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, 1998 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 November 10, 1998 was 11,721,975. 2 RAINBOW TECHNOLOGIES, INC. TABLE OF CONTENTS PART I - FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements Condensed Consolidated Balance Sheets at September 30, 1998 (unaudited) and December 31, 1997 3 Condensed Consolidated Statements of Income for the Three and Nine months ended September 30, 1998 and 1997 (unaudited) 4 Condensed Consolidated Statements of Comprehensive Income for the Three and Nine months ended September 30, 1998 and 1997 (unaudited) 5 Condensed Consolidated Statements of Cash Flows for the Nine months ended September 30, 1998 and 1997 (unaudited) 6 Notes to Condensed Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 PART II - OTHER INFORMATION Item 1 to 5 - Not applicable Item 6. Exhibits and reports on Form 8-K 15 SIGNATURES 15 2 3 RAINBOW TECHNOLOGIES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS A S S E T S September 30, 1998 December 31, 1997 ------------------ ----------------- (unaudited) Current assets: Cash and cash equivalents .................................. $ 29,519,000 $ 29,556,000 Marketable securities available-for-sale ................... 7,969,000 6,841,000 Accounts receivable, net of allowance for doubtful accounts of $340,000 and $500,000 in 1998 and 1997, respectively ... 17,502,000 16,343,000 Inventories ................................................ 11,655,000 9,780,000 Unbilled costs and fees .................................... -- 1,782,000 Prepaid expenses and other current assets .................. 3,036,000 4,803,000 ------------- ------------- Total current assets .................................. 69,681,000 69,105,000 Property, plant and equipment, at cost: Buildings .................................................. 8,610,000 8,058,000 Furniture .................................................. 1,323,000 1,191,000 Equipment .................................................. 15,522,000 12,963,000 Leasehold improvements ..................................... 907,000 636,000 ------------- ------------- 26,362,000 22,848,000 Less accumulated depreciation and amortization ............. 8,298,000 6,315,000 ------------- ------------- Net property, plant and equipment ..................... 18,064,000 16,533,000 Goodwill, net of accumulated amortization of $11,304,000 and $8,736,000 in 1998 and 1997, respectively ................. 7,035,000 5,543,000 Product licenses, net of accumulated amortization of $879,000 and $469,000 in 1998 and 1997, respectively ................ 6,163,000 6,481,000 Other assets, net of accumulated amortization of $3,441,000 and $2,763,000 in 1998 and 1997, respectively .............. 7,644,000 5,389,000 ------------- ------------- $ 108,587,000 $ 103,051,000 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable ........................................... $ 5,090,000 $ 4,937,000 Accrued payroll and related expenses ....................... 3,790,000 4,199,000 Other accrued liabilities .................................. 3,515,000 2,986,000 Income taxes payable ....................................... 706,000 861,000 Billings in excess of costs and fees ....................... 417,000 87,000 Long-term debt, due within one year ........................ 278,000 259,000 ------------- ------------- Total current liabilities ............................. 13,796,000 13,329,000 Long-term debt, net of current portion ...................... 1,524,000 1,616,000 Minority interest ........................................... 1,638,000 1,723,000 Other liabilities ........................................... 12,000 24,000 Shareholders' equity: Common stock, $.001 par value, 20,000,000 shares authorized, 11,715,093 and 11,726,754 shares issued and outstanding in 1998 and 1997, respectively ........................... 8,000 8,000 Additional paid-in capital ................................. 29,661,000 30,633,000 Accumulated other comprehensive loss ....................... (388,000) (1,906,000) Retained earnings .......................................... 62,336,000 59,811,000 ------------- ------------- 91,617,000 88,546,000 Less cost of treasury shares (133,302 shares in 1997) ...... -- (2,187,000) ------------- ------------- Total shareholders' equity ............................ 91,617,000 86,359,000 ------------- ------------- $ 108,587,000 $ 103,051,000 ============= ============= 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, 1998 1997 1998 1997 ------------ ------------ ------------ ------------ Revenues: Software protection products ................ $ 14,250,000 $ 14,741,000 $ 42,871,000 $ 44,688,000 Information security products ............... 12,498,000 7,314,000 35,650,000 20,983,000 Ion beam surface treatment .................. 9,000 201,000 27,000 212,000 ------------ ------------ ------------ ------------ Total revenues ......................... 26,757,000 22,256,000 78,548,000 65,883,000 Operating expenses: Cost of software protection products ........ 4,354,000 4,128,000 11,711,000 12,902,000 Cost of information security products ....... 9,620,000 5,975,000 27,639,000 16,930,000 Cost of ion beam surface treatment .......... 1,000 2,000 21,000 419,000 Selling, general and administrative ......... 6,551,000 5,305,000 18,526,000 16,021,000 Research and development .................... 1,924,000 2,010,000 6,708,000 5,985,000 Goodwill amortization ....................... 651,000 429,000 1,869,000 1,289,000 Provision for restructured operations ....... (222,000) -- 98,000 -- Acquired research and development ........... -- -- 4,000,000 -- ------------ ------------ ------------ ------------ Total operating expenses ............... 22,879,000 17,849,000 70,572,000 53,546,000 ------------ ------------ ------------ ------------ Operating income ............................. 3,878,000 4,407,000 7,976,000 12,337,000 Interest income .............................. 338,000 442,000 922,000 1,287,000 Interest expense ............................. (53,000) (52,000) (162,000) (192,000) Other income (expense) ....................... 138,000 (73,000) (852,000) 276,000 ------------ ------------ ------------ ------------ Income before provision for taxes ............ 4,301,000 4,724,000 7,884,000 13,708,000 Provision for income taxes ................... 1,626,000 1,937,000 5,359,000 5,675,000 ------------ ------------ ------------ ------------ Net income ................................... $ 2,675,000 $ 2,787,000 $ 2,525,000 $ 8,033,000 ============ ============ ============ ============ Net income per share: Basic ....................................... $ 0.23 $ 0.24 $ 0.22 $ 0.69 ============ ============ ============ ============ Diluted ..................................... $ 0.22 $ 0.24 $ 0.21 $ 0.68 ============ ============ ============ ============ Shares used in computing net income per share: Basic ....................................... 11,715,000 11,553,000 11,686,000 11,635,000 ============ ============ ============ ============ Diluted ..................................... 12,136,000 11,823,000 12,051,000 11,840,000 ============ ============ ============ ============ See accompanying notes. 4 5 RAINBOW TECHNOLOGIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited) Three months Ended Nine Months Ended September 30, September 30, September 30, September 30, 1998 1997 1998 1997 ------------- ------------- ------------- ------------- Net income ...................................... $ 2,675,000 $ 2,787,000 $ 2,525,000 $ 8,033,000 Other comprehensive income (loss): Foreign currency translation adjustment ....... 1,323,000 1,567,000 2,448,000 (2,328,000) Unrealized gain (loss) on securities .......... 2,000 (112,000) (2,000) (327,000) Reclassification adjustment ................... -- -- (6,000) -- ----------- ----------- ----------- ----------- Other comprehensive income (loss), before income taxes ......................... 1,325,000 1,455,000 2,440,000 (2,655,000) Provision for income taxes related to other comprehensive income (loss) ................. (501,000) (582,000) (922,000) 1,062,000 ----------- ----------- ----------- ----------- Other comprehensive income (loss), net of taxes 824,000 873,000 1,518,000 (1,593,000) ----------- ----------- ----------- ----------- Comprehensive income ........................... $ 3,499,000 $ 3,660,000 $ 4,043,000 $ 6,440,000 =========== =========== =========== =========== See accompanying notes. 5 6 RAINBOW TECHNOLOGIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) Nine Months Ended September 30, September 30, 1998 1997 ------------ ------------ Cash flows from operating activities: Net income ............................................... $ 2,525,000 $ 8,033,000 Adjustments to reconcile net income to net cash provided by operating activities: Amortization ............................................ 2,841,000 2,041,000 Depreciation ............................................ 2,177,000 1,504,000 Provision for loss in contract .......................... -- 400,000 Change in deferred income taxes ......................... (78,000) (1,153,000) Allowance for doubtful accounts ......................... (165,000) 90,000 Loss from retirement of property, plant, and equipment .. 47,000 34,000 Write-down of long-term investment ...................... 1,320,000 -- Share in investee's loss ................................ -- 45,000 Minority interest in subsidiary's earnings .............. (241,000) (392,000) Write-off of capitalized software ....................... 784,000 -- Provision for restructured operations ................... 98,000 -- Write-off of in-process research and development ........ 4,000,000 -- Changes in operating assets and liabilities: Accounts receivable ................................... (1,080,000) 2,073,000 Inventories ........................................... (951,000) (1,733,000) Unbilled costs and fees ............................... 1,782,000 (152,000) Prepaid expenses and other current assets ............. 23,000 (232,000) Accounts payable ...................................... 121,000 (455,000) Accrued liabilities ................................... (1,887,000) (80,000) Billings in excess of costs and fees .................. 330,000 (227,000) Income taxes payable .................................. 591,000 (2,765,000) ------------ ------------ Net cash provided by operating activities ............ 12,237,000 7,031,000 Cash flows from investing activities: Purchase of marketable securities ........................ (5,336,000) (9,930,000) Sale of marketable securities ............................ 4,216,000 16,211,000 Purchases of property, plant, and equipment .............. (3,280,000) (5,732,000) Net cash paid for acquisition of Wyatt River Software, Inc .......................................... (7,871,000) -- Other non-current assets ................................. (1,597,000) (775,000) Acquired cash from QM Technologies, Inc. ................. -- 556,000 Capitalized software development costs ................... (872,000) (1,150,000) ------------ ------------ Net cash used in investing activities ................ (14,740,000) (820,000) Cash flows from financing activities: Exercise of Rainbow common stock options ................. 1,439,000 936,000 Investment by new partners in QM Technologies, Inc. and Rainbow Technologies, Russia ....................... 998,000 -- Payment of long-term debt ................................ (205,000) (214,000) Purchase of treasury stock ............................... (662,000) (814,000) Purchase and retirement of common stock .................. -- (2,767,000) ------------ ------------ Net cash provided by (used in) financing activities .. 1,570,000 (2,859,000) Effect of exchange rate changes on cash ................... 896,000 (348,000) ------------ ------------ Net (decrease) increase in cash and cash equivalents ...... (37,000) 3,004,000 Cash and cash equivalents at beginning of period .......... 29,556,000 31,735,000 ------------ ------------ Cash and cash equivalents at end of period ................ $ 29,519,000 $ 34,739,000 ============ ============ Supplemental disclosure of cash flow information: Income taxes paid ........................................ $ 4,679,000 $ 8,748,000 Interest paid ............................................ 159,000 199,000 See accompanying notes. 6 7 RAINBOW TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 (Unaudited) 1. Basis of presentation The accompanying financial statements consolidate the accounts of Rainbow Technologies, Inc. (the Company) and its wholly-owned subsidiaries. All significant inter-company balances and transactions have been eliminated. Certain amounts previously reported have been reclassified to conform with the 1998 presentation. In the opinion of the Company's management, the accompanying condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial position at September 30, 1998 and results of operations for the three and nine months ended September 30, 1998 and 1997. 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, 1997 Annual Report on Form 10-K. Results of operations for the three and nine months ended September 30, 1998 are not necessarily indicative of results to be expected for the full year. The Company has subsidiaries in the United Kingdom, Germany, France, Belarus, the Netherlands, India and Russia. 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 statements of operations of those subsidiaries are translated into U.S. dollars at the weighted average exchange rates for the respective periods presented. As of January 1, 1998, the Company adopted Statement 130, "Reporting Comprehensive Income" (SFAS No. 130). SFAS No. 130 establishes new rules for the reporting and display of comprehensive income and its components; however, the adoption of this Statement had no impact on the Company's net income or shareholders' equity. SFAS 130 requires unrealized gains or losses on the Company's available-for-sale securities and foreign currency translation adjustments, which prior to adoption were reported separately in shareholders' equity to be included in other comprehensive income. Prior year financial statements have been reclassified to conform to the requirements of SFAS 130. During the three and nine months ended September 30, 1998 total comprehensive income amounted to $3,499,000 and $4,043,000 respectively. The total comprehensive income for the three and nine months ended September 30, 1997 amounted to $3,660,000 and $6,440,000, respectively. In June 1997, the Financial Accounting Standards Board (FASB) issued Statement No. 131, "Disclosures about Segments of an Enterprise and Related Information," (SFAS No. 131), which requires publicly-held companies to report financial and descriptive information about its operating segments in financial statements issued to shareholders for interim and annual periods. The statement also requires additional disclosures with respect to products and services, geographical areas of operations, and major customers. The company will adopt SFAS No. 131 effective December 31, 1998 and will restate all periods presented. 7 8 2. Earnings per share The Company adopted Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS No. 128) effective December 31, 1997. SFAS No. 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the assumed conversion of all diluted securities. Earnings per share amounts for all periods presented have been calculated in accordance with the requirements of SFAS No. 128. 3. Government Contracts The Company is both a prime contractor and a 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. 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, December 31, 1998 1997 ------------ -------------- Raw materials $ 722,000 $ 271,000 Work in process 500,000 761,000 Finished goods 4,306,000 4,257,000 Inventoried costs related to long-term contracts 6,127,000 4,491,000 ------------ -------------- $ 11,655,000 $ 9,780,000 ============ =========== 8 9 5. Acquisitions In March 1998, the Company purchased certain assets from Elan Computer Group, Inc. ("Elan") in a cash transaction. The assets included Elan's license manager software technology, which the Company had previously licensed from Elan, and Elan's end-user maintenance and support relationships. In February 1998, the Company acquired Wyatt River Software, Inc. ("Wyatt River"), including its "LicenseServe" and "LicenseTrack" technology in a cash transaction. The Company will also pay the Wyatt River shareholders an additional sum based upon sales of Wyatt River technology through June 30, 1999. 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. Also included in other assets are capitalized software development costs. Based on the Company's product development process, technological feasibility is established upon completion of a working model. Amortization of capitalized software development costs commence when the products are available for general release to customers and are determined using the straight line method over the expected useful lives of the respective products. These amounts are written off if it is determined that the projects can not be brought to market. 7. Stock split On March 17, 1998 the Company announced that its Board of Directors approved a 3-for-2 split of its common stock. The effective date was July 1, 1998 and the payout date was July 15, 1998. These financial statements have been adjusted to reflect the impact of the stock split. 8. Subsequent Event Globetrotter Software, Inc. filed suit against Rainbow Technologies, Inc and Rainbow Technologies North America, Inc. on or about September 1, 1998, alleging that Rainbow Technologies' Sentinel LM product infringes US Patent No. 5,390,297 which Globetrotter Software, Inc. purchased from another company. Rainbow Technologies, Inc. believes that the Sentinel LM product does not infringe on this patent and intends to vigorously defend the suit. The Company does not believe the outcome will have a material adverse effect on the financial position of the company. 9 10 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. RESULTS OF OPERATIONS (dollars in thousands) Three Months Ended September 30, -------------------------------- 1998 1997 -------- -------- Revenues Software Protection Products $ 14,250 $ 14,741 Information Security Products 12,498 7,314 IBEST 9 201 -------- -------- Consolidated $ 26,757 $ 22,256 ======== ======== Operating Income Software Protection Products $ 2,406 $ 4,176 Information Security Products 1,697 303 IBEST (225) (72) -------- -------- Consolidated $ 3,878 $ 4,407 ======== ======== Nine Months Ended September 30, ------------------------------- 1998 1997 -------- -------- Revenues Software Protection Products $ 42,871 $ 44,688 Information Security Products 35,650 20,983 IBEST 27 212 -------- -------- Consolidated $ 78,548 $ 65,883 ======== ======== Operating Income Software Protection Products $ 4,424 $ 11,616 Information Security Products 4,251 1,718 IBEST (699) (997) -------- -------- Consolidated $ 7,976 $ 12,337 ======== ======== REVENUES Revenues from software protection products for the three and nine months ended September 30, 1998 decreased by 3% and 4%, respectively, when compared to the same period in 1997. The overall business has been impacted by the economic problems in Asia and other emerging markets as well as by the erosion of average selling prices. Revenues from Europe increased by 5% while revenues from the US decreased by 9% for the nine months ended September 30, 1998 compared with the same period in 1997. The decrease in US revenues is due to slower sales to US customers who export their products to Asia as well as lower direct sales to Asian distributors. The average selling price per product in the quarter ended September 30, 1998 decreased approximately 3% when compared to the same period in 1997. Unit volume for the three months ended September 30, 1998 decreased by 6% while unit volume for the nine months ended September 30, 1998 increased by 4% when compared to the corresponding 1997 periods. The decrease in average selling prices and the increase in unit volume is primarily due to a change in customer mix. 10 11 Revenues from information security products for the three and nine months ended September 30, 1998 increased by 71% and 70%, respectively, when compared to the same period in 1997. The revenue growth was primarily due to strong demand for network security products. GROSS PROFIT Gross profit from software protection products for the three months ended September 30, 1998 decreased to 69% of revenues compared to 72% of revenues for the corresponding period in 1997. For the nine months ended September 30, 1998 gross profit increased to 73% of revenues compared to 71% of revenues for the same period in 1997. The decrease in the gross profit was due to several inventory adjustments. Gross profit from information security products for the three months ended September 30, 1998 increased to 23% of revenues compared to 18% for the three months ended September 30, 1997. Gross profit from information security products for the nine months ended September 30, 1998 decreased to 22% of revenues compared to 19% for the nine months ended September 30, 1997. The decrease for the nine month period is due to the change in mix from predominantly contract revenues to predominantly product revenues. SELLING, GENERAL AND ADMINISTRATIVE Selling, general and administrative expenses for the three and nine months ended September 30, 1998 increased by 23% and 16%, respectively, when compared to the corresponding 1997 period. The increase was due to increased staffing and professional expenses, new product introductions in software protection and information security products, and higher marketing expenses. RESEARCH AND DEVELOPMENT Total research and development expenses for the three months ended September 30, 1998 decreased by 4% when compared to the corresponding 1997 period. The decrease in research and development expenses was due primarily to the deferral of non-recurring engineering expenses related to several projects. Total research and development expenses for the nine months ended September 30, 1998 increased by 12% when compared to the corresponding 1997 period. The increase was primarily due to the write-off of previously capitalized computer software development expenses of $784,000 in the first quarter of 1998. PROVISION FOR RESTRUCTURED OPERATIONS The sum of $98,000 for the nine months ended September 30, 1998 represents the Company's estimate of the costs of restructuring certain operations. Approximately $222,000 previously reserved for cancellation of the lease on a building was reversed in the current quarter when the Company was successful in securing a third party to assume the lease. ACQUIRED RESEARCH AND DEVELOPMENT Based on the results of third-party appraisals, the Company recorded charges of $4,000,000 in the three months ended March 31, 1998 to expense in-process research and development costs related to the acquisition of Wyatt River. In the opinion of management and the appraiser, the acquired in-process research and development had not yet reached technological feasibility and had no alternative future use. 11 12 OTHER INCOME (EXPENSE) Interest income for the quarter ended September 30, 1998 decreased by 24% compared to $442,000 for the quarter ended September 30, 1997 because of lower balances of cash and cash equivalents. The Company recorded $65,000 in other income related to the minority interest in QMT for the three months ended September 30, 1998 compared to a loss of $36,000 in the corresponding period in 1997. The income of $65,000 is a result of adjustments to prior quarters' losses. QMT received additional investment of $962,000 from a third party during the three months ended September 30, 1998. PROVISION FOR INCOME TAXES The effective tax rate was 38% for the three months ended September 30, 1998 compared to 41% for the corresponding period in 1997. The effective tax rate for the first nine months of 1998 was negatively affected due to non-deductibility of the charges related to acquired in-process research and development, and a timing difference related to the write-off of the original investment in Elan. Excluding the effect of these charges, the effective tax rate was 41% for the nine months ended September 30, 1998 and 1997. The lower tax rate is due to the benefits of restructuring foreign operations. 12 13 LIQUIDITY AND CAPITAL RESOURCES The Company's principal sources of operating funds have been from operations and proceeds from sales of the Company's equity securities. The Company's cash flow from operations for the nine months ended September 30, 1998 and 1997 were $12,237,000 and $7,031,000, respectively. The increase in cash flow from operations is attributable to benefits from overall operating efficiencies of its information security product line. The Company intends to use its capital resources to expand its product lines and for the acquisition of additional products and technologies. The Company has no significant capital commitments or requirements at this time. The Company's use of cash includes purchases of property, plant and equipment, repayment of long-term debt and investment in long-term assets. Management believes the Company's current working capital of $55,885,000 and anticipated working capital to be generated by future operations will be sufficient to support the Company's requirement for at least the next twelve months. IMPACT OF YEAR 2000 Year 2000 Compliance. Many existing computer systems and applications, and other control devices, use only two digits to identify a year in the date field, without considering the impact of the upcoming change in the century. Others do not correctly process "leap year" dates. As a result, such systems and applications could fail or create erroneous results unless corrected to process data related to the year 2000 and beyond. The problems are expected to increase in frequency and severity as the year 2000 approaches, and are commonly referred to as the "Year 2000 Problem." The Company relies on its systems, applications and devices in operating and monitoring all major aspects of its business, including systems (such as general ledger, accounts payable, and payroll modules), customer services, infrastructure, embedded computer chips, networks and telecommunications equipment. The Company also relies, directly and indirectly, on external systems of business enterprises such as customers, suppliers, creditors, financial organizations and governmental entities, both domestic and international, for accurate exchange of data. The Company is continuing to assess the impact that the Year 2000 Problem may have on its operations and has identified the following four key areas of its business that may be affected: Products: The Company has completed Year 2000 compliance testing on its currently supported products. The products were classified into two categories: category I having no date related processing and category II having internal date clocks which will properly handle and roll-over calendar data. Based upon the evaluation and testing completed, the Company believes that its currently supported products are Year 2000 compliant. The Company's testing did not assess compliance of products modified by customers or third parties nor did it assess compliance of products connected to individual customer work environments. The Company has listed its currently supported products and test data on its Internet site. Internal Business Systems. The Year 2000 Problem could affect the systems, transaction processing computer applications and devices used by the Company to operate and monitor all major aspects of its business, including financial systems (such as general ledger, accounts payable and payroll), customer services, infrastructure, materials requirement planning, master production scheduling, networks and telecommunications systems. The Company has completed its assessment phase and believes that it has identified substantially all of the major systems, software applications and related equipment used in connection with its internal operations that must be modified or upgraded in order to minimize the possibility of a material disruption to its business. The Company is currently in its remediation phase of modifying and upgrading all affected systems and expects to complete this phase by the end of the first quarter of 1999. The Company estimates that it will be Year 2000 compliant by the end of the fourth quarter of 1999. However, any unforeseen problems which occur during the testing phase may adversely effect the Company's Year 2000 readiness. 13 14 Third-Party Suppliers. The Company relies, directly and indirectly, on external systems utilized by its suppliers for products used in the manufacture of its products. The Company will request confirmation from its suppliers of their Year 2000 compliance; however, there can be no assurance that these suppliers will resolve any or all Year 2000 Problems with their systems in a timely manner. Any failure of these third parties to resolve their Year 2000 Problems in a timely manner could result in the material disruption of the business of the Company. Any such disruption could have a material adverse effect on the Company's business, financial condition and results of operations. Facility Systems. Systems such as heating, sprinklers, elevators, test equipment and security systems at the Company's facilities may also be affected by Year 2000 Problem. The Company has contacted the Irvine facility owners seeking assurances of Year 2000 compliance. The Company has not yet assessed its facilities at other locations. The Company has incurred approximately $150,000 as of the nine-month period ended September 30, 1998, to address its Year 2000 issues. The Company presently estimates that the total cost of addressing its Year 2000 issues will be approximately $250,000. This estimate was derived utilizing numerous assumptions. First, the current staff is adequate to finish the project. Second, the product is already Year 2000 compliant. Next, to the best of its knowledge, the Company estimates that approximately half of the work is already done and that no system changes are anticipated. However, there can be no guarantee that these assumptions are accurate, and actual results could differ materially from those anticipated. The Company recognizes the need for developing contingency plans to address the Year 2000 issues that may pose a significant risk to its on-going operations. Such plans could include the implementation of manual procedures to compensate for system deficiencies. During the remediation phase of the internal business systems, the Company will be evaluating potential failures and attempt to develop responses in a timely manner. However, there can be no assurance that any contingency plans evaluated and potentially implemented by the Company would be adequate to meet the Company's needs without materially impacting its operations, that any such plan would be successful or that the Company's results of operations would not be materially and adversely affected by the delays and inefficiencies inherent in conducting operations in an alternative manner. 14 15 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 11, 1998 RAINBOW TECHNOLOGIES, INC. By: /s/ Patrick Fevery --------------------------------- Chief Financial Officer 15