisdiction (I.R.S. Employer of organization or incorporation) Identification Number) 15450 S.W. Koll Parkway Beaverton, Oregon 97006-6063 (Address of principal executive offices, including zip code) (503) 626-5700 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such report), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 43,772,277 common shares were issued and outstanding as of November 12, 1998. SEQUENT COMPUTER SYSTEMS, INC. PART I. FINANCIAL INFORMATION Page No. Item 1. Consolidated Financial Statements Consolidated Balance Sheets - October 3, 1998 and January 3, 1998 3 Consolidated Statements of Operations - Three months and nine months ended October 3, 1998 and October 4, 1997 4 Consolidated Statements of Shareholders' Equity - January 3, 1998 through October 3, 1998 5 Consolidated Statements of Cash Flows - Nine months ended October 3, 1998 and October 4, 1997 6 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 19 Item 1. CONSOLIDATED FINANCIAL STATEMENTS SEQUENT COMPUTER SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except per share amounts) October 3, 1998 January 3, 1998 (unaudited) ASSETS Current assets: Cash and cash equivalents $ 157,606 $ 133,299 Restricted deposits 27,275 68,791 Receivables, net 226,481 328,884 Inventories 95,119 112,228 Prepaid royalties and other 25,509 28,147 Total current assets 531,990 671,349 Property and equipment, net 139,469 134,728 Capitalized software costs, net 70,893 66,244 Other assets, net 31,883 14,356 Total assets $ 774,235 $ 886,677 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Notes payable $ 28,755 $ 69,893 Accounts payable and other 106,183 128,157 Accrued payroll 14,463 22,843 Unearned revenue 43,396 40,946 Income taxes payable 5,840 3,134 Current obligations under capital leases 2,265 2,310 Total current liabilities 200,902 267,283 Other accrued expenses 8,736 8,700 Long-term obligations under capital leases 8,075 9,910 Total liabilities 217,713 285,893 Shareholders' equity: Common stock, $.01 par value, 100,000 shares authorized, 43,770 and 42,962 shares outstanding 438 430 Paid-in capital 517,014 508,858 Retained earnings 44,710 99,402 Foreign currency translation adjustment (5,640) (7,906) Total shareholders' equity 556,522 600,784 Total liabilities and shareholders' equity $ 774,235 $ 886,677 See notes to consolidated financial statements. SEQUENT COMPUTER SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS - Unaudited (in thousands, except per share amounts) Three Months Ended Nine Months Ended October 3, 1998 October 4, 1997 October 3, 1998 October 4, 1997 Revenue: Product $ 130,491 $ 147,000 $ 369,237 $ 406,989 Service 70,907 60,320 200,906 168,358 Total revenue 201,398 207,320 570,143 575,347 Costs and expenses: Cost of products sold 82,503 76,326 227,950 205,371 Cost of service revenue 51,013 43,968 146,508 124,965 Research and development 19,382 16,516 56,138 48,434 Selling, general and administrative 50,616 57,051 158,473 166,884 Restructuring charges (credits) (1,350) -- 61,548 -- Total costs and expenses 202,164 193,861 650,617 545,654 Operating income (loss) (766) 13,459 (80,474) 29,693 Interest, net 1,620 413 3,503 (1,624) Other, net (799) (962) (2,227) (1,535) Income (loss) before provision for (benefit from) income taxes 55 12,910 (79,198) 26,534 Provision for (benefit from) income taxes 17 2,612 (24,506) 6,931 Net income (loss) $ 38 $ 10,298 $ (54,692) $ 19,603 Net income (loss) per share - basic $ 0.00 $ 0.26 $ (1.26) $ 0.54 Net income (loss) per share - diluted $ 0.00 $ 0.24 $ (1.26) $ 0.50 Shares used in the calculation of net income (loss) per share - basic 43,607 39,436 43,507 36,264 Shares used in the calculation of net income (loss) per share - diluted 43,753 43,357 43,507 39,195 See notes to consolidated financial statements. SEQUENT COMPUTER SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in thousands) Foreign currency Common Stock Paid-in Retained translation Shares Amount capital earnings adjustment Total Balance, January 3, 1998 42,962 $430 $508,858 $ 99,402 $(7,906) $600,784 Common shares issued 654 6 8,626 - - 8,632 Tax benefit of option exercises - - 256 - - 256 Net income - - - 4,022 - 4,022 Foreign currency translation adjustment - - - - 1,252 1,252 Balance, April 4, 1998 (unaudited) 43,616 436 517,740 103,424 (6,654) 614,946 Common shares issued 424 4 6,343 - - 6,347 Common shares repurchased (400) (4) (4,941) - - (4,945) Tax benefit of option exercises - - 76 - - 76 Net loss - - - (58,752) - (58,752) Foreign currency translation adjustment - - - - (667) (667) Balance, July 4, 1998 (unaudited) 43,640 436 519,218 44,672 (7,321) 557,005 Common shares issued 601 6 2,763 - - 2,769 Common shares repurchased (471) (4) (5,004) - - (5,008) Tax benefit of option exercises - - 37 - - 37 Net income - - - 38 - 38 Foreign currency translation adjustment - - - - 1,681 1,681 Balance, October 3, 1998 (unaudited) 43,770 $438 $517,014 $44,710 $(5,640) $556,522 See notes to consolidated financial statements. SEQUENT COMPUTER SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS - Unaudited (in thousands) Nine Months Ended October 3, 1998 October 4, 1997 Cash flow from operating activities: Net income (loss) $ (54,692) $ 19,603 Reconciliation of net income (loss) to cash and cash equivalents provided by operating activities - Depreciation and amortization 65,639 61,413 Restructuring charges not affecting cash 57,058 -- Deferred income taxes (24,200) (4,536) Changes in assets and liabilities - Receivables, net 102,403 (65,996) Inventories 17,109 (32,544) Prepaid royalties and other (12,553) (1,246) Accounts payable and other (25,888) 38,913 Accrued payroll (8,889) (9,263) Unearned revenue 2,450 8,361 Income taxes payable 2,706 (1,325) Other, net (20,690) 2,444 Net cash provided by operating activities 100,453 15,824 Cash flow from investing activities: Restricted deposits 41,516 (7,652) Purchases of property and equipment, net (53,855) (50,108) Capitalized software costs (29,959) (25,351) Intangibles and other assets -- (3,565) Net cash used for investing activities (42,298) (86,676) Cash flow from financing activities: Notes payable, net (41,138) (6,429) Payments under capital lease obligations (1,883) (1,914) Stock issuance proceeds 18,117 176,121 Stock repurchases (9,953) -- Net cash provided by (used for) financing activities (34,857) 167,778 Effect of exchange rate changes on cash 1,009 (1,436) Net increase in cash and cash equivalents 24,307 95,490 Cash and cash equivalents at beginning of period 133,299 37,979 Cash and cash equivalents at end of period $ 157,606 $ 133,469 Supplemental schedule of noncash investing and financing activities: Conversion of Subordinated Debentures to Equity, net $ 8,947 See notes to consolidated financial statements. SEQUENT COMPUTER SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS October 3, 1998 Basis of Presentation The accompanying consolidated financial statements are unaudited and have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission and in the opinion of management include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1998. The Company's fiscal year is based on a 52-53 week year ending the Saturday closest to December 31. The accompanying consolidated financial statements include the accounts of Sequent Computer Systems, Inc. and its wholly-owned subsidiaries (the Company or Sequent). All significant intercompany accounts and transactions have been eliminated. The results for interim periods are not necessarily indicative of the results for the entire year. Management Estimates 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 these estimates. Significant estimates and judgments made by management of the Company include matters such as collectibility of accounts receivable, realizability of inventories and recoverability of capitalized software costs, prepaid royalties and deferred tax assets. Reclassifications Certain reclassifications have been made to amounts as previously reported in prior periods. These reclassifications had no impact on previously reported results of operations or shareholders' equity. Recently Issued Accounting Standards In June 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information (FAS 131). The objective of the standard is to provide information about the different types of business activities in which an enterprise engages and the different economic environments in which it operates. The Company adopted the standard effective January 4, 1998. FAS 131 does not need to be applied to interim periods in the initial year of application; however, comparative information for interim periods in the initial year of application will be reported in the financial statements for interim periods in fiscal 1999. This Statement has no impact on reported earnings and management expects that it will not have a material effect on the Company's consolidated financial position or results of operations. In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133). This Statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. This statement is effective for fiscal years beginning after June 15, 1999 (January 1, 2000 for the Company). The Company is currently assessing the impact that the adoption of FAS 133 will have on its consolidated financial statements. Accounts Receivable At October 3, 1998, accounts receivable in the accompanying consolidated balance sheet is net of $29.5 million received by the Company under its agreement to sell its domestic accounts receivable. Inventories Inventories consist of the following: (in thousands) October 3, January 3, 1998 1998 Raw materials $ 14,699 $ 16,375 Work-in-progress 1,404 3,155 Finished goods 79,016 92,698 $ 95,119 $ 112,228 Property and Equipment Property and equipment consist of the following: (in thousands) October 3, January 3, 1998 1998 Land $ 6,307 $ 5,037 Operational equipment 228,507 209,372 Furniture and office equipment 85,818 89,569 Leasehold improvements 27,440 22,889 348,072 326,867 Less accumulated depreciation (208,603) (192,139) $ 139,469 $ 134,728 Research and Development Amortization of capitalized software costs, generally based on a three-year life, was $22.8 million and $20.1 million for the nine months ended October 3, 1998 and October 4, 1997, respectively. Notes Payable The Company has an unsecured line of credit agreement with a group of banks which provides short-term borrowings of up to $80 million. The line of credit agreement extends through April 3, 2001. There were no borrowings outstanding under the line of credit at October 3, 1998 or January 3, 1998. The Company has a short-term borrowing agreement with a foreign bank as a hedge to cover certain foreign currency exposures. Borrowings under the agreement are denominated in various foreign currencies. Proceeds from the borrowings are converted into U.S. dollars and placed in a term deposit account with the foreign bank. At October 3, 1998, maximum borrowings allowed under the agreement were approximately $90.1 million. The maximum borrowing limit is denominated in specified foreign currencies and fluctuates with the change in foreign exchange rates. Amounts outstanding were $27.3 million and $68.8 million at October 3, 1998 and January 3, 1998, respectively. In addition to the above borrowing agreements, the Company has entered into certain other miscellaneous borrowing arrangements with a foreign bank. At October 3, 1998 and January 3, 1998, $1.5 million and $1.1 million were outstanding, respectively. Common Stock During the second quarter of 1998, the Company announced a plan to repurchase up to 4,000,000 shares of its outstanding common stock. As of October 3, 1998, the Company has repurchased 871,000 shares at an average price of $11.43 per share. Subsequent to October 3, 1998, 125,000 shares have been repurchased at an average price of $10.13. In the third quarter of 1997, the Company completed a public offering of its common stock. Section 7(e) of the Underwriting Agreement requires that the Company's Form 10-Q for the third quarter of 1998 include an earnings statement for the twelve months ended October 3, 1998. The following Statement of Operations is pursuant to that agreement: CONSOLIDATED STATEMENTS OF OPERATIONS - Unaudited (in thousands, except per share amounts) Twelve Months Ended October 3, 1998 Revenue: Product $ 562,744 Service 265,938 Total revenue 828,682 Costs and expenses: Cost of products sold 331,596 Cost of service revenue 193,137 Research and development 73,118 Selling, general and administrative 225,626 Restructuring charges 61,548 Total costs and expenses 885,025 Operating loss (56,343) Interest, net 4,136 Other, net (3,013) Loss before benefit from income taxes (55,220) Benefit from income taxes 19,612 Net loss $ (35,608) Net loss per share - basic $ (0.82) Net loss per share - diluted $ (0.82) Shares used in the calculation of net loss per share - basic 43,331 Shares used in the calculation of net loss per share - diluted 43,331 Income Taxes The Company's general practice is to reinvest the earnings of its foreign subsidiaries operations, unless it would be advantageous to the Company to repatriate the foreign subsidiaries' retained earnings. The effective tax rate differs from the statutory tax rate principally due to the benefit from the Company's foreign sales corporation and the federal research and experimentation tax credit. Restructuring Charges During the second quarter of 1998, the Company recorded restructuring charges of $62.9 million in connection with management's decision to accelerate changes in its business model to leverage the strength of its technology roadmap and market position. Please refer to the discussion of restructuring costs included in Management's Discussion and Analysis of Financial Condition and Results of Operations. Comprehensive Income Three Months Ended Nine Months Ended October 3, October 4, October 3, October 4, (in thousands) 1998 1997 1998 1997 Net income (loss) $ 38 $10,298 $(54,692) $19,603 Other comprehensive income (loss): Foreign currency translation adjustment 1,681 (1,126) 2,266 (3,927) Total comprehensive income (loss) $ 1,719 $ 9,172 $(52,426) $15,676 The foreign currency translation adjustment represents the Company's only significant other comprehensive income element. The cumulative translation adjustment consists of unrealized gains/losses from translation adjustments and intercompany foreign currency transactions that are of a long-term investment nature. These items are reflected in the statement of shareholders' equity in accordance with Statement of Financial Accounting Standards No. 52, Foreign Currency Translation. Earnings Per Share (in thousands, except per share amounts) Income/(Loss) Shares Per-Share (Numerator) (Denominator) Amount Three Months Ended Three Months Ended Three Months Ended Oct. 3, Oct. 4, Oct. 3, Oct. 4, Oct. 3, Oct. 4, 1998 1997 1998 1997 1998 1997 Basic EPS Income (loss) available to common shareholders $ 38 $ 10,298 43,607 39,436 $ 0.00 $ 0.26 Effect of Dilutive Securities Stock options 30 3,709 Employee stock purchase plan and debentures 116 212 Diluted EPS Income (loss) available to common shareholders + assumed conversions $ 38 $ 10,298 43,753 43,357 $ 0.00 $ 0.24 Income/(Loss) Shares Per-Share (Numerator) (Denominator) Amount Nine Months Ended Nine Months Ended Nine Months Ended Oct. 3, Oct. 4, Oct. 3, Oct. 4, Oct. 3, Oct. 4, 1998 1997 1998 1997 1998 1997 Basic EPS Income (loss) available to common shareholders $(54,692) $19,603 43,507 36,264 $(1.26) $0.54 Effect of Dilutive Securities Stock options -- 2,578 Employee stock purchase plan and debentures -- 353 Diluted EPS Income (loss) available to common shareholders + assumed conversions $(54,692) $19,603 43,507 39,195 $(1.26) $0.50 Significant Customers The core business operations of the Company include the design, manufacture and marketing of high-performance computer systems and operating environment software. Project-oriented offerings include consulting and professional services to help customers solve complex information technology problems. The Company had no single customer that represented greater than 10% of total revenue for the third quarter of 1998. Approximately 13% of the Company's revenue in the third quarter of 1997 was from one customer. Geographic Segment Information Export and foreign revenue was $104.4 million (52% of total revenue) for the three months ended October 3, 1998 and $290.1 million (51% of total revenue) for the first nine months of 1998. Export and foreign revenue was $89.7 million and $267.3 million (43% and 46% of total revenue, respectively) for the corresponding periods in 1997. The Company's United States operations generated operating losses of $15 million for the three months ended October 3, 1998 and $25.6 million for the first nine months of 1998. Foreign operations generated net operating profit of $12.9 million and $6.7 million for the same periods, respectively. The results of comparable periods in 1997 were operating income of $21.1 million and $50 million for the United States operations and net operating losses of $7.7 million and $20.3 million for foreign operations. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Three Months Ended Nine Months Ended (dollars in thousands) October 3, October 4, October 3, October 4, 1998 1997 1998 1997 Total Revenue $ 201,398 $ 207,320 $ 570,143 $ 575,347 Product $ 130,491 $ 147,000 $ 369,237 $ 406,989 Service 70,907 60,320 200,906 168,358 US $ 96,948 $ 117,580 $ 280,007 $ 307,973 International 104,450 89,740 290,136 267,374 Net Income (loss) $ 38 $ 10,298 $ (54,692) $ 19,603 OVERVIEW The Company's total revenue declined slightly in the third quarter and first nine months of 1998 compared to the same periods in 1997. During the third quarter and first nine months of 1998, the Company recorded approximately breakeven results and a net loss of $54.7 million, respectively. Included in the $54.7 million loss is a pretax net restructuring charge of $61.5 million ($62.9 million was recorded in the second quarter of 1998 and a subsequent credit of $1.3 million was recorded in the third quarter of 1998). Without the net restructuring charge, the Company would have recorded an after-tax net loss of $12.2 million for the first nine months of 1998. The Company's product revenue decreased in the third quarter and first nine months of 1998 over the same periods in 1997. The main factor contributing to the decrease in product revenue was a significant reduction in revenue from the Company's largest domestic customer during the third quarter of 1998. Offsetting the reduction in product revenue were increases in service revenue, including the positive impact of solid growth in the Company's professional service organization. REVENUE During the third quarter of 1998, the Company experienced a significant decrease in product revenue from its largest domestic customer. This decline contributed to the Company's decrease in total product revenue of 11% and 9% in the third quarter and first nine months of 1998, respectively, over the same periods in 1997. The Company's product revenue in 1998 was also negatively impacted by the transition from its Pentium Pro-based NUMA-Q products to its new Pentium II Xeon-based NUMA product line. The Company began shipment of its new product line late in the third quarter of 1998. Decreases in product revenue were partially offset by increases in service revenue, particularly from the Company's professional service organization. Revenue increases in professional services were approximately 37% and 33% in the third quarter and first nine months of 1998 over the same periods in 1997. Continued growth in the number and size of new projects, with both new and existing customers, contributed to the overall increase in revenue within the Company's professional services organization. The following table sets forth certain operating data as a percentage of total revenue: Three Months Ended Nine Months Ended October 3, October 4, October 3, October 4, 1998 1997 1998 1997 Revenue: End-user products 64.8% 70.6% 64.7% 69.9% OEM products - 0.3 0.1 0.8 Service 35.2 29.1 35.2 29.3 Total revenue 100.0 100.0 100.0 100.0 Cost of products and service 66.3 58.0 65.7 57.4 Gross profit 33.7 42.0 34.3 42.6 Operating expenses: Research and development 9.6 8.0 9.8 8.4 Selling, general and administrative 25.1 27.5 27.8 29.0 Restructuring charges (credits) (0.6) - 10.8 - Total operating expenses 34.1 35.5 48.4 37.4 Operating income (loss) (0.4) 6.5 (14.1) 5.2 Interest income (expense), net 0.8 0.2 0.6 (0.3) Other expense, net (0.4) (0.5) (0.4) (0.3) Income (loss) before provision for (benefit from) income taxes 0.0 6.2 (13.9) 4.6 Provision for (benefit from) income taxes 0.0 1.2 (4.3) 1.2 Net income (loss) 0.0% 5.0% (9.6)% 3.4% COST OF SALES/GROSS MARGINS Three Months Ended Nine Months Ended October 3, October 4, October 3, October 4, 1998 1997 1998 1997 Cost of product sold as a percentage of product revenue 63.2% 51.9% 61.7% 50.5% Cost of service as a percentage of service revenue 71.9% 72.9% 72.9% 74.2% Total cost of sales as a percentage of total revenue 66.3% 58.0% 65.7% 57.4% The factors influencing gross margins in a given period generally include unit volumes (which affect economies of scale), product configuration mix, changes in component and manufacturing costs, product pricing and the mix between product and service revenue. Total cost of sales as a percentage of total revenue increased in the third quarter and first nine months of 1998 over the same periods in 1997. Product margins were lower in the third quarter and first nine months of 1998 due to competitive pricing pressures and the impact of the product transition at the end of the third quarter. The Company's Pentium Pro-based product line was nearing the end of its product life cycle, which resulted in heavier discounting of the products sold during the third quarter of 1998. The Company's new Xeon-based NUMA-Q products were announced to the marketplace near the end of the third quarter; however, formal introduction and shipment of the products did not begin until the fourth quarter of 1998. Additionally, product margins were also impacted by certain non-recurring charges for inventory obsolescence provisions made during the second quarter of 1998. The Company's total product gross margins were approximately 37% and 38% in the third quarter and first nine months of 1998, respectively, and service gross margins were approximately 28% and 27%, respectively, during the same periods in 1998. The Company's total gross margins were positively impacted by service margins, particularly from the professional service organization, which increased slightly during the third quarter and first nine months of 1998 over the same periods in 1997. RESEARCH AND DEVELOPMENT Three Months Ended Nine Months Ended (dollars in millions) October 3, October 4, October 3, October 4, 1998 1997 1998 1997 Research and development expense $19.4 $16.5 $56.1 $48.4 As a percentage of total revenue 9.6% 8.0% 9.8% 8.4% Software costs capitalized $ 9.7 $ 8.6 $29.9 $25.4 Research and development expense continued to increase in amount, by approximately 18% and 16% in the third quarter and first nine months of 1998, respectively, compared to the same periods in 1997, as the Company continued to make enhancements to its NUMA-Q architecture, specifically with the development of its new Xeon-based product line. During the third quarter of 1998, increases to capitalized software costs were related to continued investments in new software technology. SELLING, GENERAL AND ADMINISTRATIVE Three Months Ended Nine Months Ended (dollars in millions) October 3, October 4, October 3, October 4, 1998 1997 1998 1997 Selling, general and administrative $50.6 $57.1 $158.5 $166.9 As a percentage of total revenue 25.1% 27.5% 27.8% 29.0% Comparing the third quarter and first nine months of 1998 to the same periods in 1997, selling, general and administrative expenses decreased 11% and 5%, respectively. Factors contributing to the decrease included the effects of cost control measures implemented by the Company during 1998 and from cost savings achieved through the Company's restructure which took place in the second quarter of 1998. The overall decrease to the Company's selling, general and administrative expenses resulted primarily from reductions in payroll, employee training and travel expenses. RESTRUCTURING CHARGES During the second quarter of 1998, the Company recorded restructuring charges of $62.9 million in connection with management's decision to accelerate changes in its business model to leverage the strength of its technology roadmap and market position. As part of the restructuring process, which was substantially completed during the second quarter of 1998, the Company has reorganized its operations to focus on vertical markets where the Company has demonstrated success with continuing business and can focus on solid relationships with key partners. In addition, the Company plans to broaden its product offerings, including an emphasis on its Intel-based architecture, as well as developing a new product family expected to be introduced by the end of the year. The restructuring charges of $62.9 million included employee termination and other related costs ($7.2 million); facilities and office space costs ($13.7 million); write-offs of non-strategic assets, principally prepaid software licenses ($27.2 million), capital assets ($7.9 million), capitalized software ($2.5 million), goodwill ($2.5 million), and other assets, principally prepaid expenses ($1.9 million). The employee termination costs resulted from the elimination of 265 positions worldwide. The employee groups covered by such elimination encompass all functions within the Company. All termination costs pertaining to the eliminated positions are included as restructuring costs in the accompanying Statements of Operations. Approximately 39% of the employee termination costs accrued during the second quarter of 1998 were paid prior to the end of the quarter. During the third quarter of 1998, an additional 37% of employee termination costs were paid. Excluding employee termination costs from the total restructuring charges, there are no material incremental future cash outlays resulting from the restructuring. In addition, a change in the restructuring estimate during the third quarter resulted in a $1.3 million credit. It is anticipated that the restructuring actions taken in the second quarter will yield annualized operating cost reductions of approximately $40 million during 1998 and 1999. The following table presents a summary of the restructuring charges recorded in the second and third quarters of 1998 and the resulting net balance sheet amounts recorded as of October 3, 1998. The balance of accrued restructuring costs of $16.5 million at October 3, 1998 is included in Accounts Payable and Other in the accompanying balance sheet. Second Third Restructuring Quarter Write-offs/ Balance at Quarter Write-offs/ Balance at (dollars in millions) Costs Expenditures Adjustments July 4, 1998 Expenditures Adjustments October 3, 1998 Employee termination and related $ 7.2 $ (2.5) $ (0.3) $ 4.4 $ (2.5) $ (0.2) $ 1.7 Prepaid software licenses 27.2 - (24.9) 2.3 - (0.6) 1.7 Facilities 13.7 (0.1) - 13.6 (0.7) 0.1 13.0 Capital assets 7.9 - (7.9) - - 0.1 0.1 Capitalized software 2.5 - (2.5) - - - - Goodwill 2.5 - (2.5) - - - - Other assets 1.9 - (1.9) - - - - $ 62.9 $ (2.6) $ (40.0) $ 20.3 $ (3.2) $ (0.6) $ 16.5 INTEREST AND OTHER, NET Three Months Ended Nine Months Ended (dollars in millions) October 3, October 4, October 3, October 4, 1998 1997 1998 1997 Interest income $ 2.3 $ 1.9 $ 6.9 $ 3.4 Interest expense $ 0.7 $ 1.5 $ 3.4 $ 5.0 Other expense, net $(0.8) $(1.0) $(2.2) $(1.5) Interest income is primarily generated from invested cash and cash equivalents and restricted deposits held at foreign and domestic banks. The increase in interest income in the third quarter and first nine months of 1998 is a result of investments of cash proceeds from the Company's stock offering in August 1997. Interest expense includes costs related to foreign currency hedging loans, interim short-term borrowings, capital lease obligations and, in 1997, convertible debentures. The decrease in interest expense in 1998 over 1997 is attributed to the decrease in the use of the Company's line of credit in 1998 resulting from use of proceeds received from the August 1997 stock offering and the conversion of the Company's Convertible Subordinated Debentures to shares of common stock in August and September 1997. Other expense consists primarily of the discount from the sale of accounts receivable and the net realized and unrealized foreign exchange gains and losses. INCOME TAXES The provision for income taxes includes benefits related to the Company's foreign sales corporation and the research and experimentation credit. The effective tax rate benefit for the third quarter of 1998 was 30.9%, compared to an effective tax rate of 20% for the corresponding period in 1997 and an overall annual effective tax rate of 23.4% for 1997. The change in the effective tax rate for the third quarter of 1998, when compared to the annual effective tax rate for 1997, is due primarily to the impact of recording a tax benefit related to the net operating loss reported for the second quarter. LIQUIDITY AND CAPITAL RESOURCES Working capital was $331.1 million at October 3, 1998 compared to $404.1 million at January 3, 1998. The Company's current ratio increased to 2.65:1 from 2.51:1 at January 3, 1998. Cash and cash equivalents increased $24 million during the first nine months of 1998. The Company's cash and cash equivalents were primarily impacted by the $102 million decrease in accounts receivable. During the third quarter, the Company focused resources on collection efforts, substantially decreasing the number and size of outstanding accounts. Offsetting the impact of the decrease in accounts receivable were investing activities of $42 million and financing activities of $35 million. The Company has a $40 million receivable sales facility with a group of banks. At October 3, 1998, accounts receivable in the accompanying consolidated balance sheet is net of $29.5 million received by the Company under this agreement to sell its domestic accounts receivable. Additionally, the Company entered into a specific transaction to factor certain foreign receivables, without recourse, at an average rate of 8.75%. As of October 3, 1998, $3.5 million relating to this transaction was netted against accounts receivable in the accompanying consolidated balance sheet. The Company maintains an $80 million revolving line of credit agreement. The line is unsecured and extends through April 3, 2001. The line contains certain financial covenants and prohibits the Company from paying dividends without the lenders' consent. At October 3, 1998, there was no outstanding balance under the line of credit. The Company maintains a short-term borrowing agreement with a foreign bank to cover foreign currency exposures. Maximum borrowings allowed under the foreign bank agreement were $90.1 million, of which $27.3 million was outstanding at October 3, 1998 (based on currency exchange rates on such date). The Company also maintains a miscellaneous borrowing arrangement with a foreign bank. At October 3, 1998 $1.5 million was outstanding under this agreement. Management expects that its cash resources, funds from operations and the bank lines of credit will provide adequate resources to meet the Company's anticipated operational cash requirements for at least the next twelve months. IMPACT OF THE YEAR 2000 ISSUE The Year 2000 Issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's software programs and microcircuitry that have date-sensitive features may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations. The Year 2000 Issue affects the Company's internal systems as well as any of the Company's products that include date-sensitive software. Sequent is executing a company-wide Year 2000 Readiness Program (Program) for the Company's products, on-going operations (operations), mission-critical information systems (IS), and key suppliers (suppliers). The Program's goal is to identify and conduct remediation of critical century date change issues by the end of 1998. Ongoing remediation, testing, and contingency planning are expected to continue throughout 1999. The Year 2000 Readiness Program is organized into six major phases: 1) exposure inventory, 2) risk assessment, 3) prioritization, 4) remediation (either by repair or replacement), 5) contingency planning, and 6) testing/verification. These stages have been largely completed for the Company's standard products and are in progress for ongoing operational issues as well as critical suppliers. The Program organization consists of a Steering Committee made up of Company executives, a Year 2000 taskforce representing each of the Company's major departments, and a Year 2000 Project Management Office. In addition, several Focus Teams have been set up to deal with cross-functional issues related to customers, partners, and suppliers. Operational program work is being done by each of the Company's departments with oversight by a Year 2000 Program Office. Operational program work includes the Company's critical business computer applications, data, and infrastructure. Mission-critical third party service and equipment suppliers are being contacted via written inquiry, as well as direct discussion, to understand and mitigate potential risks. The current status of the Company's Year 2000 Readiness Program is as follows: The Company's current line of hardware products, which are designed and manufactured to the Company's specifications, are Year 2000 ready if utilized with the appropriate version of the operating system software. The Company cannot ensure that its software products do not contain undetected problems associated with Year 2000 compliance. Such problems, should they occur, may result in material adverse effects on future operating results. The Company's Operations remediation phase is on schedule and approximately 70% complete. Critical exposures have been identified and are expected to be resolved by the first quarter of 1999. The Company's Supplier readiness program is managed through its Strategic Sourcing group. Approximately 75% of the Company's critical suppliers (and 65% of the remaining suppliers) have completed the remediation process. The Company's Information Systems group is remediating critical IS applications and infrastructure (worldwide). This process is approximately 75% complete. Non-IS application remediation has been outsourced. In both cases, the Program's goal is to identify and resolve critical century date change by the end of the first quarter of 1999. In addition, the Company has made available to its customers Year 2000 readiness information concerning its products, services and support. The total cost of the Program is currently estimated to be approximately $10 million and is being funded through operating cash flows. The Company is expensing costs associated with identification and resulting changes to these systems, but does not expect the amounts to have a material effect on its financial position or results of operations. These costs are not incremental as the Company's IS development resources have been re-directed solely to the Year 2000 remediation effort in 1998. As of October 3, 1998 the total amount expended on the Program was approximately $4 million, with the majority of the costs representing hardware and labor expenditures. The Company has determined worst case scenarios as either 1) Year 2000 related failures in internal business critical information system applications or 2) the development of service or product supply difficulties by business critical suppliers. These circumstances are not considered probable, but have been reviewed as part of the Company's due diligence efforts. In regards to Year 2000 failures in internal applications (scenario 1), business critical applications have been identified, assessed as to possible business impact of their failure and are being repaired, upgraded or replaced based on the severity of potential impact. For each of these applications, a business continuity contingency plan is expected to be in place by the end of the first half of 1999. In the case of service and product suppliers, an inventory has been completed and the business critical suppliers have been identified. A variety of risk reduction strategies have commenced, including but not limited to, developing possible alternative suppliers, acquiring safety stock and establishing enhanced testing programs and process audits. For the identified business critical suppliers, the Company expects to establish a contingency plan by mid 1999. There can be no assurance, however, that the systems or products of other companies on which the Company's systems also rely will be timely converted or that any such failure to convert by a vendor, customer or another company would not have an adverse effect on the Company's systems or results of operations. FORWARD-LOOKING STATEMENTS Information in this report that is not historical information, including information regarding product development, anticipated savings resulting from the restructure and year 2000 issues, constitutes forward-looking statements that involve a number of risks and uncertainties. A number of factors could cause actual results to differ materially from the forward-looking statements. New product development may be delayed or unsuccessful due to technical difficulties encountered, resource constraints and other reasons. Factors that affect year 2000 issues are set forth above. Additional information regarding factors that may affect the Company's future results is set forth at the end of Item 1 in the Company's Annual Report on Form 10-K for the year ended January 3, 1998. The Company's forward-looking statements apply only as of the date made. The Company undertakes no obligation to publicly release the results of any revisions to forward-looking statements which may be made to reflect events or circumstances after the date made or to reflect the occurrence of unanticipated events. Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibit 27 - Financial Data Schedule (b) No reports on Form 8-K were filed by the Company during the fiscal quarter Ended October 3, 1998. SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SEQUENT COMPUTER SYSTEMS, INC. ________________________________ /s/Robert S. Gregg Sr. Vice President of Finance and Legal and Chief Financial Officer Date: November 13, 1998