================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1998 or TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ...... to ...... Commission file number 0-19654 - -------------------------------------------------------------------------------- VITESSE SEMICONDUCTOR CORPORATION (Exact name of registrant as specified in its charter) - -------------------------------------------------------------------------------- Delaware 77-0138960 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 741 CALLE PLANO Camarillo, CA 93012 (Address of principal executive offices) (805) 388-3700 (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 and (2) has been subject to such filing requirements for the past 90 days: Yes (X) NO ( ). As of June 30, 1998, there were 73,224,698 shares of $0.01 par value common stock outstanding. ================================================================================ VITESSE SEMICONDUCTOR CORPORATION TABLE OF CONTENTS ----------------- Page Number PART I FINANCIAL INFORMATION Item 1 Financial Statements: Consolidated Balance Sheets as of June 30, 1998 2 and September 30, 1997 Consolidated Statements of Operations for the Three 3 Months ended June 30, 1998, June 30, 1997, and March 31, 1998, and the Nine Months ended June 30, 1998 and June 30, 1997. Consolidated Statements of Cash Flows for the Nine 4 Months ended June 30, 1998 and June 30, 1997 Notes to Consolidated Financial Statements 5 Item 2 Management's Discussion and Analysis of 6 Financial Condition and Results of Operations PART II OTHER INFORMATION Item 6 Exhibits and Reports on Form 8-K 12 1 PART I FINANCIAL INFORMATION VITESSE SEMICONDUCTOR CORPORATION CONSOLIDATED BALANCE SHEETS (in thousands, except share data) June 30, 1998 Sept. 30, 1997 ------------- -------------- (Unaudited) ASSETS Current assets: Cash and cash equivalents $ 64,435 $ 97,358 Short-term investments 85,785 58,486 Accounts receivable, net 34,725 21,072 Inventories, net: Raw material 3,397 2,421 Work in process 8,884 6,762 Finished goods 2,702 2,626 -------- -------- 14,983 11,809 Prepaid expenses 2,782 1,121 Deferred tax asset 17,700 14,800 -------- -------- Total current assets 220,410 204,646 -------- -------- Property and equipment, net 55,227 41,684 Restricted long-term deposits 65,736 45,556 Other assets 220 394 -------- -------- $341,593 $292,280 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current installments of capital lease obligations and term loans $ 148 $ 256 Accounts payable 15,003 19,758 Accrued expenses and other current liabilities 12,297 7,017 -------- -------- Total current liabilities 27,448 27,031 -------- -------- Capital lease obligations and term loans, less current installments 33 147 Shareholders' equity: Common stock, $.01 par value. Authorized 100,000,000 shares; issued and outstanding 73,224,698 shares on June 30, 1998, and 71,827,476 shares on Sept. 30, 1997 732 718 Additional paid-in capital 289,444 276,810 Retained earnings (accumulated deficit) 23,936 (12,426) -------- -------- Net shareholders' equity 314,112 265,102 -------- -------- $341,593 $292,280 ======== ======== 2 VITESSE SEMICONDUCTOR CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (in thousands, except share and per share data) Three Months Ended Nine Months Ended --------------------------------------------- ----------------------------- June 30, 1998 June 30, 1997 Mar. 31, 1998 June 30, 1998 June 30, 1997 ------------- ------------- ------------- ------------- ------------- Revenues, net $ 46,108 $ 27,607 $ 40,212 $ 121,021 $ 74,001 Costs and expenses: Cost of revenues 18,168 11,875 16,012 48,374 32,566 Engineering, research and development 7,375 4,427 6,462 19,392 11,821 Selling, general and administrative 5,635 3,684 4,849 14,746 9,889 ----------- ----------- ----------- ----------- ----------- Total costs and expenses 31,178 19,986 27,323 82,512 54,276 ----------- ----------- ----------- ----------- ----------- Income from operations 14,930 7,621 12,889 38,509 19,725 ----------- ----------- ----------- ----------- ----------- Other income, net 2,467 2,329 2,181 6,931 5,540 ----------- ----------- ----------- ----------- ----------- Income before income taxes 17,397 9,950 15,070 45,440 25,265 Income taxes 3,470 995 3,014 9,078 2,525 ----------- ----------- ----------- ----------- ----------- Net income $ 13,927 $ 8,955 $ 12,056 $ 36,362 $ 22,740 =========== =========== =========== =========== =========== Net income per share Basic $ 0.19 $ 0.13 $ 0.17 $ 0.50 $ 0.34 =========== =========== =========== =========== =========== Diluted $ 0.18 $ 0.12 $ 0.15 $ 0.46 $ 0.30 =========== =========== =========== =========== =========== Basic weighted average common shares outstanding 72,978,699 70,291,811 72,355,878 72,433,897 67,417,033 =========== =========== =========== =========== =========== Diluted weighted average common shares outstanding 79,347,508 77,405,325 78,776,600 78,702,546 75,180,427 =========== =========== =========== =========== =========== 3 VITESSE SEMICONDUCTOR CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (in thousands) Nine Months Ended ------------------------------- June 30, 1998 June 30, 1997 -------------- -------------- Cash flows from operating activities: Net income $ 36,362 $ 22,740 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 9,591 4,734 (Increase) decrease in: Receivables, net (13,653) (1,071) Inventories (3,174) (1,028) Prepaid expenses (1,661) (122) Other assets 174 42 Increase (decrease) in: Accounts payable (4,755) 5,090 Accrued expenses and other current liabilities 10,106 5,232 -------- -------- Net cash provided by operating activities 32,990 35,617 -------- -------- Cash flows from investing activities: Short-term investments (27,299) (47,777) Capital expenditures (23,134) (17,306) Restricted long-term investment (20,180) (16,800) -------- -------- Net cash used in investing activities (70,613) (81,883) -------- -------- Cash flows from financing activities: Principal payments under capital lease obligations & term loans (222) (718) Proceeds from issuance of common stock, net 4,922 122,349 -------- -------- Net cash provided by financing activities 4,700 121,631 -------- -------- Net (decrease) increase in cash & cash equivalents (32,923) 75,365 Cash & cash equivalents at beginning of period 97,358 52,436 -------- -------- Cash & cash equivalents at end of period $ 64,435 $127,801 ======== ======== Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 30 $ 153 ======== ======== Income taxes $ 1,001 $ 81 ======== ======== 4 VITESSE SEMICONDUCTOR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. General The accompanying consolidated financial statements include the accounts of Vitesse Semiconductor Corporation and its subsidiaries. All intercompany accounts and transactions have been eliminated. In management's opinion, all adjustments (consisting only of normal recurring accruals) which are necessary for a fair presentation of financial condition and results of operations are reflected in the attached interim financial statements. All amounts are unaudited except the September 30, 1997 balance sheet. This report should be read in conjunction with the audited financial statements presented in the 1997 Annual Report. Footnotes and other disclosures which would substantially duplicate the disclosures in the Company's audited financial statements for fiscal year 1997 contained in the Annual Report have been omitted. The interim financial information herein is not necessarily representative of the results to be expected for any subsequent period. In February 1997, the Financial Accounting Standards Board issued SFAS No. 128, "Earnings Per Share." SFAS No. 128 specifies new standards designed to improve the earnings per share (EPS) information provided in financial statements by simplifying the existing computational guidelines, revising the disclosure requirements and increasing the comparability of EPS data on an international basis. Some of the changes made to simplify the EPS computations include: (a) eliminating the presentation of primary EPS and replacing it with basic EPS, for which common stock equivalents are not considered, (b) eliminating the modified treasury stock method and 3% materiality provision and (c) revising the contingent share provision and the supplemental EPS data requirements. SFAS No. 128 also makes a number of changes to existing disclosure statements issued for periods ending after December 15, 1997, including interim periods. All earnings per share amounts for all periods have been presented and, where necessary, restated to conform to SFAS No. 128 requirements. NOTE 2. YEAR 2000 PROBLEM The "Year 2000 Problem" is the result of computer programs being written using two digits rather than four to define the applicable year. This can affect both information technology ("IT") and non-IT systems, as non-IT systems typically include embedded technology such as microcontrollers. The Company has commenced taking actions to correct internal IT systems, and is in the early stages of assessing any related problems of non-IT systems. The Company expects all IT and non-IT systems to be compliant by the end of fiscal 1999. The Company is also in the early stages of conducting an audit of its third party suppliers as to the Year 2000 compliance of their systems. The Company does not believe that the cost of these actions will have a material adverse affect on the Company's business, financial condition or operating results. Note 3. Stock Split On April 21, 1998, the Board of Directors approved a 2 for 1 stock split of the Company's Common Stock that was effected on May 26, 1998. All references to the number of common shares, weighted average number of common shares and per share data for all periods presented have been adjusted to reflect the stock split. 5 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth in "Management's Discussion and Analysis of Financial Condition and Results of Operations" below includes "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), in particular, in "Results of Operations-- Revenues and Income Taxes," and in "Liquidity and Capital Resources--Investing and Financing Activities," and is subject to the safe harbor created by that section. Factors that realistically could cause results to differ materially from those projected in the forward looking statements are set forth below in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Risk Factors." RESULTS OF OPERATIONS Revenues Total revenues in the third quarter of fiscal 1998 were $46,108,000, a 67% increase over the $27,607,000 recorded in the third quarter of fiscal 1997 and a 15% increase over the $40,212,000 recorded in the prior quarter. For the nine months ended June 30, 1998, total revenues were $121,021,000, a 64% increase over the $74,001,000 recorded in the nine months ended June 30, 1997. The increase in total revenues in the third quarter of 1998 and in the nine months ended June 30, 1998 was due to an increase in production revenues as a result of increased shipments to customers in the communications and automatic test equipment markets. Cost of Revenues Cost of revenues as a percentage of total revenues in the third quarter of fiscal 1998 was 39.4% compared to 43.0% in the third quarter of fiscal 1997 and 39.8% in the prior quarter. For the nine months ended June 30, 1998 and 1997, cost of revenues as a percentage of total revenues was 40.0% and 44.0%, respectively. The decrease in cost of revenues as a percentage of total revenues was due to a reduction in per unit costs associated with increased production, as well as increased manufacturing yields. The Company's manufacturing yields vary significantly among products, depending on a particular IC's complexity and the Company's experience in manufacturing it. Historically, the Company has experienced difficulties achieving acceptable yields on some ICs, which has resulted in shipment delays. The Company's overall yields are lower than yields experienced in a silicon process because of the large number of different products manufactured in limited volume and because the Company's H-GaAs process technology is significantly less developed. The Company expects that many of its current and future products may never be produced in volume. Regardless of the process technology used, the fabrication of semiconductors is a highly complex and precise process. Defects in masks, impurities in the materials used, contamination of the manufacturing environment, equipment failure and other difficulties in the fabrication process can cause a substantial percentage of wafers to be rejected or numerous die on each wafer to be nonfunctional. 6 Because the majority of the Company's costs of manufacturing are relatively fixed, maintenance of the number of shippable die per wafer is critical to the Company's results of operations. Yield decreases can result in substantially higher unit costs and may result in reduced gross profit and net income. There can be no assurance that the Company will not suffer periodic yield problems in connection with new or existing products which could cause the Company's business, operating results and financial condition to be materially adversely affected. Inventory is valued at the lower of cost or market. Because allocable manufacturing costs can be high, new product inventory is often valued at market. In addition, a portion of work-in-process inventory consists of wafers in various stages of fabrication. Consequently, the Company estimates yields per wafer in order to estimate the value of inventory. If yields are materially different than projected, work-in-process inventory may need to be revalued. There can be no assurance that such adjustments will not occur in the future and have a material adverse effect on the Company's results of operations. Engineering, Research and Development Costs Engineering, research and development expenses were $7,375,000 in the third quarter of fiscal 1998 compared to $4,427,000 in the third quarter of fiscal 1997 and $6,462,000 in the prior quarter. For the nine months ended June 30, 1998, engineering, research and development costs were $19,392,000 compared to $11,821,0000 in the nine months ended June 30, 1997. The increases were principally due to increased headcount and higher costs to support the Company's continuing efforts to develop new products. As a percentage of total revenues, engineering, research and development costs were 16% in the third quarters of 1998 and 1997, and in the prior quarter, and in the nine months ended June 30, 1998 and 1997. The Company's engineering, research and development costs are expensed as incurred. Selling, General and Administrative Expenses Selling, general and administrative expenses (SG&A) were $5,635,000 in the third quarter of 1998, compared to $3,684,000 in the third quarter of 1997 and $4,849,000 in the prior quarter. For the nine months ended June 30, 1998, SG&A expenses were $14,746,000 compared to $9,889,000 in the same period in 1997. The increase in SG&A expenses was due to increased headcount and salary increases. As a percentage of total revenues, SG&A expenses decreased to 12% in the third quarter of 1998 from 13% in the third quarter of 1997 and was unchanged from the prior quarter. For the nine months ended June 30, 1998, SG&A expenses as a percentage of total revenues decreased to 12% from 13% in the comparable period a year ago. These decreases were the result of the Company's revenues growing faster than SG&A expenses. Other Income, Net Other income consists of interest income, net of interest and other expenses. Other income increased to $2,467,000 in the third quarter of fiscal 1998 from $2,329,000 in the third quarter of 1997 and $2,181,000 in the prior quarter. For the nine months ended June 30, 1998, other income increased to $6,931,000 from $5,540,000 in the comparable period a year ago. These increases were the result of a higher average cash balance in the third quarter of fiscal 1998 as 7 compared to the third quarter of 1997, and the first nine months of fiscal 1998 as compared to the same period of fiscal 1997. Income Taxes The Company recorded a provision for income taxes in the amount of $3,470,000 in the third quarter of fiscal 1998 and $995,000 in the third quarter of fiscal 1997 principally for federal alternative minimum taxes, state income taxes, and taxes due to foreign jurisdictions. The Company has a net deferred tax asset balance in the amount of $17,700,000 as of June 30, 1998, net of a valuation allowance of $3,531,000. The Company has net operating loss carryforwards of $30,046,000 for federal income tax purposes. In determining the future realizability of deferred tax assets associated with net operating loss carryforwards, the Company has determined that it is more likely than not that it will fully realize the deferred tax asset. The Company has considered the full realization of the deferred tax asset in establishing the effective tax rate for fiscal 1998. LIQUIDITY AND CAPITAL RESOURCES Operating Activities The Company generated $32,990,000 and $35,617,000 from operating activities in the nine-month periods ended June 30, 1998 and 1997, respectively. Investing Activities Capital expenditures, principally for manufacturing and test equipment, were $23,134,000 in the nine-month period ended June 30, 1998 compared to $17,306,000 in the nine-month period ended June 30, 1997. The Company intends to continue investing in manufacturing, test and engineering equipment and currently expects to spend an additional $5 to $10 million for capital expenditures in fiscal 1998, which the Company intends to finance with working capital. Financing Activities In the nine month period ended June 30, 1998, the Company generated $4,700,000 in financing activities. Net proceeds from the issuance of common stock was $4,922,000, offset by $222,000 in payments on debt obligations. 8 FACTORS AFFECTING FUTURE OPERATING RESULTS CUSTOMER AND INDUSTRY CONCENTRATION The Company is, and intends to continue, focusing its sales efforts on a relatively small number of companies in the telecommunications, data communications and ATE markets that require high performance ICs. Certain of these companies are also competitors of Vitesse. VARIABILITY OF QUARTERLY RESULTS The Company's quarterly results of operations have varied significantly in the past and may continue to do so in the future. These variations have been due to a number of factors, including: the loss of major customers; variations in manufacturing yields; the timing and level of new product and process development costs; changes in inventory levels; changes in the type and mix of products being sold; changes in manufacturing capacity and variations in the utilization of this capacity; and customer design changes, delays or cancellations. The Company has also from time to time incurred significant new product and process development costs due to the Company's policy of expensing costs as incurred relating to the manufacture of new products and the development of new process technology. There can be no assurance that the Company will not incur such charges or experience revenue declines in the future. MANUFACTURING CAPACITY LIMITATIONS; NEW PRODUCTION FACILITY The Company has begun volume commercial production from its six-inch wafer fabrication facility in Colorado Springs, Colorado. The facility includes a 10,000 square foot Class 1 clean room with the capability for future expansion to 15,000 square feet. The successful continued operation of the new wafer fabrication facility, as well as the Company's overall production operations, will be subject to numerous risks. The Company has no prior experience with the operation of equipment or the processes involved in producing finished six-inch wafers, which differ significantly from those involved in the production of four-inch wafers. The Company does not have excess production capacity at its Camarillo facility to offset any failure of the new facility to meet planned production goals. As a result of these and other factors, the failure of the Company to successfully operate the new wafer fabrication facility could have a material adverse effect on its business, operating results or financial condition. The Company also has to effectively coordinate and manage the Colorado Springs and Camarillo facilities to successfully meet its overall production goals. The Company has limited experience in coordinating and managing full-scale production facilities which are located at different sites. The failure to successfully coordinate and manage the two sites could adversely affect the Company's overall production and could have a material adverse effect on its business, operating results or financial condition. COMPETITION The high-performance semiconductor market is highly competitive and subject to rapid technological change, price erosion and heightened international competition. The telecommunications, data communications and ATE industries, which are the primary target 9 markets for the Company, are also becoming intensely competitive because of deregulation and heightened international competition, among other factors. The Company currently competes against other GaAs-based companies such as Triquint Semiconductor, the GaAs fabrication operations of system companies such as Rockwell, and Silicon IC manufacturers employing ECL and BiCMOS technologies such as Fujitsu, Hewlett Packard, Motorola, National Semiconductor, Texas Instruments, Applied Micro Circuits Corporation and Synergy Semiconductor Corporation. Many of these companies have significantly greater financial, technical, manufacturing and marketing resources than the Company. In addition, in lower-frequency applications, the Company faces increasing competition from CMOS-based products, particularly as the performance of such products continues to improve. Competition in the Company's markets for high-performance ICs is primarily based on price/performance, product quality and the ability to deliver products in a timely fashion. Some prospective customers may be reluctant to adopt Vitesse's products because of perceived risks relating to GaAs technology. In addition, product qualification is typically a lengthy process and certain prospective customers may be unwilling to invest the time or incur the costs necessary to qualify suppliers such as the Company. Prospective customers may also have concerns about the relative speed, complexity and power advantages of the Company's products compared to more familiar ECL of BiCMOS semiconductors or about the risks associated with relying on a relatively small company for a critical sole-sourced component. ASIAN ECONOMIC ISSUES The Company's international business is subject to risks customarily encountered in foreign operations, including the recent financial turmoil in Asia. Although management believes that the financial turmoil in Asia will not have a material impact on the financial statements, there can be no assurance that the Company will not be affected by such economic issues in Asia. PRODUCT AND PROCESS DEVELOPMENT AND TECHNOLOGICAL CHANGE The market for the Company's products is characterized by rapid changes in both product and process technologies. The Company believes that its future success will depend, in part, upon its ability to continue to improve its product and process technologies and develop new technologies in order to maintain its competitive position, to adapt its products and processes to technological changes and to adopt emerging industry standards. There can be no assurance that the Company will be able to improve its product and process technologies and develop new technologies in a timely manner or that such improvements or developments will result in products that achieve market acceptance. The failure to successfully improve its existing technologies or develop new technologies in a timely manner could adversely affect the Company's business, operating results and financial condition. DEPENDENCE ON THIRD PARTIES The Company depends upon third parties for performing certain processes and providing a variety of components and materials necessary for the production of its H-GaAs ICs. A majority of the Company's ICs are packaged in plastic by third parties since the Company has no internal 10 capability to perform such plastic packaging. The balance of the Company's ICs are packaged in its Camarillo facility using customized ceramic packaging which is presently sole sourced. Other components and materials for H-GaAs ICs are available from only a limited number of sources. The inability to obtain sufficient sole- or limited-source services or components as required could result in delays or reductions in product shipments which could adversely affect the Company's business, operating results and financial condition. ENVIRONMENTAL REGULATIONS The Company is subject to a variety of federal, state and local governmental regulations related to the use, storage, discharge and disposal of toxic, volatile or otherwise hazardous chemicals used in its manufacturing process. Any failure to comply with present or future regulations could result in the imposition of fines on the Company, the suspension of production or a cessation of operations. In addition, such regulations could restrict the Company's ability to expand its facilities at its present location or could require the Company to acquire costly equipment or to incur other significant expenses to comply with environmental regulations or to clean up prior discharges. The Company uses significant amounts of water throughout its manufacturing process. Previous droughts in California have resulted in restrictions being placed on water use by manufacturers and residents in the states. In the event of future drought, reductions in water use may be mandated generally, and it is unclear how such reductions will be allocated among California's different users. No assurance can be given that near term reductions in water allocations to manufacturers will not occur, possibly requiring a reduction in the Company's level of production, and materially and adversely affecting the Company's operations. See "Business--Environmental Matters." MANAGEMENT OF GROWTH The management of the Company's growth requires qualified personnel and systems. In particular, the operation of the Company's wafer fabrication facility in Colorado Springs and its integration with the Company's Camarillo facility requires significant management, technical and administrative resources. There can be no assurance that the Company will be able to manage its growth or effectively integrate its Colorado Springs wafer fabrication facility, and failure to do so could have a material adverse effect on the Company's business, operating results or financial condition. DEPENDENCE ON KEY PERSONNEL The Company's success depends in part upon attracting and retaining the services of its managerial and technical personnel. The competition for qualified personnel is intense. There can be no assurance that the Company can retain its key managerial and technical employees or that it can attract, assimilate or retain other skilled technical personnel in the future, and failure to do so could have a material adverse effect on the Company's business, operating results or financial condition. 11 PART II OTHER INFORMATION Item 6. Exhibits & Reports on Form 8-K (A) EXHIBITS Exhibit 27 Financial Data Schedule. (B) REPORTS ON FORM 8-K None. 12 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. VITESSE SEMICONDUCTOR CORPORATION August 12, 1998 By: /s/ Eugene F. Hovanec ------------------------------- Eugene F. Hovanec Vice President, Finance and Chief Financial Officer 13