1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 000-25120 SECURITY DYNAMICS TECHNOLOGIES, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 04-2916506 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 20 CROSBY DRIVE BEDFORD, MA 01730 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (781) 687-7000 ------------------------ 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 July 31, 1998, there were 40,924,242 shares of the Registrant's Common Stock, $.01 par value per share, outstanding. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2 SECURITY DYNAMICS TECHNOLOGIES, INC. FORM 10-Q FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 1998 TABLE OF CONTENTS PAGE ---- PART I FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets as of June 30, 1998 and December 31, 1997....................................... 3 Condensed Consolidated Statements of Income for the three and six months ended June 30, 1998 and 1997................. 4 Condensed Consolidated Statements of Cash Flows for the three and six months ended June 30, 1998 and 1997........... 5 Notes to Condensed Consolidated Financial Statements........ 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk........................................................ 19 PART II OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders......... 20 Item 5. Other Events................................................ 20 Item 6. Exhibits and Reports on Form 8-K............................ 21 Signature................................................... 22 2 3 PART I. FINANCIAL INFORMATION SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) (IN THOUSANDS, EXCEPT SHARE DATA) ITEM 1. FINANCIAL STATEMENTS JUNE 30, 1998 DECEMBER 31, 1997 ------------- ----------------- ASSETS Current assets: Cash and equivalents...................................... $ 29,003 $ 96,595 Marketable securities..................................... 129,319 68,064 Accounts receivable (less allowance for doubtful accounts of $705 in 1998 and $742 in 1997)...................... 29,961 27,551 Inventory................................................. 7,981 3,035 Prepaid expenses and other................................ 6,313 9,338 Prepaid income taxes...................................... -- 2,562 Deferred taxes............................................ 1,062 1,426 -------- -------- Total current assets.............................. 203,639 208,571 -------- -------- Property and equipment -- net............................... 23,114 17,515 -------- -------- Other assets: Investments............................................... 20,158 3,699 Purchased technology and capitalized software costs, net.................................................... 41 86 Deferred taxes............................................ -- 3,371 Other..................................................... 1,050 733 -------- -------- Total other assets................................ 21,249 7,889 -------- -------- Total....................................................... $248,002 $233,975 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable.......................................... $ 8,299 $ 11,137 Accrued payroll and related benefits...................... 5,594 5,254 Accrued expenses and other................................ 4,154 4,071 Income taxes payable...................................... 1,865 159 Deferred revenue.......................................... 8,269 9,602 -------- -------- Total current liabilities......................... 28,181 30,223 -------- -------- Deferred taxes............................................ 950 -- -------- -------- Minority interests........................................ 2,641 3,099 -------- -------- Commitments and contingencies: (notes 4 and 7) Stockholders' equity: Common stock, $.01 par value; authorized 80,000,000 shares; issued, 40,921,042 and 40,467,118 shares in 1998 and 1997; outstanding, 40,920,533 and 40,466,609 shares in 1998 and 1997................................ 409 405 Additional paid-in capital................................ 168,575 165,751 Retained earnings......................................... 48,525 35,284 Deferred stock compensation............................... (79) (116) Treasury stock, common, at cost, 509 and 296 shares in 1998 and 1997.......................................... -- -- Accumulated other comprehensive income.................... (1,200) (671) -------- -------- Total stockholders' equity........................ 216,230 200,653 -------- -------- Total....................................................... $248,002 $233,975 ======== ======== See notes to condensed consolidated financial statements. 3 4 SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA) THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------ ------------------ 1998 1997 1998 1997 ------- ------- ------- ------- Revenue............................................. $43,372 $34,255 $83,618 $63,574 Cost of revenue..................................... 11,893 6,787 20,509 13,243 ------- ------- ------- ------- Gross profit........................................ 31,479 27,468 63,109 50,331 ------- ------- ------- ------- Costs and expenses: Research and development.......................... 7,525 4,998 14,638 8,946 Purchased research and development................ -- -- 210 -- Marketing and selling............................. 14,774 10,301 28,254 19,170 General and administrative........................ 4,941 4,619 9,660 8,209 Merger and integration............................ -- -- 2,600 -- ------- ------- ------- ------- Total..................................... 27,240 19,918 55,362 36,325 ------- ------- ------- ------- Income from operations.............................. 4,239 7,550 7,747 14,006 Interest income and other........................... 2,082 1,459 4,492 2,760 Gain on sale of marketable securities............... -- 222 -- 197 Gain from increase in market value of equity investment........................................ 11,976 -- 11,976 -- Equity in loss from operations of equity investment........................................ (1,173) -- (1,173) -- ------- ------- ------- ------- Income before provision for income taxes............ 17,124 9,231 23,042 16,963 Provision for income taxes.......................... 6,661 3,355 9,863 6,218 Minority interests.................................. 210 -- 458 -- ------- ------- ------- ------- Net income.......................................... $10,673 $ 5,876 $13,637 $10,745 ======= ======= ======= ======= Basic earnings per share: Per share amount.................................. $ 0.26 $ 0.15 $ 0.33 $ 0.28 ======= ======= ======= ======= Weighted average shares........................... 40,907 38,656 40,815 38,425 ======= ======= ======= ======= Diluted earnings per share: Per share amount.................................. $ 0.25 $ 0.15 $ 0.32 $ 0.27 ======= ======= ======= ======= Weighted average shares........................... 40,907 38,656 40,815 38,425 Effect of dilutive options........................ 968 1,655 1,186 1,661 ------- ------- ------- ------- Adjusted weighted average shares.................... 41,875 40,311 42,001 40,086 ======= ======= ======= ======= See notes to condensed consolidated financial statements. 4 5 SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (IN THOUSANDS) SIX MONTHS ENDED JUNE 30, -------------------- 1998 1997 --------- ------- Cash flows from operating activities: Net income................................................ $ 13,637 $10,745 Adjustments to reconcile net income to net cash provided by operating activities: Gain from increase in market value of equity investment............................................ (11,976) -- Loss from operations of equity investment.............. 1,173 -- Deferred taxes......................................... 4,685 224 Purchased research and development..................... 210 -- Depreciation and amortization.......................... 2,841 1,461 Stock compensation..................................... 597 621 License write off...................................... 3,000 Minority interests..................................... (458) -- Increase (decrease) in cash from changes in: Accounts receivable.................................. (2,405) (3,719) Inventory............................................ (4,947) (583) Prepaid expenses and other........................... (272) (773) Accounts payable..................................... (3,151) (503) Accrued payroll and related benefits................. 332 725 Accrued expenses and other........................... 64 882 Prepaid and income taxes payable..................... 4,351 (914) Deferred revenue..................................... (1,334) (416) --------- ------- Net cash provided by operating activities......... 6,347 7,750 --------- ------- Cash flows from investing activities: Purchases of marketable securities........................ (140,993) (48,027) Proceeds from sale and maturities of marketable securities............................................. 79,651 55,628 Purchases of property and equipment....................... (8,389) (4,000) Investments and other..................................... (5,971) 211 --------- ------- Net cash provided by (used for) investing activities...................................... (75,702) 3,812 --------- ------- Cash flows from financing activities: Proceeds from exercise of stock options................... 2,298 -- Proceeds from sales of common stock, net of issuance costs and other.............................................. -- (369) Payment to Acquisition shareholders....................... -- 1,704 Minority interests........................................ -- 1,389 --------- ------- Net cash provided by financing activities......... 2,298 2,724 --------- ------- Effects of exchange rate changes on cash and equivalents.... (535) (346) --------- ------- Net increase (decrease) in cash and equivalents........... (67,592) 13,940 Cash and equivalents, beginning of period................... 96,595 11,688 --------- ------- Cash and equivalents, end of period......................... $ 29,003 $25,628 ========= ======= See notes to condensed consolidated financial statements. 5 6 SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements include the accounts of Security Dynamics Technologies, Inc. (the "Company") and its wholly owned subsidiaries and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 1997, as amended. In the opinion of management, the accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements, and include all adjustments, consisting only of normal recurring adjustments, necessary for fair presentation of the results of the interim periods presented. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year. On July 15, 1997, the Company completed an acquisition of DynaSoft AB ("DynaSoft") (the "DynaSoft Acquisition"). On March 26, 1998, the Company completed an acquisition of Intrusion Detection Inc. ("IDI") (the "IDI Acquisition"). The DynaSoft Acquisition and the IDI Acquisition have been accounted for as poolings of interests and therefore the consolidated financial statements for all periods prior to the respective acquisitions have been restated to include the accounts and operations of DynaSoft and IDI with those of the Company. 2. EARNINGS PER COMMON SHARE In the fourth quarter of 1997, the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 128 "Earnings per Share." The Company changed the method used to compute earnings per share and restated all prior periods in accordance with SFAS No. 128. SFAS No. 128 supersedes Accounting Principles Board Opinion No. 15 and is intended to simplify the computation of earnings per share and to make the U.S. computations more comparable with international computations by requiring the presentation of basic and fully diluted earnings per share. The Company's only dilutive stock equivalents are stock options. 3. INCOME TAXES The Company provides for income taxes at the end of each interim period based on the estimated effective tax rate for the full year. Cumulative adjustments to the tax provision are recorded in the interim period in which a change in the estimated annual effective rate is determined. Cash payments for income taxes were approximately $551 and $678 for the three and six months ended June 30, 1998, respectively, and $3,956 and $7,277 for the three and six months ended June 30, 1997, respectively. 4. CONTINGENCIES The Company is not a party to any litigation that it believes could have a material adverse effect on the Company or its business. During the second quarter of 1998, the Company reached a favorable settlement in lawsuits relating to certain of its intellectual property rights. The settlement was recorded as revenue and represented less than 5% of consolidated second quarter revenue. 6 7 SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 5. INVESTMENTS VERISIGN In January 1998, VeriSign, Inc. ("VeriSign") had an initial public offering of three million shares of its common stock. The VeriSign series A and B convertible preferred stock held by the Company converted to common stock in connection with the offering. The offering diluted the Company's ownership to approximately 22% but increased the value of the Company's equity in VeriSign. The market value of the Company's investment in VeriSign was approximately $168,100 at June 30, 1998. As a result of VeriSign's initial public offering, in accordance with the equity method of accounting, the Company recognized as a gain the increase in the amount of its investment in VeriSign, representing its proportionate share of VeriSign's equity as of December 31, 1997, after considering VeriSign's net proceeds from the offering. The Company recorded the increase in its investment of $11,376 and its proportionate share of VeriSign's first quarter net loss of $1,173 in the second quarter of 1998. The Company recognizes its proportionate interest in VeriSign's operating results one quarter in arrears. On July 27, 1998, VeriSign announced it had incurred a net loss of $4,900 and $10,100 for the three and six months ended June 30, 1998, respectively, and at June 30, 1998 had total assets and liabilities of $61,400 and $14,900, respectively. An officer of the Company serves as Chairman of the Board of VeriSign. VPNET In December 1996, the Company purchased 250,000 shares of Series B Preferred Stock of VPNet Technologies, Inc. ("VPNet") of San Jose, California, for an aggregate purchase price of $1,500. VPNet was organized to develop and market products and technologies for implementing high-performance virtual private networks. In January 1998, the Company purchased $120 of VPNet 8% convertible debt. The debt is convertible into preferred stock which is convertible into common stock. The Company also received a warrant to purchase VPNet Common Stock. The Company's investment in VPNet represents a minority interest of less than 10% of VPNet's capitalization. An officer of the Company serves as a director of VPNet. TRINTECH On March 31, 1998 the Company purchased, in a non-cash transaction, 482,756 ordinary shares of Trintech Group ("Trintech") for $2,000. Trintech Group is an Irish development company organized to develop and market software products designed to enable secure payment in the electronic marketplace. In June 1998, the Company purchased 500,000 shares of Trintech's Series A Convertible Preferred Shares for $3,000 cash. The Company's investment represents a minority interest of less than 10% of Trintech's capitalization. An officer of the Company serves as a director of Trintech. nCIPHER In October 1997, the Company purchased 175,285 Ordinary Shares of nCipher Corporation Limited ("nCipher") for an aggregate purchase price of $512. nCipher is located in the United Kingdom and develops products designed to accelerate cryptographic processes in Internet security, electronic commerce and other applications. In January 1998, the Company purchased 93,896 Ordinary Shares of nCipher for an aggregate purchase price of $336. In July 1998, the Company purchased 563,910 Ordinary Shares of nCipher for an aggregate purchase price of $2,500. The Company's investment in nCipher represents a minority interest of less than 20% of nCipher's capitalization. An officer of the Company serves as a director of nCipher. C2NET In June 1998, the Company made a bridge loan to C2Net, Inc. ("C2Net") in the amount of $200. The debt is convertible at the Company's option into equity of C2Net or may be used to offset any financial obligation which may arise from future licensing agreements between the Company and C2Net. C2Net was 7 8 SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) organized to develop commercial Internet security software. FINJAN In August 1997, the Company purchased 877,193 Series C Preferred Shares of Finjan Software Ltd. ("Finjan") for an aggregate purchase price of $1,000. Finjan is an Israeli software company organized to develop and market products for the Java Internet security market. The Company's investment in Finjan represents a minority interest of less than 5% of Finjan's capitalization. 6. ACQUISITIONS In connection with the IDI Acquisition, the Company issued approximately 784,000 shares of common stock in exchange for all of IDI's outstanding common stock. IDI develops and markets intrusion detection software. Merger and integration expenses incurred in connection with the IDI acquisition were approximately $2,600. No adjustments were required to conform accounting policies of the Company and IDI. Revenue and net income (loss) for each of the previously separate companies for the following periods were: THREE MONTHS ENDED SIX MONTHS ENDED YEAR ENDED JUNE 30, JUNE 30, DECEMBER 31, ------------------- ----------------- ------------ 1998 1997 1998 1997 1997 -------- -------- ------- ------- ------------ REVENUE Security Dynamics(a)........................ $43,372 $32,955 $82,718 $61,374 $135,930 IDI......................................... -- 1,300 900 2,220 4,700 ------- ------- ------- ------- -------- Total............................... $43,372 $34,255 $83,618 $63,574 $140,630 ======= ======= ======= ======= ======== NET INCOME (LOSS) Security Dynamics(a)........................ $10,673 $ 5,515 $13,774 $10,076 $ 16,368 IDI......................................... -- 361 (137) 669 680 ------- ------- ------- ------- -------- Total............................... $10,673 $ 5,876 $13,637 $10,745 $ 17,048 ======= ======= ======= ======= ======== - --------------- (a) For periods subsequent to the acquisitions, includes revenues and net income for IDI and DynaSoft. 7. COMMITMENTS Effective April 1, 1998, the Company amended its agreement with Progress Software Corporation ("Progress Software") for the right to use certain of its software to enhance the functionality of the Company's ACE/Server software. In order to obtain favorable pricing, the Company agreed to prepay $6,000 in installments over the remaining three quarters of 1998. Installments of $3,300 have been paid as of June 30, 1998. The prepaid royalty is recorded as a component of cost of sales as the related products are sold. In June 1998 the Company entered into an agreement with Aventail Corporation ("Aventail") under which the Company will distribute Aventail's products. The Company prepaid license and maintenance fees aggregating $1,200 in July 1998 in connection with the agreement. 8 9 SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 8. COMPREHENSIVE INCOME Effective January 1, 1998, the Company adopted the provisions of SFAS No. 130, "Reporting Comprehensive Income." Comprehensive income, presented in accordance with SFAS No. 130, was as follows for the three and six months ended June 30, 1998 and 1997: THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, ---------------- ----------------- 1998 1997 1998 1997 ------- ------ ------- ------- Net income................................................. $10,673 $5,876 $13,637 $10,745 Other comprehensive income, net of tax: Unrealized holding (loss) gain on securities arising during period......................................... 14 (55) (87) (1,353) Foreign currency translation adjustments................. (270) (448) (443) (687) ------- ------ ------- ------- Comprehensive income....................................... $10,417 $5,373 $13,107 $ 8,705 ======= ====== ======= ======= Accumulated other comprehensive income consists of the following: UNREALIZED FOREIGN HOLDING ACCUMULATED CURRENCY (LOSS) OTHER TRANSLATION GAIN ON COMPREHENSIVE ADJUSTMENTS SECURITIES INCOME ----------- ---------- ------------- Balance, December 31, 1997................................. $ (750) $ 79 $ (671) Period change.............................................. (173) (102) (275) ------- ----- ------- Balance, March 31, 1998.................................... (923) (23) (946) Current period change...................................... (270) 14 (254) ------- ----- ------- Balance, June 30, 1998..................................... $(1,193) $ (8) $(1,200) ======= ===== ======= 9. RECENT ACCOUNTING PRONOUNCEMENTS In October 1997, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") No. 97-2, "Software Revenue Recognition", which supersedes SOP No. 91-1. The Company adopted SOP No. 97-2 prospectively on January 1, 1998. SOP No. 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of the elements. In March 1998, AICPA postponed the adoption date of certain provisions of SOP No. 97-2. The adoption of SOP No. 97-2 did not have a material effect on the Company's revenues and operating results for the three and six months ended June 30, 1998. In June 1997, the Financial Accounting Standards Board issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". The Company will be required to adopt the provisions of this statement in its annual financial statements for fiscal 1998. SFAS No. 131 establishes new standards for reporting information about operating segments. The Company believes the segment information required to be disclosed under SFAS No. 131 will be more comprehensive than previously provided, including expanded disclosure of income statement and balance sheet items for each reportable operating segment. The Company has not yet completed its analysis of the operating segments on which it will report. 10. 1994 STOCK OPTION PLAN On January 22, 1998 and March 8, 1998, the Board of Directors adopted, and on April 30, 1998 the stockholders approved, an amendment and restatement of the 1994 Stock Option Plan, as amended (the "Plan") increasing the number of shares of Common Stock authorized for issuance thereunder from 6,570,000 to 9,570,000 shares in the aggregate. On July 24, 1998 and August 6, 1998, the Board of Directors of the Company approved a stock option repricing program pursuant to which each holder (other than certain executive officers and the directors of the 9 10 SECURITY DYNAMICS TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Company) of an outstanding stock option granted under the Plan during the period commencing on January 1, 1996 and ending on June 30, 1998 (collectively, the "Old Options"), could elect to receive a new stock option (collectively, "New Options") granted on August 12, 1998 under the Plan in exchange for cancellation of each Old Option. The Company repriced the options because the exercise prices of such options were significantly higher than the fair market value of the Company's common stock, and therefore did not provide the desired incentive to employees. The Company believes that stock options are a valuable tool in retaining employees. Each New Option is, among other things, (i) exercisable for the number of shares of the Company's Common Stock covered by the outstanding unexercised portion of the Old Option cancelled in exchange therefor; (ii) has an exercise price of $12.125 (equal to the closing price of the Common Stock on the Nasdaq National Market on August 12, 1998 and the fair market value of the Common Stock on such date); and (iii) has the identical vesting schedule as the Old Option, provided, however, that each such New Option shall not be exercisable prior to February 12, 1999, with such prohibition on exercise expiring at a rate of 25% at the end of each three-month period thereafter. New Options to purchase an aggregate of approximately 5.3 million shares of Common Stock were granted in exchange for Old Options with exercise prices ranging from $19.00 to $44.125. 11. LICENSE AGREEMENT During the second quarter of 1998 and in connection with a refinement of its product offering strategy, the Company determined it will no longer actively market secure email products obtained from a third party under a license agreement. Prepaid license fees paid under the license agreement with the third party of $3,000 were determined to have no future value and were charged to cost of revenue in the second quarter of 1998. 10 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PERCENTAGE DATA) OVERVIEW This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believes," "anticipates," "plans," "expects," and similar expressions are intended to identify forward-looking statements. There are a number of factors that could cause the Company's actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth below under the caption "Certain Factors That May Affect Future Results." The IDI Acquisition was completed on March 26, 1998 and has been accounted for as a pooling of interests. Accordingly, the results of operations for all periods discussed below have been restated to include the financial results of IDI. See Notes 1 and 6 of Notes to Condensed Consolidated Financial Statements. RESULTS OF OPERATIONS The following table sets forth income and expense items as a percentage of total revenue, and the percentage change in dollar amounts of such items, for the three and six months ended June 30, 1998 and 1997. PERCENTAGE OF PERIOD-TO- PERCENTAGE OF PERIOD-TO- TOTAL PERIOD TOTAL PERIOD REVENUE CHANGE REVENUE CHANGE ---------------- ---------- -------------- ---------- THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, ------------------------------ ---------------------------- 1998 1997 1998 1997 ------ ------ ----- ----- Revenue............................... 100.0% 100.0% 26.6% 100.0% 100.0% 31.5% Cost of revenue....................... 27.4 19.8 75.2 24.5 20.8 54.9 ------ ------ ------ ----- ----- ------ Gross profit.......................... 72.6 80.2 14.6 75.5 79.2 25.4 ------ ------ ------ ----- ----- ------ Costs and expenses: Research and development............ 17.3 14.6 50.6 17.5 14.1 63.6 Purchased research and development...................... -- -- -- .3 -- (100.0) Marketing and selling............... 34.1 30.1 43.4 33.7 30.2 47.4 General and administrative.......... 11.4 13.5 7.0 11.6 12.9 17.7 Merger and integration.............. -- -- -- 3.1 -- 100.0 ------ ------ ------ ----- ----- ------ Total....................... 62.8 58.2 36.8 66.2 57.2 52.4 ------ ------ ------ ----- ----- ------ Income from operations................ 9.8 22.0 (43.9) 9.3 22.0 (44.7) Interest income and other............. 4.8 4.3 42.7 5.4 4.4 62.8 Gain on sale of marketable securities.......................... -- .6 (100.0) -- .3 (100.0) Gain from increase in market value of equity investment................... 27.6 -- 100.0 14.3 -- 100.0 Equity in loss from operations of equity investment................... (2.7) -- 100.0 (1.4) -- (100.0) ------ ------ ------ ----- ----- ------ Income before provision for income taxes............................... 39.5 26.9 85.5 27.6 26.7 35.8 Provision for income taxes............ 15.4 9.8 98.5 11.8 9.8 58.6 Minority interests.................... .5 -- 100.0 .5 -- 100.0 ------ ------ ------ ----- ----- ------ Net income............................ 24.6% 17.1% 81.6% 16.3% 16.9% 26.9% ====== ====== ====== ===== ===== ====== 11 12 REVENUE The Company's revenue is derived principally from the sales of SecurID tokens; licensing of ACE/ Server, BoKS and SecurPC software; licensing of BSAFE, JSAFE, TIPEM, S/PAY and S/MAIL encryption engines; licensing of patents; licensing of Kane Security Analyst and Kane Security Monitor software and revenues from maintenance and professional services. Total revenue increased 26.6% in the second quarter of 1998 to $43,372 from $34,255 in the second quarter of 1997. Total revenue increased 31.5% in the first six months of 1998 to $83,618 from $63,574 in the first six months of 1997. The increases in revenue reflected increases in unit sales of all of the Company's products, except ACM/400 and ACM/1600 hardware products. During the second quarter and first six months of 1998, approximately 41% and 51%, respectively, of the increase in revenue was attributable to increased sales of SecurID tokens, approximately 24% and 24%, respectively, of the increase in revenue was attributable to increased sales of ACE/Server and ACM software products, and approximately 23% and 18%, respectively, of the increase in revenue was attributable to increased sales of encryption engine licenses and patent licensing. The balance of the increase in revenue during the second quarter and the first six months of 1998 resulted from increased sales of BoKS software products, Kane Security Analyst and Kane Security Monitor products, and maintenance and professional services revenue offset by decreased hardware and SecurPC revenue. The Company believes that the overall increase in sales was attributable in part to growth of the information security market, with the increased use of the Internet and corporate intranets and extranets continuing to play significant roles in developing new opportunities for the Company. International revenue (excluding Canada) increased 21.6% in the second quarter of 1998 to $10,700 from $8,800 in the second quarter of 1997 and increased 43.5% in the first six months of 1998 to $21,100 from $14,700 in the first six months of 1997. International revenue accounted for 24.7% and 25.7% of total revenue in the second quarters of 1998 and 1997, respectively, and 25.2% and 23.1% of total revenue in the first six months of 1998 and 1997, respectively. The increases in international revenue were primarily attributable to the continuing expansion of the Company's international direct sales force and increased market penetration of the Company's products in foreign markets. During the second quarter of 1998, the Company reached a favorable settlement in lawsuits relating to certain of its intellectual property rights. This settlement was recorded as revenue and represented less than 5% of consolidated second quarter revenue. COST OF REVENUE AND GROSS PROFIT The Company's cost of revenue consists primarily of costs associated with the manufacture and delivery of SecurID tokens and hardware products. The Company's utilizes assembly contractors for most manufacturing. Cost of revenue also includes royalty fees incurred on the sale of ACE/Server software, royalty fees payable on the licensing of patent technology and royalties payable under certain OEM agreements. Cost of revenue includes customer support costs and production costs, which include labor costs associated with the programming of SecurID tokens, inspection and quality control functions and shipping costs. The Company's gross profit increased 14.6% in the second quarter of 1998 to $31,479 from $27,468, in the second quarter of 1997 and increased 25.4% in the first six months of 1998 to $63,109 from $50,332, in the first six months of 1997. Gross profit as a percentage of revenue declined, however, in the second quarter and the first six months of 1998 to 72.6% and 75.5% of revenues, respectively, compared to 80.2% and 79.2% of revenue, respectively for the second quarter and first six months of 1997. The decline was primarily attributable to the write-off in the second quarter to cost of revenue of prepaid license fees of $3,000 under a license agreement with a third party determined to have no further value. Excluding the effects of this write-off, gross profit as a percentage of revenue was 79.5% and 79.1% during the second quarter and first six months of 1998, respectively. During the second quarter and first six months of 1998 and excluding the effect of the license write-off, approximately 43% and 53%, respectively, of the increase in gross profit were attributable to increased unit sales of SecurID tokens and hardware, approximately 25% and 21%, respectively of the increases in gross profit were attributable to increased licensing sales of encryption engine technology and patent licensing, and approximately 37% and 26%, respectively of the increases in gross profit were attributable 12 13 to increased licensing sales of ACE/Server software. In addition, gross profit increased due to increased maintenance revenue. In the future, gross profit may be affected by several factors, including changes in product mix and distribution channels, price reductions (resulting from volume discounts or otherwise), competition, increases in the cost of revenue (including increases in material costs associated with the manufacture of SecurID tokens and hardware products and any software license fees or royalties payable by the Company) and other factors. RESEARCH AND DEVELOPMENT Research and development expenses consist primarily of personnel costs as well as fees for development services provided by consultants. Research and development expenses increased 50.6% in the second quarter of 1998 to $7,525 from $4,998 in the second quarter of 1997, and increased 63.6% in the first six months of 1998 to $14,638 from $8,946 in the first six months of 1997. Research and development expenses increased as a percentage of revenue to 17.3% and 17.5%, respectively, in the second quarter and the first six months of 1998 from 14.6% and 14.1%, respectively, in the second quarter and the first six months of 1997 primarily due to increased payroll costs associated with the employment of additional staff. MARKETING AND SELLING Marketing and selling expenses consist primarily of salaries, commissions and travel expenses of direct sales and marketing personnel and marketing program expenses. Marketing and selling expenses increased 43.4% in the second quarter of 1998 to $14,774 from $10,301 in the second quarter of 1997, and increased 47.4% in the first six months of 1998 to $28,254 from $19,170 in the first six months of 1997. Marketing and selling expenses increased as a percentage of revenue to 34.1% and 33.7%, respectively, in the second quarter and first six months of 1998 from 30.1% and 30.2%, respectively, in the second quarter and first six months of 1997. Approximately 59% and 68%, respectively of the increase in marketing and selling expenses during the second quarter and the first six months of 1998 were attributable to increased payroll costs associated with the employment of additional staff. Approximately 15% and 19%, respectively, of the increases in marketing and selling expenses during the second quarter and the first six months of 1998 resulted from increased travel expenses and marketing program expenses. GENERAL AND ADMINISTRATIVE General and administrative expenses consist primarily of personnel costs for administration, finance, human resources, general management and legal and accounting fees. General and administrative expenses increased 7.0% and 17.7%, respectively during the second quarter and the first six months of 1998 to $4,941, and $9,660, respectively or 11.4% and 11.6%, respectively of revenue, from $4,619, and $8,209, respectively or 13.5% and 12.9%, respectively of revenue, in the during the second quarter and the first six months of 1997. The increases in general and administrative expenses were primarily due to increased payroll costs associated with the employment of additional staff. MERGER AND INTEGRATION EXPENSES Merger and integration expenses, consisting of legal, accounting, investment banking and other expenses, incurred in connection with the IDI Acquisition were $2,600 in the first six months of 1998. INTEREST INCOME AND OTHER Interest income and other consists primarily of interest earned on the Company's cash balances and marketable securities. 13 14 Interest income increased 42.7% and 62.8%, respectively in the second quarter and the first six months of 1998 to $2,082 and $4,492, respectively from $1,459 and $2,760, respectively in the second quarter and the first six months of 1997 due to interest earned on higher cash and marketable securities balances. GAIN ON SALE OF MARKETABLE SECURITIES Gains on sale of marketable securities were $222,000 and $197,000 in the three and six months ended June 30, 1998, respectively. EQUITY INVESTMENT INCOME AND LOSS The Company recorded a non-recurring gain of $12,000 resulting from the write-up under the equity method of its investment in VeriSign, Inc. during the second quarter of 1998. The gain was partially offset by the Company's proportionate share of VeriSign's loss for the first quarter of 1998. See Note 5 of Notes to Condensed Consolidated Financial Statements. PROVISION FOR INCOME TAXES The provision for income taxes increased to $6,661 and $9,863, respectively, during the second quarter and the first six months of 1998 from $3,355 and $6,218, respectively, in the second quarter and the first six months of 1997, primarily due to higher income subject to taxation and to higher effective tax rates. The Company's effective tax rate was 38.9% and 42.8%, respectively, for the second quarter and the first six months of 1998 compared to 36.3% and 36.7%, respectively, for the second quarter and the first six months of 1997. The effective tax rate increases were due to non-deductible merger and integration expenses incurred in correction with the IDI Acquisition, partially offset by benefits resulting from the Company's foreign tax strategy. MINORITY INTERESTS Minority interests in the consolidated net income were $210 and $458, respectively, during the second quarter and the first six months of 1998. An aggregate of 26% of RSA's Japanese subsidiary is owned by minority interest stockholders. NET INCOME As a result of the above factors, net income in the second quarter and the first six months of 1998 increased to $10,673 and $13,637, respectively or 24.6% and 16.3% of revenue, respectively, from $5,876 and $10,745, respectively, or 17.1% and 16.9% of revenue, in the second quarter and the first six months of 1997. LIQUIDITY AND CAPITAL RESOURCES Liquidity At June 30, 1998, the Company had cash, cash equivalents and marketable securities of $158,300 and working capital of $175,500. The Company has historically funded its operations primarily from cash generated from its operating activities. During the first six months of 1998 the Company used the cash provided by operations principally for working capital needs and to finance certain costs in connection with the IDI Acquisition. The Company believes that working capital will be sufficient to meet its anticipated cash requirements through at least 1999. Mergers and Acquisitions On July 15, 1997, the Company acquired approximately 95% of the outstanding shares and certain of the outstanding options to acquire shares of DynaSoft in exchange for approximately 2.7 million shares of the Company's Common Stock. The Company also paid approximately $6,000 in cash to certain of stockholders of DynaSoft in exchange for the remaining outstanding shares and options. The DynaSoft Acquisition costs were approximately $5,700, which included integration costs, primarily severance, of $300. 14 15 On March 26, 1998, a wholly owned subsidiary of the Company acquired IDI. The Company issued approximately 784,000 shares of Common Stock of the Company in exchange for all of IDI's outstanding common stock. The IDI Acquisition costs were approximately $2,600. The DynaSoft Acquisition and the IDI Acquisition were accounted for as poolings of interests. See Note 6 of Notes to the Company's Consolidated Financial Statements. The Company intends to seek acquisitions of businesses, strategic investments, products and technologies that are complementary to those of the Company. The Company is continuing to identify and prioritize additional security technologies which it may wish to develop, either internally or through the licensing or acquisition of products from third parties. While the Company engages from time to time in discussions with respect to potential acquisitions, there can be no assurances that any such acquisitions will be made or that the Company will be able to successfully integrate any acquired business. In order to finance such acquisitions, it may be necessary for the Company to raise additional funds through public or private financings. Any equity or debt financings, if available at all, may be on terms which are not favorable to the Company and, in the case of equity financings, may result in dilution to the Company's stockholders. Sales of Common Stock In October 1997, the Company sold 1,626,000 shares of Common Stock in a follow-on public offering, which generated $61,100 of net cash proceeds to the Company. The Company generated $2,300 of cash from employees exercising stock options during the first six months of 1998. Strategic Investments During 1995, RSA granted certain rights and privileges in certain technology to VeriSign in connection with VeriSign's incorporation and received 4,000,000 shares of VeriSign common stock. On April 17, 1995 and February 20, 1996, the Company purchased 425,000 shares of Series A and 72,091 shares of Series B Convertible Preferred Stock, respectively, of VeriSign for an aggregate purchase price of $687. VeriSign was organized to provide digital certificates and related services that use public-key cryptography to ensure essential privacy and authentication features. VeriSign introduced its first products and services in June 1995; as such, it has a limited operating history and through December 31, 1997 has incurred significant net losses in each year since its inception. There can be no assurance that VeriSign will achieve profitability in the foreseeable future. The Company's voting interest in VeriSign was approximately 27% and 26% at December 31, 1996 and 1997, respectively. The Company uses the equity method to account for its investment in VeriSign. The market value of the Company's investment in VerSign was approximately $168,100 at June 30, 1998. In January 1998, VeriSign had an initial public offering which diluted the Company's ownership to approximately 22% but increased the Company's equity in VeriSign. As a result of VeriSign's initial public offering, in accordance with the equity method of accounting, the Company recognized an increase in the amount of its investment in VeriSign, representing its proportionate share of VeriSign's equity as of December 31, 1997, after considering VeriSign's net proceeds from the offering. The increase in the investment was recorded with a corresponding increase to additional paid in capital, net of deferred income taxes payable. The Company recorded the increase in its investment of $11,376 and its proportionate share of VeriSign's first quarter net loss of $1,173 in the second quarter of 1998 when the Company recognized its proportionate interest in VeriSign's operating results one quarter in arrears. On July 27, 1998, VeriSign announced it had incurred a net loss of $4,900 for the second quarter and $10,100 the first six months of 1998 and at June 30, 1998 had total assets and liabilities of $61,400 and $14,900, respectively. An officer of the Company serves as Chairman of the Board of VeriSign. In December 1996, the Company purchased 250,000 shares of Series B Preferred Stock of VPNet Technologies, Inc. ("VPNet") of San Jose, California, for an aggregate purchase price of $1,500. VPNet was organized to develop and market products and technologies for implementing high-performance virtual private networks. In January 1998, the Company purchased $120 of VPNet 8% convertible debt. The debt is convertible into preferred stock which is convertible into common stock. The Company also received a warrant 15 16 to purchase VPNet common stock. The Company's investment in VPNet represents a minority interest of less than 10% of VPNet's capitalization. An officer of the Company serves as a director of VPNet. On March 31, 1998 the Company purchased, in a non-cash transaction, 482,756 ordinary shares of Trintech Group ("Trintech") for $2,000. Trintech Group is an Irish development company organized to develop and market software products designed to enable secure payment in the electronic marketplace. In June 1998 the Company purchased 500,000 shares of Trintech's Series A Convertible Preferred Shares for $3,000 cash. The Company's investment represents a minority interest of less than 10% of Trintech's capitalization. An officer of the Company serves as a director of Trintech. In October 1997, the Company purchased 175,285 Ordinary Shares of nCipher Corporation Limited ("nCipher") for an aggregated purchase price of $512. nCipher is located in the United Kingdom and develops products designed to accelerate cryptographic processes in Internet security, electronic commerce and other applications. In January 1998, the Company purchased 93,896 Ordinary Shares of nCipher for an aggregate purchase price of $336. In July 1998, the Company purchased 563,910 Ordinary Shares of nCipher for an aggregate purchase price of $2,500. The Company's investment in nCipher represents a minority interest of less than 20% of nCipher's capitalization. An officer of the Company serves as a director of nCipher. In June 1998, the Company made a bridge loan to C2Net in the amount of $200. The debt is convertible at the Company's option into equity of C2Net or may be used to offset any financial obligation which may arise from future licensing agreements between the Company and C2Net. C2Net was organized to develop commercial Internet security software. In August 1997, the Company purchased 877,193 Series C Preferred Shares of Finjan Software Ltd. ("Finjan") for an aggregate purchase price of $1,000. Finjan is an Israeli software company organized to develop and market products for the Java Internet security market. The Company's investment in Finjan represents a minority interest of less than 5% of Finjan's capitalization. Capital Expenditures The Company's capital expenditures during the first six months of 1998 were $8,400 and were for additional leasehold improvements, office furniture and equipment, as well as computer equipment for product development, testing and support to accommodate the Company's continued growth. During the fourth quarter of 1997, the Company commenced implementation of an information system which is designed to better meet the Company's growing world-wide information and business process needs. The Company expects the system, which is represented by the manufacturer to be Year 2000 compliant, to be operational in 1998 and estimates the total cost at approximately $5,000, of which approximately $3,500 will be spent in 1998 ($2,500 was spent in the first six months of 1998). Leasing Expenditures In March 1998, the Company entered into an amendment to its noncancelable operating lease for facilities in Bedford, Massachusetts. The facilities leased under the amended agreement provide for approximately 183,000 square feet of office space, and the annual base rent is approximately $2,600 per year through February 2008. In August and December 1997, the Company entered into two noncancelable ten-year leases expiring in 2008 for RSA offices in San Mateo, California. The first facility consists of approximately 27,000 square feet of office space, and the annual base rent is approximately $1,000. The second facility consists of approximately 31,000 square feet of office space, and the annual base rent is approximately $912 and annual operating expenses of approximately $245. Both leases have rent escalation provisions covering years two through ten based on the Consumer Price Index. License Agreements, Royalty Arrangements, and Purchased Research and Development Effective April 1, 1998, the Company amended its agreement with Progress Software for the right to use certain of its software to enhance the functionality of the Company's ACE/Server software. In order to obtain 16 17 favorable pricing, the Company agreed to prepay $6,000 in installments over the remaining three quarters of 1998. Installments of $3,300 have been paid as of June 30, 1998. The prepaid royalty is recorded as a component of cost of sales as products are sold. During the second quarter of 1998 and in connection with a refinement of its product offering strategy, the Company determined it will no longer actively market secure email products obtained from a third party under a license agreement. Prepaid license fees paid under the license agreement with the third party of $3,000 were determined to have no further value and were charged to cost of revenue in the second quarter of 1998. In June 1998, the Company entered into an agreement with Aventail under which the Company will distribute Aventail's products. The Company prepaid license and maintenance fees aggregating $1,200 in connection with the agreement. The Company expended approximately $210 for purchased research and development technology during the first six months of 1998. Stock Option Repricing On July 24, 1998 and August 6, 1998, the Board of Directors of the Company approved a stock option repricing program pursuant to which each holder (other than certain executive officers and the directors of the Company) of an outstanding stock option granted under the Plan during the period commencing on January 1, 1996 and ending on June 30, 1998 (collectively, the "Old Options"), could elect to receive a new stock option (collectively, "New Options") granted on August 12, 1998 under the Plan in exchange for cancellation of each Old Option. The Company repriced the options because the exercise prices of such options were significantly higher than the fair market value of the Company's common stock, and therefore did not provide the desired incentive to employees. The Company believes that stock options are a valuable tool in retaining employees. Each New Option is, among other things, (i) exercisable for the number of shares of the Company's Common Stock covered by the outstanding unexercised portion of the Old Option cancelled in exchange therefor; (ii) has an exercise price of $12.125 (equal to the closing price of the Common Stock on the Nasdaq National Market on August 12, 1998 and the fair market value of the Common Stock on such date); and (iii) has the identical vesting schedule as the Old Option, provided, however, that each such New Option shall not be exercisable prior to February 12, 1999, with such prohibition on exercise expiring at a rate of 25% at the end of each three-month period thereafter. New Options to purchase an aggregate of approximately 5.3 million shares of Common Stock were granted in exchange for Old Options with exercise prices ranging from $19.00 to $44.125. YEAR 2000 COMPLIANCE Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. These date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, software and computer systems may need to be upgraded or replaced in order to comply with such "Year 2000" requirements. Although the Company believes that its products and systems are or will be made Year 2000 compliant in the ordinary course of business, the Company utilizes third-party equipment and software that may not be Year 2000 compliant. Failure of such third-party equipment or software to operate properly with regard to the year 2000 and thereafter could require the Company to incur unanticipated expenses to remedy any problems, which could have a material adverse effect on the Company's business, financial condition, and results of operations. Furthermore, the purchasing patterns of customers or potential customers may be affected by Year 2000 issues as companies expend significant resources to correct their current systems for Year 2000 compliance. These expenditures may result in reduced funds available to implement the infrastructure needed to conduct trusted and secure communications and commerce over information networks or to purchase products and services such as those offered by the Company, which could have a material adverse effect on the Company's business, operating results, financial condition, and results of operations. The Company has formed a Year 2000 task force. The task force consists of employees world-wide with expertise in areas the Company believes could be affected if not Year 2000 compliant. The task force has 17 18 established a Year 2000 compliance plan. The scope of the plan is to (i) identify the third-party equipment, software, vendors, systems and suppliers used by the Company which are not Year 2000 compliant, (ii) replace non-compliant third party equipment and software with compliant equipment and software and find alternatives to non-compliant vendors, systems and suppliers, and (iii) work with Company customers to overcome questions and concerns they may have about the impact of Year 2000 compliance on the Company and its products. The task force has almost completed the identification phase of the project and anticipates completion of the replacement phase of the project in 1998. The task force has approached the plan from a risk priority perspective. For systems identified as having a high risk of Year 2000 non-compliance, the task force has completed the identification phase of the project and has made significant progress in the replacment phase. Significant process has also been made in communicating with customers and vendors about Year 2000 concerns. Except for the previously described worldwide business and information system, the Company does not believe the identification and replacement of third party equipment and software will have a material cost to the Company. RECENT ACCOUNTING PRONOUNCEMENTS In October 1997, the AICPA issued SOP No. 97-2, "Software Revenue Recognition", which supersedes SOP No. 91-1. The Company adopted SOP No. 97-2 prospectively on January 1, 1998. SOP No. 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of the elements. In March 1998, the AICPA postponed the adoption date of certain provisions of SOP No. 97-2. The adoption of SOP No. 97-2 did not have a material effect on the Company's revenues and operating results for the six months ended June 30, 1998. In June 1997, the Financial Accounting Standards Board issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". The Company will be required to adopt the provisions of this statement in its annual financial statements for fiscal 1998. SFAS No. 131 establishes new standards for reporting information about operating segments. The Company believes the segment information required to be disclosed under SFAS No. 131 will be more comprehensive than previously provided, including expanded disclosure of income statement and balance sheet items for each reportable operating segment. The Company has not yet completed its analysis of the operating segments on which it will report. CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS This Quarterly Report on Form 10-Q contains certain 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. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believes," "anticipates," "plans," "expects" and similar expressions are intended to identify forward-looking statements. The following important factors, among others, could cause actual results to differ materially from those indicated by forward-looking statements made in this report and presented elsewhere by management from time to time. Such forward-looking statements represent management's current expectations and are inherently uncertain. Investors are warned that actual results may differ from management's expectations. A number of uncertainties exist that could affect the Company's future operating results, including, without limitation, general economic conditions, the Company's continued ability to develop and introduce products, the introduction of new products by competitors, pricing practices of competitors, expansion of the Company's sales distribution capability, the cost and availability of components and the Company's ability to control costs. The Company's success is dependent in part on its ability to complete its integration of the operations of IDI and DynaSoft in an efficient and effective manner. The successful combination of the Company, IDI, and DynaSoft in a rapidly changing high technology industry may be more difficult to accomplish than in other industries. The combination of these companies and any future acquisitions will require, among other things, integration of the companies' respective product offerings and coordination of their sales and marketing and research and development efforts. There can be no assurance that such integration will be accomplished smoothly or successfully. The difficulties of such integration may be increased by the necessity of coordinating 18 19 geographically separated organizations. The integration of certain operations will require the dedication of management resources which may temporarily distract attention from the day-to-day business of the combined company. The inability of management to successfully integrate the operations of these companies could have a material adverse effect on the business and results of operations of the Company. The Company's success is also dependent on the success of its SecurSight strategy, which is a family of enterprise security solutions being developed by the Company that would enable organizations to support and manage the growing use of public and private keys, digital signatures and digital certificates for assuring confidentiality and privacy on an enterprise-wide scale. The success of SecurSight is dependent on a number of factors, including without limitation delays in product development, undetected software errors or bugs, competitive pressures, technical difficulties, market acceptance of new technologies, including without limitation the use and implementation of various certificate management and key management technologies, changes in customer requirements and government regulations, delays in developing strategic partnerships and general economic conditions. The Company's success is highly dependent on its ability to enhance its existing products and to develop and introduce new products in a timely manner. If the Company were to fail to introduce new products on a timely basis, the Company's operating results could be adversely affected. To date, substantially all of the Company's revenues have been attributable to sales of its enterprise network and data security products, the licensing of encryption engines and the provision of related services, and existing and new versions of such products are expected to continue to represent a high percentage of the Company's revenue for the foreseeable future. As a result, any factor adversely affecting sales of these products and services could have a material adverse effect on the Company's financial condition and results of operations. Certain components of the Company's products are currently purchased from a single or limited sources and any interruption in the supply of such components could adversely affect the Company's operating results. The Company's quarterly operating results may vary significantly depending on a number of factors, including the timing of the introduction or enhancement of products by the Company or its competitors, the sizes, timing and shipment of individual orders, market acceptance of new products, changes in the Company's operating expenses, personnel changes, mix of products sold, changes in product pricing, development of the Company's direct and indirect distribution channels and general economic conditions. International sales have represented a significant portion of the Company's sales. The international business and financial performance of the Company may be affected by general economic conditions abroad, fluctuations in foreign exchange rates, difficulties in managing accounts receivable, tariff regulations and difficulties in obtaining export licenses. All of the Company's products are subject to export controls under U.S. law and applicable foreign government restrictions, including without limitation restrictions on the export of encryption technology. The Company believes it has obtained necessary export approvals for the export of the products it currently exports. There can be no assurance, however, that the list of products and countries for which export approval is required, and the regulatory policies with respect thereto, will not be revised from time to time, or that the Company will be able to obtain necessary regulatory approvals for the export of future products. The inability of the Company to obtain required approvals under these regulations could adversely affect the ability of the Company to make international sales. In addition, 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. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. 19 20 PART II. OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the 1998 Annual Meeting of Stockholders of the Company (the "Annual Meeting") held on April 30, 1998, the following matters were acted upon by the stockholders of the Company: 1. The election of Joseph B. Lassiter, III and Charles R. Stuckey, Jr. as Class I Directors for the ensuing three years; 2. The approval of the amendment and restatement of the Company's 1994 Stock Option Plan to (i) increase from 6,570,000 to 9,570,000 the number of shares of Common Stock authorized thereunder; and (ii) provide for the grant by the Company of restricted stock and other stock-based awards thereunder; and 3. Ratification of the appointment of Deloitte & Touche LLP as independent auditors of the Company for the current year. The number of shares of Common Stock outstanding and entitled to vote at the Annual Meeting was 39,265,833. The other directors of the Company, whose terms of office as directors continued after the Annual Meeting, are D. James Bidzos, Richard L. Earnest, Sanford M. Sherizen, George M. Middlemas and James K. Sims. The results of the voting on each of the matters presented to stockholders at the Annual Meeting are set forth below: VOTES VOTES VOTES BROKER FOR WITHHELD AGAINST ABSTENTIONS NON-VOTES ---------- --------- ---------- ----------- --------- 1. Election of Class I Directors: Joseph B. Lassiter, III................... 32,584,610 2,587,551 N.A. N.A. N.A. Charles R. Stuckey, Jr.................... 32,584,610 2,587,551 N.A. N.A. N.A. 2. Amendment and Restatement of 1994 Stock Option Plan............................... 16,746,977 N.A. 14,204,959 32,158 4,188,067 3. Ratification of Independent Auditors.. 32,723,879 N.A. 2,433,996 14,286 N.A. ITEM 5. OTHER EVENTS Stockholder Proposals for 1999 Annual Meeting Any proposal that a stockholder of the Company wishes to be considered for inclusion in the Company's proxy statement and proxy card for the Company's 1999 Annual Meeting of Stockholders (the "1999 Annual Meeting") must be submitted to the Secretary of the Company at its offices, 20 Crosby Drive, Bedford, Massachusetts 01730, no later than December 2, 1998. If a stockholder of the Company wishes to present a proposal before the 1999 Annual Meeting, but does not wish to have the proposal considered for inclusion in the Company's proxy statement and proxy card, such stockholder must also give written notice to the Secretary of the Company at the address noted above. The Secretary must receive such notice not less than 60 days nor more than 90 days prior to the 1999 Annual Meeting; provided that, in the event that less than 70 days' notice or prior public disclosure of the date of the 1999 Annual Meeting is given or made, notice by the stockholder must be received not later than the close of business on the 10th day following the date on which such notice of the date of the meeting was mailed or such public disclosure was made, whichever occurs first. If a stockholder fails to provide timely notice of a proposal to be presented at the 1999 Annual Meeting, the proxies designated by the Board of Directors of the Company will have discretionary authority to vote on any such proposal. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (A) EXHIBITS The Exhibits listed in the Exhibit Index immediately preceding such Exhibits are filed as part of or are included in this Quarterly Report on Form 10-Q. 20 21 (B) REPORTS ON FORM 8-K: On April 3, 1998, the Company filed a Current Report on Form 8-K, dated April 2, 1998, announcing under Item 5 (Other Events) that results for the first quarter of 1998 would fall short of the Company's operating plan. No financial statements were required to be filed with such report. On April 22, 1998, the Company filed a Current Report on Form 8-K, dated April 2, 1998, announcing under Item 5 (Other Events) the Company's financial results for the first quarter of 1998. No financial statements were required to be filed with such report. On May 22, 1998, the Company filed a Current Report on Form 8-K, dated May 20, 1998, filing under Item 5 (Other Events) the Company's Selected Consolidated Financial Data, Management's Discussion and Analysis of Financial Condition and Results of Operations and Consolidated Financial Statements as of December 31, 1996 and 1997 and for the years ended December 31, 1995, 1996 and 1997, each restated for the IDI Acquisition, which was accounted for as a pooling of interests. 21 22 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SECURITY DYNAMICS TECHNOLOGIES, INC. /s/ MARIAN G. O'LEARY --------------------------------------- Marian G. O'Leary Senior Vice President, Finance, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer) Dated: August 13, 1998 22 23 EXHIBIT INDEX ITEM DESCRIPTION - ---- ----------- *10.1 Fourth Amendment to Progress Software Application Partner Agreement, dated as of April 1, 1998, between the Registrant and Progress Software Corporation. 11 Computation of Income Per Common and Common Equivalent Share. 27 Financial Data Schedule. - --------------- * Confidential treatment requested as to certain portions, which portions have been omitted and filed separately with the Securities and Exchange Commission. 23