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 September 30, 2001
Commission File No. 0-27742
CYLINK CORPORATION
(Exact name of registrant as specified in its charter)
California 95-3891600
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3131 Jay Street
Santa Clara, California 95054
(Address of principal executive offices)
(408) 855-6000
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
------- --------
As of November 12, 2001, there were 32,864,900 shares of the Registrant's
common stock outstanding.
CYLINK CORPORATION
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2001
INDEX
Page
----
PART I FINANCIAL INFORMATION
Item 1 Financial Statements
a) Condensed Consolidated Balance Sheets at September 30, 2001 and December 31, 2000 2
b) Condensed Consolidated Statements of Operations for the three and nine months ended
September 30, 2001 and October 1, 2000 3
c) Condensed Consolidated Statement of Cashflows for the nine months ended
September 30, 2001 and October 1, 2000 4
d) Notes to Condensed Consolidated Financial Statements 5
Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 8
PART II OTHER INFORMATION 21
Item 1. Legal Proceedings 21
Item 4. Submission of Matters to a Vote of Security Holders 21
Item 5. Other Information 21
Item 6. Exhibits 21
Signature 22
1
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CYLINK CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share and par value data; unaudited)
September 30, December 31,
2001 2000
--------- ---------
Assets
Current assets:
Cash and cash equivalents $ 10,393 $ 15,250
Accounts receivable, net of allowances of $984 and $1,499 7,651 14,927
Income tax receivable 109 --
Inventories 5,620 10,741
Deferred income taxes -- 800
Other current assets 1,036 1,697
--------- ---------
Total current assets 24,809 43,415
Restricted cash 1,400 1,400
Property and equipment, net 6,847 10,241
Acquired technology, goodwill and other intangibles 17,418 20,707
Notes receivable from employees and former employees 1,961 2,310
Other assets 1,055 811
--------- ---------
$ 53,490 $ 78,884
========= =========
Liabilities and Shareholders' Equity
Current liabilities:
Current portion of lease obligations and equipment line of credit $ 174 $ 288
Accounts payable 2,354 5,137
Accrued liabilities 5,983 9,346
Income taxes payable 413 359
Deferred revenue 2,944 3,147
--------- ---------
Total current liabilities 11,868 18,277
--------- ---------
Capital lease obligations and equipment line of credit -- 86
Deferred revenue and other accruals, less current portion 1,160 1,368
--------- ---------
Total long-term liabilities 1,160 1,454
--------- ---------
Commitments and contingencies (Notes 6, 10 & 12)
Shareholders' equity:
Preferred Stock, $0.01 par value; 5,000,000 shares authorized;
none issued and outstanding
Common stock; $0.01 par value: 55,000,000 shares authorized;
32,861,000 and 32,681,000 shares issued and outstanding 328 327
Additional paid-in capital 158,201 158,805
Deferred compensation related to stock options -- (1,231)
Accumulated other comprehensive income (loss) (26) (16)
Accumulated deficit (118,041) (98,732)
--------- ---------
Total shareholders' equity 40,462 59,153
--------- ---------
$ 53,490 $ 78,884
========= =========
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
2
CYLINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data; unaudited)
Three months ended Nine months ended
------------------------ ------------------------
September 30, October 1, September 30, October 1,
2001 2000 2001 2000
-------- -------- -------- --------
Revenue $ 10,345 $ 17,192 $ 36,528 $ 52,575
Cost of revenue 4,905 6,173 15,203 18,852
-------- -------- -------- --------
Gross profit 5,440 11,019 21,325 33,723
-------- -------- -------- --------
Operating expenses:
Research and development, net 3,716 5,659 14,851 15,571
Selling and marketing 3,133 8,254 13,895 25,479
General and administrative 2,838 3,426 8,581 10,654
Amortization of acquired intangibles 768 817 2,447 2,257
Loss from divestiture of Algorithmic Research, Ltd. 294 -- 2,797 --
Purchased in-process technology -- 3,681 -- 3,681
-------- -------- -------- --------
Total operating expenses 10,749 21,837 42,571 57,642
-------- -------- -------- --------
Loss from operations (5,309) (10,818) (21,246) (23,919)
Other income (expense):
Interest income, net 223 281 596 1,108
Write-down of investment in unaffiliated company (253) -- (253) --
Royalty and other income (expense), net 580 (171) 417 (237)
-------- -------- -------- --------
550 110 760 871
-------- -------- -------- --------
Loss before income taxes (4,759) (10,708) (20,486) (23,048)
Income tax benefit -- -- (1,177) 8
-------- -------- -------- --------
Net loss $ (4,759) $(10,708) $(19,309) $(23,056)
======== ======== ======== ========
Loss per share - basic & diluted: $ (0.15) $ (0.35) $ (0.60) $ (0.76)
======== ======== ======== ========
Shares used in per share calculation - basic & diluted 32,623 31,007 32,437 30,519
======== ======== ======== ========
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
3
CYLINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands; unaudited)
Nine months ended
----------------------------
September 30, October 1,
2001 2000
-------- --------
Cash flows from operating activities:
Net loss $(19,309) $(23,056)
Adjustments to reconcile net loss to net
cash used in operating activities:
Write-down of investment in unaffiliated company 253 --
Loss on divestiture of ARL 2,797 --
Loss on disposition of fixed assets 31 --
Depreciation 2,597 2,532
Amortization 2,447 2,258
Write-off of acquired in-process research & development -- 3,681
Deferred income taxes 800 (4)
Amortization of imputed interest on note receivable (211) (182)
Deferred compensation related to stock options 528 536
Changes in operating assets and liabilities (net of effects of
acquisition and divestitures):
Accounts receivable 6,415 (995)
Inventories 4,722 (5,421)
Income tax receivable (109) --
Other assets 309 331
Accounts payable (2,427) (1,060)
Accrued liabilities (2,192) (404)
Income taxes payable (7) (6)
Deferred revenue 509 1,322
-------- --------
Net cash used in operating activities (2,847) (20,468)
Cash flows from investing activities:
Acquisition of property and equipment (605) (2,622)
Collections of employee notes receivable 560 --
Cash transferred with divestiture of SDI (28) --
Cash transferred with divestiture of ARL (1,900) --
Acquisition of Celotek Corporation -- (1,061)
-------- --------
Net cash used in investing activities (1,973) (3,683)
-------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock, net 82 6,209
Other (109) (13)
-------- --------
Net cash provided by (used in) financing activities (27) 6,196
-------- --------
Effect of exchange rate changes on cash and cash equivalents (10) 72
-------- --------
Net increase (decrease) in cash and cash equivalents (4,857) (17,883)
Cash and cash equivalents at beginning of period 15,250 33,170
-------- --------
Cash and cash equivalents at end of period $ 10,393 $ 15,287
======== ========
Supplemental disclosures
Acquisition of Celotek in exchange for Common Stock $ -- $ 25,759
Cash refunds of income tax 3,342 --
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
4
CYLINK CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation
The unaudited condensed consolidated financial statements included herein
contain all adjustments, consisting only of normal recurring adjustments, which,
in the opinion of management, are necessary to state fairly the consolidated
financial position, results of operations and cash flows of Cylink Corporation
("Cylink" or the "Company") for the periods presented. These financial
statements should be read in conjunction with the Company's audited financial
statements included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2000. Interim results of operations are not necessarily
indicative of the results to be expected for the full year.
The statements have been prepared in accordance with generally accepted
accounting principles in the United States of America for interim information
and the instructions to Form 10-Q and Article 10 of Regulation S-X.
Certain 2000 financial statement amounts were reclassified to conform with
2001 classifications. These reclassifications had no effect on net loss or
shareholders' equity as previously reported.
2. Accounting Changes
Effective January 1, 2001, the Company adopted SFAS 133, "Accounting for
Derivative Instruments and Hedging Activities," as amended. The statement
requires that all derivatives, whether designated in hedging relationships or
not, are to be recorded on the balance sheet at fair value. If the derivative is
designated as a fair value hedge, changes in the fair value of the derivative
and of the hedged item attributable to the hedged risk are recognized in
earnings. If the derivative is designated as a cash flow hedge, the effective
portions of the changes in the fair value of the derivative are recorded in
other comprehensive income (OCI) and are recognized in the income statement when
the hedged item affects earnings. Ineffective portions of changes in the fair
value of cash flow hedges are recognized in earnings. The adoption of SFAS 133
did not result in a transition adjustment at January 1, 2001.
The Company uses derivative instruments, primarily forward exchange
contracts, to manage the foreign currency exchange rate risk associated with
certain assets and forecasted transactions which are denominated in currencies
other than the U.S. Dollar. The Company monitors its foreign currency exposures
regularly to maximize the overall effectiveness of its foreign currency hedge
positions, with the principal currency hedged being the British Pound. The
Company has not designated any of its forward exchange contracts as hedging
instruments under SFAS 133, and therefore the changes in fair value of these
forward contracts has been included in interest and other income in the quarter
ended September 30, 2001. The fair value of these instruments as of September
30, 2001 was not significant.
3. Inventories
September 30, December 31,
2001 2000
--------------------------------
(in thousands)
Raw materials $ 2,677 $ 5,708
Work in process and subassemblies 1,974 2,768
Finished goods 969 2,265
-------- ---------
$ 5,620 $ 10,741
======== =========
4. Loss Per Share
Basic loss per share is based on the weighted-average number of common
shares outstanding, excluding shares in escrow. Diluted loss per share is based
on the weighted-average number of shares outstanding and dilutive potential
common shares outstanding, excluding contingent shares held in escrow. The
Company's only potentially dilutive securities are stock options. As of
September 30, 2001 and October 1, 2000, the Company had 8,452,000 and 6,943,000
stock options outstanding with a weighted average exercise price of $4.05 and
$4.95, respectively. These
5
options expire on various dates through 2008. All potentially dilutive
securities have been excluded from the computation of diluted loss per share, as
their effect is anti-dilutive on the net loss for the periods presented.
5. Comprehensive Loss
The components of comprehensive loss, consisting of the Company's reported
net loss and unrealized gains or losses in the translation of foreign
currencies, are as follows:
Three Months Ended Nine Months Ended
-------------------- --------------------
Sept. 30, Oct. 1, Sept. 30, Oct. 1,
2001 2000 2001 2000
-------- -------- -------- --------
(in thousands) (in thousands)
Net loss $ (4,759) $(10,708) $(19,309) $(23,056)
Other comprehensive
income (loss) (67) 41 (10) 72
-------- -------- -------- --------
Total comprehensive loss $ (4,826) $(10,667) $(19,319) $(22,984)
======== ======== ======== ========
6. Contingencies
Cylink is currently engaged in litigation. See Part II, Item 1. "Legal
Proceedings."
7. Divestitures
On April 9, 2001, the Company sold its entire interest in its U.S.-based
professional services subsidiary, Security Design International, in exchange for
209,425 shares of Series C preferred stock in a private company representing a
minority interest in that company. No gain or loss was recorded on the
transaction. The Company evaluated the carrying value of its investment in the
preferred shares of that Private Company at September 30, 2001, and recorded a
third quarter charge for impairment of the value of that investment in the
amount of $0.3 million.
On June 22, 2001, the Company announced that it would close or sell its
Israeli subsidiary, Algorithmic Research, Ltd. ("ARL"). The Company recorded a
$2.5 million charge during the second quarter of 2001, resulting from the
write-down of assets associated with the wind-up of that subsidiary. On August
9, 2001, Cylink executed an Allotment and Conversion Agreement and various
related documents (collectively the "ARL Divestiture"), under which Cylink
transferred an 81% ownership in ARL to a trustee acting on behalf of ARL's
existing employees, and converted its remaining minority interest and its
intercompany debt of approximately $13.1 million to preferred stock having
certain rights and privileges in the event of ARL's sale or liquidation. No
value has been assigned to Cylink's ownership interest in the preferred stock.
As part of the ARL Divestiture, Cylink paid $1.5 million, and forgave an
additional $1.45 million in intercompany debt, for sale of ARL's virtual private
networking technology, a royalty free, irrevocable license to ARL's remaining
base of existing intellectual property solely for incorporating into Cylink
Products, and a release and waiver from all of ARL's existing employees. Cylink
also agreed to assign certain contracts to ARL concerning licenses of ARL's
products, and to wind up ARL's subsidiaries operations in Germany and Singapore.
Under the ARL Divestiture, ARL will retain ownership and responsibility for all
of its other assets and liabilities. The Company incurred an additional $0.3
million loss in connection with the divestiture during the third quarter of
2001.
8. Restructuring
On July 20, 2001, Cylink announced further expense reduction actions,
including a further reduction in its workforce by approximately 28% (excluding
the wind-up previously disclosed of ARL). The severance related costs associated
with the workforce reduction are approximately $0.5 million were recorded in the
third quarter of 2001.
9. CFE Repair
On August 2, 2001, Cylink determined that a hardware design could cause a
premature failure of the backup battery on its Cylink Frame Entcyptor (CFE)
product. Cylink has announced a program to give its customers the option of
updating their CFE units by returning them to the factory, or receiving an
extended warranty covering the battery through the end of December 2002. Cylink
has accrued approximately $1.0 million in warranty costs during the second
quarter associated with this program.
6
10. Working Capital Loan
On June 27, 2001, the Company entered into a loan and security agreement
with a bank under which it can borrow up to $7.5 million by way of revolving
advances. This loan is secured by all of Cylink's tangible assets. The revolving
loan provides for loan advances up to 85% of Cylink's eligible accounts
receivable, bears interest at the bank's prime rate of interest (6.25% as of
September 30, 2001) plus 1.75% and is due April 30, 2002. The loan contains a
tangible net worth covenant. There have been no borrowings under the loan.
In conjunction with the acquisition of Celotek Corporation in August 2000,
Cylink assumed an equipment loan with an outstanding balance of $0.3 million.
This loan matures December 1, 2002 and bears interest at the prime rate plus 1%.
As of September 30, 2001, the outstanding balance under the equipment line was
$0.2 million.
11. NASDAQ Listing Notice.
On July 25, 2001, Cylink received a notice from NASDAQ that the Company's
stock had failed to satisfy one of NASDAQ's listing requirements, that is,
maintaining a minimum bid price of $1.00 per share for more than 30 consecutive
trading days. The notice stated that the Company had 90 days to re-establish its
compliance by maintaining a minimum bid price of at least $1.00 per share for at
least 10 consecutive trading days. If the Company failed to do so, then the
NASDAQ listing staff would issue a notice of delisting, at which time the
Company would have an opportunity to appeal the staff's decision to the NASDAQ
listing qualifications panel. On September 27, 2001, NASDAQ suspended its
minimum bid price requirements until January 2002.
12. Subsequent Events
Supplier insolvency. During telephonic discussions in October 2001, the
Company received reports that the sole OEM supplier of its ISDN encryptor
product was experiencing financial difficulties, and may face insolvency
proceedings. The commencement of insolvency proceedings would have a significant
impact on the Company's ability to fulfill ISDN orders and a consequent negative
impact on revenues for the fourth quarter of 2001 and the first half of 2002.
13. Recently issued accounting pronouncements.
On July 20, 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standard (SFAS) No. 141, "Business Combinations," and
SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that
all business combinations initiated after June 30, 2001 be accounted for under
the purchase method and addresses the initial recognition and measurement of
goodwill and other intangible assets acquired in a business combination. SFAS
No. 142 addresses the initial recognition and measurement of intangible assets
acquired outside of a business combination and the accounting for goodwill and
other intangible assets subsequent to their acquisition. SFAS No. 142 provides
that intangible assets with finite useful lives be amortized and that goodwill
and intangible assets with indefinite lives will not be amortized, but will
rather be tested at least annually for impairment. Cylink will adopt SFAS No.
142 for its fiscal year beginning January 1, 2002. Upon adoption of SFAS 142,
Cylink will stop the amortization of goodwill with an expected net carrying
value of $5,859,000 at the date of adoption and annual amortization of
$1,034,000 that resulted from business combinations completed prior to the
adoption of SFAS 141. Goodwill acquired subsequent to June 30, 2001 will not be
amortized.
The Company will evaluate goodwill under the SFAS 142 transitional
impairment test and has not yet determined whether or not there will be a
related impairment loss. Any transitional impairment loss will be recognized as
a change in accounting principle under provisions of Accounting Principles Board
Opinion No. 20.
In July 2001, the Financial Accounting Standards Board issued SFAS 143,
"Accounting for Asset Retirement Obligations" ("FAS 143"). FAS 143 addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. It applies to legal obligations associated with the retirement of
long-lived assets that result from the acquisition, construction, development,
and (or) the normal operation of a long-lived asset, except for certain
obligations of lessees. The provisions of FAS 143 will be effective for fiscal
years beginning after June 15, 2002, however early application is permitted. The
Company is currently in the process of evaluating the impact of this Statement
on its financial condition and results of operations.
In August 2001, the Financial Accounting Standards Board issued SFAS 144
Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS 144").
This Statement addresses financial accounting and reporting for the impairment
or disposal of long-lived assets. This Statement supersedes FASB Statement No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of, and amends the accounting and reporting provisions of
APB Opinion No. 30. Reporting the Results of Operations -- Reporting the Effect
of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions, for the disposal of a segment of
a business. The provisions of FAS 144 will be effective for fiscal years
beginning after December 15, 2001. The Company is currently evaluating the
implications of adoption of FAS 144 and anticipates adopting its provisions in
fiscal year 2002.
7
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following Management's Discussion and Analysis of Financial Condition
and Results of Operations should be read in conjunction with the unaudited
condensed financial statements and notes thereto included in Part I Item 1 of
this Report on Form 10-Q and the audited financial statements and notes thereto
and Management's Discussion and Analysis of Financial Condition and Results of
Operations included in the Company's 2000 Report on Form 10-K. This Report on
Form 10-Q includes statements that reflect Cylink's beliefs concerning future
events and financial performance. Statements that are not purely historical in
nature are called "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. We generally identify forward-looking statements with such words as
"expects," "anticipates," "intends," "believes" or similar words concerning
future events.
You should not rely on these forward-looking statements. They are subject
to certain risks and uncertainties that may cause actual results to differ
materially from past results or Cylink's predictions. For a description of these
risks see the reasons described in Item 2 "Risk Factors That May Affect Future
Results," and other sections of this Report on Form 10-Q. You should also
consult the risk factors listed from time to time in Cylink's Reports on Form
10-K, 10-Q, and 8-K.
All forward-looking statements included in this document are based on
information available to Cylink as of the date of this Report on Form 10-Q, and
Cylink assumes no obligation to (and disclaims any obligation to) update or
alter any such forward-looking statements, or to update the reasons why actual
results could differ from those projected in the forward-looking statements or
after the date hereof, whether as a result of changes, new information, future
events, or otherwise.
RESULTS OF OPERATIONS
The following table sets forth certain consolidated statement of operations
data as a percentage of revenue for the periods indicated:
Three months ended Nine months ended
--------------------------- --------------------------
September 30, October 1, September 30, October 1,
2001 2000 2001 2000
------------- ---------- ------------- ----------
Revenue 100.0% 100.0% 100.0% 100.0%
Cost of revenue 47.4 35.9 41.6 35.9
------- ------- ------- -------
Gross profit 52.6 64.1 58.4 64.1
------- ------- ------- -------
Operating expenses:
Research and development, net 35.9 32.9 40.7 29.6
Selling and marketing 30.3 48.0 38.0 48.5
General and administrative 27.4 19.9 23.5 20.3
Amortization of acquired intangibles 7.4 4.8 6.7 4.3
Loss from divestiture of Algorithmic Research, Ltd. 2.8 -- 7.7 --
Purchased in-process technology -- 21.4 -- 7.0
------- ------- ------- -------
Total operating expenses 103.8 127.0 116.6 109.7
------- ------- ------- -------
Loss from operations (51.2) (62.9) (58.2) (45.6)
Other income, net 5.3 0.6 2.1 1.7
------- ------- ------- -------
Loss before income taxes (45.9) (62.3) (56.1) (43.9)
Income tax benefit -- -- (3.2) --
------- ------- ------- -------
Net loss (45.9)% (62.3)% (52.9)% (43.9)
======= ======= ======= =======
8
Revenue. Revenue decreased 40% from $17.2 million for the three months
ended October 1, 2000 to $10.3 million for the three months ended September 30,
2001, and decreased 31% from $52.6 million for the nine months ended October 1,
2000 to $36.5 million for the nine months ended September 30, 2001. The decrease
is primarily due to a market slowdown. International revenue was 32% and 33% of
total revenue for the third quarter of 2001 and 2000, respectively.
Gross Profit. Gross profit decreased from $11.0 million for the three
months ended October 1, 2000 to $5.4 million for the three months ended
September 30, 2001 and decreased from $33.7 million for the nine months ended
October 1, 2000 to $21.3 million for the nine months ended September 30, 2001.
The decrease in dollars was primarily a result of the decrease in revenue. As a
percentage of sales, gross profit was approximately 64% and 53% for the quarters
ended October 1, 2000 and September 30, 2001, respectively. The decrease in
gross profit as a percentage of revenue was a result of higher provisions for
inventory writedowns, manufacturing inefficiencies due to low production levels,
lower margins on non-core revenue, offset by margin improvements from our ATM
encryptor product resulting from our acquisition of Celotek Corporation and
margin improvements in customer support.
Research and Development. Research and development expenses consist
primarily of salaries and other personnel related expenses, depreciation of
development equipment, facilities and supplies. Gross research and development
expenses decreased 35% from $5.7 million for the three months ended October 1,
2000 to $3.7 million for the three months ended September 30, 2001 and decreased
5% from $15.6 million for the nine months ended October 1, 2000 to $14.9 million
for the nine months ended September 30, 2001. Gross research and development
expenses as a percentage of revenue were 33% for the third quarter of 2000 and
36% for the third quarter 2001. The dollar decrease resulted from reduced
project spending and headcount as a result of cost savings initiatives,
partially offset by the acquisition of the Celotek ATM development team. The
increase in expense as a percentage of revenue for the third quarter of 2001 is
due to a greater decline in revenues than the reduction in product development
expenditures.
Selling and Marketing. Selling and marketing expenses consist primarily of
personnel expenses, including sales commissions and bonuses, and expenses for
advertising, public relations, seminars and trade shows. Selling and marketing
expenses decreased 63% from $8.3 million for the three months ended October 1,
2000 to $3.1 million for the three months ended September 30, 2001, and
decreased 45% from $25.5 million for the nine months ended October 1, 2000 to
$13.9 million for the nine months ended September 30, 2001. Selling and
marketing expenses as a percentage of revenue were 48% and 30% for the third
quarter of 2000 and 2001, respectively. Sales expenses decreased for the third
quarter of 2001 compared to the third quarter of 2000 primarily due to lower
commission spending driven by decreased revenues, lower headcount spending
driven by the reduction in workforce actions taken during the fourth quarter of
2000, and lower marketing and bonus spending due to the implementation of cost
savings initiatives. Selling and marketing expenses, expressed as a percentage
of revenue, decreased as a result of the above spending reductions which were
greater than the percentage revenue declines for the same period.
General and Administrative. General and administrative expenses consist
primarily of personnel and related costs, recruitment expenses, information
systems costs, and audit, legal and other professional service fees. General and
administrative expenses decreased 18% from $3.4 million for the three months
ended October 1, 2000 to $2.8 million for the three months ended September 30,
2001, and decreased 20% from $10.7 million for the first nine months of 2000 to
$8.6 million for the first nine months of 2001. General and administrative
expenses as a percentage of revenue were 20% and 27% for the third quarter of
2000 and 2001, respectively. The dollar decrease in the third quarter of 2001
versus the third quarter of 2000 was primarily due to lower headcount spending
driven by the reduction in workforce actions taken during the fourth quarter of
2000 as well as the third quarter of 2001, and lower bonus spending due to the
implementation of cost savings initiatives. The increase in expense as a
percentage of revenue for the third quarter of 2001 is due to greater decline in
revenues than the reduction in general and administrative expenditures.
Loss from divestiture of Algorithmic Research, Ltd. In the quarter ended
September 30, 2001, the Company recorded an additional charge of $0.3 million to
cover additional losses associated with the divestiture of that subsidiary. (See
Note 7 to condensed consolidated interim financial statements.) The Company had
previously recorded a charge in the second quarter of 2001 of $2.5 million to
cover the impairment in the value of assets associated with the wind-up of that
subsidiary.
9
Amortization of Acquired Intangibles. Amortization relating to goodwill and
other intangibles remained constant at $0.8 million for the first three months
ended October 1, 2000 and the three months ended September 30, 2001,
respectively, and increased 4% from $2.3 million for the nine months ended
October 1, 2000 to $2.4 million for the nine months ended September 30, 2001.
The dollar increase in the first nine months of 2001 versus the first nine
months of 2000 was primarily due to the acquisition of Celotek Corporation in
the third quarter of 2000, offset in part by reduced amortization of intangibles
related to the acquisition of Algorithmic Research, Ltd ("ARL").
Other Income (Expense), Net. Other income (expense), net consists primarily
of interest income and interest expense, foreign exchange gains or losses,
royalty income, and impairment losses from investments in non-operating
companies. Other income, net increased from $0.1 million for the quarter ended
October 1, 2000 to $0.6 million for the quarter ended September 30, 2001,
principally due to interest income on the recognition of deferred income from
the payment of an employee note receivable, and foreign currency gains, offset
by the recognition of an impairment loss of $0.3 million on the Company's
investment in an unaffiliated company.
Provision for Income Taxes. No significant provision for or benefit from
income taxes was recognized in the either the quarter ended October 1, 2000 or
the quarter ended September 30, 2001, as the Company incurred a net operating
loss for income tax purposes and the tax benefit therefrom was offset by an
increase in the valuation allowance on the deferred tax asset.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 2001, the Company had working capital of $12.9 million
(including cash and cash equivalents of $10.4 million) and minimal long-term
obligations. For the nine months ended September 30, 2001, the Company recorded
a net loss of $19.3 million. Net cash used in operating activities for the first
nine months of 2001 was $2.8 million consisting primarily of the loss from
operations partially offset by a decrease in working capital requirements, which
included a decrease in accounts receivable of $6.4 million, a decrease in
inventories of $4.7 million, an increase in deferred revenue of $0.5 million,
partially offset by a decrease in accounts payable and accrued liabilities of
$4.6 million, tax refunds of $3.3 million, and an increase in other assets of
$0.3 million. The decrease in accounts receivable was due to lower shipments
during the quarter supported by improved collection activities. The decrease in
inventories and the decrease in accounts payable were the result of stricter
purchasing controls. The decrease in accrued liabilities was due principally to
decreased commission, bonus, and legal liabilities, along with decreased
employment liabilities resulting from reduced headcount. Net cash used in
operating activities for the first nine months of 2000 was $20.5 million
consisting primarily of the loss from operations, an increase in accounts
receivable of $1.0 million, an increase in inventories of $5.4 million, a
decrease in accounts payable and accrued liabilities of $1.5 million, offset in
part by an increase in deferred revenue of $1.3 million.
Cash used in investing activities for the nine months ended September 30,
2001 and October 1, 2000 was $2.0 million and $3.7 million, respectively. Cash
used in investing activities for the first nine months of 2001 provided for the
acquisition of $0.6 million of property, plant and equipment, $1.9 million
transferred in connection with the divestiture of our Algorithmic Research, Ltd.
subsidiary, and was offset by $0.6 million collection of an employee note
receivable. Cash used in investing activities for the first nine months of 2000
provided for the acquisition of $2.6 million of property, plant and equipment
and $1.1 million for the acquisition of Celotek Corporation.
Cash used in financing activities for the nine months ended September 30,
2001 was not material. Cash provided by financing activities for the nine months
ended October 1, 2000 was $6.2 million, resulting from proceeds from the sale of
1,006,000 shares of stock, pursuant to the exercise of stock options.
The Company is currently engaged in litigation. See Part II, Item 1 "Legal
Proceedings." Management believes that the ultimate resolution of these matters
will not have a material adverse effect on the Company's financial position or
results of operations.
Assuming the Company's financial restructuring plan provides the intended
beneficial cost reduction, the Company believes that existing cash balances and
prospective borrowing will be sufficient to fund operations through the next
twelve months. Cylink has a $7.5 million revolving line of credit with its bank
that will assist the Company, if necessary, in meeting its working capital
requirements. This line of credit is subject to the Company's satisfaction of a
10
tangible net worth covenant during the term of the loan. There have been no
advances under the Company's current or pre-existing line since inception. In
the event the Company's financial plan is unsuccessful, or it is otherwise
unable to satisfy the conditions for use of this revolving line of credit, the
Company may require additional funds in the near term to support working capital
requirements or for other purposes and may seek to raise such additional funds
through public or private equity or debt financing, sales of assets, or from
other sources. No assurance can be given that additional financing will be
available or that, if available, will be on terms favorable to the Company or
its shareholders.
11
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
We have a history of losses and expect this to continue for the foreseeable
future.
We have incurred significant net losses in the third quarter of 2001 and in
prior years. The Company had an accumulated deficit of $118 million as of
September 30, 2001. We expect to continue to incur net losses at least through
2001. We might not increase or maintain our revenue or be profitable on a
quarterly or an annual basis for the foreseeable future. Our continuing losses
may adversely impact our ability to raise additional capital when required. Our
restructuring plans may not succeed, or may not be sufficient to allow us to
achieve break-even.
The Company believes that its principal sources of liquidity, which include
cash and cash equivalents of $10.4 million as of September 30, 2001 and
prospective borrowing via the Company's working capital loan, will satisfy the
Company's current anticipated working capital and capital expenditure
requirements through at least the next twelve months. The Company's working
capital loan matures in April 2002 and provides for up to $7.5 million of
borrowings, depending on the amount of eligible domestic accounts receivable, as
defined in the agreement. The Company has renegotiated its credit facility in
order to obtain more favorable covenants. There is no guarantee, however, that
the Company can continue to meet those covenants, and there is no guarantee that
the loan will be renewed in April 2002. If the Company fails to do either, the
line of credit will not be available to fund our operations if it is needed.
During the fourth quarter of 2000 and the first, second and third quarters
of 2001, the Company began to realize the benefits of the actions taken to
reduce operating costs in its core business, and believes such cost reductions
are sustainable for the rest of 2001. However, there can be no assurance that
the Company will be able to continue reducing costs at a pace that reflects
reductions in revenues, and no assurance that the Company will not need to raise
additional capital to fund operations within this period. There can be no
assurance that additional financing can be obtained on acceptable terms, or at
all. If additional funds are raised by issuing equity securities, dilution to
shareholders may result. If adequate funds are not available, the Company, its
business, and the price of our Common Stock will be adversely affected.
Our quarterly operating results may vary in the future, which could cause our
stock price to drop.
We have historically experienced significant fluctuations in our operating
results on a quarterly basis and could experience such fluctuations in the
future. Our revenues and operating results could be affected by a number of
factors including the following:
o our inability to accurately forecast revenues and respond in a timely
manner to changes in revenue levels;
o the timing of the introduction by us or by our competitors of new or
enhanced products;
o market acceptance of our new products and those of our competitors;
o the timing, cancellation or delay of customer orders, including
cancellation or delay in anticipation of new product introductions or
enhancements, or resulting from uncertainty relating to intellectual
property infringement claims;
o changes in our pricing policies or those of our competitors;
o changes in operating costs and expenses, including those resulting
from changes in available production capacity of independent foundries
and other suppliers and the availability of raw materials;
o changes in the revenue mix from products or services sold;
o changes in the percentage of products sold through our direct sales
force;
o loss of an important customer;
o failure to grow our customer base in accordance with market
expectations;
o customer discounts and credits;
12
o our limited ability to reduce expenses to offset any unexpected
shortfall in revenue growth or decrease in revenue;
o delays in manufacturing due to shortages in components or
unanticipated revisions in product design;
o disruption in the supply of OEM products caused by financial hardship
of suppliers;
o expenses incurred in seeking to enforce or defend claims with respect
to intellectual property rights;
o changes in the economy that affect the purchasing decisions of our
customers; and
o disruption in our operations caused by reductions in our workforce.
Many of these factors are outside of our control. Unforeseen reductions in
revenue can materially and adversely affect our ability to raise capital or
sustain ongoing operations.
We introduced a number of new products during 2000, and plan to release new
versions of existing products in 2001. The failure of any such products to
achieve market acceptance when anticipated, or at all, would materially and
adversely affect our financial condition and results of operations.
Pending Litigation
See Part II, Item 1. "Legal Proceedings."
Our sales cycles are long and unpredictable, which makes period-to-period
revenues difficult to predict.
Sales of our products generally involve a significant commitment of capital
by customers, with the attendant delays frequently associated with large capital
expenditures. For these and other reasons, the sales cycle associated with our
products is typically lengthy and subject to a number of significant risks over
which we have little or no control. We are often required to ship products
shortly after we receive orders. Consequently, order backlog at the beginning of
any period has, at times in the past, represented only a small portion of that
period's expected revenue. Furthermore, increases in backlog from quarter to
quarter may be due to placement of orders calling for delivery dates extended
over a much longer period of time into future periods. Consequently, our order
backlog becomes more vulnerable to customer cancellations. As a result of these
fluctuations in our sales cycle and order backlog, product revenue in any period
has been and will continue to be substantially dependent on orders booked and
shipped in that period. We typically plan our production and inventory levels
based on internal forecasts of customer demand, which are highly unpredictable
and can fluctuate substantially. In particular, market forces beyond our
control, including recession, labor strikes among our customers, and limits or
changes in government spending may have a material affect on customer demand for
our products. If revenue falls significantly below anticipated levels, as it has
in the current quarter and at times in the past, our financial condition and
results of operations would be materially and adversely affected. In addition,
our operating expenses are based on anticipated revenue levels and a high
percentage of our expenses are generally fixed in the short term. Based on these
factors, a small fluctuation in the timing of sales can cause operating results
to vary significantly from period to period. It is possible that in the future
our operating results will again be below the expectations of securities
analysts and investors. In such an event, or in the event that adverse
conditions prevail or are perceived to prevail generally or with respect to our
business, or the market sector in which we operate, the price of our Common
Stock would likely be adversely affected. These factors make it difficult to
predict our financial performance. As our quarterly results fluctuate, they may
fall below the expectations of public market analysts or investors. If this
occurs, the price of our Common Stock may drop.
The overall economic climate continues to be weak.
Our products typically represent substantial capital commitments by
customers, involving a potentially long sales cycle. As a result, customer
purchase decisions may be significantly affected by a variety of factors
including trends in capital spending for telecommunications or enterprise
software for contact center servers, market competition, and the availability or
announcement of alternative technologies. Continued recent weakness in general
economic conditions has resulted in many of our customers delaying and/or
reducing their capital spending related to information systems. If the economy
continues to be weak, demand for the Company's products could decrease resulting
in lower revenues and a decline in the overall rate of the Company's revenue
growth.
13
We are dependent on recently introduced and new network security products.
Our future results of operations will be highly dependent on the successful
marketing and manufacture of the NetHawk product, as well as successful
marketing and manufacture of the Cylink Link Encryptors, PrivaCy Manager, Cylink
ATM, and Cylink Frame Encryptor products. To date, we have made only limited
commercial shipments of our NetHawk product, which began shipping in mid-year
2000. This product may require additional development work, enhancement, and
testing or further refinement before it achieves widespread commercial success.
If this or other new or recently introduced products have performance,
reliability, quality or other shortcomings, such products could fail to achieve
adequate market acceptance. The failure of our new or existing products to
achieve or enjoy market acceptance, whether for these or other reasons, could
cause us to experience reduced orders, higher manufacturing costs, delays in
collecting accounts receivable and additional warranty and service expenses,
which in each case could have a material adverse effect on our business,
financial condition and results of operations. Furthermore, we have relied on a
third party original equipment manufacturer to supply our ISDN Encryptor
product, and we have had limited control over the supply of this product. Our
former supplier of ISDN products declared bankruptcy, our current supplier has
also advised us of its probable insolvency, and we may not be able to engage an
equivalent substitute. Our NetAuthority product is presently installed with the
United States Postal Service under a license agreement signed in 2000. A
decision by the Postal Service to attempt to withdraw from or renegotiate this
license could have a material adverse impact on our business.
We face significant competition from other providers of network security systems
Competition is intense among providers of network security systems, and we
expect such competition to increase in the future. Significant competitive
factors in these markets include:
o the development of new products and features;
o product quality and performance;
o customer perception regarding the adequacy of security provided by
existing software and routers;
o adoption of embedded security solutions in other vendor's hardware and
software products;
o the quality and experience of our sales, marketing and service
organizations;
o product price;
o name recognition; and
o perception of our stability and long-term viability.
Many of these competitive factors are beyond our control.
Our competitors in the information security markets, including companies
that offer products similar to, or as an alternative to, the Company's products,
include Axent Technologies, Inc., Checkpoint Software Technologies, Ltd.,
Network Associates, Inc., SafeNet, Inc., Secure Computing Corporation, RSA
Security, Inc., and Thales e-Security, Inc. Our NetHawk VPN appliance competes
with numerous other products, including those offered or under development by
Cisco Systems, Inc., Newbridge Networks Corporation, Netscreen Technologies,
Inc., Nokia Corp, and SonicWall, Inc. A number of significant vendors, including
Microsoft Corporation, and Cisco Systems, Inc. have embedded security solutions
in their software. To the extent that these embedded or optional security
capabilities provide all or a portion of the functionality provided by our
products, our products may no longer be required by customers to attain network
security.
Certicom Corporation and RSA Security, Inc. license various methods of
implementing public key cryptography, including some that are different from
(and incompatible with) the method of implementing public key cryptography
currently used in some of our products. Although we have a license to use all of
the public key methods promoted by Certicom and RSA, (and some of the methods
promoted by RSA have entered the public domain), to the extent significant
segments of the network security market adopt technical standards different from
those currently used by us, to the exclusion of our methods, sales of our
existing and planned products in that market segment may be adversely impacted,
which could have a material adverse effect on our financial condition and
results of operations.
14
Many of our competitors have substantially greater financial, technical,
marketing, distribution and other resources, greater name recognition and longer
standing relationships with customers than we possess. Competitors with greater
financial resources are better able to engage in more aggressive marketing
campaigns and sustained price reductions in order to gain market share. Any
period of sustained price reductions would have a material adverse effect on our
financial condition and results of operations. We may not be able to compete
successfully in the future and competitive pressures may result in price
reductions, loss of market share or otherwise have a material adverse effect on
our financial condition and results of operations.
We face the risks from tort and warranty claims that may be made against us.
We face the risks from tort and warranty claims that may be made against
us. Customers rely on our network security products to prevent unauthorized
access to their networks and data transmissions. A malfunction or the inadequate
design of our products could result in tort or warranty claims. A breach of a
customer's network by an unauthorized party, which is attributable to an alleged
defect in our products, may cause substantial damages due to loss or compromise
of the customer's valuable information. Furthermore, there is inadequate legal
precedent for allocating responsibility for such losses caused by the wrongful
acts of third parties. Although we attempt to reduce the risk of such losses
through warranty disclaimers and liability limitation clauses in our sales and
license agreements and by maintaining product liability insurance, there can be
no assurance that such measures will be effective in limiting our liability for
any such damages. Any liability for damages resulting from security breaches
could be substantial and could have a material adverse effect on our business,
financial condition and results of operations.
On August 2, 2001, Cylink determined that a hardware design could cause a
premature failure of its the backup battery on its Cylink Frame Encryptor (CFE)
product. Cylink has announced a program to give its customers the option of
updating their CFE units by returning them to the factory, or receiving an
extended warranty covering the battery through the end of December 2002. Cylink
accrued approximately $1.0 million in warranty costs during the second quarter
associated with this program. While this reserve was based on reasonable
estimates based on information available to us at the time, actual costs could
exceed these reserves.
In addition, a well-publicized actual or perceived security breach could
adversely affect the market's perception of security products in general, or our
products in particular, regardless of whether such breach is attributable to our
products. This could result in a decline in demand for our products, which would
have a material adverse effect on our business, financial condition and results
of operations.
We may be unable to retain our executive officers and key personnel that are
critical to our business.
Our future success will depend in large part on the abilities of our
executive officers, key management and technical personnel and our ability to
retain qualified and competent individuals following our recent reductions in
the employee workforce. There is no guarantee that our present executive
management and technical staff will remain with the Company, particularly if our
performance is not up to expectations. The loss of the services of one or more
of our executive officers or key personnel, or the inability to attract and
retain additional executives and other qualified personnel, could delay product
development cycles or otherwise have a material adverse effect on our business
and operating results
We may not be able to hire and retain sufficient technical, marketing and
management personnel that we need to succeed because these people are limited in
number and are in high demand.
We may not be able to hire and retain sufficient technical, marketing and
management personnel that we need to succeed because these people are limited in
number and are in high demand. We recently experienced, and may continue to
experience, substantial fluctuations in the number of employees and the scope of
our operations in the network security business, resulting in increased
responsibilities for management. To manage our business effectively, we will
need to continue to improve our operational, financial and management
information systems and to hire, train, motivate and manage our employees. In
the recent past, competition has been intense for qualified technical, marketing
and management personnel. In particular, the current availability of qualified
engineers in our field is quite limited, and we compete with other companies,
academic institutions, government entities and other organizations for skilled
and experienced engineers. Furthermore, the recent reductions in our workforce,
and reduction in our stock price, may create greater uncertainty amongst our
existing employees, who may decide not to continue employment with the Company.
There can be no assurance that we will be able effectively to achieve or manage
any future
15
growth, and our failure to do so could delay product development cycles or
otherwise have a material adverse effect on our financial condition and results
of operations.
Any inability to protect our intellectual property could reduce our competitive
advantage, divert management attention, require additional intellectual property
to be developed or cause us to incur expenses to enforce our rights.
We rely on patents, trademarks, copyrights, licenses and trade secret law
to establish and preserve our intellectual property rights. We own a number of
U.S. patents covering certain aspects of our network security product designs,
and have additional U.S. patent applications pending. There can be no assurance
that any patent, trademark, copyright or license owned or held by us will not be
invalidated, circumvented or challenged, that the rights granted thereunder will
provide competitive advantages to us or that any of our pending or future patent
applications will be issued with the scope of the claims sought by us, if at
all. Further, there can be no assurance that others will not develop
technologies that are similar or superior to our technology, duplicate our
technology, misappropriate our trade secrets, or design around the patents owned
by us. Resorting to the courts to protect our intellectual property would
require significant financial and management resources. In addition, the laws of
certain countries in which our products are or may be developed, manufactured or
sold may not protect our products and intellectual property rights to the same
extent as the laws of the United States. Our inability to protect our
intellectual property adequately could have a material adverse effect on our
financial condition and results of operations.
The computer, communications, software and network security industries are
characterized by substantial litigation regarding patent and other intellectual
property rights. In the past, we have received communications from third parties
asserting that our patents, features or content of certain of our products
infringe upon the intellectual property rights held by third parties, and we may
receive such communications in the future. There can be no assurance that third
parties will not assert claims against us that result in litigation, including
claims that may arise out of the ATM Encryptor business we acquired in August
2000. Any litigation, whether or not determined in our favor, could result in
significant expense to us and could divert management and other resources. In
the event of an adverse ruling in any litigation involving intellectual
property, we might be required to discontinue the use of certain processes,
cease the manufacture, use and sale of infringing products, expend significant
resources to develop non-infringing technology or obtain licenses to the
infringing technology and may suffer significant monetary damages, which could
include treble damages. There can be no assurance that under such circumstances
a license would be available to us on reasonable terms or at all. In the event
of a successful claim against us and our failure to develop or license a
substitute technology on commercially reasonable terms, our financial condition
and results of operations would be adversely affected. There can be no assurance
that existing claims or any other assertions (or claims for indemnity from
customers resulting from infringement claims) will not materially and adversely
affect our financial condition and results of operations.
If we are unable to adapt our services to rapidly changing technology, or if the
market for our network security products fails to develop, our business and
operating results could suffer.
The market for our network security products is characterized by rapidly
changing technology, emerging industry standards, new product introductions and
changes in customer requirements and preferences. Our future success will depend
in part upon end users' demand for network security products in general, and
upon our ability to enhance our existing products and to develop and introduce
new products and technologies that meet customer requirements. We face
continuing challenges to educate customers as to the value of our security
products. We believe that many potential customers do not appreciate the need
for our security products unless and until they have faced a major security
breach. Many potential customers prefer not to disclose significant security
breaches of their networks or are reluctant to invest in the development of a
professional security architecture to protect their networks. This market
resistance is compounded by our limited resources to invest in marketing
campaigns for our products and services.
If we are unable successfully to educate potential customers as to the
value of, and thereby obtain broad market acceptance for, our products and
services, we will continue to rely primarily on selling new and existing
products to our base of existing customers, which will significantly limit any
opportunity for growth. In addition, any significant advance in technologies for
attacking cryptographic systems could render some or all of our existing and new
products obsolete or unmarketable. To the extent that a specific method other
than ours is adopted as the standard for implementing network security in any
segment of the network security market, sales of our existing and planned
products in that market segment may be adversely impacted, which could have a
material adverse effect on our
16
business, financial condition and results of operations. The National Institute
of Standards and Technology has recently announced that it will adopt a new
Advanced Encryption Standard, or AES, which we expect to integrate into our
products. Our ability to timely implement the AES into our products may
materially affect our development costs and ability to timely market our
solutions. Network security-related products or technologies developed by others
may adversely affect our competitive position or render our products or
technologies noncompetitive or obsolete.
In addition, a portion of the sales of our network security products will
depend upon a robust industry and infrastructure for providing access to public
switched networks, such as the Internet. The infrastructure or complementary
products necessary to make these networks into viable commercial marketplaces
may not be fully developed, and once developed, these networks may not become
viable commercial marketplaces.
If our research and development activities are unsuccessful, we will not be able
to market new products and services and our business operations and financial
results could be harmed.
The markets for our products are characterized by rapidly changing
technologies, extensive research and new product introductions. We believe that
our future success will depend in part upon our ability to continue to enhance
our existing products and to develop, manufacture and market new products. As a
result, we expect to continue to make a significant investment in engineering,
research and development. We may not be able to develop and introduce new
products or enhancements to our existing products in a timely manner that
satisfy customer needs, achieve market acceptance or address technological
changes in our target markets. If we fail to develop products and introduce them
successfully and in a timely manner, this could adversely affect our competitive
position, financial condition and results of operations.
We face risks associated with our international operations.
We plan to continue to expand our foreign sales channels and to enter
additional international markets, both of which will require significant
management attention and financial resources. International sales are subject to
a number of risks, including unexpected changes in regulatory requirements,
export control laws, tariffs and other trade barriers, political and economic
instability in foreign markets, difficulties in the staffing, management and
integration of foreign operations, longer payment cycles, greater difficulty in
collecting accounts receivable, currency fluctuations and potentially adverse
tax consequences. Since most of our foreign sales are denominated in U.S.
dollars, our products become less price competitive in countries in which local
currencies decline in value relative to the U.S. dollar. The uncertainties of
monetary exchange values have caused, and may in the future cause, some foreign
customers to delay new orders or delay payment for existing orders. The
long-term impact of such devaluation, including any possible effect on the
business outlook in other developing countries, cannot be predicted.
Our ability to compete successfully in foreign countries is dependent in
part on our ability to obtain and retain reliable and experienced in-country
distributors and other strategic partners. We do not have long-term
relationships with any of our value added resellers and distributors and,
therefore, have no assurance of a continuing relationship within a given market.
Due to U.S. government regulations restricting the export of cryptographic
devices and software, including our network security products to non-civilian
agencies of foreign governments, we are often at a disadvantage in competing for
international sales compared to companies located outside the United States that
are not subject to such restrictions. Although the Department of Commerce
continues to relax the export control laws as they apply to sales of our
products to our commercial customers, we still face export controls on sales to
certain foreign governments and transfers of our technology to foreign partners.
We may incur additional claims arising from the ARL Divestiture.
Under the ARL Divestiture, ARL assumes liability for all of the tax
consequences to ARL of the divestiture, the forgiveness of debt, and for the
sale and licenses of ARL's intellectual property. ARL also retains liability for
its contractual obligations, including those arising under certain contracts
assigned to ARL. Although Cylink is indemnified by ARL under the ARL Divestiture
from such obligations, third parties may seek to hold Cylink liable, instead of
or in addition to ARL, for ARL's legal obligations that arose or were incurred
prior to Cylink's divestiture of its controlling interest in ARL.
17
We face risks from our dependence on third party subcontractors and suppliers.
Our ability to deliver our products in a timely manner is dependent upon
the availability of quality components and subsystems used in these products. We
depend in part upon subcontractors to manufacture, assemble and deliver certain
items in a timely and satisfactory manner. We obtain certain components and
subsystems from a single, or a limited number of, sources. A significant delay
in obtaining a source of supply for components selected by our design engineers
or interruption in the delivery of such items could have a material adverse
effect on our financial condition and results of operations.
During telephonic discussions in October 2001, the Company received reports
that the sole OEM supplier of its ISDN encryptor product was experiencing
financial difficulties, and may face insolvency proceedings. The commencement of
insolvency proceedings would have a significant impact on the Company's ability
to fulfill ISDN orders and a consequent negative impact on revenues for the
fourth quarter of 2001 and the first half of 2002.
Cylink Common Stock could be delisted from the NASDAQ National Market, which
could adversely affect Cylink and its shareholders.
On July 25, 2001, the Company received a notice from the staff of the
Nasdaq National Market that its Common Stock had failed to maintain the minimum
bid price of $1.00 over the prior 30 trading days as required for continued
listing on the Nasdaq National Market. The notice states that if during the 90
days following the date of the notice the bid price of Cylink Common Stock does
not close at or above $1.00 for at least 10 consecutive trading days, then
Cylink Common Stock could be delisted.
Prior to any actual delisting, Cylink will have an opportunity to request a
hearing. At a hearing, Cylink may present a plan demonstrating that the Company
can comply with the continued listing requirements. At present, the Company has
made no decision with respect to a course of action but will continue to
evaluate alternatives, including accepting a delisting determination.
On September 27, 2001, NASDAQ suspended its minimum bid price requirements
until January 2002.
If Cylink Common Stock is delisted from the Nasdaq National Market, the
Company may or may not apply for listing on the Nasdaq SmallCap Market, the OTC
Bulletin Board or another quotation system or exchange on which the Company
could qualify. The Company cannot guarantee, however, that it would apply for
listing on another quotation system or exchange if the Company is delisted from
the Nasdaq National Market or that if the Company does apply for listing that it
would be eligible initially for such listing or that if the Company did become
listed, that it would be able to maintain eligibility. Listing on another
quotation system or exchange may negatively affect the price of Cylink Common
Stock because stocks trading on over-the-counter markets are typically less
liquid and trade with larger variations between the bid and ask prices. In
addition, the delisting of Cylink Common Stock from the Nasdaq National Market
would adversely affect or limit or restrict the Company's ability to raise funds
through stock issuances.
If the market price for Cylink Common Stock falls below $1.00 per share and
Cylink is no longer listed on the Nasdaq National Market, Cylink Common Stock
may be deemed to be penny stock. If Cylink Common Stock is considered penny
stock, it would be subject to rules that impose additional sales practices on
broker-dealers who sell Cylink securities. For example, broker-dealers must make
a special suitability determination for the purchaser and have received the
purchaser's written consent to the transaction prior to sale. Also, a disclosure
schedule must be prepared prior to any transaction involving a penny stock and
disclosure is required about sales commissions payable to both the broker-dealer
and the registered representative and current quotations for the securities.
Monthly statements are also required to be sent disclosing recent price
information for the penny stock held in the account and information on the
limited market in penny stock. Because of these additional obligations, some
brokers may be unwilling to effect transactions in penny stocks. This could have
an adverse effect on the liquidity of Cylink Common Stock.
18
Terrorist attacks may negatively impact all aspects of our operations, revenues,
costs and stock price.
Recent terrorist attacks in the United States, as well as future events
occurring in response or connection to them, including, without limitation,
future terrorist attacks against United States targets, rumors or threats of
war, actual conflicts involving the United States or its allies or military or
trade disruptions impacting our domestic or foreign suppliers of merchandise,
may impact our operations, including, among other things, causing delays or
losses in the delivery of merchandise to us and decreased sales of the products
we carry. More generally, any of these events have affected, and will continue
to affect, the general economy and customers' demand for capital equipment. Any
of these occurrences could have a significant impact on our operating results,
revenues and costs, may result in the volatility of the market price for our
Common Stock and, have an adverse impact on the future price of our Common
Stock.
We face risks associated with our recently completed acquisition of Celotek
Corporation.
On August 30, 2000 we closed our acquisition of Celotek Corporation, or
Celotek, a privately held developer of high-performance Asynchronous Transfer
Mode network security appliances, in exchange for 1,590,137 shares of our Common
Stock with a fair market value of $22,386,000 and cash of approximately
$515,000. In addition, we converted outstanding options to purchase Celotek
Common Stock into options to purchase 307,500 shares of our Common Stock with an
aggregate fair market value of $2,329,000. Celotek employees who became our
employees were issued an additional 40,913 shares of our Common Stock, as an
incentive to remain in Cylink's employment. The shares issued in this
acquisition have increased the number of shares of our Common Stock outstanding,
and therefore will result in earnings per share dilution unless we are able to
realize sufficient financial benefits from the transaction. While we believe we
will achieve financial benefits that will offset the dilution, acquisitions
inherently involve risks and uncertainties. These include potential costs and
management distractions associated with integrating the operations of the two
organizations, the potential loss of key employees of Celotek, the potential
loss of key customers, and potential operational challenges that Celotek may
have and which are sometimes unforeseeable. Any such circumstances could result
in the acquisition of Celotek not rendering sufficient financial benefits to
offset the cost of the acquisition.
Changes in accounting practices could adversely affect the calculation of our
future operating results.
In connection with the acquisition of Algorithmic Research Limited, or ARL,
in September 1997, we allocated $63.9 million of the purchase price to
in-process research and development, or IPR&D, and in accordance with accounting
principles generally accepted in the United States of America recorded an
immediate charge off of that amount on the date of acquisition. The amount
allocated to IPR&D was determined in a manner consistent with widely recognized
appraisal practices.
In a letter dated September 15, 1998, to the American Institute of
Certified Public Accountants, the Chief Accountant of the Securities and
Exchange Commission, or SEC, stated the SEC Staff's concerns about certain
appraisal practices generally employed in determining the fair value of IPR&D.
As a result, it is possible that the SEC Staff may require that any enterprise
that recorded an IPR&D charge revise its estimate of the value of such IPR&D. To
the extent we are required by the SEC Staff to retroactively revise our estimate
of the value of IPR&D, such revision could result in the capitalization of
additional goodwill, the amortization of which would reduce future operating
results.
In November 1998, Cylink announced that its first and second quarter
earnings would have to be restated and that it would have operating losses for
each of the first three quarters of that year. During the ensuing review by the
Company and its independent accountants, certain facts became known indicating
that revenue would have to be restated for the fourth quarter of 1997 as well.
As a result, Cylink filed amended Forms 10Q/A for the first and second quarters
of 1998, and an amended Form 10-K/A for 1997. Shortly thereafter, the SEC
instituted an investigation of Cylink's accounting policies and practices, and
the events leading to the restatements.
On September 27, 2000, the SEC issued an order by consent, finding that
former Cylink executives had engaged in fraudulent accounting practices in the
fourth quarter of 1997 and the first and second quarters of 1998, that the
Company had failed to maintain adequate accounting controls, and that Cylink had
promptly undertaken remedial measures. Cylink consented to entry of a cease and
desist order ensuring maintenance of strict accounting controls in the future.
As a result, we must be diligent in our decisions regarding whether to recognize
revenue in connection with certain transactions.
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Item 3. Quantitative and Qualitative Disclosures about Market Risk
As of September 30, 2001, we held a total of $10.4 million of cash and cash
equivalents. These securities consist primarily of money market funds and
high-grade, short-term corporate obligations. Certain of these securities are
subject to interest rate risk and will decline in value if market interest rates
increase. If market interest rates were to increase immediately and uniformly by
10 % from levels as of September 30, 2001, the decline in fair value of the
portfolio would not be material.
We transact substantially all of our revenues and costs in U.S. dollars and
our results of operations would not be materially affected by fluctuations in
foreign exchange rates. Accordingly, to date, we have not used material amounts
of derivative financial instruments. As of September 30, 2001, we had no fixed
rate obligations except for capitalized leases and long-term debt of
approximately $174,000. As such, the fair value of our fixed rate obligations is
not subject to a material adverse impact from changes in interest rates.
20
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In 1998, Cylink filed amended Forms 10-Q for the first and second quarters
of 1998 and an amended Form 10K for 1997, reflecting restated financial results
for those quarters, and for the fourth quarter of 1997. Between November 6, 1998
and December 14, 1998, several securities class action complaints were filed
against Cylink and certain of its current and former directors and officers in
federal courts in California. These complaints allege, among other things, that
Cylink's previously issued financial statements were materially false and
misleading and that the defendants knew or should have known that these
financial statements caused Cylink's common stock price to rise artificially.
The actions variously allege violations of Section 10(b) of the Securities
Exchange Act of 1934 (the "Exchange Act"), as amended, and SEC Rule 10b-5
promulgated thereunder, and Section 20 of the Exchange Act.
The securities class action lawsuits have been ordered consolidated into a
single action pending in the United States District Court for the Northern
District of California, captioned In Re Cylink Securities Litigation, No.
C98-4292 (VRW). The action is currently pending before the Court.
Cylink believes it has meritorious defenses and adequate insurance for the
damages claimed in these actions and intends to defend itself vigorously.
However, it is not feasible to predict or determine the final outcome of these
proceedings, and if the outcome were to be unfavorable and exceed Cylink's
applicable insurance, Cylink's business, financial condition, cash flows and
results of operations could be materially adversely affected.
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information.
Notice was received July 25, 2001 from the NASDAQ National Market indicating
possible delisting for failure to meet NASDAQ's minimum bid requirements. On
September 27, 2001, NASDAQ suspended its minimum bid price requirements until
January 2002.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits Index:
None
(b) Reports on Form 8-K:
The registrant did not file any reports on Form 8-K during the quarter
ended September 30, 2001.
21
SIGNATURE
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.
Date: November 14, 2001 CYLINK CORPORATION
By: /s/ R. Christopher Chillingworth
--------------------------------
R. Christopher Chillingworth
Vice President of Finance
and Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)
22