============================================================================== UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ___________________ FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended 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 No. 0-23596 ___________________ C-CUBE MICROSYSTEMS INC. (Exact name of registrant as specified in its charter) Delaware 77-0192108 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1778 McCarthy Boulevard Milpitas, California 95035 (Address and zip code of principal executive offices) Registrant's telephone number, including area code: (408) 490-8000 Former name, former address and former fiscal year, if changed since last year: N/A 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. [X] Yes [ ] No Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. As of April 30, 1999, 39,147,956 shares of the registrant's Common Stock were outstanding. ============================================================================== C-CUBE MICROSYSTEMS INC. TABLE OF CONTENTS Page Part I. Financial Information Item 1. Financial Statements: Condensed Consolidated Balance Sheets March 31, 1999 and December 31, 1998................... 2 Condensed Consolidated Statements of Income Quarter ended March 31, 1999 and 1998.................. 3 Condensed Consolidated Statements of Cash Flows Quarter ended March 31, 1999 and 1998.................. 4 Notes to Condensed Consolidated Financial Statements... 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................... 8 Item 3. Quantitative and Qualitative Disclosures About Market Risk............................................ 15 Part II. Other Information Item 1. Legal Proceedings...................................... 16 Item 2. Changes in Securities and Use of Proceeds.............. 16 Item 3. Defaults Upon Senior Securities........................ 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 PART I. FINANCIAL INFORMATION Item 1. Financial Statements C-CUBE MICROSYSTEMS INC. CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except par value amounts) (Unaudited) March 31, December 31, 1999 1998 (1) --------- ----------- ASSETS Current assets: Cash and equivalents $ 163,493 $ 108,224 Short-term investments 66,273 99,603 Accounts receivable - net 50,859 36,980 Inventories 12,766 16,073 Deferred income taxes 13,065 11,170 Other current assets 18,294 19,977 --------- --------- Total current assets 324,750 292,027 Property and equipment - net 30,132 29,622 Production capacity rights 3,938 12,600 Distribution rights - net 1,442 1,483 Purchased technology - net 7,023 5,921 Other assets 1,345 1,518 --------- --------- Total $ 368,630 $ 343,171 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 22,343 $ 19,942 Accrued liabilities 29,053 29,007 Income taxes payable 14,686 15,551 Deferred contract revenue 9,199 6,706 Current portion of long-term obligations 366 355 --------- --------- Total current liabilities 75,647 71,561 Long-term obligations 20,040 23,557 Deferred income taxes 3,204 4,650 --------- --------- Total liabilities 98,891 99,768 --------- --------- Minority interest in subsidiary -- 28 Stockholders' equity: Common stock, $0.001 par value, 150,000 shares authorized; shares outstanding: 1999 - 39,008; 1998 - 38,261 238,936 225,265 Accumulated other comprehensive loss (2,119) (1,852) Retained earnings 32,922 19,962 --------- --------- Total stockholders' equity 269,739 243,375 --------- --------- Total $ 368,630 $ 343,171 ========= ========= - ------ (1) Derived from the December 31, 1998 audited balance sheet included in the 1998 Annual Report on Form 10-K of C-Cube Microsystems Inc. See notes to condensed consolidated financial statements. -2- C-CUBE MICROSYSTEMS INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts) (Unaudited) Quarter Ended March 31, ----------------------- 1999 1998 -------- -------- Net revenues $ 96,459 $ 87,317 -------- -------- Costs and expenses: Cost of revenues 43,885 41,014 Research and development 19,904 17,671 Selling, general and administrative 16,360 14,586 -------- -------- Total 80,149 73,271 -------- -------- Income from operations 16,310 14,046 Other income, net 2,117 273 -------- -------- Income before income taxes, minority interest and extraordinary item 18,427 14,319 Income tax expense 5,528 4,296 -------- -------- Income before minority interest and extraordinary item 12,899 10,023 Minority interest in net loss of subsidiary (28) (141) -------- -------- Income before extraordinary item 12,927 10,164 Extraordinary gain on repurchase of convertible notes(net of tax) 33 -- -------- -------- Net income $ 12,960 $ 10,164 ======== ======== Earnings per share: Basic $ 0.34 $ 0.27 ======== ======== Diluted $ 0.32 $ 0.27 ======== ======== Shares: Basic 38,668 36,983 ======== ======== Diluted 41,344 41,137 ======== ======== See notes to condensed consolidated financial statements. -3- C-CUBE MICROSYSTEMS INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited) Quarter Ended March 31, ------------------------ 1999 1998 --------- --------- Cash flows from operating activities: Net income $ 12,960 $ 10,164 Adjustments to reconcile net income to net cash provided by operating activities: Extraordinary gain on repurchase of convertible notes, net of taxes (33) -- Minority interest in subsidiary (28) (141) Depreciation and amortization 3,689 3,925 Deferred income taxes (3,341) (1,668) Changes in assets and liabilities: Receivables (14,041) 11,764 Inventories 3,207 (8,035) Other current assets (1,409) 1,451 Accounts payable 2,574 10,467 Accrued liabilities 2,707 (1,147) Income taxes payable (888) 5,599 Production capacity rights 11,700 -- Deferred revenue 2,493 (129) --------- --------- Net cash provided by operating activities 19,590 32,250 --------- --------- Cash flows from investing activities: Sales and maturities of short-term investments 120,295 16,510 Purchases of short-term investments (85,436) (4,128) Capital expenditures (4,837) (4,367) Other assets (2,010) 100 --------- --------- Net cash provided by investing activities 28,012 8,115 --------- --------- Cash flows from financing activities: Repayments of capital lease obligations (121) (158) Sale of common stock 11,126 3,483 Repurchase of convertible subordinated notes (3,271) -- --------- --------- Net cash provided by financing activities 7,734 3,325 --------- --------- Exchange rate impact on cash and equivalents (67) 76 --------- --------- Net increase in cash and equivalents 55,269 43,766 Cash and equivalents, beginning of period 108,224 145,034 --------- --------- Cash and equivalents, end of period $ 163,493 $ 188,800 ========= ========= Supplemental schedule of noncash investing and financing activities: Unrealized gain (loss) on investments $ (108) $ 17 Supplemental disclosure of cash flow information - Cash paid during the period for: Interest $ 125 $ 102 Income taxes 7,149 571 See notes to condensed consolidated financial statements. -4- C-CUBE MICROSYSTEMS INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Basis of presentation The unaudited condensed consolidated financial statements contained in this report have been prepared by C-Cube Microsystems Inc. ("C-Cube" or the "Company"). In the opinion of management, such financial statements include all normal recurring adjustments and accruals necessary for a fair presentation of the Company's financial position as of March 31, 1999, and the results of operations for the quarters ended March 31, 1999 and 1998 and cash flows for the quarters ended March 31, 1999 and 1998. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in accordance with the rules and regulations of the Securities and Exchange Commission. This unaudited quarterly information should be read in conjunction with the audited consolidated financial statements of C-Cube and the notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 1998. 2. Inventories Inventories are stated at the lower of cost (first-in, first-out) or market. Cost is computed on a currently adjusted standard basis (which approximates actual cost on a current average or first-in, first-out basis). Inventories consist of: March 31, December 31, 1999 1998 --------- ----------- (in thousands) Finished goods $ 6,335 $ 3,566 Work-in-process 3,689 6,281 Raw materials 2,742 6,226 -------- -------- Total $ 12,766 $ 16,073 ======== ======== 3. Production capacity rights In January 1999, Taiwan Semiconductor Manufacturing Company Ltd. (TSMC) refunded $11.7 million of an advance payment to the Company. Readers are referenced to "Item 8, Note 3. Production Capacity Rights" in the Company's most recent Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 23, 1999, for further discussion. 4. Acquisition of assets On January 21, 1999, the Company acquired the communication technology, patents and personnel of TV/COM International, Inc., a California corporation and wholly owned subsidiary of Mindport. The purchase price for the assets acquired was immaterial in amount. The purchase price was allocated on the basis of the estimated fair value of the assets acquired, which included purchased technology and fixed assets. The purchased technology portion is being amortized over 7 years. -5- 5. Earnings per share The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share amounts): Quarter Ended March 31, ------------------------ 1999 1998 -------- -------- Numerator: Income before extraordinary item $ 12,927 $ 10,164 Extraordinary item 33 -- -------- -------- Numerator for basic earnings per share 12,960 10,164 Addback interest income after tax related to convertible shares 205 937 -------- -------- Numerator for diluted earnings per share $ 13,165 $ 11,101 ======== ======== Denominator: Weighted-average shares - denominator for basic earnings per share 38,668 36,983 Convertible shares 716 2,809 Dilutive common stock equivalents, using treasury stock method 1,960 1,345 -------- -------- Denominator for diluted earnings per share 41,344 41,137 ======== ======== Basic earnings per share $ 0.34 $ 0.27 ======== ======== Diluted earnings per share $ 0.32 $ 0.27 ======== ======== 6. Comprehensive income For the quarters ended March 31, 1999 and 1998, comprehensive income, which was comprised of the Company's net income for the periods, changes in accumulated translation adjustments and unrealized gains (losses) on investments, was $12.7 million and $10.2 million, respectively. 7. Extraordinary item During the first quarter, the Company repurchased $3.4 million of the face value of the Company's 5-7/8% Convertible Subordinated Notes due 2005 at 95.5% of the principal amount, with accrued interest to the date of repurchase, and recognized an extraordinary gain of $33,000 (zero effect per diluted share), net of related income taxes of $23,000. 8. Segment information On December 31, 1998, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and Related Information." Readers are referenced to "Item 8, Note 17. Segment Information" in the Company's most recent Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 23, 1999, for further discussion. -6- Segment information is as follows: Quarter Ended March 31, ----------------------- 1999 1998 --------- --------- (in thousands) Revenues: (1) Semiconductor $ 58,287 $ 56,823 DiviCom 38,172 30,494 --------- --------- Consolidated net revenues $ 96,459 $ 87,317 ========= ========= Income from operations: Semiconductor $ 11,966 $ 10,489 DiviCom 4,344 3,557 --------- --------- Consolidated income from operations $ 16,310 $ 14,046 ========= ========= Segment assets: Semiconductor $ 277,129 $ 257,335 DiviCom 91,501 74,525 --------- --------- Consolidated net assets $ 368,630 $ 331,860 ========= ========= ----- (1) Revenues are shown net of eliminations of intersegment revenues. This presentation is consistent with the Company's internal presentation of financial information to management. 9. Recently issued accounting standards In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Adoption of this statement is not expected to materially impact the Company's consolidated financial position, results of operations or cash flows. The Company is required to adopt this statement in the first quarter of fiscal year 2000, with early adoption permitted. -7- Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The forward-looking statements involve risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements as a result of certain factors, including those set forth in this Item 2, those described elsewhere in this report and those described in the Company's Form 10-K for the year ended December 31, 1998, other Form 10-Qs and other reports under the Securities Exchange Act of 1934. Such forward-looking statements include, but are not limited to, those statements marked with an asterisk (*) in this report. The Company assumes no obligation to update any forward-looking statements. Quarter Ended March 31, 1999 The following table sets forth certain operating data as a percentage of net revenues for the quarters ended March 31, 1999 and 1998: Quarter Ended March 31, ---------------------- 1999 1998 ------ ------ Net revenues 100.0% 100.0% Costs and expenses: Cost of revenues 45.5 47.0 Research and development 20.6 20.2 Selling, general and administrative 17.0 16.7 ------ ------ Total 83.1 83.9 ------ ------ Income from operations 16.9 16.1 Interest income, net 2.2 0.3 ------ ------ Income before income taxes, minority interest and extraordinary item 19.1 16.4 Income tax expense 5.7 4.9 ------ ------ Income before minority interest and extraordinary item 13.4 11.5 Minority interest in net loss of subsidiary -- (0.2) Income before extraordinary item 13.4 11.6 ------ ------ Extraordinary gain (net of tax) -- -- Net income 13.4% 11.6% ====== ====== Production Capacity Rights In January 1999, Taiwan Semiconductor Manufacturing Company Ltd. (TSMC) refunded $11.7 million of an advance payment to the Company. Readers are referenced to "Item 8, Note 3. Production Capacity Rights" in the Company's most recent Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 23, 1999, for further discussion. Net Revenues Net revenues in the first quarter of 1999 were $96.5 million, an increase of 10.5% over the $87.3 million reported in the corresponding quarter a year ago. This increase was led by growth in sales of DiviCom's encoder products, attributable to design improvements and feature and quality enhancements on next generation products, as well as significant growth in international sales. During 1999, DiviCom recognized additional revenue growth from higher volume shipments of its cable and data networking products. Semiconductor revenues increased primarily from higher volumes of decoder chips used in DVD consumer applications and DVD-ROMs on PCs, resulting from customers' adoption of the Company's ZiVA(tm) family of decoder chips and wider acceptance of the DVD format. Growth in sales of -8- codec products also contributed to the increase in semiconductor revenues. These increases were partially offset by decreased sales of decoder chips sold into the China market. This decline was due to a reduction in shipments and increased price competition. The reduction to revenues caused by the decrease in volume of VideoCD decoder chips is partially offset by higher average selling prices for Chaoji VCD decoder chips, also sold into the China market. The Company believes the market for VideoCD and Chaoji VCD applications will gradually decline as the market becomes saturated and as consumers adopt DVD applications in their place.* International revenues accounted for 65% of net revenues for the first quarter, compared to 61% for the same period last year. The Company expects that international revenues will continue to represent a significant portion of net revenues.* The Company's success will depend in part upon its ability to manage international marketing and sales operations. In addition, C-Cube purchases a substantial portion of its manufacturing services from foreign suppliers. C-Cube's international manufacturing and sales are subject to changes in foreign political and economic conditions and to other risks including currency or export/import controls, changes in tax laws, tariffs and freight rates and changes in the ownership and/or leadership of international customers that may result in delayed or canceled orders. For example, China is the primary market for VideoCD and Chaoji VCD players utilizing the Company's decoder products. As a consequence, any political or economic instability in China could significantly reduce demand for the Company's products. The Company has made a significant investment in additional foundry capacity in Taiwan and is subject to the risk of political instability in Taiwan, including but not limited to the potential for conflict between Taiwan and the People's Republic of China. The Company sells products to customers in Korea and is subject to the risk of economic and political instability in Korea, including the potential for conflict between North and South Korea. In addition, the Company sells certain of its products in international markets and buys certain products from its foundries in currencies other than the U.S. dollar and, as a result, currency fluctuations could have a material adverse effect on the Company's business and results of operations. With respect to international sales that are denominated in U.S. dollars, increases in the value of the U.S. dollar relative to foreign currencies can increase the effective price of and reduce demand for the Company's products relative to competitive products priced in the local currency. The United States has considered trade sanctions against Japan and has had disputes with China relating to trade and human rights issues. If trade sanctions were imposed, Japan or China could enact trade sanctions in response. Because a number of the Company's current and prospective customers and suppliers are located in Japan and China, trade sanctions, if imposed, could have a material adverse effect on C-Cube's business and results of operations. Similarly, protectionist trade legislation in either the United States or foreign countries could have a material adverse effect on the Company's ability to manufacture or sell its products in foreign markets. The Asian consumer electronics markets accounted for approximately 49% of total Company sales in the first quarter of 1999 and are expected to continue to account for a substantial, though declining, percentage of sales in the future.* The economic instability in Asia has been characterized by increases in idle production capacity, real estate vacancies, unemployment and bank failures, and has resulted in currency devaluation, falling consumer spending and domestic price deflation. Any of these factors could significantly reduce the demand for the end user goods in which the Company's products are incorporated. In the first quarter of 1999, most of the Company's sales in Asia were of decoder chips, which are used in VideoCD and Chaoji VCD players. The Company believes purchases of VideoCD and Chaoji VCD players are not as likely to be deferred as are purchases of higher priced consumer durables and production equipment, which have dramatically impacted U.S. export sales.* However, there can be no assurance that the Company will not experience reduced sales of its semiconductor products into Asia because of declining consumer spending or because of its customers' increasing difficulty in obtaining letters of credit, which the Company generally requires prior to shipment. -9- Gross Margin C-Cube's gross margin for the first quarter of 1999 was 54.5% compared to a gross margin of 53.0% for the same quarter last year. This increase was primarily the result of changes in product mix, as sales of products with higher gross margins contributed more to revenues in the first quarter of 1999. This was primarily due to increased sales of DiviCom's encoder products and Semiconductor's DVD and codec products. The Company also realized operating efficiencies, including reduced material costs relating to its semiconductor and DiviCom products, refinement of its semiconductor fabrication process and the reduction of outside manufacturing costs, all of which led to improvements in gross margin during the period. These operating efficiencies were partially offset by higher product transition costs, higher employee-related costs for headcount growth in integration and support services and higher project materials costs. The improvements to gross margin were additionally offset by reductions in the average selling prices of many of the Company's semiconductor products during the current period. The markets into which C-Cube sells its products are subject to extreme price competition. Thus, the Company expects to continue to experience declines in the selling prices of its products over the life cycle of each product.* In particular, C-Cube expects to continue to experience significant price competition in the markets for decoder chips.* In order to offset or partially offset declines in the selling prices of its products, C-Cube must continue to reduce the costs of products through product design changes, manufacturing process changes, volume discounts, yield improvements and other savings negotiated with its manufacturing subcontractors. Since the Company does not believe that it can continually achieve cost reductions which fully offset the price declines of its products, it expects gross margin percentages to decline for existing products over their life cycles.* C-Cube does not operate its own manufacturing facilities and must make volume commitments to subcontractors at prices that remain fixed over certain periods of time. Therefore, the Company may not be able to reduce its costs as rapidly as its competitors who perform their own manufacturing. Failure of the Company to design and introduce, in a timely manner, lower cost versions of existing products or higher gross margin new products, or to successfully manage its manufacturing subcontractor relationships, would have a material adverse effect on C-Cube's gross margins. Research and Development Expenses In the first quarter of 1999, research and development expenses were $19.9 million, or 20.6% of net revenues, compared with $17.7 million, or 20.2% of net revenues in the first quarter of 1998. The increase in research and development expenses primarily represents additional employee- related costs associated with increases in product engineering staff, reflecting the Company's continuing efforts to provide industry leading digital video solutions at the chip and systems levels. Selling, General and Administrative Expenses Selling, general and administrative expenses increased to $16.4 million, or 17.0% of net revenues, in the first quarter of 1999, compared to $14.6 million, or 16.7% of net revenues, for the same quarter last year. The increase was primarily due to increased headcount and related expenses, as the Company continues to increase its international coverage in sales and marketing. Other Income (Expense) Other income, net of other expense, increased to $2.1 million for the first quarter of 1999, compared to $0.3 million for the first quarter of 1998. The improvement over the prior year quarter is primarily due to higher interest income earned on higher average cash and investment balances and lower interest expense on lower average outstanding debt balances. -10- Income Tax Expense The Company's effective tax rate for the first quarter of 1999 was 30%. The Company's effective tax rate is less than the combined federal and state statutory rate primarily due to tax credits and lower foreign tax rates. Extraordinary Item During the first quarter, the Company repurchased $3.4 million of the face value of the Company's 5-7/8% Convertible Subordinated Notes due 2005 at 95.5% of the principal amount, with accrued interest to the date of repurchase, and recognized an extraordinary gain of $33,000 (zero effect per diluted share), net of related income taxes of $23,000. Factors that May Affect Future Results The Company's quarterly and annual operating results have been, and will continue to be, affected by a wide variety of factors that could have a material adverse effect on revenues and profitability during any particular period, including the timing of revenue recognized under its systems contracts and the level of orders which are received and can be shipped in a quarter, the rescheduling or cancellation of orders by its customers, competitive pressures on selling prices, changes in product or customer mix, availability and cost of foundry capacity and raw materials, fluctuations in yield, loss of any strategic relationships, C-Cube's ability to introduce new products and technologies on a timely basis, unanticipated problems in the performance of the Company's next generation or cost-reduced products, the ability to successfully introduce products in accordance with OEM design requirements and design cycles, new product introductions by the Company's competitors, market acceptance of products of both C-Cube and its customers, compatibility of new products with emerging digital video standards, purchase commitments for customized components procured in advance of anticipated systems contracts, supply constraints for other components incorporated into its customers' products, credit risk for international customers not using letters of credit, fluctuations in foreign currency exchange rates to the U.S. dollar, the level of expenditures in manufacturing, research and development, and sales, general and administrative functions, and a recent trend of mergers and acquisitions creating larger competitors which may have established market share or greater financial or technical resources than the Company.* In addition, C-Cube's operating results are subject to fluctuations in the markets for its customers' products, particularly the consumer electronics and personal computer markets, which have been extremely volatile in the past, and the digital satellite broadcast, cable and wireless cable markets, which are in an early stage, creating uncertainty with respect to product volume and timing. To the extent the Company is unable to fulfill its customers' purchase orders on a timely basis, these orders may be canceled due to changes in demand in the markets for its customers' products. Historically, the Company has shipped a substantial portion of its product in the last month of a given quarter. A significant portion of C-Cube's expenses are fixed in the short term, and the timing of increases in expenses is based in large part on the Company's forecast of future revenues. As a result, if revenues do not meet the Company's expectations, it may be unable to quickly adjust expenses to levels appropriate to actual revenues, which could have a material adverse effect on the Company's business and results of operations. Due to the Company's dependence on the consumer electronics market, the substantial seasonality of sales in that market could impact the Company's revenues and net income. In particular, C-Cube believes that there may be seasonality in the Asia-Pacific region related to the Chinese New Year, which falls within the first calendar quarter, which could result in relatively lower product demand during the second and third quarters of each year.* If in the future the geographic mix of the Company's sales -11- shifts towards the U.S. and Europe, C-Cube would anticipate higher revenues and net income in the third and fourth calendar quarters as system manufacturers in these regions make purchases in preparation for the holiday season, and comparatively less revenues and net income in the first and second calendar quarters.* The economic instability in Asia has been characterized by increases in idle production capacity, real estate vacancies, unemployment and bank failures, and has resulted in currency devaluation, falling consumer spending and domestic price deflation. Any of these factors could significantly reduce the demand for the end user goods in which the Company's products are used. As a result of the foregoing, the Company's operating results and stock price may be subject to significant volatility, particularly on a quarterly basis. Any shortfall in net revenues or net income from levels expected by securities analysts could have an immediate and significant adverse effect on the trading price of the Company's common stock. The market price of C-Cube's common stock has fluctuated significantly since its initial public offering in April 1994. The market price of the common stock could be subject to significant fluctuations in the future based on factors such as announcements of new products by C-Cube or its competitors, quarterly fluctuations in C-Cube's financial results, quarterly fluctuations in other semiconductor or digital video networking companies' financial results, changes in analysts' estimates of C-Cube's financial performance, general conditions in the semiconductor and digital video networking industries, conditions in the financial markets and general conditions in the global economy which might adversely affect consumer purchasing. In addition, the stock market in general has experienced extreme price and volume fluctuations, which have particularly affected the market prices for many high technology companies and which have often been unrelated to the operating performance of the specific companies. The market price of C-Cube's common stock has declined substantially from its historic highs, and may continue to experience significant fluctuations in the future. Year 2000 The Company is aware of the issues associated with the programming code in existing computer systems as the millennium (Year 2000) approaches. The Year 2000 problem is pervasive and complex, as virtually every computer operation will be affected by the rollover of the two digit year value to 00. The issue is whether computer systems will properly recognize date sensitive information when the year changes to 2000. Systems that do not properly recognize such information could generate erroneous data or cause a system to fail. C-Cube has initiated a Year 2000 project designed to identify and assess the risks associated with its information systems, products, operations and infrastructure, suppliers and customers that are not Year 2000 compliant, and to develop, implement and test remediation and contingency plans to mitigate these risks. C-Cube is replacing or upgrading systems, equipment and facilities that are known to be Year 2000 non- compliant. For the Year 2000 non-compliance issues identified to date, the Company does not expect the cost of upgrade or remediation to exceed $500,000, which is not expected to be material to the Company's operating results.* If implementation of replacement systems is delayed, or if significant new non-compliance issues are identified, the Company's results of operations or financial condition could be materially adversely affected. INFORMATION SYSTEMS. A review of the Company's information systems has been completed and the Company has initiated the work necessary for the existing systems to become Year 2000 compliant. Testing of all information systems will be conducted and completed before the end of 1999.* The Company is also actively reviewing its hardware and systems infrastructure, such as networks, in order to ensure that they are Year 2000 compliant. Based on the current status of the assessments and remediation plans made to date, the Company expects to have all critical Year 2000 information -12- systems issues resolved and does not expect total Year 2000 related costs pertaining to its information systems and hardware and systems infrastructure to be material.* PRODUCTS. The Company has assessed the capabilities of its semiconductor products sold to customers and has not identified any significant problems related to Year 2000 compliance. The Company has identified and assessed the risks related to integrated systems sold by its DiviCom segment. Products manufactured by DiviCom are either Year 2000 compliant or have an available upgrade to bring them into compliance. To be in compliance for the Year 2000, the Company suggests that customers obtain a full system upgrade. All customers will be sent a notification letter describing the compliance status of the products purchased by the customer, along with the procedures necessary to bring those products into compliance for the Year 2000. Such letters will be mailed to such customers during the second quarter of 1999.* Customers with service contracts and customers with whom the Company has specific Year 2000 contractual obligations will be offered upgrades at no charge. The Company expects to complete this process before the end of 1999.* DiviCom products are often installed with third party hardware and software. The Company does not comment as to the Year 2000 compliance of third party hardware and software products. Accordingly, DiviCom recommends that customers verify the Year 2000 compliance status of third party hardware and software products and that customers schedule their own Year 2000 system validation tests during 1999 after Year 2000 upgrades are performed. DiviCom has not assessed all possible customer configurations, nor can it anticipate all customer situations, particularly those involving third party products. As a result, the Company may see an increase in warranty and other claims resulting from the Year 2000 transition process. In addition, litigation against the Company regarding Year 2000 compliance issues may occur in the future. For these reasons, the impact of customer claims could have a material adverse impact on the Company's results of operations or financial condition. OPERATIONS AND INFRASTRUCTURE. Machinery and equipment and other items used in the operations and facilities of the Company have been inventoried and are currently being assessed for Year 2000 compliance. This assessment has determined that the company's security systems are not Year 2000 compliant. The Company is currently in the process of replacing such system with a Year 2000 compliant system. This process will be completed before the end of 1999.* No other material deficiencies were detected from our assessments. SUPPLIERS. C-Cube is in the process of contacting its critical suppliers to determine whether their operations, products and services are Year 2000 compliant. Where practicable, C-Cube will attempt to mitigate its risks with respect to the failure of suppliers to be Year 2000 compliant. In the event that suppliers are not Year 2000 compliant, the Company will seek alternative sources of supplies. However, such failures remain a possibility and could have a material adverse impact on the Company's results of operations or financial condition. CUSTOMERS. The Company is actively responding to all customer requests for compliance, surveys and other general information related to its Year 2000 programs. GENERAL. The Company does not currently expect its costs associated with the Year 2000 problem to exceed $500,000, and expects to be able to fund these costs through operating cash flows.* However, the Company has not yet completed its assessments, developed remediation plans for all problems, developed contingency plans, or completely implemented or tested any of its remediation plans. The risks associated with the Year 2000 problem can be difficult to identify and to address, and could result in material adverse consequences to the Company. Even if the Company, in a timely manner, completes all of its assessments, identifies and tests remediation plans believed to be adequate and develops contingency plans believed to be adequate, some problems may not be identified or corrected in time to prevent material adverse consequences to the Company. -13- As the Year 2000 project continues, the Company may discover additional Year 2000 problems, may not be able to develop, implement, or test remediation or contingency plans in a timely manner, or may find that the costs of these activities exceed current expectations and become material. In many cases, the Company is relying on assurances from suppliers and customers that new and upgraded information systems and other products will be Year 2000 compliant. The Company plans to test certain third-party products, but cannot be sure that its tests will be adequate or that, if problems are identified, they will be addressed by the supplier in a timely and satisfactory way. Because the Company uses a variety of information systems and has additional systems embedded in its operations and infrastructure, the Company cannot be sure that all of its systems will work together in a Year 2000-compliant fashion. Furthermore, the Company cannot 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 related to its products in a timely manner, it could be exposed to liability to third parties. The Company has not developed a "worst case" scenario with respect to Year 2000 issues, but instead has focused its resources on identifying material, remediable problems and reducing uncertainties generally, through the Year 2000 project described above. If the Company or the third parties with which it has relationships were to cease or not successfully complete its or their Year 2000 remediation efforts, the Company would encounter disruptions to its business that could have a material adverse effect on its business, financial position and results of operations. The Company could be materially and adversely impacted by widespread economic or financial market disruption or by Year 2000 computer system failures at third parties with which it has relationships. Liquidity and Capital Resources Cash, cash equivalents and short-term investments were $229.8 million at March 31, 1999 compared to $207.8 million at the end of 1998. Working capital increased to $249.1 million at March 31, 1999 from $220.5 million at the end of 1998. The Company's operating activities generated cash of $19.6 million in the first quarter of 1999, primarily from net income and a refund of $11.7 million prepaid production capacity rights, partially offset by increased accounts receivable. Receivable days outstanding increased from 35 days at December 31, 1998 to 47 days at March 31, 1999 primarily due to DiviCom's growing percentage contribution to consolidated revenues since a substantial portion of DiviCom's revenues are generated under long-term contracts which generally have longer collection cycles than the semiconductor business. C-Cube's investing activities, exclusive of sales and maturities of $120.3 million and purchases of $85.4 million of short-term investments, used cash of $6.8 million, primarily for $4.8 million capital expenditures. Cash provided by financing activities was $7.7 million, primarily from proceeds of $11.1 million from sales of stock pursuant to employee stock plans, partially offset by $3.3 million used to repurchase a portion of the Company's Convertible Subordinated Notes. At March 31, 1999, the Company had an available bank line of credit of $30.0 million which expires in May 2001. Borrowings bear interest at LIBOR plus 1.25% or the bank's prime rate (7.75% at March 31, 1999). The line of credit agreement requires that the Company, among other things, maintain a -14- minimum tangible net worth, a minimum annual net income (no quarterly loss exceeding $3 million) and certain financial ratios. In addition, this agreement prohibits the payment of cash dividends. At March 31, 1999, the Company was in compliance with these covenants, and there were no outstanding balances under this line. Based on current plans and business conditions, C-Cube expects that its cash, cash equivalents and short-term investments together with any amounts generated from operations and available borrowings, will be sufficient to meet the Company's cash requirements for at least the next 12 months.* However, there can be no assurance that the Company will not be required to seek other financing sooner or that such financing, if required, will be available on terms satisfactory to the Company, or at all. In addition, the Company has considered and will continue to consider various possible transactions with foundries to secure additional foundry capacity, which could include, without limitation, equity investments, prepayments, non- refundable deposits or loans in exchange for guaranteed capacity, "take or pay" contracts that commit the Company to purchase specified quantities of wafers over extended periods, joint ventures or other partnership relationships. Item 3. Quantitative and Qualitative Disclosures About Market Risk Readers are referenced to "Part II, Item 7A. Quantitative and Qualitative Disclosures about Market Risk", in the Company's most recent Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 23, 1999. -15- C-CUBE MICROSYSTEMS INC. PART II. OTHER INFORMATION Item 1. Legal Proceedings From time to time the Company is party to certain litigation or legal claims. Management has reviewed all pending legal matters and believes that the resolution of such matters will not have a significant adverse effect on the Company's financial position or results of operations. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information Not applicable. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit Number Description ------- ----------------------- 27.1 Financial Data Schedule (b) Reports on Form 8-K None. -16- 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. C-Cube Microsystems Inc. (Registrant) Dated: May 14, 1999 By: /s/ Walt Walczykowski ----------------- ---------------------------- Walt Walczykowski Vice President of Finance and Chief Financial Officer -17-