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 March 31, 1996
Commission File Number 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 Number)
910 Hermosa Court
Sunnyvale, California 94086
(Address of principal executive offices)
(408) 735-5800
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 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.
(1) YES X NO
--------------- ---------------
(2) YES X NO
--------------- ---------------
As of March 31, 1996, there were 24,885,374 shares of the Registrant's
common stock outstanding.
CYLINK CORPORATION
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION PAGE
Item 1. Financial Statements
Condensed Consolidated Balance Sheets
at March 31, 1996 and December 31, 1995 3
Condensed Consolidated Statements of Operations
for the three months ended March 31, 1996 and 19 4
Condensed Consolidated Statements of Cash Flows
for the three months ended March 31, 1996 and 19 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 8
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 22
Item 6. Exhibits and Reports on Form 8-K
SIGNATURES 25
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CYLINK CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data; unaudited)
March 31, December 31,
1996 1995
ASSETS --------- ---------
Current assets:
Cash and cash equivalents$ $ 81,215 $ 3,240
Marketable securities 2,833 2,858
Accounts receivable, net of allowances
of $459 and $483 5,936 6,013
Inventories 7,112 6,096
Deferred income taxes 2,209 1,556
Other current assets 342 483
--------- ---------
Total current assets 99,647 20,246
Property and equipment, net 2,445 2,295
Other assets 122 184
--------- ---------
$ 102,214 $ 22,725
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Bank borrowings under line of credit $ 0 $ 1,000
Current portion of lease obligation 109 144
Accounts payable 2,588 1,378
Accrued liabilities 4,598 3,741
Income taxes payable 117 90
--------- ---------
Deferred revenue 1,216 1,289
--------- ---------
Total current liabilities 8,628 7,642
--------- ---------
Lease obligations, long-term 236 291
--------- ---------
Deferred income taxes 187 187
Shareholders' equity:
Preferred stock, $.01 par value; 5,000,000
shares authorized; none issued and outstanding 0 0
Common stock, $.01 par value; 40,000,000
shares authorized; 24,885,374 and 17,682,105
shares issued and outstanding 249 191
Additional paid-in capital 88,619 8,864
Notes receivable from shareholders (531) (515)
Deferred compensation related to stock options (396) --
Cumulative marketable securities valuation adjustment 0 (416)
Cumulative translation adjustment (161) (135)
Retained earnings 5,383 6,616
--------- ---------
Total shareholders' equity 93,163 14,605
--------- ---------
$ 102,214 $ 22,725
========= =========
See accompanying notes to Condensed Consolidated Financial Statements.
3
CYLINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data; unaudited)
Three Months Ended
March 31,
----------------------
1996 1995
---- ----
Revenue $ 8,483 $ 7,691
Cost of revenue 3,877 2,815
-------- --------
Gross profit 4,606 4,876
-------- --------
Operating expenses:
Research and development, net 2,602 2,915
Selling and marketing 2,727 2,184
General and administrative 1,135 1,059
-------- --------
Total operating expenses 6,464 6,158
-------- --------
Loss from operations (1,858) (1,282)
Other income (expense):
Interest income, net 364 39
Licensing and other income (expense), net (374) 255
-------- --------
Loss before income taxes (1,868) (988)
Benefit for income taxes (635) (408)
-------- --------
Net loss $ (1,233) $ (580)
======== ========
Net loss per share $ (0.05) $ (0.03)
======== ========
Shares used to compute net loss per share 22,432 19,081
======== ========
See accompanying notes to Condensed Consolidated Financial Statements.
4
CYLINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands; unaudited)
Three Months Ended
March 31,
-------------------
1996 1995
Cash flows from operating activities: ---- ----
Net loss $ (1,233) $ (580)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Write-down of marketable securities 441 -
Depreciation and amortization 211 166
Deferred compensation related to stock options 21 -
Deferred income taxes (653) (55)
Changes in assets and liabilities:
Accounts receivable 77 (843)
Inventories (1,016) (1,444)
Other assets 181 (274)
Accounts payable 1,210 1,728
Accrued liabilities 857 65
Income taxes payable 27 (35)
Deferred revenue (73) 17
-------- ------
Net cash provided by (used in) operating
activities 50 (1,255)
-------- ------
Cash flows used in investing activities
for acquisition of property and equipment (318) (284)
-------- ------
Cash flows from financing activities:
Repayment of borrowings under line of credit (1,000) -
Proceeds from issuance of common stock, net 79,380 26
Repayment of capital lease obligations (133) -
-------- ------
Net cash provided by financing activities 78,247 26
-------- ------
Effect of exchange rate changes on cash and cash
equivalents (4) 10
-------- ------
Net increase (decrease) in cash and cash equivalents 77,975 (1,503)
Cash and cash equivalents at beginning of period 3,240 4,031
-------- ------
Cash and cash equivalents at end of period $ 81,215 $ 2,528
======== =======
Supplemental disclosures:
Cash paid for interest $ 42 $ -
Noncash investing and financing activities:
Property and equipment acquired through capital leases $ 43 $ -
See accompanying notes to Condensed Consolidated Financial Statements.
5
CYLINK CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except share and per share data; 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 fairly state the Company's
consolidated financial position, results of operations, and cash flows for the
periods presented. These financial statements should be read in conjunction with
the Company's audited financial statements as included in the Company's
Registration Statement on Form S-1 as declared effective by the Securities and
Exchange Commission on February 15, 1996 (Reg. No. 33-80719). The consolidated
results of operations for the period ended March 31, 1996 are not necessarily
indicative of the results to be expected for any subsequent quarter or for the
entire calendar year ending December 31, 1996.
2. Initial Public Offering
In February and March 1996, the Company completed its initial public
offering (the "Offering") and issued 5,750,000 shares of its common stock to the
public at a price of $15.00 per share. The Company received approximately $79.3
million of cash, net of underwriting discounts, commissons and other offering
costs.
In December 1995, the Board of Directors approved an increase in the
number of common shares authorized to 40,000,000, to be effective upon the
closing of the Offering.
3. Net Loss Per Share
Net loss per share is computed using the weighted average number of
outstanding shares of common stock and common stock equivalents. Common stock
equivalents consist of stock options (using the treasury stock method). Common
stock equivalents are excluded from the computation if their effect is
antidilutive, except that, pursuant to the requirements of the Securities and
Exchange Commission, common stock equivalents issued subsequent to November 30,
1994 through February 15, 1996 (using the treasury stock method and the initial
public offering price) have been included in the computation as if they were
outstanding for all periods presented through the date of the offering.
4. Balance Sheet Details
March 31, December 31,
1996 1995
------- -------
Inventories:
Raw materials $ 3,610 $ 3,042
Work in process and subassemblies 1,925 1,773
Finished goods 1,577 1,281
------- -------
$ 7,112 $ 6,096
======= =======
Property and equipment:
Machinery and equipment $ 5,211 $ 4,995
Furniture and fixtures 262 179
Leasehold improvements 329 267
------- -------
5,802 5,441
Less: accumulated depreciation and amortization (3,357) (3,146)
------- -------
$ 2,245 $ 2,295
======= =======
6
CYLINK CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except share and per share data; unaudited)
4. Balance Sheet Details (Continued)
March 31, December 31,
1996 1995
------- -------
Accrued liabilities:
Accrued compensation and benefits $ 1,443 $ 1,037
Accrued professional fees 1,112 1,365
Other accrued liabilities 2,043 1,339
------- -------
$ 4,598 $ 3,741
======= =======
7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations
The statements contained in this Report on Form 10-Q that are not purely
historical are forward looking statements within the meaning of Section 27A of
the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of
1934, including statements regarding the Company's expectations, hopes,
intentions, beliefs or strategies regarding the future. Forward looking
statements include Cylink's statement regarding liquidity, anticipated cash
needs and availability, and anticipated expense levels in "Management's
Discussion and Analysis of Financial Condition and Results of Operations";
expected product introductions in "Risk Factors - Recent Losses; Potential
Fluctuations in Operating Results; Future Operating Results"; and expected
growth in "Risk Factors - Management of Growth"; and expected research and
development expenditures and new product introductions in "Risk Factors - Rapid
Technological Change." All forward looking statements included in this document
are based on information available to the Company on the date hereof, and the
Company assumes no obligation to update any such forward looking statement. It
is important to note that the Company's actual results could differ materially
from those in such forward looking statements. Among the factors that could
cause actual results to differ materially are the factors detailed below and the
risks discussed in the "Risk Factors" section included in the Company's
Registration Statement Form S-1, as declared effective by the Securities and
Exchange Commission on February 15, 1996 (Reg. No. 33-80719). You should also
consult the risk factors listed from time to time in the Company's Reports on
Form 10-Q, 8-K, 10-K and Annual Reports to the Stockholders.
RESULTS OF OPERATIONS
Revenue. The Company's total revenue is derived primarily from sales of
its family of commercial information security products and its medium speed
spread spectrum radio products. Fees for maintenance and support services are
charged separately. Revenue from product sales is recognized upon shipment to
the customer. Concurrently, a provision is made for estimated cost to repair or
replace products under warranty arrangements. Revenue from sales to distributors
is recognized upon shipment; no right of return, stock rotation or price
protection is given. Revenue from sales to value added resellers is recognized
upon shipment and concurrently a provision for estimated returns is recorded.
The Company's revenue increased by 10% from $7.7 million for the three
months ended March 31, 1995 to $8.5 million for the three months ended March 31,
1996. Sales of information security products decreased by 24% from $5.1 million
for the three months ended March 31, 1995 to $3.9 million for the three months
ended March 31, 1996 primarily as a result of a decrease in the demand for the
Company's CIDEC encryption product line, which is used in private linked
networks. Sales of wireless communications products increased 77% from $2.4
million for the three months ended March 31, 1995 to $4.2 million for the three
months ended March 31, 1996 primarily as a result of increased demand in
international markets. Maintenance, support and other miscellaneous revenues
increased 72% from $201,000 for the three months ended March 31, 1995 to
$346,000 for the three months ended March 31, 1996.
International product revenue was 37% of total revenue in the three
months ended March 31, 1995, and was 57% of total revenue in the three months
ended March 31, 1996. The increase in international product revenue was due
primarily to increased unit sales of the Company's wireless
8
communication products and to a lesser extent the Company's existing information
security products.
Gross Profit. Gross profit decreased 6% from $4.9 million for the three
months ended March 31, 1995 to $4.6 million for the three months ended March 31,
1996. Gross margins were 63% for the three months ended March 31, 1995 and 54%
for the three months ended March 31, 1996. Gross margin in the first quarter of
1995 was positively affected by increased sales, as a percentage of revenue, of
information security products, which generally have a higher gross margin than
wireless communication products. Gross margins declined in the first quarter of
1996 as a result of higher sales, as a percentage of revenue, of wireless
communication products, which typically have a lower gross margin than
information security products.
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 increased 25% from $3.0 million for the three months ended March 31,
1995 to $3.7 million for the three months ended March 31, 1996. Research and
development expenses as a percentage of revenue were 39% and 44% for the three
months ended March 31, 1995 and 1996, respectively. From time to time, the
Company receives engineering funding for development projects to apply or
enhance the Company's technology to a particular customer's need. The amounts
recognized under these research and development contracts are offset against
research and development expenses. Amounts recognized under non-recurring
engineering contracts totaled $50,000 for the three months ended March 31, 1995
and $1,119,000 for the three months ended March 31, 1996.
The Company believes that a significant level of investment in product
research and development is required to remain competitive and, accordingly, the
Company anticipates that it will continue to devote substantial resources to
product research and development for at least the remainder of fiscal 1996. The
Company expects research and development expenses will increase in absolute
dollars for at least the remainder of fiscal 1996.
Selling and Marketing. Selling and marketing expenses consist primarily
of personnel costs, including sales commissions, and all costs of advertising,
public relations, seminars and trade shows. Selling and marketing expenses
increased 25% from $2.2 million in the three months ended March 31, 1995 to $2.7
million for the three months ended March 31, 1996. Selling and marketing
expenses as a percentage of revenue were 28% and 32% for the three months ended
March 31, 1995 and 1996, respectively. The percentage increase was primarily due
to costs associated with the
9
expansion of the Company's direct sales force, personnel increases in the
marketing group, and increased costs associated with advertising, public
relations and trade shows.
General and Administrative. General and administrative expenses consist
primarily of personnel and related costs, recruitment expenses, MIS costs, and
audit, legal, and other professional service fees. General and administrative
expenses increased from $1,059,000 for the three months ended March 31, 1995 to
$1,135,000 for the three months ended March 31, 1996. General and administrative
expenses as a percentage of revenue were 14% and 13% for the three months ended
March 31, 1995 and 1996, respectively. The increase in dollar amount was
primarily due to increased staffing and professional fees necessary to manage
and support the Company's recent growth and provide infrastructure required for
a public company. The Company believes that its general and administrative
expenses will increase in absolute dollar amounts for at least the remainder of
fiscal 1996 as the Company continues to expand its administrative staff and due
to increased professional fees related to reporting requirements as a public
company.
Other Income,(Expense) Net. Other income,(expense) net, primarily
consists of royalties, interest income and interest expense. Other income
decreased from $294,000 in the three months ended March 31, 1995 to a net
expense of $10,000 in the three months ended March 31, 1996. The decrease was
principally due to a decrease in royalty income from two licensees of the
Company's wireless application specific integrated circuit ("ASIC") products for
cordless telephones from $187,000 to $44, offset by an increase in interest
income from $39,000 in the three months ended March 31, 1995 to $364,000 for the
three months ended March 31, 1996. The increase in interest income was due to
the funds derived from the Company's initial public offering in February. The
Company wrote down its investment in marketable securities in the first quarter
of 1996 by $441,000 as management concluded the decline in value was permanent.
Benefit for Income Taxes. The benefit for income taxes as a percentage
of loss before taxes was 41% for the three months ended March 31, 1995 and 34%
for the three months ended March 31, 1996.
LIQUIDITY AND CAPITAL RESOURCES
In February 1996, the Company completed its initial public offering and
its common stock began trading on the Nasdaq National Market under the symbol
CYLK. Through the offering, the Company sold 5,750,000 shares of its common
stock which generated approximately $79.3 million, net of underwriting
discounts, commissions and other offering costs.
10
As of March 31, 1996, the Company had $84.0 million in cash, cash
equivalents and marketable securities. Net cash provided by operating activities
was $50,000 for the three months ended March 31, 1996. Cash provided by
operating activities consisted primarily of increases in accounts payable and
accrued expenses and a decrease in other assets, which were partially offset by
the net loss and an increase in inventory.
The Company has a credit agreement with a bank which provides a line of
credit for working capital advances of up to $5.0 million or a specified
percentage of eligible accounts receivable. Interest on borrowings under the
line of credit is set at the 30-day LIBOR plus 2.0%. At March 31, 1996, no
borrowings were outstanding under the line of credit.
The Company believes that its current cash, cash equivalents,
marketable securities and line of credit will be sufficient to fund necessary
purchases of capital equipment and to provide working capital through at least
1996.
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
Recent losses; Potential Fluctuations in Operating Results, Future Operating
Results Uncertain.
Due primarily to increased research and development, sales and
marketing, and litigation expenses, the Company incurred losses in 1994 and 1995
and the first quarter of 1996. There can be no assurances that the Company will
increase or maintain its revenue or be profitable on a quarterly or an annual
basis in the future.
The Company has historically experienced significant fluctuations in
its operating results on an annual and a quarterly basis and could experience
such fluctuations in the future. The Company's operating results are affected by
a number of factors, many of which are outside of the Company's control,
including: the timing of the introduction of new or enhanced products by the
Company or its competitors; market acceptance of new products of the Company,
its customers and its competitors; the timing, cancellation or delay of customer
orders, including cancellation or delay in anticipation of new product
introduction or enhancement or resulting from uncertainty relating to
intellectual property claims; competitive factors, including pricing pressures;
changes in operating expenses, including those resulting from changes in
available production capacity of independent foundries and other suppliers and
the availability of raw materials; expenses associated with obtaining, enforcing
and
11
defending claims with respect to intellectual property rights; the mix of
products sold; changes in the percentage of products sold through the Company's
direct sales force; personnel changes; general economic conditions; and
fluctuations in foreign currency exchange rates. The Company expects to
introduce a number of new products in 1996. The failure of such new products to
achieve market acceptance at the time anticipated by the Company, or at all,
would materially and adversely affect the Company's financial condition and
results of operations.
Lengthy Sales Cycle
Sales of the Company's 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 the Company's products is typically lengthy and
subject to a number of significant risks over which the Company has little or no
control. The Company is often required to ship products shortly after it
receives orders and, consequently, order backlog at the beginning of any period
has in the past represented only a small portion of that period's expected
revenue. As a result, product revenue in any period is substantially dependent
on orders booked and shipped in that period. The Company typically plans its
production and inventory levels based on internal forecasts of customer demand,
which is highly unpredictable and can fluctuate substantially. If revenue falls
significantly below anticipated levels, the Company's financial condition and
results of operations would be materially and adversely affected. In addition,
the Company's operating expenses are based on anticipated revenue levels and a
high percentage of the Company's 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. In addition, it
is possible that in the future the Company's operating results will 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 the Company's business, the price of the Company's Common Stock
would likely be materially adversely affected.
Pending Litigation
The Company is currently engaged in several litigation matters relating
to the patents that cover Public Key Cryptography. Certain of the pending cases
pertain to the Company's sublicensing rights to certain patents originally
developed at Stanford University that claim the invention of Public Key
cryptography. The Public Key Cases also pertain to the rights of RSA Data
Security, Inc. ("RSA DSI"), which holds a right to license a patent developed at
the
12
Massachusetts Institute of Technology that claims a particular implementation of
Public Key cryptography using the algorithm known as "RSA". Certain of these
cases seek to invalidate the Stanford Patents. An additional litigation matter
relates to Cylink's use of a federal government standard for sending digital
signatures. An unfavorable outcome in certain of the litigation matters in which
the Company is involved could have a material adverse effect on the Company's
financial condition and results of operations. In addition, the Company may
incur significant additional legal expenses in the future with respect to
litigation.
Dependence on Recently Introduced and New Information Security Products
The Company's future results of operations will be highly dependent on
the successful completion of the design, development, introduction, marketing
and manufacture of the SecureFrame, SecureManager and Secure Node products,
which are under development, and the SecureGate, SecureTraveler, SecurePocket
Traveler and SecureDomain products, which were recently introduced. To date, the
Company has made only limited commercial shipments of certain of such products
and no commercial shipments of the remainder of such products. No assurance can
be given that any of such products will not require additional development work,
enhancement, testing or further refinement before they can be introduced and
made commercially available by the Company or that they will achieve market
acceptance. If such new and recently introduced products have performance,
reliability, quality or other shortcomings, then such products could fail to
achieve market acceptance and the Company may experience reduced orders, higher
manufacturing costs, delays in collecting accounts receivables and additional
warranty and service expenses, which in each case could have a material adverse
effect on the Company's results of operations. Failure of such products to
achieve market acceptance would have a material adverse effect on the Company's
financial condition and results of operations.
Competition
Competition is intense among providers of information security systems
and wireless communications equipment and systems, and the Company expects such
competition to increase in the future. Significant competitive factors in these
markets include the development of new products and features, product quality
and performance, the quality and experience of sales, marketing and service
organizations, product price and name recognition. Many of these factors are
beyond the Company's control.
The Company's competitors in the information security markets include
Security Dynamics, Inc., Racal-Guardata, Inc.
13
and Information Resources Engineering, Inc. Recently, AT&T Corp. ("AT&T"),
Northern Telecom Limited, Motorola, Inc., Digital Equipment Corporation and Sun
Microsystems, Inc. have begun to offer certain information security products as
part of their overall networking solutions. In addition, a number of significant
software vendors, including Lotus Development Corporation, Microsoft
Corporation, Computer Associates, Netscape Communications Corporation and
Spyglass Inc., have embedded security solutions in their software or announced
their intention to do so. To the extent these embedded or optional security
capabilities provide all or a portion of the functionality provided by the
Company's products, the Company's products may no longer be required by
customers to attain information security.
RSA DSI licenses a method of implementing Public Key cryptography that
is different than (and incompatible with) the method of implementing Public Key
cryptography used by the Company. The Company and RSA DSI are each attempting to
establish their respective methods as industry standards. To the extent that RSA
DSI's method is adopted as a standard for implementing Public Key cryptography
in any segment of the information security market, sales of the Company's
existing and planned products in that segment may be adversely impacted, which
could have a material adverse effect on the Company's financial condition and
results of operations.
The Company competes with a large number of companies in the wireless
communications markets, including U.S. local exchange carriers and foreign
telephone companies. The most significant competition for sub-T1 rate AirLink
products in the wireless market is from telephone companies that offer leased
line data services. The Company also competes with other suppliers of wireless
products such as Digital Wireless Inc., Western Multiplex Corporation and
California Microwave Inc.
Many of the Company's competitors have substantially greater financial,
technical, marketing, distribution and other resources, greater name recognition
and longer standing relationships with customers than the Company. Competitors
with greater financial resources are better able to engage in sustained price
reductions in order to gain market share. Any period of sustained price
reductions would have a material adverse effect on the Company's financial
condition and results of operations. There can be no assurance that the Company
will be able to compete successfully in the future or that competitive pressures
will not materially and adversely affect the Company's financial condition and
results of operations.
Product Liability Risks
14
Customers rely on the Company's information security products
to prevent unauthorized access to their networks and data transmissions. A
malfunction or the inadequate design of the Company's products could result in
tort or warranty claims. Although the Company attempts to reduce the risk of
such losses through warranty disclaimers and liability limitation clauses in its
sales agreements and by maintaining product liability insurance, there can be no
assurance that such measures will be effective in limiting the Company's
liability for any such damages. Any liability for damages resulting from
security breaches could be substantial and could have a material adverse effect
on the Company's business and results of operations. In addition, a
well-publicized actual or perceived security breach could adversely affect the
market's perception of security products in general, or the Company's products
in particular, regardless of whether such breach is attributable to the
Company's products. This could result in a decline in demand for the Company's
products, which would have a material adverse effect on the Company's financial
condition and results of operations.
Management of Growth
The Company has recently experienced and may continue to experience
substantial growth in the number of its employees and the scope of its
operations, resulting in increased responsibilities for management. To manage
growth effectively, the Company will need to continue to improve its
operational, financial and management information systems and to hire, train
motivate and manage a growing number of employees. Competition is intense for
qualified technical, marketing and management personnel, particularly highly
skilled engineers. In particular, the current availability of qualified
engineers is quite limited, and competition among companies, academic
institutions, government entities and other organizations for skilled and
experienced engineering personnel is very intense. The Company is currently
attempting to hire a number of engineering personnel and has experienced delays
in filling such positions. The Company expects to experience continued
difficulty in filling its needs for qualified engineers and other personnel.
There can be no assurance that the Company will be able to effectively achieve
or manage any future growth, and its failure to do so could delay product
development cycles or otherwise have a material adverse effect on the Company's
financial condition and results of operations.
Patents and Proprietary Rights
The Company relies on patents, trademarks, copyrights, licenses and
trade secret law to establish and preserve its intellectual property rights. The
Company owns twelve U.S.
15
patents covering certain aspects of its product design. The Company also has the
exclusive right to sublicense the Stanford Patents, which expire in 1997. There
can be no assurance that any patent, trademark, copyright or license owned or
held by the Company will not be invalidated, circumvented or challenged, that
the rights granted thereunder will provide competitive advantages to the Company
or that any of the Company's pending or future patent applications will be
issued with the scope of the claims sought by the Company, if at all. Further,
there can be no assurance that others will not develop technologies that are
similar or superior to the Company's technology, duplicate the Company's
technology or design around the patents owned by the Company. The Company may be
subject to or may initiate interference proceedings in the U.S. Patent Office,
which can require significant financial and management resources. In addition,
the laws of certain countries in which the Company's products are or may be
developed, manufactured or sold may not protect the Company's products and
intellectual property rights to the same extent as the laws of the United
States. The inability of the Company to protect its intellectual property
adequately could have a material adverse effect on its financial condition and
results of operations.
The network information security and the wireless communications
industries in which the Company sells its products are characterized by
substantial litigation regarding patent and other intellectual property rights.
From time to time, the Company has received communications from third parties
asserting that the Company's patents or that features or content of certain of
the Company's products infringe upon the intellectual property rights held by
third parties, and the Company may receive such communications in the future.
For example, the Company has recently been notified of certain patents held by a
leading telecommunications company that apply to certain general techniques for
data scrambling and an error correction method for certain T1 transmissions. The
Company is not aware that its patents or the features or content of its products
wrongfully infringe on any valid intellectual property rights of others.
However, there can be no assurance that this telecommunications company or other
third parties will not assert claims against the Company that result in
litigation. The Company is currently engaged in several litigation matters
related to the patents that cover the practice of Public Key cryptography. Any
litigation, whether or not determined in favor of the Company, could result in
significant expense to the Company and could divert management and other
resources. In the event of an adverse ruling in any litigation involving
intellectual property, the Company 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-
16
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 the Company on reasonable terms or at all. In the event of a successful claim
against the Company and the Company's failure to develop or license a substitute
technology on commercially reasonable terms, the Company's financial condition
and results of operations would be adversely affected. There can be no assurance
that existing claims or any other assertions will not materially and adversely
affect the Company's financial condition and results of operations.
Evolving Information Security Market
The market for the Company's information security products is only
beginning to emerge. This market is characterized by rapidly changing
technology, emerging industry standards, new product introductions and changes
in customer requirements and preferences. The Company's future success will
depend in part upon end users' demand for information security products in
general, and upon the Company's ability to enhance its existing products and to
develop and introduce new products and technologies that meet customer
requirements. Any significant advance in technologies for attacking
cryptographic systems could render some or all of the Company's existing and new
products obsolete or unmarketable. To the extent that a specific method other
than the Company's is adopted as the standard for implementing information
security in any segment of the information security market, sales of the
Company's existing and planned products in that market segment may be adversely
impacted, which could have a material adverse effect on the Company's financial
condition and results of operations. There can be no assurance that information
security-related products or technologies developed by others will not adversely
affect the Company's competitive position or render its products or technologies
noncompetitive or obsolete.
In addition, a portion of the sales of the Company's products will
depend upon a robust industry and infrastructure for providing access to public
switched networks, such as the Internet. There can be no assurance that the
infrastructure or complementary products necessary to make these networks into
viable commercial marketplaces will be developed, or, if developed, that these
networks will become viable commercial marketplaces.
Rapid Technological Change
The markets for the Company's products are characterized by rapidly
changing technologies, extensive research and new product introductions. The
Company believes that its future success will depend in part upon its ability to
continue to
17
enhance its existing products and to develop, manufacture and market new
products. As a result, the Company expects to continue to make a significant
investment in engineering, research and development. There can be no assurance
that the Company will be able to develop and introduce new products or
enhancements to its existing products in a timely manner which satisfy customer
needs, achieve market acceptance or address technological changes in its target
markets. The failure of the Company to develop products and introduce them
successfully and in a timely manner could adversely affect the Company's
competitive position, financial condition and results of operations.
Wireless Communications Industry Regulatory Environment
Wireless communications are subject to regulations by United States and
foreign laws and international treaties. In the United States, the Company's
wireless communications products are subject to various regulations of the
Federal Communications Commission (the "FCC"). Current FCC regulations permit
license-free operation of certain FCC certified wireless products. The future of
remote wireless communications is highly volatile, due in part to ongoing
uncertainty regarding telecommunications deregulation and the status of recent
initiatives relating to the auction of licenses for personal communications
service ("PCS") frequencies. Regulatory changes, including changes in the
allocation of available frequencies, could significantly affect the Company's
operations by diverting the Company's development efforts, making current
products obsolete or increasing the opportunity for additional competition.
There can be no assurance that new regulations will not be promulgated which
could have a material adverse effect on the Company's financial condition and
results of operations.
The Company also is subject to regulatory requirements in foreign
markets. Equipment can be marketed in a country only if permitted by suitable
frequency allocations and regulations, and only if such equipment has received
type approval by the country in question. The process of complying with new
regulations and of obtaining type approval is often complex and lengthy and can
result in significant expense and delays in the introduction of products in new
countries.
Changes in, or the failure by the Company to comply with, applicable
domestic and international regulations could have a material adverse effect on
the Company's business and operating results. There can be no assurance that the
Company will be able to comply with regulations in any particular country.
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Risks Associated with International Sales; Reliance Upon Local Partners;
Restrictions on Export
International product sales represented approximately 32.5%, 34.6%,
46.5% and 56.6% of revenue in 1993, 1994, 1995 and the three months ended March
31, 1996 respectively. In particular, sales of the Company's wireless
communications products are currently concentrated in developing countries. The
Company plans to continue to expand its foreign operations 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,
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 the Company's foreign sales are denominated in U.S. dollars, the
Company's products become less price competitive in countries in which local
currencies decline in value relative to the U.S. dollar. The uncertainty of
monetary exchange values has 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.
The Company's ability to complete successfully in foreign countries is
dependent in part on the Company's ability to obtain and retain reliable and
experienced in-country value added resellers ("VARs"), distributors and other
strategic partners. The Company does not have long-term relationships with any
of its VARs and distributors and, therefore, has no assurance of a continuing
relationship within a given market.
United States government regulations restrict the export of certain
cryptographic devices, including certain of the Company's information security
products. As a result, the Company may be at a disadvantage in competing for
international sales compared to companies located outside the United States that
are not subject to such restrictions.
Dependence On Component Availability, Subcontractor Performance And Key
Suppliers
The Company's ability to timely deliver its products is dependent upon
the availability of quality components and subsystems used in these products.
The Company depends in part upon subcontractors to manufacturer, assemble and
deliver certain items in a timely and satisfactory manner. The Company obtains
certain components and subsystems from
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single, or a limited number of, sources. A significant interruption in the
delivery of such items could have a material adverse effect on the Company's
financial condition and results of operations.
Dependence on Key Personnel
The Company's future success will depend to a large extent on the
continued contributions of its executive officers and key management and
technical personnel, including Lewis C. Morris, the Company's President and
Chief Executive Officer, and Jimmy K. Omura, the Company's Chief Technical
Officer. Except for Mr. Morris and Dr. Omura, none of such persons has an
employment agreement with the Company and the Company does not maintain any key
person life insurance policy on any such persons. The loss of the services of
one or more of the Company's executive officers or key personnel or the
inability to continue to attract qualified personnel could delay product
development cycles or otherwise have a material adverse effect on the Company's
business and operating results.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
Item 6. Exhibits and Reports on Form 8-K
(b) No reports on Form 8-K were filed during the quarter ended March 31
1996.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
The Company is currently engaged in several litigation matters relating
to the patents that cover Public Key cryptography. Certain of the pending cases
(N.D. Cal. Nos. C-94-02322 (the MIT Patent Case), MMC; C-94-20512 SW (the Third
Party Case); and C-95-03256 WHO (the Stanford Patents Case) (collectively the
Public Key Cases)) pertain to the patents issued to Stanford University (U.S.
Patents Nos. 4,200,770, 4,218,582, and 4,424,414) that claim the invention of
Public Key cryptography (the Stanford Patents) and the Companys sublicensing
rights with respect to those patents. The Public Key Cases also pertain to a
patent developed at the Massachusetts Institute of Technology that claims a
particular implementation of Public Key cryptography (U.S. Patent No. 4,405,892)
using the algorithm known as RSA (the MIT Patent) and the rights of RSA DSI with
respect to the Stanford Patents. An additional litigation matter (D.D.C. No.
CV02121) (the DSS Case) relates to the digital signature standard (DSS) adopted
by the National Institute of Standards and Technology (NIST). The Third Party
Case was brought by an individual seeking, among other things, to invalidate the
Stanford Patents and the MIT Patent.
The Public Key Cases. The Companys wholly-owned subsidiary Caro-Kann
Corporation (Caro-Kann) holds exclusive sublicensing rights to the Stanford
Patents, and RSA DSI currently holds the exclusive sublicensing rights to MIT
Patent. In 1990, the Company and RSA DSI formed Public Key Partners, a
California general partnership (PKP). The partners assigned to PKP exclusive
sublicensing rights with respect to all of their Public Key patents, including
the Stanford Patents and the MIT Patent. Certain disputes arose between Cylink,
Caro-Kann and RSA DSI in the years following the formation of PKP. In April
1994, Cylink and Caro-Kann initiated private arbitration proceedings against RSA
DSI (the Arbitration). In the Arbitration, Cylink sought relief with respect to
its contractual claim to a license for the MIT Patent and to damages resulting
from RSA DSIs alleged diversion of PKP business opportunities. RSA DSI made
certain counterclaims against Cylink for breach of fiduciary duty. The
arbitrators issued a ruling in September 1995, which determined that: (i) PKP
was to be dissolved, effective as of September 6, 1995; (ii) Cylink has an
option to a patent license to the MIT Patent, subject to certain then
unspecified conditions requiring inclusion of RSA DSI software in Cylink
products covered by the MIT Patent; and (iii) RSA DSI did not have, and never
had during PKPs existence, sufficient rights to grant to its customers the right
to make copies of software incorporating the Stanford Patents without a license
under the Stanford Patents. With PKPs dissolution, the exclusive right to
sublicense the Stanford Patents was returned to Caro-Kann, and the exclusive
right to sublicense the MIT Patent was returned to RSA DSI. The arbitrators
further ruled that neither party prevailed on the material breach issues.
22
Both parties submitted further briefing with respect to their claims
for damages based on other alleged breaches of the partnership agreement and
their fiduciary duties and requested clarification on the conditions to Cylinks
license to the MIT Patent. On February 1, 1996, the arbitrators issued an
additional ruling, in which the arbitrators (i) clarified that Cylink could
include all or any part of RSA DSIs software code in its products, rather than
merely selected software specified by RSA DSI, (ii) ordered RSA DSI to use its
best efforts to provide Cylink with the requirements for licensing the software
and (iii) stated the royalty terms on which such software was to be licensed to
Cylink for use in stand-alone software products as well as hardware products. In
that ruling, the arbitrators further denied the parties claims for damages
against each other and stated that each party had the right to be indemnified by
PKP for legal expenses incurred in connection with the MIT Patent Case.
In June 1994, after RSA DSI threatened to sue Cylink for patent
infringement, Cylink initiated the MIT Patent Case (N.D. Cal. No. 94-02332 MMC),
seeking a declaratory judgment that the MIT Patent is invalid or unenforceable
against Cylink. RSA DSI has counterclaimed in this action seeking unspecified
damages from Cylink for infringement of the MIT Patent with respect to products
that practice the MIT Patent technology. The Company has obtained an opinion
from its patent counsel that the MIT Patent is unenforceable. However, if the
MIT Patent is not adjudicated to be unenforceable, Cylink believes that its only
products that may rely on the MIT Patent are the Secure X.25L and the Secure
X.25H encryptor products. As a result, the Company does not believe that an
adverse determination in the MIT Patent Case with respect to infringement will
have a material adverse effect on the Companys financial condition, liquidity or
results of operations. In addition to its claims of infringement, RSA DSI has
also asserted certain claims for breach of fiduciary duty relating to PKP and
for other matters that were addressed in the Arbitration.
In September 1995, RSA filed the Stanford Patents Case (N.D. Cal. No.
C95-03256 WHO) against Cylink seeking declaratory relief to invalidate the
Stanford Patents. The Stanford Patents Case is in the discovery phase. The
Company has obtained an opinion from its patent counsel that the two principal
Stanford Patents are valid. Even if the Stanford Patents were adjudicated to be
invalid, Cylink has not historically received significant royalty or license
fees with respect to the Stanford Patents, and the Stanford Patents expire in
1997. As a result, the Company believes that the RSA DSI claims against the
Stanford Patents, even if successful, would not have a material adverse effect
on the Companys financial condition, liquidity or results of operations.
Caro-Kann has cross-complained against RSA DSI in the Stanford Patents Case for
contributory infringement and inducement of infringement of the Stanford
Patents.
In July 1994, an individual filed the Third Party Case (N.D. Cal. No.
C94-20512 SW) against PKP and RSA DSI seeking, among other things, to invalidate
the Stanford Patents and the MIT Patent. Caro-Kann has been allowed to intervene
in light of the dissolution of PKP for the limited purpose of defending the
validity of the Stanford Patents. At present, there are summary judgment motions
pending in the Third Party Case
23
as to the Stanford Patents and the MIT Patent, and as to various business torts
alleged against RSA DSI and PKP by the plaintiff. In February 1996, the Stanford
Patents Case and the Third Party Case were consolidated into a single action.
The DSS Case. The Company filed the DSS Case (D.D.C. No. 95-CV02121) on
November 15, 1995 to seek a declaratory judgment consistent with NISTs
previously stated position that the practice of the digital signal algorithm
(DSA) in complying with the DSS, a Federal Information Processing Standard, does
not infringe a patent owned by Dr. Claus P. Schnorr (U.S. Patent No. 4,995,082)
(the Schnorr Patent). Dr. Schnorr has publicly stated that the DSS infringes the
Schnorr Patent and that he would initiate infringement actions against anyone
who used the DSS without a license from Dr. Schnorr. In addition, RSA DSI claims
to represent Dr. Schnorr with respect to the Schnorr Patent and may claim to
hold sublicensing rights with respect to the Schnorr Patent. RSA DSI has
demanded that Cylink cease using DSS in its products without a license to the
Schnorr Patent. The Company began sales of products incorporating the DSA in the
quarter ended December 31, 1994. The Company has obtained an opinion from its
counsel that DSS is not covered by the Schnorr Patent. However, should it be
determined that the Companys products infringe the Schnorr Patent, such a
determination could create confusion in the market place for DSS-based products,
require that the Company pay damages and obtain a license to the Schnorr Patent
to the extent such license is available or require the Company to redesign its
products to eliminate DSS methods. In any of such events, the Companys financial
condition and results of operations could be materially and adversely affected.
These cases involve a number of complex issues, and no assurance can be
given as to the likely outcome of the Stanford Patent Case, the RSA DSI Patent
Case, the DSS Case or the Third Party Case. The Arbitration resulted in
substantial costs and diversion of effort by the Company, and the Company may
continue to incur significant legal expenses with respect to litigation.
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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.
Date: May , 1996 CYLINK CORPORATION
(Registrant)
By: /s/ John H. Daws
--------------------------------------------
John H. Daws
Vice President of Finance and
Administration and Chief Financial Officer
(Duly Authorized Officer and Principal
Financial Officer)
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