SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 27, 1999
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.)
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 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 August 9, 1999, there were 29,460,000 shares of the Registrant's common
stock outstanding.
1
CYLINK CORPORATION
FORM 10-Q FOR THE QUARTER ENDED JUNE 27, 1999
INDEX
Page
----
Facing Sheet 1
Index 2
Part I Financial information
Item 1 Financial Statements and Supplementary Data
a) Condensed Consolidated Balance Sheets at June 27, 1999 and December 31, 1998 3
b) Condensed Consolidated Statements of Operations for the three
and six months ended June 27, 1999 and June 28, 1998 4
c) Condensed Consolidated Statement of Cash Flows for the six
months ended June 27, 1999 and June 28, 1998 5
d) Notes to Condensed Consolidated Financial Statements 6
Item 2 Management's discussion and analysis of financial condition and results of operations 9
Part II Other Information 21
Signature 23
Exhibit Exhibit 27.1, Financial data schedule 24
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CYLINK CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data; unaudited)
June 27, December 31,
1999 1998
--------- ---------
Assets
Current assets:
Cash and cash equivalents $ 41,797 $ 46,575
Accounts receivable, net of allowances of $1,495 and $1,251 11,737 7,958
Note receivable 3,545 3,545
Inventories 5,864 10,289
Deferred income taxes 4,469 4,495
Other current assets 4,598 6,675
--------- ---------
Total current assets 72,010 79,537
Property and equipment, net 5,860 5,731
Acquired technology, goodwill and other intangibles 3,947 5,341
Notes receivable from employees or former employees 2,665 2,558
Other assets 1,814 1,151
--------- ---------
$ 86,296 $ 94,318
========= =========
Liabilities and Shareholders' Equity
Current liabilities:
Current portion of lease obligations and long-term debt $ 76 $ 120
Accounts payable 4,072 3,656
Accrued liabilities 7,453 8,230
Accrued liabilities related to discontinued operations 3,351 3,878
Income taxes payable 1,085 1,091
Deferred revenue 1,973 1,975
--------- ---------
Total current liabilities 18,010 18,950
--------- ---------
Capital lease obligations and long-term debt 128 147
--------- ---------
Shareholders' equity:
Preferred stock, $0.01 par value; 5,000,000 shares authorized;
none issued and outstanding -- --
Common stock, $0.01 par value; 40,000,000 shares authorized;
29,138,000 and 29,115,000 shares issued and outstanding 291 291
Additional paid-in capital 123,991 123,929
Deferred compensation related to stock options (125) (167)
Accumulated other comprehensive loss (109) (61)
Accumulated deficit (55,890) (48,771)
--------- ---------
Total shareholders' equity 68,158 75,221
--------- ---------
$ 86,296 $ 94,318
========= =========
<FN>
See accompanying notes to Condensed Consolidated Financial Statements.
</FN>
3
CYLINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except per share data; unaudited)
Three Months Ended Six Months Ended
------------------------- -------------------------
June 27, June 28, June 27, June 28,
1999 1998 1999 1998
-------- -------- -------- --------
(restated) (restated)
Revenue $ 15,209 $ 12,363 $ 27,094 $ 20,425
Cost of revenue 4,769 3,990 8,881 6,621
-------- -------- -------- --------
Gross profit 10,440 8,373 18,213 13,804
-------- -------- -------- --------
Operating expenses:
Research and development, net 3,940 2,770 7,493 5,815
Selling and marketing 6,218 6,207 11,637 11,780
General and administrative 3,303 1,852 5,916 3,330
Amortization of purchased intangibles 680 680 1,360 1,359
-------- -------- -------- --------
Total operating expenses 14,141 11,509 26,406 22,284
-------- -------- -------- --------
Loss from operations (3,701) (3,136) (8,193) (8,480)
Other income (expense):
Interest income, net 628 687 936 839
Royalty and other income (expense), net 19 (115) 138 (115)
-------- -------- -------- --------
647 572 1,074 724
-------- -------- -------- --------
Loss from continuing operations before income taxes (3,054) (2,564) (7,119) (7,756)
Benefit for income taxes -- (897) -- (2,714)
-------- -------- -------- --------
Loss from continuing operations (3,054) (1,667) (7,119) (5,042)
Income (loss) from discontinued operations, net of
income tax benefit of $139 -- -- -- (259)
Gain on disposal of discontinued operations
net of income tax expense of $12,358 -- -- -- 22,776
-------- -------- -------- --------
Net income (loss) $ (3,054) $ (1,667) $ (7,119) $ 17,475
======== ======== ======== ========
Earnings (loss) per share - basic:
Continuing operations $ (0.10) $ (0.06) $ (0.24) $ (0.17)
Discontinued operations -- -- -- 0.77
-------- -------- -------- --------
Net income (loss) $ (0.10) $ (0.06) $ (0.24) $ 0.60
======== ======== ======== ========
Earnings (loss) per share - diluted:
Continuing operations $ (0.10) $ (0.06) $ (0.24) $ (0.17)
Discontinued operations -- -- -- 0.77
-------- -------- -------- --------
Net income (loss) $ (0.10) $ (0.06) $ (0.24) $ 0.60
======== ======== ======== ========
Shares used in per share calculation - basic 29,127 29,011 29,122 28,916
======== ======== ======== ========
Shares used in per share calculation - diluted 29,127 29,011 29,122 28,916
======== ======== ======== ========
<FN>
See accompanying notes to Condensed Consolidated Financial Statements.
</FN>
4
CYLINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands; unaudited)
Six Months Ended
---------------------------
June 27, June 28,
1999 1998
-------- --------
(restated)
Cash flows from operating activities:
Net loss from continuing operations $ (7,119) $ (5,042)
Adjustments to reconcile net loss to net
cash used in operating activities:
Depreciation 1,238 856
Amortization 1,360 1,359
Deferred Income Taxes 26 (107)
Amortization of imputed interest on Note Receivable (132) --
Deferred compensation related to stock options 42 42
Deferred compensation related to Notes Receivable 251 --
Changes in assets and liabilities
Accounts receivable (3,650) (76)
Inventories 4,425 (2,195)
Other current assets 1,059 182
Accounts payable 416 (280)
Accrued liabilities (777) (2,588)
Income taxes payable (6) (4,271)
Deferred revenue (2) 1,375
-------- --------
Net cash used in continuing operations (2,869) (10,745)
Net cash provided by (used in) discontinued operations (527) (6,907)
-------- --------
Net cash used in operating activities (3,396) (17,652)
-------- --------
Cash flows from investing activities:
Acquisition of property and equipment (1,333) (1,578)
Loans to employees in exchange for notes receivable -- (2,230)
Proceeds from sale of discontinued operations -- 46,000
Acquisition of preferred stock of unaffiliated company -- (3,000)
-------- --------
Net cash provided by (used in)
investing activities (1,333) 39,192
-------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock, net 62 1,628
Other (63) (94)
-------- --------
Net cash provided by (used in) financing activities (1) 1,534
-------- --------
Effect of exchange rate changes on
cash and cash equivalents (48) 1
-------- --------
Net increase (decrease) in cash and cash equivalents $ (4,778) $ 23,075
Cash and cash equivalents at beginning of year 46,575 22,977
-------- --------
Cash and cash equivalents at end of year $ 41,797 $ 46,052
======== ========
Supplemental disclosures:
Cash paid for income taxes $ -- $ 6,054
Income tax refund 2,500 --
Cash paid for interest 3 30
<FN>
See accompanying notes to Condensed Consolidated Financial Statements.
</FN>
5
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 fairly
state the consolidated financial position, results of operations and cash
flows of Cylink Corporation ("Cylink" or the "Company") for the periods
presented. These interim condensed consolidated financial statements and
notes thereto should be read in conjunction with Cylink's audited
consolidated financial statements and notes thereto included in Cylink's
Annual Report on Form 10-K for the year ended December 31, 1998. Interim
results of operations are not necessarily indicative of the results to be
expected for the fiscal year ending December 31, 1999.
2. Restatement of Financial Results
On November 5, 1998, Cylink publicly announced that it and its
independent accountants had initiated a review of revenue recognition
practices which would result in a restatement of previously issued first
and second quarter 1998 results and that all three quarters of 1998 were
expected to show substantial operating losses. During the review, certain
facts became known indicating errors had been made in the application of
revenue recognition policies which also impacted the fourth quarter of
1997, and as a result, 1997 full-year results have been restated along with
first and second quarter 1998 results. These restated results were
announced in a press release dated December 16, 1998.
As a result of the restatement, the statements of operations and
financial position for the six months ended June 28, 1998 have been
restated as follows:
Three Months Ended Six Months Ended
June 28, 1998 June 28, 1998
---------------------------- ----------------------------
As Originally As Originally
Reported As Restated Reported As Restated
-------- -------- -------- --------
(in thousands)
Sales $ 18,035 $ 12,363 $ 33,864 $ 20,425
Operating expenses 11,479 11,509 22,184 22,284
Income (loss) from
continuing operations 1,732 (1,667) 2,814 (5,042)
Net income (loss) $ 1,732 $ (1,667) $ 25,438 $ 17,475
======== ======== ======== ========
Earnings (loss) per share - diluted
Continuing operations $ 0.06 $ (0.06) $ 0.09 $ (0.17)
Discontinued operations -- -- 0.75 0.77
======== ======== ======== ========
Net income (loss) $ 0.06 $ (0.06) $ 0.84 $ 0.60
======== ======== ======== ========
As of June 28, 1998
-------------------------
Accumulated deficit $ (25,526) $ (36,457)
========= =========
6
3. Discontinued Operations
On March 27, 1998, Cylink sold its Wireless Communications Group
("Wireless") to P-Com, Inc. for $60.5 million ($46.0 million in cash and an
unsecured promissory note in the amount of $14.5 million due 100 days after
closing, subject to closing adjustments). The sale resulted in an after tax
gain of approximately $22.8 million. As a result, the operations of
Wireless have been classified as discontinued operations in the
accompanying Condensed Consolidated Financial Statements and related Notes.
Accrued expenses in the amount of approximately $6.8 million, primarily for
professional services, anticipated excess facilities expenses, and certain
other transaction-related accruals were charged to discontinued operations
and reduced the gain on disposal. Pursuant to the restatement referred to
in Note 2, certain revenues of Wireless previously recognized in the fourth
quarter of 1997 and the first quarter of 1998 were adjusted. On July 14,
1998, P-Com made a partial payment on its promissory note, which along with
other credits, totaled $8.9 million. P-Com is disputing the remaining
balance of the note which Cylink presently records at $3.5 million.
Wireless revenues were $4.4 million in the first quarter of 1998 through
the date of disposal.
4. Inventories
June 27, December 31,
1999 1998
---------------------------
(in thousands)
Raw materials $ 1,935 $ 2,813
Work in process and subassemblies 2,270 1,877
Finished goods 1,659 5,599
------- -------
$ 5,864 $10,289
======= =======
5. Earnings (Loss) Per Share
Basic earnings (loss) per share is based on the weighted-average number
of common shares outstanding. Diluted earnings (loss) per share is based on
the weighted-average number of shares outstanding and dilutive potential
common shares outstanding. Cylink's only potentially dilutive securities
are stock options. All potentially dilutive securities have been excluded
from the computation of diluted earnings (loss) per share as their effect
is anti-dilutive on the loss from continuing operations for the periods
presented.
As of June 27, 1999 and June 28, 1998, Cylink had 6,422,000 and
6,141,000 stock options outstanding with a weighted average exercise price
of $4.74 and $8.97, respectively.
6. Comprehensive Loss
The components of comprehensive loss are as follows (in thousands):
Three Months Ended Six Months Ended
June 27, June 28, June 27, June 28,
1999 1998 1999 1998
------------- ---------- ------------- --------
(restated- (restated-
See Note 2) See Note 2)
(in thousands) (in thousands)
Net income (loss) $ (3,054) $ (1,667) $ (7,119) $ 17,475
Other comprehensive income (loss) (36) (15) (48) 1
-------- -------- -------- --------
Total comprehensive income (loss) $ (3,090) $ (1,682) $ (7,167) $ 17,476
======== ======== ======== ========
7
7. New Lease
On May 10, 1999, Cylink reached agreement to lease approximately 96,000
square feet of office and manufacturing space located in Santa Clara,
California for use as it principal office and manufacturing facility. The
lease term is for 120 months commencing approximately September 1, 1999,
and includes an option to extend the lease for an additional 5 years on
commercially reasonable terms. The Landlord is obligated to contribute up
to $2.4 million for the construction of tenant's interior improvements;
however, tenant's interior improvements are expected to exceed this
allowance by approximately $1.9 million which is expected to be expended by
Cylink during the third quarter of fiscal 1999. The lease agreement
provides for the payment of rent on a net industrial lease basis commencing
at $174,000 per month for the first year and escalating to $228,000 per
month in the tenth year of the lease. Cylink's lease on its present 86,000
square foot headquarters facility has expired, and it is Cylink's intention
to sublease its present manufacturing facility which occupies 34,500 square
feet, which lease expires in June 2001.
8. Subsequent Events
On July 21, 1999, Cylink acquired Virginia-based Security Design
International, Inc., a security consulting and professional services
company which provides network vulnerability assessments. Terms of the
acquisition include a $400,000 cash payment, issuance of approximately
306,000 shares of Cylink's common stock to a three year escrow, and a
deferred cash payout totaling $1.925 million based on revenue and operating
income performance over a three year period. Total potential cost of the
acquisition is up to $3.5 million.
On August 5, 1999, Cylink amended the above referenced lease, to add an
additional 46,000 square feet adjacent to its newly leased 96,000 square
feet in Santa Clara, CA, for use as expansion space. The lease term on the
additional space is 119 months commencing approximately October 1, 1999,
and includes an option to extend the lease for an additional 5 years on
commercially reasonable terms. The Landlord is obligated to make
substantially all of tenant's interior improvements, currently estimated to
cost $450,000. The lease agreement provides for the payment of rent on a
net industrial lease basis commencing at $47,880 per month for the first
year and escalating to $64,025 per month in the tenth year of the lease.
Currently, the second floor of the facility is leased to an outside tenant
for 5 years, at which point the leasehold interest will revert to Cylink on
similar terms and conditions. Cylink intends to seek a subtenant for
approximately half the remaining space on the first floor until its planned
use.
9. Contingencies
Cylink is currently engaged in litigation. See Part II, Item 1, "Legal
Proceedings."
8
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
This Report on Form 10-Q includes statements that reflect Cylink's
belief concerning future events and financial performance. Statements which
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 sometimes identify
forward-looking statements with such words as "expects", "anticipates",
"intends", "believes" or similar words concerning future events.
You should not rely too heavily 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 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 other
Exchange Act Reports.
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 update any such forward-looking
statements, or to update the reasons why actual results could differ from
those projected in the forward-looking statements.
RESTATEMENT OF FINANCIAL RESULTS
On November 5, 1998, Cylink publicly announced that it and its
independent accountants had initiated a review of revenue recognition
practices which would result in a restatement of previously issued first
and second quarter 1998 results and that all three quarters of 1998 were
expected to show substantial operating losses. Second quarter 1998 results
reported in this Form 10-Q reflect the results of the restatement.
DISCONTINUED OPERATIONS
Pursuant to an asset purchase agreement dated March 27, 1998, Cylink
sold its Wireless business to P-Com, Inc. See Note 3 of Notes to Condensed
Consolidated Financial Statements. The sale resulted in an after tax gain
of approximately $22.8 million. Except where noted, the following comments
are associated with the continuing network security business.
9
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 Six Months Ended
-------------------- ----------------------
June 27, June 28, June 27, June 28,
1999 1998 1999 1998
-------- ---------- --------- -----------
(restated) (restated)
Revenue 100.0% 100.0% 100.0% 100.0%
Cost of revenue 31.4% 32.3% 32.8% 32.4%
----- ----- ----- -----
Gross profit 68.6% 67.7% 67.2% 67.6%
----- ----- ----- -----
Operating expenses:
Research and development, net 25.9% 22.4% 27.7% 28.5%
Selling and marketing 40.9% 50.2% 43.0% 57.7%
General and administrative 21.7% 15.0% 21.8% 16.3%
Amortization of purchased intangibles 4.5% 5.5% 5.0% 6.7%
----- ----- ----- -----
Total operating expenses 93.0% 93.1% 97.5% 109.1%
----- ----- ----- -----
Loss from operations -24.3% -25.4% -30.2% -41.5%
Other income 4.3% 4.6% 4.0% 3.5%
----- ----- ----- -----
Loss from continuing operations -20.1% -20.7% -26.3% -38.0%
==== ===== ===== =====
Revenue. Revenue increased 23% from $12.4 million for the three months
ended June 28, 1998 to $15.2 million for the three months ended June 27,
1999, and increased 33% from $20.4 million for the six months ended June
28, 1998 to $27.1 million for the six months ended June 27, 1999. The
increase is attributable to increases in unit shipments of existing
products, the introduction of products with higher average selling prices,
and increased revenues associated with software maintenance and support
services. International revenue was 37% and 48% of total revenue for the
first quarter of 1998 and 1999, respectively.
Cylink's revenue is derived primarily from sales of its family of
commercial network security products, and to a lesser extent, from the
license of software products. Fees for software maintenance and support
services are charged separately. Revenue arising from sales of hardware
products is recognized upon shipment to customers. 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
based on historical and anticipated experience.
Cylink also derives revenue from the license of its software products
as well as fees for software maintenance and support. Cylink's revenue
recognition policy is consistent with Statement of Position 97-2, Software
Revenue Recognition, and the related amendment SOP 98-4. Software license
revenue is recognized when a written purchase order, license agreement or
contract has been executed; delivery of software has occurred; no
significant Company obligations remain; the fee is fixed and determinable;
collectibility is probable and vendor-specific objective evidence exists to
allocate the total fee to elements of the arrangement. Vendor-specific
objective evidence is based on the price generally charged when an element
is sold separately, or if not yet sold separately, is established by
authorized management. Allowances for estimated future returns, which to
date have been immaterial, are provided upon shipment and adjusted
periodically by management based on historical and anticipated experience.
Maintenance and support revenue consists of ongoing support and product
updates and is deferred and recognized ratably over the term of the
maintenance contract, which is typically twelve months. Software revenue,
including related maintenance and support fees, was not material in any
period presented.
10
Gross Profit. Gross profit increased 25% from $8.4 million for the
three months ended June 28, 1998 to $10.4 million for the three months
ended June 27, 1999, and increased 32% from $13.8 million for the six
months ended June 28, 1998 to $18.2 million for the six months ended June
27, 1999. The increase in dollars was primarily a result of the increase in
revenue. As a percentage of sales, gross profit was 68% and 69% for the
first quarter of 1998 and 1999, respectively. The increase in gross margin
resulted primarily from improved manufacturing utilization and a higher
profit margin product mix.
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 41% from $3.2 million for the three months
ended June 28, 1998 to $4.4 million for the three months ended June 27,
1999, and increased 36% from $6.2 million for the six months ended June 28,
1998 to $8.4 million for the six months ended June 27, 1999. Gross research
and development expenses as a percentage of revenue were 26% for the second
quarter of 1998 compared to 29% for the second quarter of 1999, and 30% for
the first half of 1998 compared to 31% for the first half of 1999. The
dollar increase resulted from increased spending on externally funded
contracts, increased personnel, and development costs of new products,
particularly in Israel. The increase in expense as a percentage of revenue
is due to the accelerated spending on new products at a rate of growth
faster than the growth rate of the revenues.
From time to time Cylink receives engineering funding for development
of projects to apply or enhance Cylink'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 $0.4
million for the second quarter of 1998 as compared to $0.5 million for the
second quarter of 1999, and $.4 million and $.9 million for the first half
of 1998 and 1999, respectively.
Selling and Marketing. Selling and marketing expenses consist primarily
of personnel expenses, including sales commissions, and expenses for
advertising, public relations, seminars and trade shows. Selling and
marketing expenses remained unchanged at $6.2 million for the both three
months ended June 28, 1998 and June 27, 1999, respectively, and decreased
1% from $11.8 million for the six months ended June 28, 1998 to $11.6
million for the six months ended June 27, 1999. Selling and marketing
expenses as a percentage of revenue were 50% for the second quarter of 1998
compared to 41% for the second quarter of 1999, and 58% for the first half
of 1998 compared to 43% for the first half of 1999. Sales and marketing
expenses remained unchanged overall for the second quarter of 1999,
although reductions in travel, headcount and payroll related costs
undertaken as a streamlining measure were offset by increased advertising,
trade shows and other marketing costs. Selling and marketing expenses,
expressed as a percentage of revenue, decreased as a result of the
increased revenue base.
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 increased 78% from $1.9 million for the
three months ended June 28, 1998 to $3.3 million for the three months ended
June 27, 1999. General and administrative expenses as a percentage of
revenue were 15% for the second quarter of 1998 compared to 22% for the
second quarter of 1999, and 16% for the first half of 1998 compared to 22%
for the first half of 1999. The dollar and percentage of revenue increases
in the second quarter of 1999 were primarily due to increases in legal fees
for litigation defense, and accounting and consulting expenses resulting
from the restatement, as well as recruiting and relocation expenses related
to senior management transition.
Amortization of Purchased Intangibles. Amortization relating to
goodwill and other intangibles was $0.7 million in each period presented
and relates to the acquisition of Algorithmic Research, Ltd and Algart
Holdings, Ltd. (collectively "ARL") in September 1997.
Benefit from Income Taxes. No provision for, or benefit from, income
taxes was recognized in the quarter ended June 27, 1999 as Cylink incurred
a net operating loss for income tax purposes and had no additional
carryback potential.
Other Income (Expense), Net. Other income (expense), net, consists
primarily of interest income, interest expense and, to a lesser extent,
royalty income. Interest income, net, decreased from $0.7 million for the
second quarter of 1998 to $0.6 million for the second quarter of 1999,
principally due to lower cash and cash equivalent balances between periods.
11
LIQUIDITY AND CAPITAL RESOURCES
At June 27, 1999, Cylink had cash and cash equivalents of $41.8
million, working capital of $54.0 million and minimal long-term
obligations. For the six months ended June 27, 1999, Cylink recorded a net
loss of $7.1 million. Net cash used in operating activities for the six
months ended June 27, 1999 of $3.4 million consisted primarily of the loss
from continuing operations and an increase in accounts receivable of $3.7
million, offset in part by a decrease in inventories of $4.4 million. Both
the increase in accounts receivable and the decrease in inventories were
the result of increased sales. For the six months ended June 28, 1998,
Cylink recorded net income of $17.5 million, principally due to the $22.8
million gain on sale of Wireless, offset by a loss from continuing
operations of $5.0 million and a loss from discontinued operations of $.3
million. Net cash used in continuing operating activities for the first
half of 1998 of $17.7 million consisted primarily of the loss from
continuing operations of $10.7 million and increases in inventories in
anticipation of increased sales and payment of estimated income taxes.
Cash used in investing activities for the six months ended June 27,
1999 was $1.3 million, primarily to fund the license and implementation of
an Oracle Enterprise Reporting and Planning System and the acquisition of
related computer hardware. Cash provided by investing activities for the
six months ended June 28, 1998 was $39.2 million, of which $46.0 million
was attributed to the sale of Wireless. The funds attributable to the
Wireless sale were partially offset by expenditures for property and
equipment of $1.6 million, long-term loans to employees of $2.2 million,
and a $3.0 million investment in the preferred stock of an unaffiliated
company.
Cylink 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 Cylink's financial
position or results of operations.
On July 21, 1999, Cylink aquired Virginia-based Security Design
International, Inc. ("SDI"), for a $400,000 cash payment, issuance of
approximately 306,000 shares of Cylink's common stock, and a deferred cash
payout of up to $1.925 million. See further description under Note 8
"Subsequent Events" above. In additon to the acquistion cost, SDI is
expected to utilize approximately $0.5 million in capitial equipment and
operating loss requirements over the next 12 months.
Cylink believes that existing cash balances and cash generated from
operations, if any, will be sufficient to fund necessary purchases of
capital equipment and to provide working capital through at least the next
twelve months. However, Cylink may require additional funds to support its
working capital requirements or for other purposes and may seek to raise
such additional funds through public or private equity financing or from
other sources. This additional financing may not be available on terms
favorable to Cylink or its shareholders, if at all.
Year 2000 Compliance
"Year 2000 Compliance" refers generally to the problems that some
software, including firmware embedded in Cylink's products, may have in
determining the correct century for the year. For example, software with
date-sensitive functions that is not Year 2000 compliant may not be able to
distinguish whether "00" means 1900 or 2000, which may result in failures
or the creation of erroneous results. Cylink has defined "Year 2000
Compliant" as the ability to: (i) correctly handle date information needed
for the December 31, 1999 to January 1, 2000 date change; (ii) function
according to the product documentation provided for this date change,
without changes in operation resulting from the advent of a new century,
assuming correct configuration; (iii) where appropriate, respond to
two-digit date input in a way that resolves the ambiguity as to century in
a disclosed, defined, and predetermined manner, such as in certificate
based products, or in accordance with Cylink's Year 2000 Compliant test
plan; and (iv) recognize year 2000 as a leap year.
Cylink has developed a Year 2000 readiness plan for the current
versions of its products. Cylink has largely completed all phases of its
plan, except for contingency planning, with respect to the current versions
of all of its products. As a result, the current versions of each of its
products currently offered for sale are believed to be "Year 2000
Compliant." In some cases, Cylink's products require an upgrade provided by
Cylink which is either sold as a complete substitute or as a kit sold with
the product in order to be Year 2000 Compliant.
Cylink has completed a review of its mission critical internal
information systems (including the third-party software for its management
information systems, networks and desktop applications, and its hardware
12
telecommunications technology) and believes it has addressed all critical
concerns. When deficiencies have been identified in critical components,
Cylink is purchasing new or upgraded versions which have been certified by
their vendors as compliant.
Cylink has funded its Year 2000 plan from operating cash. While Cylink
does not expect such costs to be material, Cylink will incur additional
amounts related to the Year 2000 plan for administrative personnel to
manage Cylink's readiness plans, technical support for its product
engineering and customer satisfaction.
Cylink has completed its plans to address Year 2000 readiness of its
critical operations based on its perception of the known risks involved.
Despite testing by Cylink and current and potential customers, and any
assurances from developers of products incorporated into Cylink's products
or in use in Cylink's business operations, Cylink's products may contain
undetected errors or defects associated with Year 2000 date functions.
Further, Cylink may be using products in its business operations which are
not Year 2000 compliant. An unanticipated Year 2000 interruption could have
material adverse financial consequences to Cylink or seriously impair
business operations for an indefinite period of time.
For a more comprehensive discussion of Cylink's Year 2000 plans and
exposures, see the "Year 2000" topic under Part I, Item 2. "Risk Factors
That May Affect Future Results."
13
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
Recent Losses; Potential Fluctuations in Operating Results, Future
Operating Results Uncertain
Cylink incurred losses from continuing operations in 1998 and for each
of the prior four years. Cylink expects to incur net losses through at
least 1999. Cylink may not increase or maintain its revenue or be
profitable on a quarterly or an annual basis in the future.
Cylink has historically experienced significant fluctuations in its
operating results on a quarterly basis and could experience such
fluctuations in the future. Cylink's operating results are affected by a
number of factors, many of which are outside of Cylink's control,
including: the timing of the introduction of new or enhanced products by
Cylink or its competitors; market acceptance of new products of Cylink, 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 defending claims with respect to intellectual
property rights; the mix of products sold; changes in the percentage of
products sold through Cylink's direct sales force; personnel changes;
general economic conditions; and fluctuations in foreign currency exchange
rates. Cylink expects to introduce a number of new products during the
remainder of 1999. The failure of such new products to achieve market
acceptance at the time anticipated by Cylink, or at all, would materially
and adversely affect Cylink's financial condition and results of
operations.
In connection with the acquisition of ARL in September 1997, Cylink
allocated $63.9 million of the purchase price to in-process research and
development ("IPR&D"), and in accordance with generally accepted accounting
principles 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 ("SEC") indicated the SEC Staff's concerns related to
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 the IPR&D. To the extent Cylink is required by the SEC Staff
to retroactively revise its 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.
Pending Litigation
See Part II, Item 1. "Legal Proceedings."
Dependence on Key Personnel
On November 4, 1998, Mr. William C. Crowell, formerly Vice President of
Product Strategy, was promoted to President and Chief Executive Officer,
and on November 16, 1998, Mr. Roger A. Barnes became Cylink's Chief
Financial Officer. Cylink's future success will depend on the abilities of
Mr. Crowell and the contributions by its other executive officers, key
management and technical personnel. The loss of the services of one or more
of Cylink's executive officers or key personnel, or the inability to
continue to attract and retain qualified personnel, could delay product
development cycles or otherwise have a material adverse effect on Cylink's
business and operating results. Retention and attraction of such qualified
personnel may become even more difficult for Cylink following Cylink's
recent restatement of its financial statements and recently determined
losses.
14
Lengthy Sales Cycle
Sales of Cylink'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 Cylink's products is typically lengthy and subject to
a number of significant risks over which Cylink has little or no control.
Cylink 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. Cylink typically plans its
production and inventory levels based on internal forecasts of customer
demand, which are highly unpredictable and can fluctuate substantially. In
addition, Cylink's current or future customers may curtail or suspend
investments in securing their existing networks as the Year 2000
approaches, or divert technology expenditures reserved for enterprise
security products in order to address Year 2000 compliance problems (see
further discussion under Year 2000 below). If revenue falls significantly
below anticipated levels, as it has at times in the past, Cylink's
financial condition and results of operations would be materially and
adversely affected. In addition, Cylink's operating expenses are based on
anticipated revenue levels and a high percentage of Cylink'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. For example, on September 14, 1998,
Cylink announced that its earnings for the third quarter of 1998 would be
below consensus estimates. It is possible that in the future Cylink's
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
Cylink's business, the price of Cylink's Common Stock would likely be
materially adversely affected.
Dependence on Recently Introduced and New Information Security Products
Cylink's future results of operations will be highly dependent on the
successful completion of the design, development, introduction, marketing
and manufacture of Cylink's virtual private networking ("VPN") hardware
product and commercial versions of its public key infrastructure ("PKI")
products, as well as successful marketing and manufacture of the Cylink
Link Encryptors, PrivaCy Manager, PrivateWire and Cylink Frame Encryptor
products. To date, Cylink has made only limited, and, in some cases, no
commercial shipments of certain versions of such products. Furthermore,
Cylink relies on a third party original equipment manufacturer to supply
Cylink's ATM Encryptor product, and Cylink is dependent on this supplier
for continued development, manufacture and support. These products may
require additional development work, enhancement, testing or further
refinement before they can achieve or in order to maintain market
acceptance. If any of Cylink's products have performance, reliability,
quality or other shortcomings, then such products could fail to achieve or
maintain market acceptance. The failure by Cylink's new or existing
products to achieve or enjoy market acceptance, whether for these or other
reasons, could cause Cylink 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 Cylink's business, financial condition and
results of operations.
Competition
Competition is intense among providers of network security systems, and
Cylink 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,
name recognition and perception of Company stability and long-term
viability. Many of these factors are beyond Cylink's control. In addition,
some factors, such as the perception of Cylink's stability and viability
over the long term may have been adversely affected by the December 1998
restatement of Cylink's 1997 and first and second quarter 1998 financial
statements, which could materially adversely impact Cylink's ability to
compete.
Cylink's competitors in the information security markets, including
companies that offer products similar to or as an alternative to Cylink's
products, include Axent Technologies, Inc., Checkpoint Software
Technologies, Ltd., Network Associates, Inc., Secure Computing Corporation,
Security Dynamics Technologies, Inc., Racal-Guardata, Inc., and Information
Resource Engineering, Inc. Cylink's OEM supplier of its ATM Encryptor
product also competes with Cylink, through distribution channels, for sales
of this product. In addition, Northern Telecom Limited, AT&T, Motorola
Corporation, and Sun Microsystems, Inc. offer certain information security
products as part of their overall networking solutions. A number of
significant vendors,
15
including Microsoft Corporation, Netscape Communications 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 Cylink's products,
Cylink's products may no longer be required by customers to attain network
security.
Certicom Corporation and RSA Data Security, Inc., a subsidiary of
Security Dynamics ("RSA DSI"), 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 by Cylink in most of its products. Although Cylink has a
license to use all of the public key methods promoted by Certicom and RSA
DSI, to the extent significant segments of the network security market
adopt technical standards different from those currently used by Cylink, to
the exclusion of Cylink's methods, sales of Cylink's existing and planned
products in that market segment may be adversely impacted, which could have
a material adverse effect on Cylink's financial condition and results of
operations.
Many of Cylink's competitors have substantially greater financial,
technical, marketing, distribution and other resources, greater name
recognition and longer standing relationships with customers than Cylink.
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 Cylink's
financial condition and results of operations. Cylink 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 Cylink's financial condition and results of operations.
Product Liability Risks
Customers rely on Cylink's network security products to prevent
unauthorized access to their networks and data transmissions. A malfunction
or the inadequate design of Cylink's products could result in tort or
warranty claims. Although Cylink attempts to reduce the risk of such losses
through warranty disclaimers and liability limitation clauses in its sales
and license agreements and by maintaining product liability insurance,
there can be no assurance that such measures will be effective in limiting
Cylink'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 Cylink's business, financial condition 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 Cylink's products in particular, regardless of whether such
breach is attributable to Cylink's products. This could result in a decline
in demand for Cylink's products, which would have a material adverse effect
on Cylink's business, financial condition and results of operations.
Year 2000
The "Year 2000 Issue" refers generally to the problems that some
software, including firmware embedded in Cylink's products, may have in
determining the correct century for the year. For example, software with
date-sensitive functions that is not Year 2000 compliant may not be able to
distinguish whether "00" means 1900 or 2000, which may result in failures
or the creation of erroneous results.
Cylink has developed a Year 2000 readiness plan for the current
versions of its products. The plan includes development of corporate
awareness, assessment, implementation (including remediation, upgrading and
replacement of certain product versions), validation testing, and
contingency planning. Cylink continues to respond to customer concerns
about prior versions of its products on a case-by-case basis.
Cylink has largely completed all phases of its plan, except for
contingency planning, with respect to the current versions of all of its
products. As a result, the current versions of each of its products
currently offered for sale are believed to be "Year 2000 Compliant" as
defined below when configured and used in accordance with the related
documentation, and provided that the underlying operating system of the
host machine and any other software used with or in the host machine or
Cylink's products are also Year 2000 Compliant. In some cases, Cylink's
products require an upgrade provided by Cylink which is either sold as a
complete substitute or as a kit sold with the product in order to be Year
2000 Compliant.
16
Cylink has defined "Year 2000 Compliant" as the ability to: (i)
correctly handle date information needed for the December 31, 1999 to
January 1, 2000 date change; (ii) function according to the product
documentation provided for this date change, without changes in operation
resulting from the advent of a new century, assuming correct configuration;
(iii) where appropriate, respond to two-digit date input in a way that
resolves the ambiguity as to century in a disclosed, defined, and
predetermined manner, such as in certificate based products, or in
accordance with Cylink's Year 2000 Compliant test plan; and (iv) recognize
year 2000 as a leap year. Cylink has not tested its products on all
platforms or all versions of operating systems that it currently supports
and has advised its customers to verify that their platforms and operating
systems support the transition to the year 2000.
Cylink has not specifically tested software obtained from third parties
(licensed software, shareware, and freeware) that is incorporated into its
products, but Cylink's test plan was designed to reveal Year 2000
deficiencies with third party software incorporated in Cylink's products.
Despite testing by Cylink and current and potential customers, and any
assurances from developers of products incorporated into Cylink's products,
Cylink's products may contain undetected errors or defects associated with
Year 2000 date functions. Also, certain prior versions of Cylink's products
are not fully Year 2000 Compliant, and Cylink is working to address these
issues by offering for sale upgrades to compliant versions. Known or
unknown errors or defects in Cylink's products could result in delay or
loss of revenue, diversion of development resources, damage to Cylink's
reputation, or increased service and warranty costs, any of which could
materially adversely affect Cylink's business, operating results, or
financial condition.
Cylink does not currently have any information concerning the Year 2000
compliance status of its customers. If Cylink's current or future customers
suspend investments in securing their existing networks while they achieve
Year 2000 compliance, or if they divert technology expenditures (especially
technology expenditures that are reserved for enterprise security products)
to address Year 2000 compliance problems, Cylink's business, results of
operations, or financial condition could be materially adversely affected.
Some commentators have predicted significant litigation regarding Year
2000 compliance issues. Because this type of litigation lacks precedent, it
is uncertain whether or to what extent Cylink may be affected by it.
Cylink has completed a review of its mission critical internal
information systems (including the third-party software for its management
information systems, networks and desktop applications, and its hardware
telecommunications technology) and believes it has addressed all critical
concerns. To the extent that Cylink is not been able to test the technology
provided by third-party vendors, Cylink will purchase upgrades for versions
which have been certified by their vendors as compliant. Although Cylink is
not currently aware of any material operational issues or costs associated
with preparing its internal information systems for the Year 2000, Cylink
may experience material unanticipated problems and costs caused by
undetected errors or defects in the technology used in its information
systems.
Cylink has funded its Year 2000 plan from operating cash. While Cylink
does not expect such costs to be material, Cylink will incur additional
amounts related to the Year 2000 plan for administrative personnel to
manage Cylink's readiness plans, technical support for its product
engineering and customer satisfaction. Cylink may experience material
problems and costs with Year 2000 compliance that could adversely affect
Cylink's business, results of operations, and financial condition.
Finally, Cylink is also subject to external forces that might generally
affect industry and commerce, such as utility or transportation company
Year 2000 compliance failures and related service interruptions.
Cylink has completed its plans to address Year 2000 readiness of its
critical operations based on its perception of the known risks involved.
However, were Cylink to experience an unanticipated Year 2000 interruption,
business operations could be seriously impaired for an indefinite period of
time until remedial efforts could be achieved.
17
Management of Growth And Reduction In Employees
Cylink has recently and may continue to experience substantial
fluctuations in the number of employees and the scope of its operations in
the network security business, resulting in increased responsibilities for
management. To manage its business effectively, Cylink will need to
continue to improve its operational, financial and management information
systems and to hire, train, motivate and manage its 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. Cylink has experienced delays in filling positions for engineering
personnel and Cylink expects to experience continued difficulty in filling
its needs for qualified engineers and other personnel, especially given the
recent announcement regarding the restatement of its financial results and
associated issues. There can be no assurance that Cylink 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 Cylink's financial condition and results of operations.
With the sale of its Wireless Communications Group (the "Wireless
Group") in March, 1998, Cylink has experienced a significant reduction in
employees, including Cylink's former Chief Technical Officer, Dr. Jim
Omura. The sale of its Wireless Group, the uncertainty created by Cylink's
recent restatements of its financial results, the initiation of highly
publicized class actions securities litigation against Cylink, and the
occasional reductions in specific engineering programs in the network
security business, has created some instability within the existing
employee population resulting in departures of certain key employees
critical to sustaining growth in Cylink's network security business.
Furthermore, sudden reductions in the number of Cylink's employees places
greater demands on the remaining employees which may distract them from
fulfilling their responsibilities necessary to accomplishing Cylink's
financial goals.
In September 1997, Cylink acquired Algorithmic Research, Ltd. ("ARL")
and assumed responsibility for management of its worldwide operations which
currently consists of approximately eighty-four employees. Cylink is
heavily dependent on ARL's success in continuing to develop marketable
technology and products, such as the PrivateWire family, including
PrivateSafe and PrivateCard, toolkits and other components, as well as
Cylink's next generation hardware VPN product. Key factors which will
determine ARL's success include whether Cylink can integrate ARL's
management, employee culture and organizational practices into Cylink,
whether Cylink can adequately fund ARL's development objectives, whether
Cylink can provide accurate information for ARL to focus its technology on
significant market opportunities, and whether Cylink can predict the most
attractive features and functions for ARL's products. Cylink's success in
realizing the anticipated return from its investment in ARL also will be
determined by Cylink's ability to position and introduce ARL's products
into Cylink's markets and channels, and Cylink's ability to provide
adequate sales and customer support for ARL's products. To date, Cylink's
efforts to market ARL's products through Cylink's direct sales channel have
not met Cylink's expectations due to differences between the sales
expertise required for selling the ARL products and that required for
Cylink's other products. Consequently, Cylink has recently reorganized the
management of ARL to strengthen ARL's responsibility for marketing and
sales of its products. In addition, ARL's improvements and development of
new products have been delayed by inadequate coordination between
engineering departments located in Sunnyvale, CA and Petach Tikva, Israel.
This inadequate coordination to date is due to differing engineering
practices concerning development planning and restrictions imposed by U.S.
export control laws governing the transfer of cryptographic expertise.
Cylink and ARL's successful working relationship may be hindered
significantly by differences between the two organizations created by time,
distance, language and culture. ARL operates from its principal offices in
Israel, a country which is vulnerable to disruption due to the sudden
outbreak of hostilities with its neighbors and various indigenous factions.
Many of ARL's employees have extensive commitments to the country's
military organizations which may require a loss of their services on the
Company's behalf in times of political instability.
Intellectual Property and Other Proprietary Rights
Cylink relies on patents, trademarks, copyrights, licenses and trade
secret law to establish and preserve its intellectual property rights.
Cylink owns a number of U.S. patents covering certain aspects of its
network security product designs, and has additional U.S. patent
applications pending. There can be no assurance that any patent, trademark,
copyright or license owned or held by Cylink will not be invalidated,
circumvented or
18
challenged, that the rights granted thereunder will provide competitive
advantages to Cylink or that any of Cylink's pending or future patent
applications will be issued with the scope of the claims sought by Cylink,
if at all. Further, there can be no assurance that others will not develop
technologies that are similar or superior to Cylink's technology, duplicate
Cylink's technology or design around the patents owned by Cylink. Cylink
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 Cylink's
products are or may be developed, manufactured or sold may not protect
Cylink's products and intellectual property rights to the same extent as
the laws of the United States. The inability of Cylink to protect its
intellectual property adequately could have a material adverse effect on
its 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. From time to time, Cylink has received
communications from third parties asserting that Cylink's patents, features
or content of certain of Cylink's products infringe upon the intellectual
property rights held by third parties, and Cylink may receive such
communications in the future. There can be no assurance that third parties
will not assert claims against Cylink that result in litigation. Any
litigation, whether or not determined in favor of Cylink, could result in
significant expense to Cylink and could divert management and other
resources. In the event of an adverse ruling in any litigation involving
intellectual property, Cylink 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
Cylink on reasonable terms or at all. In the event of a successful claim
against Cylink and Cylink's failure to develop or license a substitute
technology on commercially reasonable terms, Cylink's 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 Cylink's financial condition and results of
operations.
Evolving Network Security Market; Market Acceptance Risks
The market for Cylink's network 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. Cylink's future success will depend
in part upon end users' demand for network security products in general,
and upon Cylink's ability to enhance its existing products and to develop
and introduce new products and technologies that meet customer
requirements. Cylink faces continuing challenges to educate customers as to
the value of its security products. Cylink believes that many potential
customers do not appreciate the need for high-end security products unless
and until they have faced a major security breach. If Cylink is unable to
successfully educate potential customers as to the value of, and thereby
obtain broad market acceptance for, its products, it will continue to rely
primarily on selling new and existing products to its 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 Cylink's existing and new
products obsolete or unmarketable. To the extent that a specific method
other than Cylink's is adopted as the standard for implementing network
security in any segment of the network security market, sales of Cylink's
existing and planned products in that market segment may be adversely
impacted, which could have a material adverse effect on Cylink's business,
financial condition and results of operations. See "Competition." Network
security-related products or technologies developed by others may adversely
affect Cylink's competitive position or render its products or technologies
noncompetitive or obsolete.
In addition, a portion of the sales of Cylink's 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.
Rapid Technological Change
The markets for Cylink's products are characterized by rapidly changing
technologies, extensive research and new product introductions. Cylink
believes that its future success will depend in part upon its ability to
continue to enhance its existing products and to develop, manufacture and
market new products. As a result, Cylink expects to continue to make a
significant investment in engineering, research and development. Cylink
19
may not 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 Cylink to develop products and introduce them
successfully and in a timely manner could adversely affect Cylink's
competitive position, financial condition and results of operations.
Risks Associated with International Sales; Reliance Upon Local Partners;
Restrictions on Export
Cylink plans to continue to expand its 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 Cylink's foreign sales are denominated in U.S.
dollars, Cylink'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.
Cylink's ability to compete successfully in foreign countries is
dependent in part on Cylink's ability to obtain and retain reliable and
experienced in-country distributors and other strategic partners. Cylink
does not have long-term relationships with any of its value added resellers
and distributors and, therefore, has no assurance of a continuing
relationship within a given market.
Due to U.S. and Israeli government regulations restricting the export
of cryptographic devices and software, including certain of Cylink's
network security products, Cylink is often at a disadvantage in competing
for international sales compared to companies located outside the United
States and Israel that are not subject to such restrictions. Cylink is
unable to offer its products to certain types of foreign customers and, on
occasion, has lost sales due to uncertainty over whether Cylink will be
permitted to sell its products. The regulatory environment in the United
States for export of encryption products is particularly unsettled, with
various pending legislative initiatives and conflicting judicial decisions,
all causing substantial uncertainty in Cylink's international market. This
confusion is often exacerbated by U.S. vendors' incomplete or inaccurate
press releases concerning export licenses for their products, and foreign
competitors marketing campaigns which stress the restrictions on purchasing
encryption products from U.S. vendors. There is no assurance that this
disruption will end anytime within the near future.
Dependence on Component Availability, Subcontractor Performance and Key
Suppliers
Cylink's ability to deliver its products in a timely manner is
dependent upon the availability of quality components and subsystems used
in these products. Cylink depends in part upon subcontractors to
manufacture, assemble and deliver certain items in a timely and
satisfactory manner. Cylink obtains certain components and subsystems from
single, or a limited number of, sources. A significant interruption in the
delivery of such items could have a material adverse effect on Cylink's
financial condition and results of operations.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Cylink's market risk exposures are set forth in its Annual Report on
Form 10-K for the year ended December 31, 1998 and have not changed
significantly.
20
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On March 7, 1997, ten former employees of Cylink filed suit in action
No. CV764647 in the Superior Court of California, County of Santa Clara,
asserting claims for wrongful termination and various related causes of
action. Since the action was filed, Cylink has obtained various orders
granting summary judgement and dismissal of the majority of the claims.
Discovery with respect to the remaining claims is continuing, with trial
expected by late 1999. Although Cylink has placed its insurers on notice of
these claims and has received reimbursement from one insurer for a portion
of its legal fees and costs, all of the remaining insurers have reserved
their rights and defenses under their policies, and the extent of the
insurers' collective liability under their respective policies is
undetermined. Cylink believes the terminations were lawful, in the best
interest of Cylink, and intends to defend the matter vigorously. The
continued defense of this matter will require the expenditure of
significant legal fees and costs. An unfavorable outcome which exceeds
Cylink's insurance coverage, could also result in a material adverse effect
on Cylink's financial condition.
After asserting certain deductions arising under the contract dated
June 27, 1998, for the purchase of Cylink's Wireless Group, P-Com made a
partial payment on July 14, 1998, in the amount of $8.9 million on its
promissory note dated April 1, 1998 (the "Note"). On June 8, 1999, Cylink
initiated arbitration proceedings with P-com to obtain payment on the
outstanding balance of the Note, including interest, of approximately $6.6
million. No hearings have yet been scheduled.
On September 3, 1998, P-Com put Cylink on notice that certain shipments
in the fourth quarter of 1997 and the first quarter of 1998 by Cylink's
former Wireless Group and having an invoice value of approximately $3.5
million had been seized by an agency of the United States Department of the
Treasury and that P-Com intends to hold Cylink responsible for the
consequences of this event. P-Com is currently petitioning for release of
the goods. Based on Cylink's investigation to date, Cylink believes either
that the grounds for the seizure are unfounded or that P-Com is responsible
for this action. Cylink has no reason at this time to believe that it is
the subject of any official investigation and Cylink has been informed that
P-Com is presently petitioning for the release of the seized goods. A
failure by P-com to obtain release of the shipment due to a violation of
law by Cylink might adversely affect the amount collected from P-Com on its
outstanding obligations under the promissory note, including payment of any
relevant fines or penalties.
On September 14, 1998, Cylink announced that its earnings for the third
quarter of 1998 would be below consensus estimates. On November 5, 1998,
Cylink announced that, with the assistance of its independent accountants,
it was reviewing its revenue recognition practices, and Cylink announced
that its first and second quarter earnings of 1998 would have to be
restated and that it would have operating losses for each of the three
quarters for the period ended September 27, 1998. During the review,
certain facts became known indicating errors had been made in the
application of revenue recognition policies which also impacted the fourth
quarter of 1997, and as a result, 1997 full-year results have been restated
along with first and second quarter 1998 results. Cylink has filed amended
Forms 10-Q for the first and second quarters of 1998 and an amended Form
10-K for 1997. Between November 6 and November 25, 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.
Cylink believes it has meritorious defenses to 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, Cylink's business, financial condition, cash flows
and results of operations could be materially adversely affected.
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Item 4. Submission of Matters to a Vote of Security Holders
(a) The Registrant's Annual Meeting of Shareholders was held on May 14,
1999. The vote of holders of record of 29,118,467 shares of Cylink's
common stock outstanding at the close of business on March 29, 1999 was
solicited by proxy pursuant to Regulation 14A under the Securities Act
of 1934.
(b) The following persons were elected Directors of Cylink at the Annual
Meeting:
Votes For Votes Withholding
Elwyn Berlekamp 24,328,461 95,348
Paul Gauvreau 24,309,505 114,304
Regis McKenna 24,326,561 97,248
(c) There were no other matters voted on at the meeting.
Item 5. Other Information
Any shareholder proposal submitted with respect to Cylink's 2000 Annual
Meeting of Shareholders, which proposal is submitted outside the
requirements of Rule 14a-8 under the Securities Exchange Act of 1934, will
be considered untimely for purposes of Rule 14a-4 and 14a-5 if notice
thereof is received by Cylink after March 5, 2000.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits.
Exhibit
Number Description of Exhibit
------ ----------------------
27.1 Financial Data Schedule for the fiscal quarter ended
June 27, 1999
(b) Reports on Form 8-K.
Cylink filed a report on Form 8-K on July 19, 1999 as required by Item
4 of Form 8-K with respect to a change in accountants. On July 12, 1999,
Cylink retained Deloitte & Touche LLP as its independent accounting firm
and dismissed PricewaterhouseCoopers LLP. The change in the independent
accountants was approved by the Audit Committee of Cylink's Board of
Directors and does not reflect any disagreements with
PricewaterhouseCoopers LLP over matters of accounting principles or
practices, financial statement disclosure, or auditing scope or procedure.
Items 2 and 3 are not applicable and have been omitted.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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: August 10, 1999 CYLINK CORPORATION
By: /s/ ROGER A. BARNES
Roger A. Barnes
Vice President of Finance
and Administration and
Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)
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