1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31,1999 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 : 0-23023 MMC NETWORKS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 77-0319809 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.) INCORPORATION OR ORGANIZATION) 1134 E. ARQUES AVENUE SUNNYVALE, CA 94086 (ADDRESS OF PRINCIPAL OFFICES) (ZIP CODE) (408) 731-1600 (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 REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. YES [X] NO [ ] THE NUMBER OF SHARES OUTSTANDING OF THE ISSUER'S COMMON STOCK AS OF APRIL 30, 1999 WAS 30,512,179. ================================================================================ 2 MMC NETWORKS, INC. QUARTERLY REPORT ON FORM 10-Q INDEX PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets at March 31, 1999 and December 31, 1998................................................... 3 Condensed Consolidated Statements of Operations for the three months ended March 31, 1999 and 1998....................................... 4 Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 1999 and 1998................................ 5 Notes to the Condensed Consolidated Financial Statements................. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results Operations of....................................................... 8 PART II. OTHER INFORMATION Item 1. Legal Proceedings........................................................ 16 Item 2. Changes in Securities.................................................... 16 Item 3. Defaults Upon Senior Notes............................................... 16 Item 4. Submission of Matters to a Vote of Security Holders...................... 16 Item 5. Other Information........................................................ 16 Item 6. Exhibits and Reports on Form 8-K......................................... 16 SIGNATURES.................................................................................. 17 2 3 MMC NETWORKS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS MARCH 31, DECEMBER 31, 1999 1998 ------------- ----------- ASSETS Current assets: Cash and cash equivalents............................................... $43,810 $31,452 Short-term investments.................................................. 14,406 21,726 Accounts receivable, net of allowance of $222 and $172.................. 9,720 10,582 Inventories............................................................. 1,143 630 Prepaid expenses and other current assets............................... 3,050 3,372 ------- ------- Total current assets................................................. 72,129 67,762 Property and equipment, net.................................................. 5,179 5,487 Other assets................................................................. 156 135 ------- ------- ............................................................................. $77,464 $73,384 ======= ======= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable........................................................ $ 4,254 $ 4,400 Accrued expenses........................................................ 6,346 5,753 Capital lease obligations............................................... 200 286 ------- ------- Total current liabilities............................................ 10,800 10,439 ------- ------- Stockholders' equity: Preferred Stock: $0.001 par value; 10,000 shares authorized; no shares issued or outstanding - - Common Stock: $0.001 par value; 100,000 shares authorized; 30,425 and 30,135 shares issued and outstanding........................... 26 26 Additional paid-in capital.............................................. 55,962 55,520 Notes receivable from stockholders...................................... (107) (107) Retained earnings....................................................... 10,783 7,506 ------- ------- Total stockholders' equity........................................... 66,664 62,945 ------- ------- $77,464 $73,384 ======= ======= THE ACOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. 3 4 MMC NETWORKS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) THREE MONTHS ENDED MARCH 31, ------------------------------ 1999 1998 ---------- --------- Revenues........................................................... $ 16,110 $ 9,623 Cost of revenues................................................... 4,801 2,936 ---------- --------- Gross profit......................................... 11,309 6,687 ---------- --------- Operating expenses: Research and development, net.............................. 4,454 3,144 Selling, general and administrative........................ 2,392 2,097 ---------- --------- Total operating expenses............................. 6,846 5,241 ---------- --------- Operating income................................................... 4,463 1,446 ---------- --------- Other income (expense): Interest income............................................ 665 529 Interest expense........................................... (11) (19) ---------- --------- Total other income................................... 654 510 ---------- --------- Income before income taxes......................................... 5,117 1,956 Provision for income taxes......................................... 1,840 700 ---------- --------- Net income......................................................... $ 3,277 $1,256 ========== ========= Basic income per share............................................. $ 0.11 $ 0.04 ========== ========= Shares used to compute basic income per share...................... 30,329 29,276 ========== ========= Diluted income per share........................................... $ 0.10 $ 0.04 ========== ========= Shares used to compute diluted income per share.................... 33,499 33,717 ========== ========= THE ACOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. 4 5 MMC NETWORKS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) THREE MONTHS ENDED MARCH 31, ------------------------------ 1999 1998 ---------- --------- Cash flows from operating activities: Net income............................................................. $ 3,277 $ 1,256 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization..................................... 688 462 Changes in assets and liabilities: Accounts receivable............................................ 862 (587) Inventories.................................................... (513) (50) Prepaid expenses and other assets.............................. 301 (19) Accounts payable............................................... (146) (175) Accrued expenses............................................... 593 766 ---------- --------- Net cash provided by operating activities.................... 5,062 1,653 ---------- --------- Cash flows from investing activities: Sale (purchase) of short-term investments.............................. 7,320 (34,319) Acquisition of property and equipment.................................. (380) (945) ---------- --------- Net cash provided by (used in) investing activities.......... 6,940 (35,264) ---------- --------- Cash flows from financing activities: Proceeds from exercise of stock options and other...................... 442 32 Proceeds from the repayment of notes receivable from stockholders...... - 9 Principal payments on capital lease obligations........................ (86) (89) ---------- --------- Net cash provided by (used in) financing activities.......... 356 (48) ---------- --------- Net increase (decrease) in cash and cash equivalents....................... 12,358 (33,659) Cash and cash equivalents at beginning of period........................... 31,452 45,401 ---------- --------- Cash and cash equivalents at end of period................................. $43,810 $ 11,742 ========== ========= SUPPLEMENTAL DISCLOSURE: Cash paid for interest................................................. $ 11 $ 19 Cash paid for income taxes............................................. $ 1,287 $ 233 THE ACOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. 5 6 MMC NETWORKS, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - BASIS OF PRESENTATION In the opinion of management, the accompanying unaudited consolidated financial information reflects all adjustments, including only normal recurring adjustments, necessary for the fair presentation of the financial position, results of operations and cash flows for MMC Networks, Inc. ("the Company") for the periods presented. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 1998. Results for the interim periods are not necessarily indicative of results for the entire year. NOTE 2 - EARNINGS PER SHARE The following table reconciles the numerator and denominator of the basic and diluted EPS computations for the three months ended March 31, 1999 and 1998: 1999 1998 ----------------------------------- ---------------------------------- Per Share Per Share Income Shares Amount Income Shares Amount --------- --------- --------- --------- -------- --------- (in thousands, except per share data) Basic income per share: Net income available to common stockholders............ $ 3,277 30,329 $ 0.11 $ 1,256 29,276 $ 0.04 ====== ====== Effect of dilutive securities: Warrants............................ - 5 - 30 Stock options....................... - 3,165 - 4,411 ------- ------ ------- ------ Diluted income per share: Net income available to common stockholders............ $ 3,277 33,499 $ 0.10 $ 1,256 33,717 $ 0.04 ======= ====== ====== ======= ====== ====== At March 31, 1999 and 1998, options to purchase a total of 951,500 and 51,000 shares of Common Stock with average exercise prices of $16.55 and $18.69, respectively, are considered anti-dilutive because the options' exercise prices were greater than the average fair market value of the Company's Common Stock for the three months then ended and, as such, are excluded from the calculation of diluted net income per share. NOTE 3 - COMPOSITION OF INVENTORIES MARCH 31, -------------------------- 1999 1998 ------------ ----------- (IN THOUSANDS) Inventories: Work in process....................................... $ 480 $ - Finished goods........................................ 663 630 ------- ------ $ 1,143 $ 630 ======= ====== 6 7 MMC NETWORKS, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NOTE 4 - EQUITY On January 15, 1999 a warrant to purchase 33,963 shares of Common Stock at an exercise price of $1.77 was exercised. As consideration for the exercise, 3,277 shares of the Company's Common Stock otherwise issuable upon exercise of such warrant with a value of $60,000 were surrendered resulting in no net proceeds to the Company. NOTE 5 - FINANCING AGREEMENTS During the first half of 1998, the Company established two credit facilities with a bank, a loan agreement and a non-recourse receivables purchase agreement. The loan agreement allows the Company to borrow up to $8.0 million. Borrowings bear interest at the bank's prime rate. The agreement requires that the Company comply with certain financial covenants. In the event of default, all outstanding borrowings will accrue interest at a rate of five percentage points above the rate effective immediately prior to any such default. The loan agreement expired in May 1999 and was renewed for one year on the same terms. The non-recourse receivables purchase agreement expired in February 1999, and the Company did not renew the agreement. To date, the Company has not utilized either credit facility. 7 8 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following information should be read in conjunction with the interim condensed consolidated financial statements and the notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q and the consolidated financial statements and notes thereto contained in the Company's Annual Report on Form 10-K for the year ended December 31, 1998. This Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements which reflect the Company's current views with respect to future events which may impact the Company's results of operations and financial condition. In this report, the words "anticipates", "believes", "expects", "intends" and similar expressions identify forward-looking statements. These forward-looking statements are subject to risks and uncertainties and other factors, including those set forth below under the caption "Factors Affecting Future Results", which could cause the actual future results to differ materially from historical results or those described in the forward-looking statements. Readers are urged to carefully review the disclosures made by the Company in this Report and in the section entitled "Management's Discussion and Analysis of Results of Operations and Financial Condition - Factors Affecting Future Results" of the Company's Annual Report on Form 10-K previously filed with the Securities and Exchange Commission that describe certain risks and factors that may affect the Company's business and not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. BACKGROUND MMC Networks, Inc. (the "Company" or "MMC Networks") is a leading developer and supplier of Network Processors, which are high-performance, open-architecture, software-programmable processors optimized for network applications. The Company's Network Processors form the core silicon "engines" of LAN and WAN switches and routers and are designed to allow network equipment vendors to rapidly develop high-performance, feature-rich, cost-effective products supporting a broad range of networking functions. The Company's current products, the AF5400, AF5500, ATMS2000 and PS1000 Network Processors, provide the core functionality of high-performance Gigabit Ethernet, Fast Ethernet and Asynchronous Transfer Mode ("ATM") networking equipment. The Company believes that network equipment vendors are able to reduce design and development costs and accelerate product development cycles for high-performance routers and switches by using the Company's products. All of the Company's products are based on the Company's proprietary ViXTM architecture, which enables network equipment vendors to easily and cost-effectively implement high-performance, value-added features in their switch and router products. MMC Networks' customers employ the Company's Network Processors to develop and market multi-gigabit, wire-speed switches, routers, access concentrators, firewalls and gateways with advanced features such as Layer 3 switching, internetworking of LANs and WANs, security, class of service, quality of service and network management. The Company was incorporated in California in September 1992 and reincorporated in Delaware in October 1997. The Company's principal executive offices are located at 1134 East Arques Avenue, Sunnyvale, California 94086, and its telephone number is (408) 731-1600. 8 9 RESULTS OF OPERATIONS The following table sets forth certain statement of operations data expressed as a percentage of the Company's revenue for the interim periods presented. THREE MONTHS ENDED MARCH 31, ----------------------------- 1999 1998 ---------- -------- STATEMENT OF OPERATIONS DATA: Revenues..................................... 100.0% 100.0% Cost of revenues............................. 29.8% 30.5% ---------- -------- Gross profit.......................... 70.2% 69.5% ---------- -------- Operating expenses: Research and development, net............. 27.6% 32.7% Selling, general and administrative....... 14.9% 21.8% ---------- -------- Total operating expenses.............. 42.5% 54.5% ---------- -------- Operating income............................. 27.7% 15.0% Interest income, net......................... 4.0% 5.3% ---------- -------- Income before income taxes................... 31.7% 20.3% Provision for income taxes................... 11.4% 7.2% ========== ======== Net income................................... 20.3% 13.1% ========== ======== Revenues Revenues increased by 18.2% to $16.1 million in the first quarter of 1999 from $13.6 million in the fourth quarter of 1998 and increased by 67.4% from $9.6 million in the first quarter of 1998. Despite a marginal decline in average sales prices of the Company's products, increased unit shipments from the fourth quarter of 1998 to the first quarter of 1999 resulted in increased sales across all product lines. The increase of the first quarter of 1999 over the first quarter of 1998 is due to the increase in sales resulting from the shift into volume production of the AF5500 product outpacing the decline in the sales of the PS1000 product. The decline in sales of the PS1000 product was due to poor sales of the products of the Company's customers incorporating the PS1000 and to the economic weakness in Japan and Asia which affected the Company's customers in those areas. Cost of Revenues; Gross Profit Cost of revenues increased to $4.8 million in the first quarter of 1999 as compared to $3.9 million in the fourth quarter of 1998 and $2.9 million in the first quarter of 1998. The increase in cost of revenues compared to prior periods reflects the increase in unit shipments from period to period associated with the overall increase in sales of the Company's network processors to new and existing customers. Gross profit as a percentage of total revenues stayed relatively constant at 70.2% for the first quarter of 1999, 71.4% for the fourth quarter of 1998 and 69.5% for the first quarter of 1998. Research and Development Expenses, net Research and development expenses, net, increased by 41.7% to $4.5 million in the first quarter of 1999 as compared to $3.1 million in the first quarter of 1998. The increase in research and development expenses, net from period to period is due to increased new product development activity including the establishment of a wholly owned subsidiary in Israel during the second quarter of 1998. MMC Networks Israel Ltd. ("MMCIL") functions as a design center aimed at increasing the number of new products under development. On occasion, the Company has received partial or complete reimbursement for expenses incurred under certain contracts with its customers. These reimbursements are recorded as an offset against research and development expenses. Research and development expenses as a percentage of total revenues were 27.6% in the first quarter of 1999 as compared to 32.7% in the first quarter of 1998. This percentage decrease resulted from revenues growing faster than research and development expenses, net. Research and development expenses are 9 10 expected to continue to increase in absolute dollars during the remainder of 1999. Selling, General and Administrative Expenses Selling, general and administrative expenses increased by 14.1% to $2.4 million in the first quarter of 1999 as compared to $2.1 million in the first quarter of 1998. The increase in absolute dollars of selling, general and administrative expenses from period to period consisted of increased sales commissions resulting from higher revenues, increased selling and marketing costs associated with new products and increased costs associated with additional personnel. Selling, general and administrative expenses decreased as a percentage of revenues to 14.9% in the first quarter of 1999 from 21.8% in the first quarter of 1998 as revenue growth surpassed the increase in selling, general and administrative expenses. The Company expects selling, general and administrative expenses to increase in absolute dollars over the remainder of 1999. Interest Income, net Interest income, net reflects interest earned on average cash, cash equivalents and short-term investment balances, which is partially offset by interest expense on borrowings against lease lines to finance the acquisition of capital equipment. Interest income, net increased to $0.7 million for the three months ended March 31, 1999 from $0.5 million for the three months ended March 31, 1998. This increase is primarily due to increased cash and investment balances from period to period resulting from cash flow from operations. Provision for Income Taxes The provision for income taxes increased to $1.8 million in the first quarter of 1999 from $0.7 million in the first quarter of 1998 due to the increase in pre-tax income from period to period. The effective tax rates for the two periods were 36.0% and 35.8%, respectively. Management expects the effective tax rate for the remainder of 1999 to remain at approximately 36.0%. LIQUIDITY AND CAPITAL RESOURCES As of March 31, 1999, the Company's cash, cash equivalents and short-term investments totaled $58.2 million, and the Company's working capital was $61.3 million. Cash and cash equivalents totaled $43.8 million at March 31, 1999, up from $31.5 million at December 31, 1998. The net increase in cash and cash equivalents during the period was primarily attributable to the cash provided by operating and investing activities. Net cash totaling $5.1 million was provided by operating activities during the three months ended March 31, 1999. This positive cash flow was primarily due to net operating income adjusted for depreciation and amortization of $4.0 million. Cash provided by investing activities of $6.9 million for the three months ended March 31, 1999 consisted of the sale of short-term investments of $7.3 million offset by the acquisition of property and equipment of $0.4 million. During the first half of 1998, the Company established two credit facilities with a bank, a loan agreement and a non-recourse receivables purchase agreement. The loan agreement allows the Company to borrow up to $8.0 million. Borrowings bear interest at the bank's prime rate. The agreement requires that the Company comply with certain financial covenants. In the event of default, all outstanding borrowings will accrue interest at a rate of five percentage points above the rate effective immediately prior to any such default. The loan agreement expired in May 1999 and was renewed for one year on the same terms. The non-recourse receivables purchase agreement expired in February 1999, and the Company did not renew the agreement. To date, the Company has not utilized either credit facility. The Company believes that its existing cash balances together with the borrowing capacity under its loan agreement and cash flow from future operations will be sufficient to meet the Company's capital requirements through the next twelve months, although the Company could be required, or could elect, to seek to raise additional capital before such time. This is a forward-looking statement and the actual period of time for which the Company's resources will be sufficient will depend on many factors, including the rate of revenue growth, if any, the timing and extent of spending to support product development efforts and the expansion of sales and marketing efforts, the timing and size of business or technology acquisitions, the timing of introductions of new products and enhancements to existing products and market acceptance of 10 11 the Company's products. There can be no assurance that additional equity or debt financing, if required, will be available on acceptable terms or at all. IMPACT OF 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 computer programs that have date-sensitive software 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, including among other things a temporary inability to process transactions, send invoices or engage in similar normal business activities. The Company has completed testing its products, including semiconductors, software, and reference design systems, and believes them to be Year 2000 compliant. However, the Company can not be sure that errors will not be discovered in the future. The Company is pursuing a plan to identify and address other Year 2000 issues (the "Plan"). One component of the Plan is designed to identify and assess the risks associated with the Company's information technology ("IT") systems and non-IT systems. This component of the Plan is composed of three phases: (1) identification and assessment of risks, (2) implementation and (3) testing. Based on documentation supplied by the Company's computer hardware and software vendors, phase 1 and 2 have been completed with respect to the Company's critical IT systems and phase 3 is expected to be completed by June 1999. With respect to non-critical IT systems, phase 1 and 2 have been completed and phase 3 is expected to be completed by June of 1999. For non-IT systems such as facilities and laboratory test equipment, phase 1 and 2 have been completed and phase 3 is expected to be completed by June of 1999. The Company does not intend to create a contingency plan but will reassess the need for a contingency plan as each major phase of the Plan is completed. Another component of the Plan is to identify and assess the risks associated with the Year 2000 readiness of the Company's suppliers, including critical service suppliers such as banks. The Company believes that these risks are the greater risks associated with preparing for the Year 2000 given the Company's reliance upon its suppliers' ability to adequately resolve potential Year 2000 issues on a timely basis. This component of the Plan is composed of three phases: (1) identification and assessment of risks, (2) survey of significant or critical suppliers regarding their Year 2000 preparedness and (3) contingency planning. The Company has completed phase 1, and phases 2 and 3 are expected to be completed by June of 1999. As part of the contingency planning, the Company may be required to find alternative suppliers to replace suppliers identified as having Year 2000 compliance issues or suppliers whose published reports and or response to the Company's survey are not timely, accurate or complete. There can be no assurance that the Company will be able to adequately address Year 2000 compliance of its vendors, to find suitable alternate suppliers and contract with them on terms reasonable to the Company, or at all, and that such inability will not have a material adverse effect on the Company's business, financial condition and results of operations. Based on the status of the Company's Year 2000 efforts to date, the Company does not anticipate total expenses for implementing the Plan to exceed $50,000, excluding expenses related to internal IT staff. All expenses in this effort are expensed as incurred. However, the Company may discover additional Year 2000 problems, may not be able to develop, implement, or test contingency plans, or may find that the expenses associated with these activities exceed current expectations. In many cases, the Company is relying on assurances from suppliers and vendors that new and upgraded IT systems and other products will be Year 2000 compliant. The Company can not be sure that its tests of third-party products will be adequate or that, if problems are identified, they will be adequately addressed by the third party on a timely basis. Because the Company uses a variety of IT systems and has additional systems embedded in its infrastructure, it can not be sure that all of its systems will work together in a Year 2000-compliant fashion. Furthermore, the Company can not be sure that it will not suffer business interruptions, either because of its own Year 2000 problems or those of its customers or suppliers whose Year 2000 problems may make it difficult or impossible for them to fulfill their commitments to the Company. If the Company fails to satisfactorily resolve Year 2000 issues in a timely manner, it could also be exposed to liability to third parties. 11 12 FACTORS AFFECTING FUTURE RESULTS Past financial performance should not be considered a reliable indicator of future performance and investors should not use historical trends to anticipate results or trends in future periods. The Company operates in a rapidly changing environment that involves a number of risks and uncertainties, some of which are beyond the Company's control. In addition to the uncertainties describes elsewhere in this report and in the Company's Annual Report on Form 10-K for the year ended December 31, 1998 under the section entitled "Factors Affecting Future Results", these include: Fluctuations in Operating Results Fluctuations in the Company's revenues, operating expenses and operating income have occurred in the past and are likely to occur in the future due to a variety of factors, any of which may have a material adverse effect on the Company's operating results. In addition, the Company's quarterly results of operations may vary significantly due to general business conditions in the networking equipment and semiconductor industries, changes in demand for the network equipment products of the Company's customers, the timing and amount of orders from the Company's network equipment vendor customers, cancellations or delays of customer product orders, new product introductions by the Company or its competitors, cancellations, changes or delays of deliveries of products to the Company by its suppliers, increases in the costs of products from the Company's suppliers, fluctuations in product life cycles, price erosion, competition, changes in the mix of products sold by the Company, availability of semiconductor foundry capacity, variances in the timing and amount of nonrecurring engineering funding and operating expenses, seasonal fluctuations in demand, intellectual property disputes and general economic conditions. In addition, in the past the Company has recognized a substantial portion of its revenues in the last month of a quarter. Since a large portion of the Company's operating expenses, including rent, salaries and capital lease expenses, is fixed and difficult to reduce or modify, if revenue does not meet the Company's expectations, the material adverse effect of any revenue shortfall will be magnified by the fixed nature of these operating expenses. All of the above factors are difficult for the Company to forecast, and these and other factors could have a material adverse effect on the Company's business, financial condition and results of operations. Customer Concentration Significant customers are those customers accounting for more than 10% of the Company's total revenues. Significant customers for the three months ended March 31, 1999 were Cisco Systems, Inc. ("Cisco") and International Business Machines Corporation ("IBM") accounting for 53% and 19% of total revenues, respectively. Significant customers for the three months ended March 31, 1998 were Cisco, Mitsui Comtek Corp., a non-stocking sales representative for Japan ("Mitsui"), Cabletron and the U.S. Computer Division of Hitachi ("Hitachi") accounting for 30%, 27%, 11% and 10% of total revenues, respectively. Cabletron has not been a significant customer since the first quarter of 1998. The Company's customer base is highly concentrated. A relatively small number of customers has accounted for a significant portion of the Company's revenues to date, and the Company expects that this trend will continue for the foreseeable future. Each of the Company's network equipment vendor customers, including Cisco, IBM, Mitsui, Hitachi and Lucent Technologies (which was the Company's third largest customer in the first quarter of 1999) can cease incorporating the Company's products with limited notice to the Company and with little or no penalty. The Company has no minimum purchase agreements with its customers. The Company's future operating results are currently substantially dependent on Cisco's competitive position in the networking equipment market. The loss of one or more of the Company's customers in general and Cisco in particular, the possibility that the introduction of the customer's product may not be successful, the possibility that design wins with customers do not result in significant production levels or the inability of the Company to successfully develop relationships with additional significant network equipment vendors could have a material adverse effect on the Company's business, financial condition and results of operations. 12 13 New Product Development and Technological Change The data networking and semiconductor industries are characterized by rapidly changing technology, frequent product introductions and evolving industry standards. Accordingly, the Company's future performance depends on a number of factors, including the Company's ability to identify emerging technological trends in its target markets, develop and maintain competitive products, enhance its products by adding innovative features that differentiate its products from those of competitors, bring products to market on a timely basis at competitive prices, properly identify target markets and respond effectively to new technological changes or new product announcements by others. No assurance can be given that the Company's design and introduction schedules for any additions and enhancements to its existing and future products will be met, that these products will achieve market acceptance, or that the Company will be able to sell these products at prices that are favorable to the Company. In evaluating new product decisions, the Company must anticipate well in advance future demand for product features and performance characteristics, as well as available supporting technologies, manufacturing capacity, industry standards and competitive product offerings. The technical innovations required for the Company to remain competitive must be completed before developments in networking technologies or standards render them obsolete and must be sufficiently compelling to induce network equipment vendors to favor them over alternative technologies. To remain competitive, the Company must design new products and sometimes redesign existing products to be manufactured on newer wafer process technologies that provide smaller circuit dimensions. There is no assurance that the suppliers of these new technologies can deliver them on schedule or that the Company can complete its designs on the new processes on schedule. Moreover, the Company must generally incur substantial research and development costs before the technical feasibility and commercial viability of a product line can be ascertained. There can be no assurance that revenues from future products or product enhancements will be sufficient to recover the development costs associated with such products or enhancements, or that the Company will be able to secure the financial resources necessary to fund future development. The inability of the Company and its products to achieve market acceptance from network equipment vendors and to adequately address any of the factors discussed above could have a material adverse effect on the Company's business, financial condition and results of operations. Dependence on Independent Manufacturers Currently, the Company outsources all manufacturing, assembly and testing of its network processors. The Company purchases both fully assembled and tested products on a turnkey basis and wafers which it then consigns to subcontract assembly and test providers. For products purchased in wafer form, the Company assumes the risk of yield loss in subsequent manufacturing steps. The Company has not entered into any volume purchase agreements with its suppliers for the purchase of the wafers. Only one of the Company's products is currently manufactured by more than one supplier. The Company depends on its suppliers to deliver sufficient quantities of finished product to the Company in a timely manner. Since the Company places its orders on a purchase order basis and does not have a long-term volume purchase agreement with any of its existing suppliers, these suppliers may allocate, and in the past have allocated, capacity to the production of other products while reducing deliveries to the Company on short notice. Currently the Company must place orders approximately eight to 10 weeks in advance of expected delivery. In the future, this required lead time may increase, making it more difficult for the Company to meet customer demand. Any sudden increase in customer demand not anticipated by the Company in advance could result in the inability to deliver product on a timely basis and, as such, may reduce the Company's product revenues or increase the Company's cost of revenues and could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, the Company places orders based on forecast demand to ensure enough lead time to be able to meet anticipated customer orders. Any sudden decrease in the anticipated customer demand could have a material adverse effect on the Company's business, financial condition and results of operations. If capacity becomes less available in the future, the Company may be required to place orders earlier than eight to 10 weeks in advance of expected delivery. As the Company increases the volume of its wafer purchases in place of turnkey purchases, the Company will need to continue to invest in the capital and engineering resources necessary for production under this manufacturing flow. 13 14 Competition The data networking and semiconductor industries are intensely competitive and are characterized by constant technological change, rapid rates of product obsolescence and price erosion. The Company's products compete with semiconductor solutions from companies such as Texas Instruments, Lucent Technologies, PMC-Sierra, Intel Corporation and Broadcom. In addition, the Company expects significant competition in the future from other major semiconductor suppliers. For example, Intel Corporation and Texas Instruments have recently entered or indicated an intent to enter the network processor market. The Company also may face competition from suppliers of products based on new or emerging technologies. In addition, many of the Company's existing and potential customers internally develop ASICs, general purpose processors, network processors and other devices which attempt to perform all or a portion of the functions performed by the Company's products. Many of the Company's current and prospective competitors offer broader product lines and have significantly greater financial, technical, manufacturing and marketing resources than the Company. Failure of the Company to compete successfully could have a material adverse effect on its operating results. Protection of Intellectual Property The Company relies primarily on a combination of nondisclosure agreements and other contractual provisions as well as patent, trademark, trade secret and copyright law to protect its proprietary rights. There can be no assurance that any patents will issue pursuant to the Company's current or future patent applications or that patents issued pursuant to such applications will not be invalidated, circumvented, challenged or licensed to others. In addition, there can be no assurance that the rights granted under any such patents will provide competitive advantages to the Company or be adequate to safeguard and maintain the Company's proprietary rights. Failure of the Company to enforce and protect its intellectual property rights could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that such intellectual property rights can be successfully asserted in the future or will not be invalidated, circumvented or challenged. From time to time, third parties, including competitors of the Company, may assert patent, copyright and other intellectual property rights to technologies that are important to the Company. There can be no assurance that third parties will not assert infringement claims against the Company in the future, that assertions by third parties will not result in costly litigation or that the Company would prevail in any such litigation or be able to license any valid and infringed patents from third parties on commercially reasonable terms, if at all. Risks Associated with Expansion of International Business Activities Substantially all of the Company's sales to date have been to customers located in the United States, including sales to U.S.-based affiliates of non-U.S. network equipment vendors. If the Company's international sales increase, the Company will be subject to additional risks inherent in international operations. All of the Company's international sales to date are U.S. dollar-denominated. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could make the Company's products less competitive in international markets. In addition, the Company procures the majority of its manufacturing, assembly and test services from suppliers located outside the United States. International business activities may be limited or disrupted by the imposition of governmental controls, export license requirements, restrictions on the export of critical technology, currency exchange fluctuations, political instability, trade restrictions and changes in tariffs. Demand for the Company's products could also be adversely affected by seasonality of international sales and economic conditions in the Company's primary overseas markets. These international factors could have a material adverse effect on future sales of the Company's products to international customers and, consequently, on the Company's business, financial condition and results of operations. As a percentage of total revenues, sales to Mitsui have declined to less than 10% for the three months ended March 31, 1999 as compared to 27% for the three months ended March 31, 1998. Sales to Mitsui may remain at this lower level or decline further due to the economic downturn in Japan and Asia in general, and could have an adverse effect on the Company's revenues in the future. Expected Volatility of Stock Price. In recent years the stock market in general, and the market for shares of high technology, data networking 14 15 and semiconductor companies in particular, have experienced extreme price fluctuations, which have often been unrelated to the operating performance of affected companies. The trading price of the Company's Common Stock has been, and is expected to continue to be, subject to extreme fluctuations in response to both business-related issues, such as quarterly variations in operating results, announcements of new products by the Company or its competitors, the gain or loss of significant network equipment vendor customers, and stock market-related influences, such as changes in analysts' estimates, the presence or absence of short-selling of the Company's Common Stock and events affecting other companies that the market deems to be comparable to the Company. In addition, technology stocks have from time to time experienced extreme price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations have affected and are expected to continue to adversely affect the market price of the Company's Common Stock. Moreover, the trading prices of many high technology, data networking and semiconductor stocks are at or near their historical highs and reflect price/earnings ratios substantially above historical norms. 15 16 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Not Applicable. ITEM 2. CHANGES IN SECURITIES The effective date of the Company's first registration statement, filed on Form S-1 under the Securities Act of 1933 (No. 333-34005), was October 29, 1997 (the "Registration Statement"). The class of securities registered was Common Stock. The offering commenced on October 29, 1997 and all securities were sold in the offering. The managing underwriters for the offering were Morgan Stanley Dean Witter Discover & Co., Deutsche Morgan Grenfell and Wessels, Arnold & Henderson. A total of 4,025,000 shares were registered pursuant to the Registration Statement, all of which the Company sold for its own account, for an aggregate offering price of $44.3 million. The Company incurred expenses of approximately $4.2 million for the offering, of which $3.1 million represented underwriting discounts and commissions and $1.1 million represented other expenses. All such expenses were direct or indirect payments to others. The net offering proceeds to the Company after total expenses were approximately $40.1 million. As of March 31, 1999, the Company had used the net proceeds from the offering as follows: $0.1 million for plants, buildings and facilities, $4.3 million for the purchase and installation of machinery, equipment and purchased software, $0.4 million for the repayment of indebtedness and lease obligations, $20.9 million for working capital, and $14.4 million for temporary investments. The remaining net proceeds remain in cash and cash equivalents. None of the proceeds were used for direct or indirect payments to directors, officers, general partners of the Company or their associates or to persons owning ten (10) percent or more of any class of equity securities of the Company; or to affiliates of the Company. The use of the proceeds from the offering does not represent a material change in the use of proceeds described in the prospectus. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not Applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. ITEM 5. OTHER INFORMATION Not Applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits Exhibit No. Description of Exhibit ----------- ---------------------- 10.1 Loan Modification Agreement dated May 4, 1999, by and between Silicon Valley Bank and the Registrant. 27.1 Financial Data Schedule as of March 31, 1999 and for the 3 months then ended. (b) Reports on Form 8-K The Company filed no reports on Form 8-K during the three months ended March 31, 1999. 16 17 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Dated: May 10, 1999 MMC NETWORKS, INC. By: /s/ Douglas C. Spreng ------------------------------------- Douglas C. Spreng President, Chief Executive Officer and Director (Principal Executive Officer) By: /s/ Uday Bellary ------------------------------------- Uday Bellary Vice President, Finance, Chief Financial Officer and Assistant Secretary (Principal Financial and Accounting Officer) 17 18 INDEX TO EXHIBITS Exhibit Number Description - ------ ----------- 10.1 Loan Modification Agreement dated May 4, 1999, by and between Silicon Valley Bank and the Registrant. 27.1 Financial Data Schedule as of March 31, 1999 and for the 3 months then ended.