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 July 3, 1999 or ( ) Transition report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from __________ to __________. Commission file number: 0-15627 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. 42,214,367 common shares were issued and outstanding as of August 6, 1999. SEQUENT COMPUTER SYSTEMS, INC. PART I. FINANCIAL INFORMATION Page No. Item 1. Consolidated Financial Statements Consolidated Balance Sheets - July 3, 1999 and January 2, 1999 3 Consolidated Statements of Operations - Three months and six months ended July 3, 1999 and July 4, 1998 4 Consolidated Statements of Shareholders' Equity - January 2, 1999 through July 3, 1999 5 Consolidated Statements of Cash Flows - Six months ended July 3, 1999 and July 4, 1998 6 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk Information with respect to quantitative and qualitative disclosures about market risk is included under "Derivative and Other Financial Instruments" under "Management's Discussion and Analysis of Financial Conditions and Results of Operations." PART II. OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders 23 Item 6. Exhibits and Reports on Form 8-K 23 SEQUENT COMPUTER SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except per share amounts) July 3, 1999 January 2, 1999 (unaudited) ASSETS Current assets: Cash and cash equivalents $ 109,073 $ 192,876 Restricted deposits 14,728 28,280 Receivables, net 190,922 221,611 Inventories 108,262 86,333 Prepaid royalties and other 30,248 23,282 Total current assets 453,233 552,382 Property and equipment, net 130,445 133,831 Capitalized software costs, net 75,195 72,469 Other assets, net 48,851 37,433 Total assets $ 707,724 $ 796,115 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Notes payable $ 15,018 $ 29,908 Accounts payable and other 97,433 124,099 Accrued payroll 12,747 19,070 Unearned revenue 46,149 47,446 Income taxes payable 5,799 4,865 Current obligations under capital leases 4,335 2,320 Total current liabilities 181,481 227,708 Other accrued expenses 6,121 8,073 Long-term obligations under capital leases 6,531 7,480 Total liabilities 194,133 243,261 Shareholders' equity: Common stock, $.01 par value, 100,000 shares authorized, 42,098 and 43,471 shares outstanding 421 435 Paid-in capital 491,922 511,169 Retained earnings 31,575 46,883 Accumulated other comprehensive income: Foreign currency translation adjustment (10,327) (5,633) Total shareholders' equity 513,591 552,854 Total liabilities and shareholders' equity $ 707,724 $ 796,115 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 Six Months Ended July 3, 1999 July 4, 1998 July 3, 1999 July 4, 1998 Revenue: Product $ 73,643 $ 120,301 $ 194,171 $ 238,746 Service 69,874 65,376 143,325 129,999 Total revenue 143,517 185,677 337,496 368,745 Costs and expenses: Cost of products sold 51,294 82,541 128,478 145,447 Cost of service revenue 49,501 48,159 102,987 95,495 Research and development 18,032 19,692 35,966 36,756 Selling, general and administrative 50,881 58,237 97,194 107,857 Restructuring charges (credits) (635) 62,898 (1,633) 62,898 Total costs and expenses 169,073 271,527 362,992 448,453 Operating loss (25,556) (85,850) (25,496) (79,708) Interest, net 881 1,261 2,337 1,882 Other, net (1,260) (493) (1,180) (1,427) Loss before benefit from income taxes (25,935) (85,082) (24,339) (79,253) Benefit from income taxes 9,407 26,330 9,031 24,523 Net loss $ (16,528) $ (58,752) $ (15,308) $ (54,730) Net loss per share - basic $ (0.39) $ (1.34) $ (0.36) $ (1.26) Net loss per share - diluted $ (0.39) $ (1.34) $ (0.36) $ (1.26) Shares used in the calculation of net loss per share - basic 42,019 43,729 42,872 43,457 Shares used in the calculation of net loss per share - diluted 42,019 43,729 42,872 43,457 SEQUENT COMPUTER SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in thousands) Foreign Currency Total Common Stock Paid-in Retained translation comprehensive Shares Amount capital Earnings adjustment Total income Balance, January 2, 1999 43,471 $ 435 $511,169 $46,883 $ (5,633) $552,854 $ Common shares issued 677 7 4,362 - - 4,369 Common shares repurchased (2,055) (21) (21,117) - - (21,138) Tax benefit of option exercises - - 153 - - 153 Net income - - - 1,220 - 1,220 1,220 Foreign currency translation adjustment - - - - (3,883) (3,883) (3,883) Balance, April 3, 1999 (unaudited) 42,093 $ 421 $494,567 $48,103 $ (9,516) $533,575 $ (2,663) Common shares issued 802 8 6,486 - - 6,494 Common shares repurchased (797) (8) (9,315) - - (9,323) Tax benefit of option exercises - - 184 - - 184 Net loss - - - (16,528) - (16,528) (16,528) Foreign currency translation adjustment - - - - (811) (811) (811) Balance, July 3, 1999 (unaudited) 42,098 $ 421 $491,922 $31,575 $(10,327) $513,591 $(20,002) See notes to consolidated financial statements. SEQUENT COMPUTER SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS - Unaudited (in thousands) Six Months Ended July 3, 1999 July 4, 1998 Cash flow from operating activities: Net loss $ (15,308) $ (54,730) Reconciliation of net loss to net cash and cash equivalents provided by operating activities - Depreciation and amortization 45,979 44,325 Restructuring charges (credits) not affecting cash (307) 60,259 Deferred income taxes (12,736) (22,670) Changes in assets and liabilities - Receivables, net 30,689 88,954 Inventories (21,929) 3,739 Prepaid royalties and other (6,749) (14,421) Accounts payable and other (24,947) 30,208 Accrued payroll (6,328) (10,566) Unearned revenue (1,297) (684) Income taxes payable 934 800 Other, net (2,619) (17,840) Net cash provided (used) by operating activities (14,618) 46,958 Cash flow from investing activities: Restricted deposits 13,552 28,507 Purchases of property and equipment, net (26,013) (24,610) Capitalized software costs (21,070) (20,217) Net cash used for investing activities (33,531) (16,320) Cash flow from financing activities: Notes payable, net (14,890) (28,854) Proceeds (payments) under capital lease obligations 1,065 (1,125) Stock issuance proceeds, net 11,200 15,311 Stock repurchases (30,461) (4,945) Net cash used by financing activities (33,086) (19,613) Effect of exchange rate changes on cash (2,568) 951 Net increase (decrease) in cash and cash equivalents (83,803) 11,976 Cash and cash equivalents at beginning of period 192,876 133,299 Cash and cash equivalents at end of period $ 109,073 $ 145,275 See notes to consolidated financial statements. SEQUENT COMPUTER SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS July 3, 1999 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 2, 1999. 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 inventory and recoverability of capitalized software, prepaid royalties and deferred tax assets. Reclassifications Reclassifications have been made to amounts in certain prior years. These changes had no impact on previously reported results of operations. Recently Issued Accounting Standards In 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. The FASB has delayed the effective date to fiscal years beginning after June 15, 2000 (January 1, 2001 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 July 3, 1999, accounts receivable in the accompanying consolidated balance sheet is net of $27 million received by the Company under its agreement to sell its domestic and foreign accounts receivable. Inventories Inventories consist of the following: (in thousands) July 3, January 2, 1999 1999 Raw materials $ 13,585 $ 14,996 Work-in-progress 1,338 1,403 Finished goods 93,339 69,934 $ 108,262 $ 86,333 Property and Equipment Property and equipment consist of the following: (in thousands) July 3, January 2, 1999 1999 Land $ 6,307 $ 6,307 Operational equipment 232,858 230,449 Furniture and office equipment 79,884 86,069 Leasehold improvements 30,689 27,498 349,738 350,323 Less accumulated depreciation (219,293) (216,492) $ 130,445 $ 133,831 Research and Development Amortization of capitalized software costs, generally based on a three-year life, was $18.3 million and $15.5 million for the six month periods ended July 3, 1999 and July 4, 1998, 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. There was no outstanding balance at either July 3, 1999 or January 2, 1999. 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 with terms of fourteen days to three months. Proceeds from the borrowings are converted into U.S. dollars and placed in a term deposit account with the foreign bank. At July 3, 1999, maximum borrowings allowed under the agreement were approximately $78.2 million. The maximum borrowing limit is denominated in specified foreign currencies and fluctuates with the change in foreign exchange rates. Amounts outstanding were $14.7 million and $28.3 million at July 3, 1999 and January 2, 1999, respectively. In addition to the above borrowing agreements, the Company has entered into certain other miscellaneous borrowing arrangements with a foreign bank. At July 3, 1999 and January 2, 1999, $0.3 million and $1.6 million were outstanding, respectively. Common Stock During 1998, the Company announced a plan to repurchase up to 4,000,000 shares of its outstanding common stock. On April 27, 1999, the Board of Directors of the Company authorized the repurchase of up to 8,000,000 shares of its outstanding common stock in addition to the 4,000,000 shares previously authorized in 1998. As of July 3, 1999, the Company has repurchased 4,585,700 shares at an average price of $10.90 per share. Segment Reporting The Company has determined that its reportable segments are those that are based on the Company's primary basis of organization and method of internal reporting - (1) Product, (2) Customer Services (CS), (3) Professional Services (PS) and (4) Research and Development (R&D). The tables below present information about reported segments for the three months ended July 3, 1999 and July 4, 1998, respectively, and include a reconciliation of segment activity to consolidated net income before the provision for income taxes. Three months ended July 3, 1999: Professional Customer Research & Product Service Service Development Consolidated Revenue $ 73,643 $ 24,269 $ 45,605 $ 143,517 Cost of products sold 51,294 51,294 Cost of service revenue 22,006 27,495 49,501 Gross margin 22,349 2,263 18,110 42,722 R&D expenses 18,032 18,032 Selling, general & administrative 50,881 Restructuring credits (635) Operating income (25,556) Interest, net 881 Other income, net (1,260) Loss before benefit from income taxes $ (25,935) Six months ended July 3, 1999: Professional Customer Research & Product Service Service Development Consolidated Revenue $ 194,171 $ 50,690 $ 92,635 $ 337,496 Cost of products sold 128,478 128,478 Cost of service revenue 46,787 56,200 102,987 Gross margin 65,693 3,903 36,435 106,031 R&D expenses 35,966 35,966 Selling, general & administrative 97,194 Restructuring credits (1,633) Operating income (25,496) Interest, net 2,337 Other income, net (1,180) Loss before benefit from income taxes $ (24,339) Three months ended July 4, 1998: Professional Customer Research & Product Service Service Development Consolidated Revenue $ 120,301 $ 42,853 $ 22,523 $ 185,677 Cost of products sold 82,541 82,541 Cost of service revenue 21,796 26,363 48,159 Gross margin 37,760 21,057 (3,840) 54,977 R&D expenses 19,692 19,692 Selling, general & administrative 58,237 Restructuring charges 62,898 Operating income (85,850) Interest, net 1,261 Other expense, net (493) Loss before benefit from income taxes $ (85,082) Six months ended July 4, 1998: Professional Customer Research & Product Service Service Development Consolidated Revenue $ 238,746 $ 44,522 $ 85,477 $ 368,745 Cost of products sold 145,447 145,447 Cost of service revenue 43,063 52,432 95,495 Gross margin 93,299 1,459 33,045 127,803 R&D expenses 36,756 36,756 Selling, general & administrative 107,857 Restructuring credits 62,898 Operating income (79,708) Interest, net 1,882 Other income, net (1,427) Loss before benefit from income taxes $ (79,253) Information concerning principal geographic areas is as follows: Three Months Ended Six Months Ended July 3, 1999 July 4, 1998 July 3, 1999 July 4, 1998 Revenue from external customers: United States $ 64,963 $ 100,363 $ 166,598 $ 183,060 United Kingdom 51,891 63,783 107,114 134,781 Other foreign 23,159 22,422 53,998 41,056 Export 3,504 (891) 9,786 9,848 Total $ 143,517 $ 185,677 $ 337,496 $ 368,745 July 3, 1999 July 4, 1998 Identifiable assets: United States $ 554,009 $ 594,715 United Kingdom 92,118 123,346 Other foreign 61,597 78,054 Total $ 707,724 $ 796,115 Revenues are attributed to geographic areas based on the location of the identifiable assets producing the revenues. Foreign revenue is that which is produced by identifiable assets located in foreign countries while export revenue is that which is generated by identifiable assets located in the United States. Intercompany sales between geographic areas, primarily from the United States to Europe, were $54.4 million and $80.7 million for the six months ended July 3, 1999 and July 4, 1998, respectively. Restructuring Charges During 1998, the Company recorded restructuring charges net of estimate revisions totaling $61.4 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. In addition, a change in the restructuring estimate resulted in a $1.0 million credit in the first quarter of 1999 and a $0.6 million credit in the second quarter of 1999. Please refer to the discussion of restructuring costs and current period adjustments included in Management's Discussion and Analysis of Financial Condition and Results of Operations. 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 research tax credit and the Company's Foreign Sales Corporation. Earnings Per Share (in thousands, except per share amounts) Loss Shares Per-Share (Numerator) (Denominator) Amount Three Months Ended Three Months Ended Three Months Ended July 3, July 4, July 3, July 4, July 3, July 4, 1999 1998 1999 1998 1999 1998 Basic EPS Loss to common shareholders $(16,528) $(58,752) 42,019 43,729 $(0.39) $(1.34) Diluted EPS Loss to common shareholders $(16,528) $(58,752) 42,019 43,729 $(0.39) $(1.34) Six Months Ended Six Months Ended Six Months Ended July 3, July 4, July 3, July 4, July 3, July 4, 1999 1998 1999 1998 1999 1998 Basic EPS Loss to common shareholders $(15,308) $(54,730) 42,872 43,457 $(0.36) $(1.26) Diluted EPS Loss to common shareholders $(15,308) $(54,730) 42,872 43,457 $(0.36) $(1.26) Diluted EPS is equal to Basic EPS due to the net losses recorded for the current and comparative periods. 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 in either of the six month periods ended July 3, 1999 and July 4, 1998, respectively. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The Company reported total revenue and a net loss of $143.5 million and $(16.5) million, respectively, in the second quarter of 1999 as compared to $185.7 million and $(58.8) million, respectively, for the same period in 1998. Results for the six month periods ended July 3, 1999 and July 4, 1998 were revenues of $337.5 million and a net loss of $(15.3) million and revenues of $368.7 million and a net loss of $(54.7) million, respectively. International revenue was 54.7% of the Company's total revenue in the second quarter of 1999, up from 45.9% in the same period in 1998. The reported loss in the second quarter of 1999 is primarily due to a 39% reduction in product revenues from the same period in 1998. This reduction in product revenues is primarily attributable to the negative impact of the Company's pending merger with International Business Machines (IBM). Although the reported loss in the second quarter of 1999 was significantly lower than the same period in 1998, the 1998 loss resulted primarily from the $62.9 million restructuring charge taken in the second quarter. REVENUE/NET INCOME (dollars in millions) Three Months Ended Six Months Ended July 3, % July 4, July 3, % July 4, 1999 change 1998 1999 change 1998 Total Revenue $ 143.5 (23)% $ 185.7 $ 337.5 (8)% $ 368.7 Product $ 73.6 (39)% $ 120.3 $ 194.2 (19)% $ 238.7 Professional Service 24.3 8% 22.5 50.7 14% 44.5 Customer Service 45.6 6% 42.9 92.6 8% 85.5 US $ 65.0 (35)% $ 100.4 $ 166.6 (9)% $ 183.0 United Kingdom 51.9 (19)% 63.8 107.1 (21)% 134.8 International 26.6 24% 21.5 63.8 25% 50.9 Net Loss $ (16.5) 72% $ (58.8) $ (15.3) 72% $ (54.7) PRODUCT Product revenue for the second quarter of 1999 decreased 39% over the same period in 1998. Product revenue was down 19% for the first six months of 1999 compared to the same period in 1998. The significant decline in product revenue in the second quarter and first six months of 1999 is attributable to a variety of factors, the most significant being early press reports of the Company's pending merger with IBM. The Company believes uncertainty about the potential merger caused some customers to postpone planned purchases. Additionally, sales to the Company's largest customer declined by approximately $26 million in the second quarter of 1999 over the same period in 1998. SERVICE Revenues from customer and professional service segments increased approximately 6% and 8%, respectively, in the second quarter of 1999 over the same period in 1998. Year to date increases as of the second quarter over the prior year results were 8% and 14% for the same segments, respectively. Customer service revenue increases were based upon a growing number of installed systems under service contracts. These increases were restricted by significantly lower product revenue volumes and related installation revenues recorded by this business segment for the three and six month periods ended July 3, 1999. In addition, the impact of extended warranties granted on certain of the Company's product lines deferred revenue into future periods covered by the warranty contracts. Professional service revenue increases reflected growth in this business segment across each of the Company's major geographic operations. These increases were partially offset by a reduction in quarter over quarter revenues from the Company's largest customer totaling $1.7 million. The following table sets forth certain operating data as a percentage of total revenue: Three Months Ended Six Months Ended July 3, July 4, July 3, July 4, 1999 1998 1999 1998 Revenue: End-user products 51% 65% 58% 63% OEM products - - - 2 Service 49 35 42 35 Total revenue 100 100 100 100 Cost of products and services 70 70 69 65 Gross margin 30 30 31 35 Operating expenses: Research and development 13 11 11 10 Selling, general and administrative 35 31 29 29 Restructuring charges - 34 (1) 17 Rounding - - - 1 Total operating expenses 48 76 39 57 Operating loss (18) (46) (8) (22) Interest and other, net - 1 1 - Loss before benefit from income taxes (18) (45) (7) (22) Benefit from income taxes 7 14 3 7 Net loss (11)% (31)% (4)% (15)% GROSS MARGINS Three Months Ended Six Months Ended July 3, July 4, July 3, July 4, 1999 1998 1999 1998 Product 30% 31% 34% 39% Service 29% 26% 28% 27% Total 30% 30% 31% 35% The factors influencing total gross margins in a given period include product unit volumes (which affect economies of scale), product configuration mix (including the amount of third party products), changes in component and manufacturing costs, competitive impact on product pricing, cost containment in service delivery activities and the mix between product and service revenue. Product gross margins rates decreased in the second quarter of 1999 compared to the same period in 1998. This decrease is primarily attributable to a higher content of third party products sold (which yield lower gross margins than Sequent products) in 1999 compared to 1998, ongoing competitive pricing pressures, and lower product volumes. The magnitude of the decrease in product gross margins was diminished by certain charges for inventory obsolescence provisions taken during the second quarter of 1998, which did not reoccur in 1999. Service gross margin rates improved in the second quarter of 1999 compared to the same period in 1998. Both professional service and customer service segments improved their respective gross margin rates by cost containment initiatives that held spending to lower rates of increases than the corresponding revenue increases. RESEARCH AND DEVELOPMENT (dollars in millions) Three Months Ended Six Months Ended July 3, % July 4, July 3, % July 4, 1999 change 1998 1999 change 1998 Research and development expense $ 18.0 (9)% $ 19.7 $ 36.0 (2)% $ 36.8 As a percentage of total revenue 13% 11% 11% 10% Software costs capitalized $ 10.5 31% $ 8.0 $ 21.0 19% $ 17.7 Research and development expense dollars decreased both in the second quarter and the first half of 1999 in comparison with the same periods in 1998. Spending reductions resulted from cost efficiencies in total engineering spending, reductions in certain engineering activities outside the United States and certain other non-recurring charges taken in the second quarter of 1998. Expense as a percentage of total revenue, however, increased 2% from 11% of total revenue in the second quarter of 1998 to 13% of total revenue in the second quarter of 1999, solely due to the significant reduction in total revenues between those two periods. The Company anticipates increases in research and development expenditures in the second half of 1999 based upon product releases scheduled in the second half of the year as well as major product initiatives based on 64-bit architecture on the product roadmap for the year 2000. SELLING, GENERAL AND ADMINISTRATIVE (dollars in millions) Three Months Ended Six Months Ended July 3, % July 4, July 3, % July 4, 1999 change 1998 1999 change 1998 Selling, general and administrative $ 50.9 (13)% $ 58.2 $ 97.2 (10)% $ 107.9 As a percentage of total revenue 35% 31% 29% 29% Second quarter 1999 selling, general and administrative (SG&A) expenses decreased $7.3 million over the same period in 1998 and $10.7 million over the six month period ended July 3, 1999 compared to the same period in 1998. Substantially all of the decreases are attributable to lower headcount, particularly in field sales and support personnel, combined with lower commission costs on significantly lower revenue volumes. RESTRUCTURING CHARGES During the second quarter of 1998, the Company recorded restructuring charges totaling $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. Subsequent changes in the restructuring estimate during the first and second quarters of 1999 resulted in credits of $1.0 million and $0.6 million, respectively. It is anticipated that the restructuring actions taken in 1998 will yield operating cost reductions of approximately $25 million during 1999. Remaining cash outlays expected from the restructuring consist of $13.3 million for facilities and $0.2 million relating to employee termination and related costs. Expenditures totaling $1.3 million for facilities were made for the costs of excess space incurred during the second quarter of 1999. The following table presents a summary of the activity in the restructuring accrual during the second quarter of 1999 and the resulting net balance sheet amounts as of July 3, 1999. The balance of accrued restructuring costs of $13.5 million at July 3, 1999 is included in Accounts Payable and Other in the accompanying balance sheet. (dollars in millions) First Balance at Quarter Write-offs/ Balance at January 2, 1999 Expenditures Adjustments April 3, 1999 Employee termination and related $ 0.2 $ - $ - $ 0.2 Prepaid software licenses 0.3 - (0.3) - Facilities 16.0 (1.3) (0.1) 14.6 $16.5 $(1.3) $(0.4) $14.8 Second Balance at Quarter Write-offs/ Balance at April 3, 1999 Expenditures Adjustments July 3, 1999 Employee termination and related $ 0.2 $ - $ - $ 0.2 Prepaid software licenses - - - - Facilities 14.6 (1.3) - 13.3 $14.8 (1.3) $ - $13.5 OPERATING LOSS Three Months Ended Six Months Ended July 3, % July 4, July 3, % July 4, 1999 change 1998 1999 change 1998 Operating loss before restructuring $(26.2) 14% $(23.0) $(27.1) 61% $(16.8) Restructuring charges (credits) (0.6) 62.9 (1.6) 62.9 Operating loss $(25.6) (70)% $(85.9) $(25.5) (68)% $(79.7) Operating losses for the second quarter of 1999 decreased 70% over the same period in 1998. Losses for the first six months of 1999 decreased 68% over the same period in 1998. These losses include restructuring charges (credits) of $(0.6) million and $62.9 million for the quarters ended July 3, 1999 and July 4, 1998, and $(1.6) million and $62.9 million for the six months ended July 3, 1999 and July 4, 1999, respectively. The quarter over quarter operating loss before the impact of the restructuring charge increased 14% from 1998 to 1999, primarily due to the decrease in product revenues. INTEREST AND OTHER, NET (dollars in millions) Three Months Ended Six Months Ended July 3, % July 4, July 3, % July 4, 1999 change 1998 1999 change 1998 Interest income $ 1.2 (54)% $ 2.6 $ 3.3 (27)% $ 4.5 Interest expense $(0.3) (77)% $(1.3) $(0.9) (67)% $(2.7) Other expense, net $(1.3) 160% $(0.5) $(1.2) (14)% $(1.4) Interest income is primarily generated from invested cash and cash equivalents and restricted deposits held at foreign and domestic banks. Interest expense includes costs related to foreign currency hedging loans, interim short-term borrowings and capital lease obligations. The $1.4 million decrease in interest income for the three months ended July 3, 1999 was the result of a $38 million reduction in the average cash balance earning interest in the United States as well as a $25 million reduction in the average hedge deposit in Europe. The decrease in interest expense as of July 3, 1999 over the same period in 1998 is attributed to the decrease in the use of the Company's short-term borrowing agreement to manage foreign currency exposures. Interest income decreased $1.2 million for the six months ended July 3, 1999 compared to the first six months ended July 4, 1999 due to a reduction in average cash balances in the United States and Europe as well as lower interest rates in the United States. The $1.8 million reduction in interest expense over the same period was due to reduced usage of the Company's short-term borrowing agreement in Europe and lower interest rates in the United States. Other net expense consists primarily of net realized and unrealized foreign exchange gains and losses. The $0.8 million increase in other expense in the second quarter of 1999 over the same period in 1998 is due primarily to realized and unrealized foreign currency losses resulting from hedges of Asia Pacific and French translation exposures and transaction hedges of the British Pound and Korean Won. For the six months ended July 3, 1999 other net expense decreased over the prior year primarily due to a reduction in discount on the sale of accounts receivable. INCOME TAXES The Company recorded a $9.4 million benefit for income taxes in the second quarter of 1999 based on a net loss before tax of $25.9 million. The difference between the statutory rate and the effective tax rate of 36.2% for the second quarter of 1999 is principally due to the recording of a tax benefit related to the net operating loss reported for the quarter at the statutory federal and state tax rates less a valuation reserve for certain credits and tax attributes which may expire before they can be realized. The effective rate benefit of 36.2% for the second quarter of 1999 compares to an effective tax rate benefit of 31.0% for 1998. The change in the tax rate benefit is due primarily to permanent tax benefits such as the Foreign Sales Corporation and research and development credits which do not fluctuate based on differences in pre-tax earnings (losses) year over year. LIQUIDITY AND CAPITAL RESOURCES Working capital was $271.8 million at July 3, 1999 compared to $324.7 million at January 2, 1999. The Company's current ratio was 2.5:1 at July 3, 1999 and 2.4:1 at January 2, 1999. Cash and cash equivalents decreased $83.8 million during the first six months of 1999. The decrease resulted primarily from cash used in financing activities, specifically, payments of $14.9 million for notes payable and $30.5 million for stock repurchases, along with the impact of decreasing revenue volume. Investments during the six months in property and equipment and capitalized software approximated $26.0 million and $21.1 million, respectively. The Company has a $40 million receivable sales facility with a group of banks. At July 3, 1999, accounts receivable in the accompanying consolidated balance sheet is net of $27.0 million received by the Company under this agreement to sell its domestic and foreign accounts receivable. 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 July 3, 1999, 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 $78.2 million, of which $14.7 million was outstanding at July 3, 1999 (based on currency exchange rates on such date). The Company also maintains a miscellaneous borrowing arrangement with a foreign bank. At July 3, 1999 $0.3 million was outstanding under this agreement. Management expects that current 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). While the majority of business critical century date change issues were identified and remediated before the end of 1998, ongoing remediation, testing and contingency planning is 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, suppliers and major business process contingency plans. Operational program work is being done by each of the Company's departments with oversight by the 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. Within the Company's Operations programs, remediation of internal tools, applications and systems was completed as of the end of second quarter 1999. The Company's Supplier readiness program is managed primarily through its Global Sourcing and Procurement group. Of those suppliers identified as business critical, all have informed the Company that they have remediation plans in place. The majority have completed those plans. Supplier readiness will continue to be assessed and remediated throughout the year as new suppliers are added. All currently known business critical suppliers are expected to be ready before the end of third quarter, 1999. Initial contingency planning is complete. On- going plan testing will continue throughout the year and is expected to cause updates and plan improvements. 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 internal IS development resources were re-directed solely to the Year 2000 remediation effort during 1998. In 1999, resources required for the remediation effort have not materially affected new development projects scheduled and budgeted. As of July l3, 1999, the total amount expended on the Program was approximately $7 million, with the majority of the costs representing hardware and labor expenditures. The Company has classified potential 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. For Year 2000 type 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. For service and product supplier type failures (scenario 2), 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 identified business critical suppliers, contingency plans are in place. There is no assurance, however, that the systems or products of other companies on which the Company's systems also rely will be converted timely 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. EURO CONVERSION The European Economic and Monetary Union (EMU) and a new currency, the "Euro", went into effect in Europe on January 1, 1999. This is a significant and critical element in the European Union's (EU) plan to blend the economies of the EU's member states into one integrated market, with unrestricted and unencumbered trade and commerce across borders. Eleven European countries (the "participating countries") of the fifteen member EU countries will initially participate (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain). Other member states (Denmark, Greece, the United Kingdom and Sweden) may join in the years to come. The Euro will trade on currency exchanges and the legacy currencies will remain legal tender for a transition period between January 1, 1999 and January 1, 2002. During the transition period, public and private companies may pay for goods and services using either the Euro or the participating country's legacy currency. The Company is currently determining the necessary modifications to its internal systems to accommodate Euro-denominated transactions and is assessing the business implications of the conversion to the Euro, including long-term competitive implications and the effect of market risk with respect to financial instruments. The Company does not believe the financial impact of these matters, if any, will be material to its results of operations, financial condition or cash flows. However, the Company will continue to assess the impact of Euro conversion issues as the applicable accounting, tax, legal and regulatory guidance evolves. DERIVATIVE AND OTHER FINANCIAL INSTRUMENTS Risk Management Strategy In the normal course of business, Sequent enters into various financial instruments, including derivative financial instruments, for purposes other than trading. Derivative financial instruments are not entered into for speculative purposes. These instruments primarily consist of accounts receivable, short-term investments, short-term debt, forward exchange contracts and option contracts which are used to reduce Sequent's exposure to currency exchange rates. At inception, foreign exchange contracts are designated as hedges of firmly committed or forecasted transactions. These transactions are generally expected to be completed in less than one year. The forward contracts and options generally mature within twelve months. The majority of Sequent's foreign exchange forward contracts are to exchange Japanese Yen, Australian Dollars, New Zealand Dollars, Italian Lire and Czech Krone. The option contracts are no-cost collars and exchange British Pounds and Korean Won. Exposure to credit risk is managed through credit approvals and monitoring procedures, and management believes that the reserves for losses are adequate. The counterparties to these financial instruments are substantial and creditworthy corporations, state agencies and multinational commercial banks. In management's opinion the risk of counterparty nonperformance associated with these instruments is not considered to be significant. Interest Rate Risk The Company routinely invests in short-term financial instruments within the parameters of its investment policy with maturities of less than three months. The instruments pay a fixed rate of return. These instruments are subject to overall market interest rate sensitivity upon maturity. As part of the Company's foreign currency hedging activities, the Company maintains short-term loans with a multinational commercial bank. These loans are for durations ranging from fifteen days to three months and carry a fixed interest rate. Upon maturity, these instruments are subject to overall market interest rate sensitivity. The Company also maintains two long-term leases with variable interest rates based on LIBOR (London Inter Bank Offer Rate). The table below illustrates the effect on lease payments of a +/-10% change in the underlying base rate: 1999 Forecast Rental Payments Base Rate $1,092K Base Rate plus 10% $1,201K Base Rate less 10% $ 983K Foreign Exchange Risk The table below presents foreign exchange contracts, options and debt at July 3, 1999, April 3, 1999 and January 2, 1999 (in thousands). The notional amounts represent agreed upon amounts on which calculations of dollars to be exchanged are based, and are an indication of the extent of Sequent's involvement in such instruments. They do not represent amounts exchanged by the parties and, therefore, are not a measure of the instruments. (in thousands) Contract Carrying Amount Fair Value Amount Asset Liability Asset Liability July 3, 1999 FX Forward Contracts $ 10,889 $ - $ - $10,889 $10,889 FX Options (net) 72,228 - - 1,105 544 Debt 14,726 - 14,726 - 14,726 April 3, 1999 FX Forward Contracts $ 8,975 $ - $ - $ 8,975 $ 8,975 FX Options (net) 97,570 - - 1,439 71 Debt 10,370 - 10,370 - 10,370 January 2, 1999 FX Forward Contracts $ 8,086 $ - $ - $ 8,086 $ 8,086 FX Options (net) 129,100 - - 135 123 Debt 28,244 - 28,244 - 28,244 Fair values of financial instruments represent estimates of possible value that may not be realized in the future. EUROPEAN SALES OPERATIONS In January 1999, the Company signed a strategic partnership agreement with Comparex, one of Europe's leading suppliers of complete solutions for IT infrastructures. The partnership, which was effective March 1, 1999, allows Comparex to take responsibility for Sequent's sales activities in Austria, Belgium, Germany, the Netherlands, Portugal, Spain and Switzerland. The Company's operations in the United Kingdom and France geographies, which represent the majority of the Company's European business, were not included in the partnership agreement. The majority of the Company's personnel in the countries included under the agreement became employees of Comparex with the exception of certain individuals retained to manage and support the relationship with Comparex and to provide specialist skills and expertise. The agreement provided for the sale of certain assets to Comparex at recorded net book value. Total book value of the assets sold during the first quarter of 1999 was approximately $7 million. MERGER WITH INTERNATIONAL BUSINESS MACHINES CORPORATION On July 12, 1999, the Company entered into an Agreement and Plan of Merger with International Business Machines Corporation (IBM) that provides for the merger of a wholly owned subsidiary of IBM into the Company, with the Company surviving as a wholly owned subsidiary of IBM. There are a number of conditions which must be satisfactorily completed prior to the closing of the merger transaction which include obtaining the necessary regulatory and anti trust, as well as shareholder, approvals. Commitments and contingencies related to the pending merger with IBM could adversely affect the Company if difficulties arise in completing the merger. Due to the level of uncertainty surrounding the closure and/or timing of the merger transaction, the potential impact to the Company's financial condition and results of operations resulting from either the completion of the merger, or failure to complete the merger timely, or at all, has not been included in the discussions and analyses above. FORWARD-LOOKING STATEMENTS Information in this report that is not historical information, including information regarding development and release of new products, anticipated savings resulting from the restructure, expected levels of future revenues and expenditures, year 2000 issues and commitments and contingencies from the pending merger with IBM, 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 under the section titled "Impact of the Year 2000 Issue." Commitments and contingencies related to the pending merger with IBM could adversely affect the Company if difficulties arise in completing the merger. 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 2, 1999. 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the meeting of the shareholders of the Company held on May 11, 1999, the shareholders voted on and approved the following items: Affirmative Negative Votes Broker Votes Cast Votes Cast Abstaining Non-Votes An amendment to the Company's Employee Stock Purchase Plan 26,328,904 1,909,368 247,262 9,862,318 An amendment to the Company's Stock Option Plan 15,066,503 13,766,152 260,417 9,244,780 Election of Directors: Karl C. Powell Jr. 36,950,433 1,397,419 Frank C. Gill 37,100,290 1,247,562 Larry R. Levitan 37,091,712 1,256,140 John McAdam 37,081,530 1,266,322 Michael S. Scott Morton 37,065,050 1,282,802 Martin A. Stein 37,088,490 1,259,362 Robert W. Wilmot 37,037,751 1,310,101 Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibit 11 - Statement regarding computation of earnings per share (b) Exhibit 27 - Financial Data Schedule (c) The Company filed a report on Form 8-K, dated May 17, 1999, reporting under Item 4 that it had engaged Deloitte & Touche LLP as its independent accountants for its current fiscal year. (d) The Company filed a report on Form 8-K, dated July 12, 1999, reporting under Item 5 that it had entered into an Agreement and Plan of Merger with International Business Machines Corporation (IBM) that provides for the merger of a wholly owned subsidiary of IBM into the Company, with the Company surviving as a wholly owned subsidiary of IBM. 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 Robert S. Gregg Sr. Vice President of Finance and Legal and Chief Financial Officer Date: August 12, 1999 Exhibit 11 SEQUENT COMPUTER SYSTEMS, INC. AND SUBSIDIARIES STATEMENT SHOWING CALCULATION OF THE BASIC AND DILUTED EARNINGS PER SHARE (In thousands, except per share amounts) Loss Shares Per-Share (Numerator) (Denominator) Amount Three Months Ended Three Months Ended Three Months Ended July 3, July 4, July 3, July 4, July 3, July 4, 1999 1998 1999 1998 1999 1998 Basic EPS Loss to common shareholders $(16,528) $(58,752) 42,019 43,729 $(0.39) $(1.34) Diluted EPS Loss to common shareholders $(16,528) $(58,752) 42,019 43,729 $(0.39) $(1.34) Six Months Ended Six Months Ended Six Months Ended July 3, July 4, July 3, July 4, July 3, July 4, 1999 1998 1999 1998 1999 1998 Basic EPS Loss to common shareholders $(15,308) $(54,730) 42,872 43,457 $(0.36) $(1.26) Diluted EPS Loss to common shareholders $(15,308) $(54,730) 42,872 43,457 $(0.36) $(1.26) Diluted EPS is equal to Basic EPS due to the net losses recorded for the current and comparative periods. Exhibit 27 SEQUENT COMPUTER SYSTEMS, INC. FINANCIAL DATA SCHEDULE JULY 3, 1999 Amount Item Number Item Description 109,073,000 5-02 (1) Cash and Cash Items - 5-02 (2) Marketable Securities 194,793,000 5-02 (3)(a)(1) Notes and Accounts Receivable-Trade 3,871,000 5-02 (4) Allowances for Doubtful Accounts 108,262,000 5-02 (6) Inventory 453,234,000 5-02 (9) Total Current Assets 349,738,000 5-02 (13) Property, Plant and Equipment 219,293,000 5-02 (14) Accumulated Depreciation 707,724,000 5-02 (18) Total Assets 181,481,000 5-02 (21) Total Current Liabilities - 5-02 (22) Bonds, Mortgages and Similar Debt - 5-02 (28) Preferred Stock - Mandatory Redemption - 5-02 (29) Preferred Stock - No Mandatory Redemption 421,000 5-02 (30) Common Stock 491,922,000 5-02 (31) Other Shareholders Equity 707,724,000 5-02 (32) Total Liabilities and Stockholders' Equity 73,643,000 5-03 (b)1(a) Net Sales of Tangible Products 143,517,000 5-03 (b)1 Total Revenue 51,294,000 5-03 (b)2(a) Cost of Tangible Goods Sold 100,795,000 5-03 (b)2 Total Costs and Expenses Applicable to Sales and Revenues 68,913,000 5-03 (b)3 Other Costs and Expenses - 5-03 (b)5 Provision for Doubtful Accounts and Notes 647,000 5-03 (b)8 Interest and Amortization of Debt Discount (25,935,000) 5-03 (b)(10) Income Before Taxes and Other Items (9,407,000) 5-03 (b)(11) Income Tax Expenses (16,528,000) 5-03 (b)(14) Income/Loss Continuing Operations - 5-03 (b)(15) Discontinued Operations - 5-03 (b)(17) Extraordinary Items - 5-03 (b)(18) Change in Accounting Principle (16,528,000) 5-03 (b)(19) Net Income or Loss (0.39) 5-03 (b)(20) Earnings Per Share - Basic (0.39) 5-03 (b)(20) Earnings Per Share - Diluted