1 FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarter ended September 30, 1997 Commission file number:0-16641 RAINBOW TECHNOLOGIES, INC. (Exact name of Registrant as specified in its charter) Delaware 95-3745398 (State of incorporation) (I.R.S. Employer Identification No.) 50 Technology Drive, Irvine, California 92618 (Address of principal executive offices) (Zip Code) Indicate by check mark whether the Registrant (i) 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 (ii) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The number of shares of common stock, $.001 par value, outstanding as of September 30, 1997 was 7,738,368. 2 RAINBOW TECHNOLOGIES, INC. TABLE OF CONTENTS PART I - FINANCIAL INFORMATION Item 1. Condensed Consolidated Balance Sheets at September 30, 1997 and December 31, 1996 3 Condensed Consolidated Statements of Income for the three and nine months ended September 30, 1997 and 1996 4 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 1997 and 1996 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 PART II - OTHER INFORMATION Item 1 to 6 - Not applicable SIGNATURES 12 2 3 RAINBOW TECHNOLOGIES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS A S S E T S September 30, December 31, 1997 1996 ------------ ------------ (unaudited) Current assets: Cash and cash equivalents ................................................ $ 34,739,000 $ 31,735,000 Marketable securities available-for-sale ................................. 4,956,000 11,437,000 Accounts receivable, net of allowance for doubtful accounts of $410,000 and $330,000 in 1997 and 1996, respectively ................. 12,755,000 15,297,000 Inventories .............................................................. 9,508,000 7,853,000 Unbilled costs and fees .................................................. 2,401,000 2,249,000 Prepaid expenses and other current assets ................................ 4,390,000 2,106,000 ------------ ------------ Total current assets ................................................ 68,749,000 70,677,000 Property, plant and equipment, at cost: Buildings ................................................................ 8,154,000 9,122,000 Furniture ................................................................ 1,180,000 1,200,000 Equipment ................................................................ 12,079,000 6,026,000 Leasehold improvements ................................................... 570,000 347,000 ------------ ------------ 21,983,000 16,695,000 Less accumulated depreciation and amortization ........................... 5,774,000 4,615,000 ------------ ------------ Net property, plant and equipment ................................... 16,209,000 12,080,000 Goodwill, net of accumulated amortization of $8,348,000 and $7,936,000 in 1997 and 1996, respectively ............................... 4,385,000 4,064,000 Other assets, net of accumulated amortization of $2,939,000 and $2,199,000 in 1997 and 1996, respectively ............................ 6,048,000 6,543,000 ------------ ------------ $ 95,391,000 $ 93,364,000 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable ......................................................... $ 4,136,000 $ 4,109,000 Accrued payroll and related expenses ..................................... 3,493,000 3,339,000 Other accrued liabilities ................................................ 1,427,000 1,500,000 Income taxes payable ..................................................... -- 948,000 Billings in excess of costs and fees ..................................... 87,000 314,000 Long-term debt, due within one year ...................................... 263,000 301,000 ------------ ------------ Total current liabilities ........................................... 9,406,000 10,511,000 Long-term debt, net of current portion ........................................ 1,708,000 2,145,000 Deferred income taxes ......................................................... -- 1,515,000 Minority interest ............................................................. 861,000 80,000 Other liabilities ............................................................. 61,000 37,000 Shareholders' equity: Common stock, $.001 par value, 20,000,000 shares authorized, 7,738,368 and 7,775,389 shares issued and outstanding in 1997 and 1996, respectively ......................................... 8,000 8,000 Additional paid-in capital ............................................... 29,339,000 30,686,000 Cumulative translation adjustment ........................................ (1,648,000) (251,000) Cumulative difference between cost and market value of marketable securities .................................. (42,000) 154,000 Retained earnings ........................................................ 56,512,000 48,479,000 ------------ ------------ 84,169,000 79,076,000 Less cost of treasury shares (34,490 shares) ............................. 814,000 -- ------------ ------------ Total shareholders' equity .......................................... 83,355,000 79,076,000 ------------ ------------ $ 95,391,000 $ 93,364,000 ============ ============ See accompanying notes. 3 4 RAINBOW TECHNOLOGIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (unaudited) Three months ended Nine months ended ---------------------------- ---------------------------- September 30, September 30, September 30, September 30, 1997 1996 1997 1996 ------------ ------------ ------------ ------------ Revenues: Software protection products ........ $ 14,741,000 $ 13,981,000 $ 44,688,000 $ 43,288,000 Information security products ....... 7,314,000 5,101,000 20,983,000 17,225,000 Ion beam surface treatment .......... 201,000 -- 212,000 -- ------------ ------------ ------------ ------------ Total revenues ................. 22,256,000 19,082,000 65,883,000 60,513,000 Operating expenses: Cost of software protection products 4,128,000 4,026,000 12,902,000 12,868,000 Cost of information security products 5,975,000 4,145,000 16,930,000 14,410,000 Cost of ion beam surface treatment .. 2,000 -- 419,000 -- Selling, general and administrative . 5,305,000 5,216,000 16,021,000 14,781,000 Research and development ............ 2,010,000 1,442,000 5,985,000 4,710,000 Goodwill amortization ............... 429,000 449,000 1,289,000 1,344,000 ------------ ------------ ------------ ------------ Total operating expenses ....... 17,849,000 15,278,000 53,546,000 48,113,000 ------------ ------------ ------------ ------------ Operating income ........................ 4,407,000 3,804,000 12,337,000 12,400,000 Interest income ......................... 442,000 354,000 1,287,000 1,234,000 Interest expense ........................ (52,000) (80,000) (192,000) (248,000) Other income (expense) .................. (73,000) (197,000) 276,000 (220,000) ------------ ------------ ------------ ------------ Income before provision for income taxes 4,724,000 3,881,000 13,708,000 13,166,000 Provision for income taxes .............. 1,937,000 1,832,000 5,675,000 5,610,000 ============ ============ ============ ============ Net income .............................. $ 2,787,000 $ 2,049,000 $ 8,033,000 $ 7,556,000 ============ ============ ============ ============ Net income per common and common equivalent share .................... $ 0.35 $ 0.26 $ 1.01 $ 0.94 ============ ============ ============ ============ Weighted average common and common equivalent shares outstanding ....... 8,033,000 8,030,000 7,976,000 8,068,000 ============ ============ ============ ============ See accompanying notes. 4 5 RAINBOW TECHNOLOGIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) Nine months ending Nine months ending September 30, 1997 September 30, 1996 ------------ ------------ Cash flows from operating activities: Net income ................................................ $ 8,033,000 $ 7,556,000 Adjustments to reconcile net income to net cash provided by operating activities: Amortization ......................................... 2,041,000 2,251,000 Depreciation ......................................... 1,504,000 1,104,000 Change in deferred income taxes ...................... (1,153,000) (361,000) Provision for loss on contract ....................... 400,000 -- Allowance for doubtful accounts ...................... 90,000 (62,000) Loss from retirement of property, plant, and equipment 34,000 88,000 Write-down of long-term investment ................... -- 205,000 Share in investee's loss ............................. 45,000 266,000 Minority interest in subsidiary's earnings ........... (392,000) -- Write-off of capitalized software .................... -- 273,000 Changes in operating assets and liabilities: Accounts receivable .............................. 2,073,000 357,000 Inventories ...................................... (1,733,000) (3,766,000) Unbilled costs and fees .......................... (152,000) 2,282,000 Prepaid expenses and other current assets ........ (232,000) (17,000) Accounts payable ................................. (455,000) 532,000 Accrued liabilities .............................. (80,000) 152,000 Billings in excess of costs and fees ............. (227,000) 312,000 Income taxes payable ............................. (2,765,000) (1,622,000) ------------ ------------ Net cash provided by operating activities .... 7,031,000 9,550,000 Cash flows from investing activities: Purchase of marketable securities ......................... (9,930,000) (7,099,000) Sale of marketable securities ............................. 16,211,000 8,282,000 Purchases of property, plant, and equipment ............... (5,732,000) (2,023,000) Acquired cash from QMT .................................... 556,000 (1,000,000) Other long-term assets .................................... (775,000) (2,170,000) Capitalized software development costs .................... (1,150,000) -- ------------ ------------ Net cash used in investing activities ........ (820,000) (4,010,000) Cash flows from financing activities: Exercise of Rainbow common stock options .................. 936,000 731,000 Payment of long-term debt ................................. (214,000) (229,000) Purchase of treasury stock ................................ (814,000) -- Purchase and retirement of common stock ................... (2,767,000) (706,000) ------------ ------------ Net cash used by financing activities ........ (2,859,000) (204,000) Effect of exchange rate changes on cash ........................ (348,000) (119,000) ------------ ------------ Net increase in cash and cash equivalents ...................... 3,004,000 5,217,000 Cash and cash equivalents at beginning of period ............... 31,735,000 25,330,000 ============ ============ Cash and cash equivalents at end of period ..................... $ 34,739,000 $ 30,547,000 ============ ============ Supplemental disclosure of cash flow information: Income taxes paid ......................................... $ 8,748,000 $ 6,825,000 Interest paid ............................................. 199,000 247,000 See accompanying notes. 5 6 RAINBOW TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1997 (Unaudited) 1. Basis of presentation The accompanying financial statements consolidate the accounts of Rainbow Technologies, Inc. (the Company) and its wholly-owned subsidiaries. Amounts for the three and nine month periods ended September 30, 1996 have been restated to reflect the acquisition of Software Security, Inc. (SSI) which has been accounted for using the pooling-of-interests method (Note 5). All significant inter-company balances and transactions have been eliminated. In the opinion of the Company's management, the accompanying condensed consoldiated financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial position at September 30, 1997 and results of operations for the three and nine months ended September 30, 1997 and 1996. The condensed consolidated financial statements do not include footnotes and certain financial information normally presented annually under generally accepted accounting principles and, therefore, should be read in conjunction with the Company's December 31, 1996 Annual Report on Form 10-K. Results of operations for the three and nine months ended September 30, 1997 are not necessarily indicative of results to be expected for the full year. The Company has subsidiaries in the United Kingdom, Germany, France and Belarus. The Company utilizes the currencies of the countries where its foreign subsidiaries operate as the functional currency. In accordance with Statement of Financial Accounting Standards No. 52, the balance sheets of the Company's foreign subsidiaries are translated into U.S. dollars at the exchange rates at the respective dates. The income statements of those subsidiaries are translated into U.S. dollars at the weighted average exchange rates for the respective periods presented. 2. Earnings per share Earnings per share are based on the weighted average number of common and common equivalent shares outstanding during each period. Common equivalent shares include the potential dilution from the exercise of stock options. In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS No. 128). SFAS No. 128 redefines the standards for computing earnings per share and is effective for the Company on December 31, 1997. The Company believes adoption of SFAS No. 128 will not have a material impact on future earnings per share calculations. 3. Government Contracts The Company is both a prime contractor and subcontractor under fixed-price and cost-plus-fixed-fee contracts with the U.S. Government (Government). At the commencement of each contract or contract modification, the Company submits pricing proposals to the Government to establish indirect cost rates applicable to such contracts. These rates, after audit and approval by the Government, are used to settle costs on contracts completed during the previous fiscal year. To facilitate interim billings during the performance of its contracts, the Company establishes provisional billing rates, which are used in recognizing contract revenue and contract accounts receivable amounts in these financial statements. These provisional billing rates are adjusted to actual at year-end and are subject to adjustment after Government audit. The Company has unbilled costs and fees at September 30, 1997 of $2,401,000. Based on the Company's experience with similar contracts in recent years, the unbilled costs and fees are expected to be collected within one year. 6 7 4. Inventories Inventoried costs relating to long-term contracts are stated at the actual production costs, including pro-rata allocations of factory overhead and general and administrative costs incurred to date reduced by amounts identified with revenue recognized on units delivered. The costs attributed to units delivered under such long-term contracts are based on the estimated average cost of all units expected to be produced. Inventories, other than inventoried costs relating to long-term contracts, are stated at the lower of cost (first-in, first-out basis) or market. Inventories consist of the following: September 30, 1997 December 31, 1996 --------- --------- Raw materials $ 839,000 $ 908,000 Work in process 1,113,000 819,000 Finished goods 2,866,000 3,211,000 Inventoried costs related to long-term contracts 4,690,000 2,915,000 --------- --------- $9,508,000 $7,853,000 ========== ========== 5. Acquisitions On October 4, 1996, the Company acquired Software Security, Inc. ("SSI") in a merger transaction resulting in SSI becoming a wholly-owned subsidiary of Rainbow. SSI, headquartered in Darien, Connecticut, designs, develops and manufactures software security products to prevent the unauthorized use of intellectual property. These products are sold in the U.S. and Europe. Shareholders of SSI received 0.35 shares of Company common stock for each share of issued and outstanding SSI common stock. Accordingly, the Company issued 336,511 shares of its common stock to SSI shareholders in exchange for all outstanding SSI shares. In addition, 4,366 shares of Rainbow common stock were reserved for issuance upon the exercise of assumed SSI options. The merger was accounted for as a pooling-of-interests. Expenses associated with the merger of approximately $191,000 were included in the consolidated results of operations for the year ended December 31, 1996. There were no significant intercompany transactions between Rainbow and SSI during any period presented. On March 6, 1996 the Company entered into an agreement to acquire up to 58% of Quantum Manufacturing Technologies, Inc. ("QMT") of Albuquerque, New Mexico. QMT has obtained the exclusive worldwide license from Sandia National Laboratories for the commercial use and exploitation of patented pulsed power ion beam surface treatment technology known as "IBEST". IBEST technology benefits and enhances the durability and utility of a large number of industrial and consumer products at relatively low cost and without creating any impact on the environment. As of September 30, 1997, the Company owns 58% of QMT, although it is not a significant subsidiary of the Company. On June 1, 1995, the Company acquired Mykotronx in a merger transaction resulting in Mykotronx becoming a wholly-owned subsidiary of Rainbow. Mykotronx, headquartered in Torrance, California, designs, develops and manufactures information security products to provide privacy and security for voice communication and data transmission. These products are sold to the U.S. Government and customers in the aerospace and telecommunications industries. Shareholders of Mykotronx received 2.64 shares of Company common stock for each share of issued and outstanding Mykotronx common stock. Accordingly, the Company issued 1,620,564 shares of its common stock to Mykotronx shareholders in exchange for all outstanding Mykotronx shares. In addition, 195,096 shares of Rainbow common stock were reserved for issuance upon the exercise of assumed Mykotronx options. The merger was accounted for as a pooling-of-interests. 7 8 6. Other assets Included in other assets are certain investments in early-stage companies. The Company closely monitors the operations and cash flows of these companies to evaluate their status and ensure that amounts reported for these investments do not exceed net realizable value. If the Company determines that impairment in the investment of any such company exists, an adjustment would be made to reduce the investment amount to net realizable value. 8 9 RAINBOW TECHNOLOGIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is management's discussion and analysis of certain significant factors which have affected the consolidated results of operations and the consolidated financial position of the Company during the periods included in the accompanying condensed consolidated financial statements. This discussion should be read in conjunction with the related condensed consolidated financial statements and associated notes. Prior period financial statements have been restated to reflect the acquisition of SSI, which has been accounted for using the pooling-of-interest method. RESULTS OF OPERATIONS (dollars in thousands) Three Months Ended September 30, 1997 1996 -------- -------- Revenues Software Protection Products $ 14,741 $ 13,981 Information Security Products 7,314 5,101 IBEST 201 -- -------- -------- Consolidated $ 22,256 $ 19,082 ======== ======== Operating Income Software Protection Products $ 4,176 $ 2,872 Information Security Products 303 932 IBEST (72) -- -------- -------- Consolidated $ 4,407 $ 3,804 ======== ======== Nine Months Ended September 30, 1997 1996 -------- -------- Revenues Software Protection Products $ 44,688 $ 43,288 Information Security Products 20,983 17,225 IBEST 212 -- -------- -------- Consolidated $ 65,883 $ 60,513 ======== ======== Operating Income Software Protection Products $ 11,616 $ 9,666 Information Security Products 1,718 2,734 IBEST (997) -------- -------- Consolidated $ 12,337 $ 12,400 ======== ======== REVENUES Revenues from software protection products for the three and nine months ended September 30, 1997 increased by 5% and 3%, respectively, when compared to the same periods in 1996. The average selling price per product in the three and nine months ended September 30, 1997 decreased approximately 9% and 4% when compared to the same periods in 1996. Unit volume for the three and nine months ended September 30, 1997 increased by 18% and 4%, respectively, when compared to the corresponding 1996 periods. The Asia Pacific region grew at 33% while revenues in other international markets were impacted by the strong dollar. 9 10 Revenues from information security products for the three and nine months ended September 30, 1997 increased by 43% and by 22%, respectively, when compared to the same periods in 1996. The revenue growth was primarily due to the increase in sales of network security products to the government and the delivery of new satellite communication products to commercial customers. Revenues from IBEST are contract earnings from an equipment development contract and from validation test services. GROSS PROFIT Gross profit from software protection products for the three and nine months ended September 30, 1997 was at 72% and 71% of revenues, respectively, when compared with 71 and 70%, respectively, for the corresponding periods in 1996. The increase in gross margin was primarily due to improvements in manufacturing efficiencies. Gross profit from information security products for the three and nine months ended September 30, 1997 was 18% and 19% of revenues, respectively, when compared with 19% and 16% of revenues, respectively, for the corresponding 1996 periods. These changes were primarily due to the change in the revenue mix from less profitable research and development contracts to more profitable contracts based on deliverables. SELLING, GENERAL AND ADMINISTRATIVE Sellling, general and administrative expenses for the three and nine months ended September 30, 1997 increased by 2% and 8%, respectively, when compared to the corresponding 1996 periods. The increases were due to additional staffing, increased amortization of other assets and higher marketing expenses for the license management and internet security products. RESEARCH AND DEVELOPMENT Total research and development expenses for the three and nine months ended September 30, 1997 increased by 39% and 27%, respectively, when compared to the corresponding 1996 period. The increases were due to the research and development expenses on the Cryptoswift program and the research and development efforts of QMT. INTEREST INCOME Interest income for the three and nine months ended September 30, 1997 increased by 25% and 4%, respectively, compared to the corresponding periods in 1996. The increase is due to higher interest rates and higher balances. PROVISION FOR INCOME TAXES The effective tax rate was 41% for the three months and nine ended September 30, 1997. The effective tax rates for the corresponding periods in 1996 were 47% and 43%, respectively. The decrease in the effective tax rate was due to expenses related to the SSI acquisition incurred in the three month period ended September 30, 1996. 10 11 LIQUIDITY AND CAPITAL RESOURCES For the nine months ended September 30, 1997, the Company's principal sources of operating funds have been from operations and the sale of marketable securities. The Company's cash flow from operations for the nine months ended September 30, 1997 and 1996 were $7,031,000 and $9,550,000, respectively. The Company intends to use its capital resources to expand its product lines and for the acquisition of additional products and technologies. In October 1997, the Company announced its acquisition of the KIV-7 family of communication encrytion products from Allied Signal Inc. Under the agreement, the Company's subsidiary, Mykotronx, Inc., will acquire all intellectual property and marketing rights to the KIV-7 product line The Company's use of cash includes purchases of property, plant and equipment, repayment of long-term debt and the purchase and retirement of common stock. Management believes the Company's current working capital of $59,343,000 and anticipated working capital to be generated by future operations will be sufficient to support the Company's requirements for at least the next twelve months. 11 12 PART II OTHER INFORMATION Item 6 Exhibits and Reports on Form 8-K (a) Exhibits 27 Financial Data Schedule (b) Reports on Form 8-K None 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 thereto duly authorized. Dated: November 12, 1997 RAINBOW TECHNOLOGIES, INC. By: /s/ PATRICK E. FEVERY Patrick E. Fevery Chief Financial Officer 12