================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
-------------
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1999
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________ to ________
Commission File Number 000-27115
PC-Tel, Inc.
(Exact Name of Business Issuer as Specified in Its Charter)
Delaware 77-0364943
(State or Other Jurisdiction of (I.R.S. Employer Identification Number)
Incorporation or Organization)
1331 California Circle, Milpitas, CA 95035
(Address of Principal Executive Office) (Zip Code)
(408) 965-2100
(Registrant's Telephone Number, Including Area Code)
-------------
Indicate by checkmark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Exchange Act during the past
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 [ ] No [X] (1)
(1) The Registrant has been subject to the filing requirements of the Securities
Exchange Act of 1934 since the effective date of its Registration Statement
on Form S-1 (October 19, 1999) and has filed all required reports since such
effective date.
As of October 31, 1999, there were 16,313,072 shares of the Registrant's Common
Stock outstanding.
================================================================================
PC-Tel, Inc.
Form 10-Q
For the Quarter Ended September 30, 1999
Page
----
Part I. Financial Information
Item 1 Financial Statements
Consolidated Condensed Balance Sheets (unaudited)
as of September 30, 1999 and December 31, 1998 3
Consolidated Condensed Statements of Operations (unaudited)
for the three and nine months ended September 30, 1999 and 1998 4
Consolidated Condensed Statements of Cash Flows (unaudited)
for the nine months ended September 30, 1999 and 1998 5
Notes to the Consolidated Condensed Financial Statements (unaudited) 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 25
Part II. Other Information
Item 1 Legal Proceedings 26
Item 2 Changes in Securities and Use of Proceeds 26
Item 3 Defaults upon Senior Securities 26
Item 4 Submission of Matters to a Vote of Security Holders 26
Item 5 Other Information 27
Item 6 Exhibits and Reports on Form 8-K 27
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PC-Tel, Inc.
Consolidated Condensed Balance Sheets
(in thousands)
September 30, December 31,
1999 1998
-------------------------------------
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 18,011 $ 12,988
Short-term investments 7,056 -
Accounts receivable, net of allowance for doubtful
accounts of $5,603 and $1,689, respectively 6,048 12,931
Inventories 4,683 2,073
Prepaid expenses and other assets 586 264
Deferred tax asset 2,463 1,903
-------------- -------------
Total current assets 38,847 30,159
PROPERTY AND EQUIPMENT, net 1,845 1,042
GOODWILL AND OTHER INTANGIBLE ASSETS, net 9,231 10,812
DEFERRED TAX ASSET 2,377 2,302
OTHER ASSETS 2,356 1,681
-------------- -------------
TOTAL ASSETS $ 54,656 $ 45,996
============== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current portion of long-term debt $ 2,002 $ 1,640
Accounts payable 4,223 5,155
Accrued royalties 7,134 5,144
Income taxes payable 1,714 1,207
Accrued liabilities 6,947 3,002
-------------- -------------
Total current liabilities 22,020 16,148
-------------- -------------
LONG-TERM LIABILITIES 13,015 14,709
-------------- -------------
STOCKHOLDERS' EQUITY:
Preferred stock, $0.001 par value, 9,385,548 shares authorized;
8,510,748 issued and outstanding at September 30, 1999 and
December 31, 1998. 9 9
Common stock, $0.001 par value, 50,000,000 shares authorized;
2,512,324 and 2,412,247 shares issued and outstanding at
September 30, 1999 and December 31, 1998, respectively. 3 2
Additional paid-in capital 15,993 10,915
Deferred compensation (5,195) (214)
Retained earnings 8,811 4,427
-------------- -------------
Total stockholders' equity 19,621 15,139
-------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 54,656 $ 45,996
============== =============
3
PC-Tel, Inc.
Consolidated Condensed Statements of Operations
(in thousands, except per share data)
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
------------------------------------ ------------------------------------
(Unaudited) (Unaudited)
REVENUES $ 20,190 $ 9,063 $ 53,236 $ 21,405
COST OF REVENUES 10,440 4,902 27,437 10,849
------------------------------------ ------------------------------------
GROSS PROFIT 9,750 4,161 25,799 10,556
------------------------------------ ------------------------------------
OPERATING EXPENSES:
Research and development 2,732 1,283 7,155 3,738
Sales and marketing 2,625 1,713 7,566 4,120
General and administrative 1,571 423 3,666 1,213
Amortization of deferred compensation 271 17 403 27
------------------------------------ ------------------------------------
Total operating expenses 7,199 3,436 18,790 9,098
------------------------------------ ------------------------------------
INCOME FROM OPERATIONS 2,551 725 7,009 1,458
OTHER INCOME (EXPENSE), NET:
Interest income (expense) (155) 134 (747) 376
------------------------------------ ------------------------------------
INCOME BEFORE PROVISION FOR INCOME TAXES 2,396 859 6,262 1,834
PROVISION FOR INCOME TAXES 717 258 1,879 550
------------------------------------ ------------------------------------
NET INCOME $ 1,679 $ 601 $ 4,383 $ 1,284
==================================== ====================================
Basic earnings per share $ 0.67 $ 0.25 $ 1.78 $ 0.55
Shares used in computing basic earnings per share 2,512 2,387 2,462 2,342
Diluted earnings per share $ 0.12 $ 0.05 $ 0.34 $ 0.10
Shares used in computing diluted earnings per share 13,438 12,385 12,858 12,311
4
PC-Tel, Inc.
Consolidated Condensed Statements of Cash Flows
(in thousands)
Nine Months Ended
September 30,
1999 1998
--------------------------------------
(Unaudited)
Cash Provided by (Used in) Operating Activities
Net income $ 4,383 $ 1,284
Adjustments to reconcile net income to net cash
provided by operating activities
Depreciation and amortization 2,029 250
Amortization of deferred debt costs 233 -
Allowance for doubtful accounts 3,915 2,597
Increase in inventory reserves 5 263
Amortization of deferred compensation 403 27
Changes in operating assets and liabilities
Accounts receivable 2,969 (9,682)
Inventories (2,616) 269
Prepaid expenses and other assets (1,230) 147
Deferred tax asset (634) (179)
Accounts payable and accrued liabilities 5,512 4,022
--------------------------------------
Net Cash Provided by (Used in) Operating Activities 14,969 (1,002)
--------------------------------------
Cash Used in Investing Activities
Capital expenditures for property and equipment (1,251) (297)
Purchase of short-term investments (7,056) -
--------------------------------------
Net Cash Used in Investing Activities (8,307) (297)
--------------------------------------
Cash Provided by (Used in) Financing Activities
Proceeds from issuance of preferred stock - 5,002
Proceeds from issuance of common stock 163 30
Principal payments on capital lease obligations (24) (22)
Principal payments on notes payable (1,310) -
Costs incurred related to proposed initial public offering (468) (346)
--------------------------------------
Net Cash Provided by (Used in) Financing Activities (1,639) 4,664
--------------------------------------
Net increase in cash and cash equivalents 5,023 3,365
Cash and cash equivalents, beginning of period 12,988 6,685
--------------------------------------
Cash and cash equivalents, end of period $ 18,011 $ 10,050
======================================
5
PC-Tel, Inc.
Notes to the Consolidated Condensed Financial Statements
For the Three and Nine Months Ended: September 30, 1999
(Information for the three and nine months ended September 30, 1999 and 1998 is
unaudited)
================================================================================
1. BASIS OF PRESENTATION
The condensed financial statements included herein have been prepared by
PC-Tel, Inc. (the "Company" or "PC-Tel"), without audit, pursuant to the laws
and regulations of the Securities and Exchange Commission. Certain information
and footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations. In the opinion of management,
the disclosures are adequate to make the information not misleading. The
condensed balance sheet as of December 31, 1998 has been derived from the
audited financial statements as of that date, but does not include all
disclosures required by generally accepted accounting principles. These
financial statements and notes should be read in conjunction with the audited
financial statements and notes thereto, included in PC-Tel's Registration
Statement on Form S-1 filed with the Securities and Exchange Commission.
The audited condensed financial statements reflect all adjustments,
consisting only of normal recurring adjustments, necessary for a fair
presentation of financial position, results of operations and cash flows for the
periods indicated. The results of operations for the three and nine months ended
September 30, 1999 are not necessarily indicative of the results that may be
expected for future quarters or the year ending December 31, 1999.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the period.
Actual results could differ from those estimates.
Consolidation and Foreign Currency Translation
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries after elimination of intercompany accounts and
transactions. The functional currency of the Company's subsidiaries is the
United States dollar, accordingly, all translation gains and losses resulting
from transactions denominated in currencies other than United States dollars are
included in net income. As of September 30, 1999, the Company had subsidiaries
in the Cayman Islands and Japan.
Short-Term Investments
At September 30, 1999, short-term investments consist of money market funds
and high-grade debt security investments with an original maturity of
approximately five months. These short-term investments are classified as
available-for-sale and are recorded at their fair value. If material, any
unrealized gains or losses would be classified as other comprehensive income and
included in stockholders' equity. As of September 30, 1999, the cost and fair
value of the short-term investments were not materially different.
Inventories
Inventories are stated at the lower of cost or market and include material,
labor and overhead costs. Inventories at September 30, 1999 and December 31,
1998 were composed of finished goods only. Inventories contained finished goods
that were in excess of the Company's current estimated requirements and were
fully reserved for at September 30, 1999 and December 31, 1998. Due to
competitive pressures and technological innovation, it is possible these
estimates could change in the near term.
Revenue Recognition
Product revenues consist of sales to original equipment manufacturers
("OEM's") and distributors. Revenues from sales to OEM's are recognized upon
shipment. The Company provides for estimated sales returns and
6
allowances related to sales to OEM's at the time of shipment. Revenues from
sales to distributors are made under agreements allowing price protection and
rights of return on unsold products. In the fourth quarter of 1998, the Company
changed its revenue recognition policy relating to sales to distributors to
recognize revenue upon sell-through from the distributor to the end customer.
Prior to this change, the Company recognized revenues upon shipment to
distributors, net of reserves for estimated returns and price protection
arrangements.
The Company also generates revenues from engineering contracts. Revenues
from engineering contracts are recognized as contract milestones are achieved.
The related costs of engineering contracts are included in research and
development expenses in the accompanying statements of operations. When the
Company receives non-refundable prepaid royalties under a license agreement,
royalty revenue is recognized over the term of the royalty agreement unless the
number of units sold is known, in which case royalty revenue is recognized based
on the number of units sold.
Earnings Per Share
The Company computes earnings per share in accordance with SFAS No. 128,
"Earnings Per Share". SFAS No. 128 requires companies to compute net income per
share under two different methods, basic and diluted and present per share data
for all periods in which a statement of operations is presented. Basic earnings
per share is computed by dividing net income by the weighted average number of
shares of common stock outstanding.
Diluted earnings per share is computed using the weighted average number of
common stock and common stock equivalents outstanding during the period. Common
stock equivalents consist of preferred stock using the "if converted" method and
stock options and warrants using the treasury stock method. Preferred stock,
common stock options and warrants are excluded from the computation of diluted
earnings per share if their effect is anti-dilutive.
Pursuant to the Securities and Exchange Commission Staff Accounting
Bulletin No. 98, convertible preferred stock and common stock issued or granted
for nominal consideration prior to the anticipated effective date of the
proposed initial public offering must be included in the calculation of basic
and diluted net income per common share as if they had been outstanding for all
periods presented. To date, the Company has not had any issuances or grants for
nominal considerations.
The following table provides a reconciliation of the numerators and
denominators used in calculating basic and diluted earning per share for the
three months ended September 30, 1999 and 1998 and for the nine months ended
September 30, 1999 and 1998, respectively (in thousands, except per share data):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------ ------------------------------
1999 1998 1999 1998
------------- ------------- ------------- -------------
(Unaudited) (Unaudited)
Net income $ 1,679 $ 601 $ 4,383 $ 1,284
============= ============= ============= =============
Basic earnings per share:
Weighted average common shares outstanding 2,512 2,387 2,462 2,342
------------- ------------- ------------- -------------
Basic earnings per share $ 0.67 $ 0.25 $ 1.78 $ 0.55
============= ============= ============= =============
Diluted earnings per share:
Weighted average common shares outstanding 2,512 2,387 2,462 2,342
Weighted average common stock option grants an
outstanding warrants 2,414 1,487 1,885 1,537
Weighted average preferred stock outstanding 8,511 8,511 8,511 8,432
------------- ------------- ------------- -------------
Weighted average common shares and common stock
equivalents outstanding 13,438 12,385 12,858 12,311
------------- ------------- ------------- -------------
Diluted earnings per share $ 0.12 $ 0.05 $ 0.34 $ 0.10
============= ============= ============= =============
7
Industry Segment, Customer and Geographic Information
The Company is organized based upon the nature of the products it offers.
Under this organizational structure, the Company operates in one segment, that
segment being software-based modems using host signal processing technology.
The Company markets its products worldwide through its sales personnel,
independent sales representatives and distributors.
The Company's sales to customers outside of the United States, as a
percent of total revenues, are as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- --------------------------
1999 1998 1999 1998
--------- -------- -------- --------
(Unaudited) (Unaudited)
Taiwan 22% 36% 28% 51%
China (Hong Kong) 74% 1% 51% 2%
Singapore -- 4% 1% 4%
Rest of Asia 3% 11% 18% 8%
Other -- -- -- 1%
--------- -------- -------- --------
99% 52% 98% 66%
========= ======== ======== ========
Sales to major customers representing greater than 10% of total revenues
are as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ----------------------
Customer 1999 1998 1999 1998
-------- ---- ---- ---- ----
(Unaudited) (Unaudited)
A 12% -- 9% 12%
B 3% 33% 7% 21%
C 6% 29% 4% 20%
D -- 5% 12% 2%
E 65% -- 51% --
F 2% 17% 2% 7%
The Company's customers are concentrated in the personal computer industry
and modem board manufacturer industry segment and in certain geographic
locations. The Company actively markets and sells products in Asia. The Company
performs ongoing evaluations of its customers' financial condition and generally
requires no collateral. As of September 30, 1999, approximately 68% of gross
accounts receivable were concentrated with three customers. As of December 31,
1998, approximately 54% of gross accounts receivable were concentrated with
three customers.
Recent Accounting Pronouncements
In March 1998, the American Institute of Certified Public Accountants
issued Statement of Position No. 98-1 "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use," which was adopted by the
Company in fiscal 1999. SOP No. 98-1 requires entities to capitalize certain
costs related to internal-use software once certain criteria has been met. The
adoption did not have a material impact on our financial position or results of
operations.
In April 1998, the American Institute of Certified Public Accountants
issued SOP No. 98-5 "Reporting on the Costs of Start-Up Activities," which was
adopted by the Company in fiscal 1999. SOP No. 98-5 requires that all start-up
costs related to new operations must be expensed as incurred. In addition, all
start-up costs that were previously capitalized must be written off when SOP No.
98-5 is adopted. The adoption did not have a material
8
impact on our financial position or results of operations.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133
"Accounting for Derivative and Similar Financial Instruments and for Hedging
Activities." SFAS No. 133 requires certain accounting and reporting standards
for derivative financial instruments and hedging activities. SFAS No. 133
applies for the first quarter beginning January 1, 2001. Because we do not
currently hold any derivative instruments and do not engage in hedging
activities, we do not believe that the adoption of SFAS No. 133 will have a
material effect on our financial position or results of operations.
3. COMMITMENTS AND CONTINGENCIES:
As of September 30, 1999 and December 31, 1998, the Company has accrued
royalties of approximately $7.1 million and $5.1 million, respectively. The
Company has entered into royalty agreements in fiscal 1998 and continues to
negotiate royalty agreements with several other third parties. Accordingly, the
Company has accrued its best estimate of the amount of royalties payable based
on royalty agreements already signed or in negotiation, as well as advice from
patent counsel. Should the final agreements result in royalty rates
significantly different from these assumptions, the Company's business,
operating results and financial condition could be materially and adversely
affected.
During 1998, Motorola, Inc. ("Motorola") filed an action for patent
infringement against the Company (and one other defendant) of seven Motorola
patents. In its complaint, Motorola seeks damages for the Company's alleged
infringement, including treble damages for the Company's alleged willful
infringement and an injunction against the Company. Motorola is also seeking
attorney's fees and costs.
The Company filed an answer to Motorola's complaint denying infringement of
the seven asserted Motorola patents and asserted that each patent is invalid or
unenforceable. In addition, the Company asserted counterclaims and declaratory
relief for invalidity and/or unenforceability and noninfringements of each of
the seven asserted Motorola patents. By its counterclaims, the Company seeks
compensatory and punitive damages, an injunction against Motorola, and an award
of treble damages for Motorola's violation of the Federal and state antitrust
laws, and for violation of Massachusetts General Law. The Company also seeks
its costs and attorney's fees in this action. In September 1999, the Company
reached a settlement with Motorola as to all claims raised by both parties. The
settlement requires the Company to make royalty payments to Motorola based on
unit volume. As part of the settlement, the Company granted a cross-license to
Motorola to utilize portions of the Company's technology and Motorola granted
the Company a cross-license to utilize portions of their technology. This
settlement did not have a material effect on the Company's financial position or
operating results.
In April 1999, ESS Technology Inc. filed a complaint against us in the U.S.
District Court for the Northern District of California, alleging that we failed
to grant licenses for some of our International Telecommunications Union-related
patents to ESS on fair, reasonable and non-discriminatory terms. ESS's
complaint includes claims based on antitrust law, patent misuse, breach of
contract and unfair competition. In its complaint, ESS also seeks a declaration
that some of our International Telecommunications Union-related patents are
unenforceable and that we should be ordered by the court to grant a license to
ESS on fair, reasonable and non-discriminatory terms.
Due to the nature of litigation generally and because the lawsuit brought
by ESS is at an early stage, we cannot ascertain the outcome of the final
resolution of the lawsuit, the availability of injunctive relief or other
equitable remedies, or estimate the total expenses, possible damages or
settlement value, if any, that we may ultimately incur in connection with ESS's
suit. This litigation could be time consuming and costly, and we will not
necessarily prevail given the inherent uncertainties of litigation. However, we
believe that we have valid defenses to this litigation, including the fact that
other companies license these International Telecommunications Union-related
patents from us on the same terms that are being challenged by ESS. We believe
that it is unlikely this litigation will have a material adverse effect on our
financial condition or results of operations. We are vigorously contesting, and
intend to continue to vigorously contest, all of ESS's claims.
On November 4, 1999, the United States District Court in San Jose granted a
dismissal of the antitrust and state unfair competition claims, ruling that
ESS had failed to allege injury to competition in the market for modems. The
Court allowed the specific performance of contract claim to stand, ruling that
the license terms granted to other market participants would provide a
sufficient basis for defining contractual terms that could be applied to ESS.
The Court also denied the Motion with respect to dismissal of the declaratory
relief claims, holding that they were sufficiently ripe for adjudication. The
Court granted ESS leave to amend, and counsel for ESS have advised PC-Tel that
they intend to amend to allege sufficient facts to state claims for relief
under antitrust and unfair competition laws.
Although ESS has alleged in general terms that it has been damaged, it has
not specified any lost sales. The case is still in the pleading stage and there
has been no discovery.
The Company entered into a new operating lease for its new facilities in
Milpitas, California in September 1999. The lease expires through February 2003.
The rent expense will be recognized on a straight line basis in accordance with
SFAS No. 13 and is calculated as follows (in thousands):
1999 $ 251
2000 1,003
2001 1,003
2002 1,003
2003 167
4. SUBSEQUENT EVENTS
On October 19, 1999, the Company effected its initial public offering of
common stock. A total of 5,290,000 shares were sold at a price of $17.00 per
share (including the exercise of the underwriters' over-allotment option of
690,000 shares). The offering resulted in net proceeds to the Company of
approximately $81.8 million, net of an underwriting discount of $6.3 million and
estimated offering expenses of $1.8 million. Upon the closing of the Company's
initial public offering, all 8,510,748 shares of the Series A, B, and C
Convertible Preferred Stock converted into 8,510,748 shares of common stock.
9
On October 25, 1999, the Company used $15.5 million of the proceeds from
the offering to repay bank debt. The debt bore interest at the bank's prime
interest rate plus 0.5% and included a 3% prepayment penalty. The total payment
of $15.5 million included $15.0 million of principal, $74,000 of accrued
interest and $450,000 of prepayment penalty.
10
PC-Tel, Inc.
Item 2: Management's Discussion and Analysis of Financial Condition and
results of Operations
=========================================================================
The following information should be read in conjunction with the condensed
interim financial statements and the notes thereto included in Item 1 of this
Quarterly Report and with Management's Discussion and Analysis of Financial
Condition and Results of Operations contained in PC-Tel's Prospectus filed with
the Securities and Exchange Commission on October 19, 1999. Certain statements
contained in this Quarterly Report on Form 10-Q, including, without limitation,
statements containing the words "believes", "anticipates", "estimates",
"expects", and words of similar import, constitute "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
You should not place undue reliance on these forward-looking statements. Our
actual results could differ materially from those anticipated in these forward-
looking statements for many reasons, including the risks faced by us described
below and elsewhere in this Quarterly Report, and in other documents we file
with the SEC.
Overview
We provide cost-effective software-based communications solutions that
address internet connectivity requirements for existing and emerging
technologies. Analog networks use the existing copper infrastructure which
provides voice and data services, commonly referred to as the public telephone
network. Broadband networks use communication infrastructures that enhance voice
and data transmission capacity beyond that which is offered by public telephone
networks. Our communications products enable internet access through desktop
PCs, notebook computers and non-PC devices. From our inception in February 1994
through the end of 1995, we were a development stage company primarily engaged
in product development, product testing and the establishment of strategic
relationships with customers and suppliers. From 1996 to 1999, our total
headcount increased from 18 at the end of 1995 to 133 at September 30, 1999. We
first recognized revenue on product sales in the fourth quarter of 1995, and
became profitable in 1996, our first full year of product shipments. Revenues
increased from $16.6 million in 1996 to $24.0 million in 1997 to $33.0 million
in 1998. Revenues for the nine months ended September 30, 1999 were $53.2
million.
We sell soft modems to manufacturers and distributors principally in Asia
through our sales personnel, independent sales representatives and distributors.
Our sales to manufacturers and distributors in Asia were 74%, 77% and 76% of our
total sales for the years ended 1996, 1997 and 1998, respectively, and 65% and
99% for the nine months ended September 30, 1998 and 1999, respectively. The
predominance of our sales are in Asia because our customers are primarily
motherboard and modem manufacturers, and the majority of these manufacturers are
located in Asia. In many cases, our indirect original equipment manufacturer
customers specify that our products be included on the modem boards or
motherboards that they purchase from the board manufacturers, and we sell our
products directly to the board manufacturers for resale to our indirect original
equipment manufacturer customers. Industry statistics indicate that
approximately two-thirds of our modems manufactured in Asia are sold back to
original equipment manufacturers located in the United States.
We recognize revenues from product sales to customers upon shipment. We
provide for estimated sales returns, allowances and discounts related to such
sales at the time of shipment. We recognize revenues from product sales to
distributors only when the distributors have sold the product to the end user.
We recognize revenues from non-recurring engineering contracts as contract
milestones are achieved.
Results of Operations
Three months and nine months ended September 30, 1999 and 1998
(All amounts in tables, other than percentages, are in thousands)
Revenues
- --------------------------------------------------------------------------------------------------------------------------
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
September 30, September 30, September 30, September 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
Revenues............................................ $20,190 $9,063 $53,236 $21,405
% change from prior period.......................... 122.8% N/A 148.7% N/A
- --------------------------------------------------------------------------------------------------------------------------
11
Revenues increased $11.1 million for the three months ended September 30,
1999 compared to the same period in 1998. The increase in net revenue was
primarily attributable to a higher volume of units sold following the
implementation of a new sales channel program to key channel partners.
Revenues for the nine months ended September 30, 1999 increased $31.8
million compared to the same period in 1998. The increase in revenues was
attributable to increased units sold. We believe that the unit increase was due
principally to the general acceptance of our products in the sub-$1,000 or low
cost PC marketplace, increase of market share of our MicroModem product and the
certification by Microsoft of its Windows 98 logo for our products. The increase
in sales volume was partly offset by downward pressure on average selling prices
and sales discounts to customers. Average selling prices decreased by 54.8% due
to the elimination of an additional major hardware component in the MicroModem
product, however, we believe that decreases in the average selling price of our
product has resulted in the attainment of greater market share.
Gross Profit
- ------------------------------------------------------------------------------------------------------------------------------
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
September 30, September 30, September 30, September 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
Gross profit........................................ $9,750 $4,161 $25,799 $10,556
Percentage of revenues.............................. 48.3% 45.9% 48.5% 49.3%
% change from prior period.......................... 134.3% N/A 144.4% N/A
- ------------------------------------------------------------------------------------------------------------------------------
Cost of revenues consists primarily of chipsets we purchase from third
party manufacturers and also includes amortization of intangibles related to the
Communications Systems Division acquisition, accrued intellectual property
royalties, cost of operations, reserves for inventory obsolescence, and
distribution costs. The royalties accrued are our best estimate based on royalty
agreements already signed, negotiations or potential new agreements, advice from
patent counsel and the royalty rates we charge for use of our own patents.
Gross profit increased $5.6 million for the three months ended September
30, 1999 compared to the same period last year due to increased sales volume.
Gross profit as a percentage of revenue improved from 45.9% for the three months
ended September 30, 1998 to 48.3% for the three months ended September 30, 1999
due to increased revenue, inventory cost reduction and economies of scale.
Gross profit increased $15.2 million for the nine months ended September
30, 1999 over the same period in 1998. The increase in gross profit was the
direct result of increased revenues. Gross profit as a percentage of revenue
decreased from 49.3% for the three months ended September 30, 1998 to 48.5% for
the nine months ended September 30, 1999 because average selling prices
decreased faster than the rate of cost reduction, which adversely impacted our
profit margins. NRE and licensing revenues were a reduced percentage of total
sales in 1999, and as a result, also adversely impacted our profit margins.
Research and Development
- --------------------------------------------------------------------------------------------------------------------------------
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
September 30, September 30, September 30, September 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
Research and development............................ $2,732 $1,283 $7,155 $3,738
Percentage of revenues.............................. 13.5% 14.2% 13.4% 17.5%
% change from prior period.......................... 112.9% N/A 91.4% N/A
- --------------------------------------------------------------------------------------------------------------------------------
Research and development expenses include compensation costs for software
and hardware development, prototyping, certification and pre-production costs.
We expense all research and development costs as incurred.
Research and development expenses increased $1.4 million for the three
months ended September 30, 1999 compared to the same period in 1998. The
increase was primarily due to an increase in engineering staff, software
consulting services and system maintenance costs related to new product
development.
12
Research and development expenses increased $3.4 million for the nine
months ended September 30, 1999 compared to the same period in 1998 due to the
addition of personnel to develop new products related to the G.Lite, Audio Modem
Riser card and HIDRA projects as well as maintenance work related to v.90
modems. Headcount increased from 30 to 64 from September 30, 1998 to 1999. As a
percentage of revenues, research and development decreased for the nine months
ended September 30, 1999 because the increase in revenues was proportionally
greatly than the increased research and development expenses. Approximately 70%
of all research and development expenses are payroll related. We expect that our
research and development expenses will increase because we intend to hire
additional personnel and continue to develop new products.
Sales and Marketing
- ------------------------------------------------------------------------------------------------------------------------------
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
September 30, September 30, September 30, September 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
Sales and marketing................................. $2,625 $1,713 $7,566 $4,120
Percentage of revenues.............................. 13.0% 18.9% 14.2% 19.2%
% change from prior period.......................... 53.2% N/A 83.6% N/A
- ------------------------------------------------------------------------------------------------------------------------------
Sales and marketing expenses consist primarily of personnel costs, sales
commissions and marketing costs. Sales commissions payable to our distributors
are recognized when our products are "sold through" from the distributors to end
users. Marketing costs include promotional goods, trade shows, press tours and
advertisements in trade magazines.
Sales and marketing expenses increased $912,000 but decreased as a
percentage of total net revenue for the three months ended September 30, 1999
compared to the same period in 1998. The dollar increase reflects the addition
of sales and marketing personnel and efforts to develop new accounts and support
customers. In addition, the Company implemented a new sales forecasting and
tracking system in the third quarter of 1999 in order to manage the increased
sales volume more efficiently.
Sales and marketing expenses increased $3.4 million but decreased as a
percentage of total revenues for the nine months ended September 30, 1999,
compared to the same period in the prior year. The increase reflects the
addition of sales and marketing personnel to develop new accounts, support
customers, and to drive new product developments and product launches. We also
expanded our sales regions geographically to include Japan and Korea. Headcount
increased from 30 to 48 from September 30, 1998 to 1999. The increase in
expenses is also due to increased governmental certification of our products in
Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy,
Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United
Kingdom. The production of collateral sales materials, travel costs, trade
shows, sales programs and press tours have also resulted in an increase of the
sales and marketing expenses.
General and Administrative
- -----------------------------------------------------------------------------------------------------------------------------
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
September 30, September 30, September 30, September 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
General and administrative.......................... $1,571 $423 $3,666 $1,213
Percentage of revenues.............................. 7.8% 4.7% 6.9% 5.7%
% change from prior period.......................... 271.4% N/A 202.2% N/A
- -----------------------------------------------------------------------------------------------------------------------------
General and administrative expenses include costs associated with our
general management, human resources and finance functions as well as
professional service charges, such as legal, tax and accounting fees. Other
general expenses include rent, insurance, utilities, travel and other operating
expenses to the extent not otherwise allocated to other functions.
General and administrative expenses increased $1.1 million for the three
months ended September 30, 1999 compared to the same period in 1998. The
increase was primarily due to increases in legal expenses and manpower costs.
General and administrative expenses increased $2.5 million for the nine
months ended September 30, 1999 compared to the same period in 1998. This
increase reflected additional legal costs related to an increased number of
contract negotiations, patent submissions, additional tax planning, as well as
litigation expenses related to the Motorola lawsuit.
13
We also incurred additional expenses related to an increase in personnel.
Headcount increased from 14 to 21 from September 30, 1998 to 1999.
Amortization of Deferred Compensation
- ----------------------------------------------------------------------------------------------------------------------------
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
September 30, September 30, September 30, September 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
Amortization of deferred compensation............... $ 271 $ 17 $ 403 $ 27
Percentage of revenues.............................. 1.3% 0.2% 0.8% 0.1%
% change from prior period.......................... 1,494.1% N/A 1,392.6% N/A
- ----------------------------------------------------------------------------------------------------------------------------
In connection with the grant of stock options to employees, we have
recorded deferred compensation representing the difference between the exercise
price and deemed fair market value of our common stock on the date these stock
options were issued.
The amortization of deferred compensation increased $254,000 for the three
months ended September 30, 1999 compared to the same period in 1998 primarily
due to a higher fair market value of the stock and additional stock options
granted to new employees.
The amortization of deferred compensation increased $376,000 for the nine
months ended September 30, 1999 compared to the same period in 1998 for the
reasons discussed above. We expect that the amortization of deferred
compensation will increase to approximately $340,000 per quarter through the
third quarter of 2003, based on option grant activity through September 30,
1999.
Other Income (Expense), Net
- -----------------------------------------------------------------------------------------------------------------------------
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
September 30, September 30, September 30, September 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
Other income (expense), net......................... $ (155) $134 $ (747) $376
Percentage of revenues.............................. (0.8)% 1.5% (1.4)% 1.8%
% change from prior period.......................... N/A N/A N/A N/A
- -----------------------------------------------------------------------------------------------------------------------------
Other income, net, consists of interest income, net of any interest
expenses. Interest income is expected to fluctuate over time. Interest expense
consists primarily of interest on capital leases and the $16.3 million loan
issued to acquire Communications Systems Division. Interest expense will
decrease as we have repaid the $15.0 million remaining balance on the loan with
the proceeds from the Initial Public Offering.
Other income, net, decreased $289,000 for the three months ended September
30, 1999 compared to the same period in 1998 primarily due to the interest
expense related to the loan that we used to acquire Communications Systems
Division.
Other income, net, decreased $1.1 million for the nine months ended
September 30, 1999 compared to the same period in 1998 because of the same
reason discussed above.
Provision for Income Taxes
- -------------------------------------------------------------------------------------------------------------------------------
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
September 30, September 30, September 30, September 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
Provision for income taxes.......................... $ 717 $ 258 $1,879 $ 550
Effective tax rate.................................. 30.0% 30.0% 30.0% 30.0%
% change from prior period.......................... 177.9% N/A 241.6% N/A
- -------------------------------------------------------------------------------------------------------------------------------
Provision for income taxes increased for the three months and the nine
months ended September 30, 1999 over the comparable periods in 1998 due to
higher taxable income, while the effective tax rate remained constant at 30%.
14
Liquidity and Capital Resources
- ------------------------------------------------------------------------------------------------------------------------------------
Nine Months Nine Months
Ended ended
September 30, September 30,
1999 1998
------------- -------------
Net cash provided by (used in) operating activities........................................... $14,969 $(1,002)
Net cash used in investing activities......................................................... (8,307) (297)
Net cash provided by (used in) financing activities........................................... (1,639) 4,664
Cash, cash equivalents and short-term investments at the end of period........................ 25,067 10,050
Working capital at the end of period.......................................................... 16,827 13,714
- ------------------------------------------------------------------------------------------------------------------------------------
The increase in net cash provided by operating activities for the nine
months ended September 30, 1999 compared to 1998 was primarily due to better
collection in accounts receivable due to the use of letters of credit and higher
net income in 1999. Net cash used in investing activities for the nine months
ended September 30, 1999 reflected the purchases of short-term investments,
property and equipment. Net cash used in financing activities for the nine
months ended September 30, 1999 reflected a portion of the repayment of
principal on the notes payable arrangements associated with the Communications
Systems Division acquisition.
As of September 30, 1999, we had $25.1 million in cash, cash equivalents
and short-term investments and working capital of $16.8 million. As of September
30, 1999, we had outstanding debt of $15.0 million under notes payable
arrangements. Subsequent to September 30, 1999, the Company repaid this debt,
including a prepayment penalty of $450,000, with proceeds from the initial
public offering. See Note 4 of Notes to the Condensed Financial Statements for
more information on the initial public offering.
We believe that the net proceeds from the offering, together with existing
sources of liquidity, will be sufficient to meet our working capital and
anticipated capital expenditure requirements for at least the next 12 months.
Thereafter, we may require additional funds to support our working capital
requirements or for other purposes, and may seek, even before that time, to
raise additional funds through public or private equity or debt financing or
from other sources. Additional financing may not be available at all, and if it
is available, the financing may not be obtainable on terms acceptable to us or
that are not dilutive to our stockholders.
Year 2000 Compliance
We have completed our initial assessment of the potential overall impact of
the impending century change on our business, financial condition and operating
results. Based on our current assessment, we believe the current versions of
our products are Year 2000 compliant. However, our products operate in complex
network environments and directly or indirectly interact with a number of other
hardware and software systems that we cannot adequately evaluate for Year 2000
compliance. In a worst case scenario involving the failure of these
environments or systems as a result of Year 2000 problems, our products would be
inoperative and would have no utility to our customers or the users of these
products. Because our products depend upon the communication capabilities of
the devices in which they are used, we would not be able to solve Year 2000
problems affecting these devices. As a result, our business would be dependent
upon the manufacturers of these devices, including our customers, to correct
Year 2000 deficiencies that might arise. The following are summaries of Year
2000 action plans for our material suppliers:
. Silicon Labs' Year 2000 program consists of comprehensive review and
testing of hardware and software used in mission-critical applications,
review of Year 2000 readiness of suppliers of critical materials and
services, and a contingency plan to ensure uninterrupted product
delivery for unforeseen problems that may occur. Their contingency plan
involves building an additional product inventory buffer. The buffer
will be maintained over the year end and then depleted after Silicon
Labs has ascertained that no Year 2000 related supply problems exist.
Silicon Labs has also implemented a verification process where they will
review internal Year 2000 compliance for server hardware, operating
systems, business applications and PC and workstation BIOSes. They will
also use representative test platforms to run existing business
applications after changing system dates to 1/1/00.
. ST Microelectronics has had a top priority project underway since the
second quarter of 1997. Their definition of Year 2000 Compliance means
that the functions, calculations, and other computing process of each of
their projects perform in a consistent manner regardless of the date and
time on which the processes are actually performed, whether before, on,
or January 1, 2000, and whether or not the dates are affected by leap
years.
. Taiwan Semiconductor Manufacturing Corporation has completed their Year
2000 compliance testing on their manufacturing equipment, information
technology infrastructure, commercial software, and in-house
application.
15
. Kawasaki/LSI has completed their testing and is Year 2000 compliant.
We may face claims based on Year 2000 problems in other companies'
products, or issues arising from the integration of multiple products within an
overall system. We have not been a party to any litigation of arbitration
proceeding involving our products or services related to Year 2000 compliance
issues. We may in the future be required to defend our products or services in
such proceedings, or to negotiate resolutions of claims based on Year 2000
issues.
We have reviewed our internal management information and other critical
business systems to identify any Year 2000 problems. We also have communicated
with the external vendors that supply us with material software and information
systems and with significant suppliers to determine their Year 2000 readiness.
Based on a review of vendor representations made in letters provided to us by
our vendors and a review of representations made by our vendors at their
individual Web sites, we believe that the third-party hardware and software we
use is Year 2000 compliant.
To date, we have not incurred any material costs directly associated with
Year 2000 compliance efforts, except for compensation expense associated with
salaried employees who have devoted some of their time to Year 2000 assessment
and remediation efforts. We do not expect the total cost of Year 2000 problems
to be material to our business, financial condition or operating results.
However, during the months prior to the century change, we will continue to
evaluate new versions of our products, new software and information systems
provided by third parties and any new infrastructure systems that we acquire, to
determine whether they are Year 2000 compliant. Despite our current assessment,
we may not identify and correct all significant Year 2000 problems on a timely
basis. Year 2000 compliance efforts may involve significant time and expense and
unremediated problems could harm our business, financial condition and operating
results. We currently do not have any estimate of potential costs related to
potential Year 2000 problems. We currently have no contingency plans to address
the risks associated with unremediated Year 2000 problems.
Factors Affecting Operating Results
This quarterly report on Form 10-Q contains forward-looking statements
which involve risks and uncertainties. Our actual results could differ
materially from those anticipated by such forward-looking statements as a result
of certain factors including those set forth below.
Risks Related to Our Business
Our sales are concentrated among a limited number of customers and the loss of
one or more of these customers could cause our sales revenues to decrease.
Our sales are concentrated among a limited number of customers. If we were
to lose one or more of these customers, or if one or more of these customers
were to delay or reduce purchases of our products, our sales revenues may
decrease. For the nine months ended September 30, 1999, approximately 83% of our
revenues were generated by five of our customers with one customer representing
51% of revenues. These customers may in the future decide not to purchase our
products at all, purchase fewer products than they did in the past or alter
their purchasing patterns, because:
. we do not have any long-term purchase arrangements or contracts with
these or any of our other customers,
. our product sales to date have been made primarily on a purchase order
basis, which permit our customers to cancel, change or delay product
purchase commitments with little or no notice and without penalty, and
. many of our customers also have pre-existing relationships with current
or potential competitors which may affect our customers' purchasing
decisions.
We expect that a small number of customers will continue to account for a
substantial portion of our revenues for at least the next 12 to 18 months and
that a significant portion of our sales will continue to be made on the basis of
purchase orders.
We have significant sales and operations concentrated in Asia. Continued
political and economic instability in Asia and difficulty in collecting accounts
receivable may make it difficult for us to maintain or increase market demand
for our products.
Continued political and economic instability in Asia and difficulty in
collecting accounts receivable may make it difficult for us to maintain or
increase market demand for our products. Our sales to customers located in Asia
accounted for 99% of our total revenues for the nine months ended September 30,
1999. The predominance of our sales are in Asia, mostly in Taiwan and China,
because our customers are primarily motherboard or modem
16
manufacturers that are located there. In many cases, our indirect original
equipment manufacturer customers specify that our products be included on the
modem boards or motherboards, the main printed circuit board containing the
central processing unit of a computer system, that they purchase from board
manufacturers, and we sell our products directly to the board manufacturers for
resale to our indirect original equipment manufacturer customers. Industry
statistics indicate that approximately two thirds of modems manufactured in Asia
are sold back to original equipment manufacturers located in the United States.
Due to the industry-wide concentration of modem manufacturers in Asia, we
believe that a high percentage of our future sales will continue to be
concentrated with Asian customers. As a result, our future operating results
could be uniquely affected by a variety of factors outside of our control,
including:
. political and economic instability, such as the recent political
instability in Indonesia and the economic turmoil in Japan,
. changes in tariffs, quotas, import restrictions and other trade barriers
which may make our products more expensive compared to our competitors,
. delays in collecting accounts receivable, which we have experienced from
time to time, and
. fluctuations in the value of Asian currencies relative to the U.S.
dollar, which may make it more costly for us to do business in Asia which
may in turn make it difficult for us to maintain or increase our
revenues.
To successfully expand our sales in Asia and internationally, we must
strengthen foreign operations, hire additional personnel and recruit additional
international distributors and resellers. This will require significant
management attention and financial resources. To the extent that we are unable
to effect these additions in a timely manner, we may not be able to maintain or
increase market demand for our products in Asia and internationally, and our
operating results could be hurt.
The recent earthquake in Taiwan and subsequent aftershocks may cause our
revenues or profitability to decrease.
Because our products are sold to motherboard or modem manufacturer
customers in Taiwan, the recent earthquake in Taiwan may result in less demand
for our products and may cause our revenues to decrease. Our customers who are
outside of Taiwan may also be dependent on other components manufactured in
Taiwan. The recent earthquake may disrupt the operations of our customers' other
suppliers who are located in Taiwan, and may result in a decrease in demand of
our products. We are also dependent on our suppliers who manufacture product
components in Taiwan. The recent earthquake may disrupt the operations of these
suppliers. If they are not able to adequately supply us, we may not be able to
meet the demand for our products. We do not currently believe that the effect of
this earthquake on our business will be material. However, it is impossible that
our sales to customers in Asia may be affected in the next few quarters.
Continuing decreases in the average selling prices of our products could result
in decreased revenues.
Product sales in the connectivity industry have been characterized by
continuing erosion of average selling prices. Price erosion experienced by any
company can cause revenues and gross margins to decline. The average selling
price of our products has decreased by approximately 55% from October 1995 to
September 30, 1999. We expect this trend to continue.
In addition, we believe that the widespread adoption of industry standards
in the soft modem industry is likely to further erode average selling prices,
particularly for analog modems. Adoption of industry standards is driven by the
market requirement to have interoperable modems. End users need this
interoperability to ensure modems from different manufacturers communicate with
each other without problems. Historically, users have deferred purchasing modems
until these industry standards are adopted. However, once these standards are
accepted, it lowers the barriers to entry and price erosion has resulted.
Decreasing average selling prices in our products could result in decreased
revenues even if the number of units that we sell increases. Therefore, we must
continue to develop and introduce next generation products with enhanced
functionalities that can be sold at higher gross margins. Our failure to do this
could cause our revenues and gross margin to decline.
Our gross margins may vary based on the mix of sales of our products and
services, and these variations may hurt our net income.
We derive a significant portion of our sales from our software-based
connectivity products. We expect margins on newly introduced products generally
to be higher than our existing products. However, due in part to the
17
competitive pricing pressures that affect our products and in part to increasing
component and manufacturing costs, we expect margins from both existing and
future products to decrease over time. In addition, licensing revenues from our
products historically have provided higher margins than our product sales.
Changes in the mix of products sold and the percentage of our sales in any
quarter attributable to products as compared to licensing revenues will cause
our quarterly results to vary and could result in a decrease in net income.
Our revenues may fluctuate each quarter due to both domestic and international
seasonal trends.
We have experienced and expect to continue to experience seasonality in
sales of our connectivity products. These seasonal trends materially affect our
quarter-to-quarter operating results. Our revenues are higher during the
back-to-school and holiday seasons which fall in the third and fourth calendar
quarters. Revenue in our third and fourth quarters are typically higher relative
to other quarters because many purchasers of PCs make purchase decisions based
on their calendar year-end budgeting requirements. As a result, we generally
expect revenue levels for the first quarter to be less than those for the
preceding quarter.
We are currently expanding our sales in international markets, particularly
in Asia, Europe and South America. To the extent that our revenues in Asia,
Europe or other parts of the world increase in future periods, we expect our
period-to-period revenues to reflect seasonal buying patterns in these markets.
Any delays in our normally lengthy sales cycles could result in customers
canceling purchases of our products.
Sales cycles for our products with major customers are lengthy, often
lasting six months or longer. In addition, it can take an additional six months
or more before a customer commences volume production of equipment that
incorporates our products. Sales cycles with our major customers are lengthy for
a number of reasons:
. our original equipment manufacturer customers usually complete a lengthy
technical evaluation of our products, over which we have no control,
before placing a purchase order,
. the commercial integration of our products by an original equipment
manufacturer is typically limited during the initial release to evaluate
product performance, and
. the development and commercial introduction of products incorporating new
technologies frequently are delayed.
A significant portion of our operating expenses is relatively fixed and is
based in large part on our forecasts of volume and timing of orders. The lengthy
sales cycles make forecasting the volume and timing of product orders difficult.
In addition, the delays inherent in lengthy sales cycles raise additional risks
of customer decisions to cancel or change product phases. If customer
cancellations or product changes were to occur, this could result in the loss of
anticipated sales without sufficient time for us to reduce our operating
expenses.
We expect that our operating expenses will increase substantially in the future
and these increased expenses may diminish our ability to remain profitable.
Although we have been profitable in recent years, we may not remain
profitable on a quarterly or annual basis in the future. We anticipate that our
expenses will increase substantially over at least the next three years as we:
. further develop and introduce new applications and functionality for our
host signal processing technology,
. explore emerging product opportunities in digital technologies and
wireless and cable communications,
. expand our distribution channels, both domestically and in our
international markets, and
. pursue strategic relationships and acquisitions.
In order to maintain profitability we will be required to increase our
revenues to meet these additional expenses. Any failure to significantly
increase our revenues as we implement our product, service, distribution and
strategic relationship strategies would result in a decrease in our overall
revenues.
To date, we have principally relied upon our distributor sales organization
for product sales to smaller accounts. Our direct sales efforts have focused
principally on board manufacturers and smaller PC original equipment
18
manufacturers. To increase penetration of our target customer base, including
large, tier-one original equipment manufacturers, we must significantly increase
the size of our direct sales force and organize and deploy sales teams targeted
at specific domestic tier-one original equipment manufacturer accounts. If we
are unable to expand our sales to additional original equipment manufacturers,
our revenues may not meet analysts' expectations which could cause our stock
price to drop.
We must accurately forecast our customer demand for our modem products. If
there is an unexpected fluctuation in demand for our products, we may incur
excessive operating costs or lose product revenues.
We must forecast and place purchase orders for specialized semiconductor
chips, the application specific integrated circuit, coder/decoder and discrete
access array, or data access arrangement, components of our modem products,
several months before we receive purchase orders from our own customers. This
forecasting and order lead time requirement limits our ability to react to
unexpected fluctuations in demand for our products. These fluctuations can be
unexpected and may cause us to have excess inventory, or a shortage, of a
particular product. In the event that our forecasts are inaccurate, we may need
to write down excess inventory. For example, we were required to write down
inventory in the second quarter of 1996 in connection with a product transition
within our 14.4 Kbps product family. Similarly, if we fail to purchase
sufficient supplies on a timely basis, we may incur additional rush charges or
we may lose product revenues if we are not able to meet a purchase order. These
failures could also adversely affect our customer relations. Significant write-
downs of excess inventory or declines in inventory value in the future could
cause our net income and gross margin to decrease.
We rely heavily on our intellectual property rights which offer only limited
protection against potential infringers. Unauthorized use of our technology may
result in development of products that compete with our products which could
cause our market share and our revenues to be reduced.
Our success is heavily dependent upon our proprietary technology. We rely
primarily on a combination of patent, copyright and trademark laws, trade
secrets, confidentiality procedures and contractual provisions to protect our
proprietary rights. These means of protecting our proprietary rights may not be
adequate. We hold a total of 35 patents, a number of which cover technology that
is considered essential for International Telecommunications Union standard
communications solutions, and also have 30 additional patent applications
pending or filed. These patents may never be issued. These patents, both issued
and pending, may not provide sufficiently broad protection against third party
infringement lawsuits or they may not prove enforceable in actions against
alleged infringers. Other than the Motorola and ESS lawsuits described elsewhere
in this Form 10-Q, to date, no material lawsuits relating to intellectual
property have been filed against us.
Despite precautions that we take, it may be possible for unauthorized third
parties to copy aspects of our current or future products or to obtain and use
information that we regard as proprietary. We may provide our licensees with
access to our proprietary information underlying our licensed applications.
Additionally, our competitors may independently develop similar or superior
technology. Finally, policing unauthorized use of software is difficult and some
foreign laws, including those of various countries in Asia, do not protect our
proprietary rights to the same extent as United States laws. Litigation may be
necessary in the future to enforce our intellectual property rights, to protect
our trade secrets or to determine the validity and scope of the proprietary
rights of others. Litigation could result in substantial costs and diversion of
resources.
We have received, and may receive in the future, communications from third
parties asserting that our products infringe on their intellectual property
rights. These claims could affect our relationships with existing customers and
may prevent potential future customers from purchasing our products or licensing
our technology. Because we depend upon a limited number of products, any claims
of this kind, whether they are with or without merit, could be time consuming,
result in costly litigation, cause product shipment delays or require us to
enter into royalty or licensing agreements. In the event that we do not prevail
in litigation, we could be prevented from selling our products or be required to
enter into royalty or licensing agreements on terms which may not be acceptable
to us. We could also be prevented from selling our products or be required to
pay substantial monetary damages. Should we cross license our intellectual
property in order to obtain licenses, we may no longer be able to offer a unique
product.
New patent applications may be currently pending or filed in the future by
third parties covering technology that we use currently or may use in the
future. Pending U.S. patent applications are confidential until patents are
issued, and thus it is impossible to ascertain all possible patent infringement
claims against us. We believe that several of our competitors, including
Motorola, Lucent and ESS Technology, may have a strategy of protecting their
market
19
share by filing intellectual property claims against their competitors and may
assert claims against us in the future. The legal and other expenses and
diversion of resources associated with any such litigation could result in a
decrease in our revenues.
In addition, some of our customer agreements include an indemnity clause
that obligates us to defend and pay all damages and costs finally awarded by a
court should third parties assert patent and/or copyright claims against our
customers. As a result, we may be held responsible for infringement claims
asserted against our customers. If our financial reserves for potential future
license fees are less than any actual fees that we are required to pay, our net
income would be reduced.
If our financial reserves for potential future license fees are less than any
actual fees that we are required to pay, our net income would be reduced.
We have established and recorded on a monthly basis a financial per-unit
reserve for payment of future license fees based upon our estimate as to the
likely amount of the licensing fees that we may be required to pay in the event
that licenses are obtained. We believe that it is typical for participants in
the modem industry to obtain licenses in exchange for grants of cross licenses
rather than for payment of fees and we have based our estimates on our
understanding of the license fee practices of other segments of our industry.
Our reserves may not be adequate because of factors outside of our control and
because these license fee practices in the modern industry may not be applicable
to our experience.
Competition in the connectivity market is intense, and if we are unable to
compete effectively, the demand for, or the prices of, our products may be
reduced.
The connectivity device market is intensely competitive. We may not be able
to compete successfully against current or potential competitors. Our current
competitors include 3Com, Conexant, ESS Technology, Lucent Technologies and
Motorola. Motorola introduced soft modems in the third quarter of 1998 and
Conexant introduced soft modems in the fourth quarter of 1998. We expect
competition to increase in the future as current competitors enhance their
product offerings, new suppliers enter the connectivity device market, new
communication technologies are introduced and additional networks are deployed.
We may in the future also face competition from other suppliers of products
based on host signal processing technology or on new or emerging communication
technologies, which may render our existing or future products obsolete or
otherwise unmarketable. We believe that these competitors may include Alcatel,
Analog Devices, Aware, Broadcom, Com21, Efficient Networks, Orckit, Terayon
Communications and Texas Instruments.
We believe that the principal competitive factors required by users and
customers in the connectivity product market include compatibility with industry
standards, price, functionality, ease of use and customer service and support.
Although we believe that our products currently compete favorably with respect
to these factors, we may not be able to maintain our competitive position
against current and potential competitors.
We recently hired a new President and Chief Operating Officer. If he is not
successful in carrying out his duties, we may not be able to maintain our
current profitability or increase our revenue.
In August 1999, we hired William F. Roach as our new President and Chief
Operating Officer. Mr. Roach must be successfully integrated into our
organizational structure. If for any reason Mr. Roach does not successfully
carry out his duties or lead our organization in an effective manner, we may not
be able to maintain our current profitability or increase our revenue.
In order for us to maintain our profitability and continue to introduce and
develop new products for emerging markets, we must attract and retain our
executive officers and qualified technical, sales, support and other
administrative personnel.
Our past performance has been and our future performance is substantially
dependent on the performance of our current executive officers and certain key
engineering, sales, marketing, financial, technical and customer support
personnel. If we lost the services of one or more of our executives or key
employees, a replacement could be difficult to recruit and we may not be able to
grow our business.
We maintain "key person" life insurance policies on Peter Chen, our
Chairman and Chief Executive Officer, William Wen-Liang Hsu, our Vice President,
Engineering, and Han Yeh, our Vice President, Technology, in the face
20
amount of $1 million for each individual. However, these insurance policies may
not adequately compensate for the loss of services of any of these individuals.
We intend to hire a significant number of additional engineering, sales,
support, marketing and finance personnel in the future. Competition for
personnel, especially engineers and marketing and sales personnel in Silicon
Valley, is intense. We are particularly dependent on our ability to identify,
attract, motivate and retain qualified engineers with the requisite education,
backgrounds and industry experience. As of September 30, 1999, we employed a
total of 64 people in our engineering department, over half of whom have
advanced degrees. In the past we have experienced difficulty in recruiting
qualified engineering personnel, especially developers, on a timely basis. If we
are not able to hire at the levels that we plan, our ability to continue to
develop products and technologies responsive to our markets will be impaired.
We have experienced significant growth in our business in recent periods and
failure to manage our growth could strain our management, financial and
administrative resources.
Our ability to successfully sell our products and implement our business
plan in rapidly evolving markets requires an effective management planning
process. Future expansion efforts could be expensive and put a strain on our
management by significantly increasing the scope of their responsibilities and
resources by increasing the number of people using them. We have increased, and
plan to continue to increase, the scope of our operations at a rapid rate. Our
headcount has grown and will continue to grow substantially. At December 31,
1998, we had a total of 95 employees and at September 30, 1999, we had a total
of 133 employees. In addition, we expect to continue to hire a significant
number of new employees. To effectively manage our growth, we must maintain and
enhance our financial and accounting systems and controls, integrate new
personnel and manage expanded operations.
We rely on independent companies to manufacture, assemble and test our products.
If these companies do not meet their commitments to us, our ability to sell
products to our customers would be impaired.
We do not have our own manufacturing, assembling or testing operations.
Instead, we rely on independent companies to manufacture, assemble and test the
semiconductor chips which are integral components of our products. Most of these
companies are located outside of the United States. There are many risks
associated with our relationships with these independent companies, including
reduced control over:
. delivery schedules,
. quality assurance,
. manufacturing costs,
. capacity during periods of excess demand, and
. availability of access to process technologies.
In addition, the location of these independent parties outside of the
United States creates additional risks resulting from the foreign regulatory,
political and economic environments in which each of these companies exists.
While to date we have not experienced any material problems, failures or delays
by our manufacturers to provide the semiconductor chips that we require for our
products, or any material change in the financial arrangements we have with
these companies, could have an adverse impact on our ability to meet our
customer product requirements.
We design, market and sell application specific integrated circuits and
outsource the manufacturing and assembly of the integrated circuits to a third
party fabrication. The majority of our products and related components are
manufactured by five principal companies: Taiwan Semiconductor Manufacturing
Corporation, ST Microelectronics, Kawasaki/LSI, Silicon Labs and Delta
Integration. We expect to continue to rely upon these third parties for these
services. Currently, the data access arrangement chips used in our soft modem
products are provided by a sole source, Silicon Labs, on a purchase order basis,
and we have only a limited guaranteed supply arrangement under a contract with
our supplier. We are currently in the process of qualifying a second source for
our data access arrangement chips. Although we believe that we would be able to
qualify an alternative manufacturing source for data access arrangement chips
within a relatively short period of time, this transition, if necessary, could
result in loss of purchase orders or customer relationships, which could result
in decreased revenues.
21
Undetected software errors or failures found in new products may result in loss
of customers or delay in market acceptance of our products.
Our products may contain undetected software errors or failures when first
introduced or as new versions are released. To date, we have not been made aware
of any significant software errors or failures in our products. However, despite
testing by us and by current and potential customers, errors may be found in new
products after commencement of commercial shipments, resulting in loss of
customers or delay in market acceptance.
If we, our key suppliers or our customers fail to be ready for the year 2000
calendar change, our business may be disrupted and our net revenues may decline.
The Year 2000 issue refers to computer programs which use two digits rather
than four to define a given year and which might read a date using "00" as the
year 1900 rather than the Year 2000. As a result, many companies' systems and
software may need to be upgraded or replaced in order to function correctly
after December 31, 1999.
Our Software. Our connectivity products are incorporated into computer
products of our customers which may not be Year 2000 compliant, or which may be
perceived by their markets as not meeting Year 2000 compliance requirements. As
a result, it is likely that any failure of the computer products into which our
products may be incorporated to be Year 2000 compliant, or any slowdown in the
connectivity markets as a result of Year 2000 compliance concerns, will hurt our
product sales. In addition, we believe that the purchasing patterns of customers
and potential customers may be affected by Year 2000 issues as companies expend
significant resources to correct or upgrade their current software systems for
Year 2000 compliance. These expenditures may result in reduced funds available
to purchase our products. To the extent Year 2000 issues cause a significant
delay in, or cancellation of, decisions to purchase our products or services,
our business would suffer. In the ordinary course of our business, we test and
evaluate our software modems. We believe that our current products are Year 2000
compliant, meaning that the use or occurrence of dates on or after January 1,
2000 will not materially affect the performance of our software products or the
ability of our products to transmit data involving dates.
Third Party Equipment And Software. We use third party equipment and
software that may not be Year 2000 compliant. This equipment and software
includes our key internal systems such as for our internal accounting systems or
controls. If this equipment or software does not operate properly with regard to
the Year 2000, we may incur unexpected expenses to remedy any problems. These
costs may materially adversely affect our business. In addition, if our key
internal systems fail as a result of Year 2000 problems, we could incur
substantial costs and disruption of our business.
Compliance. Despite our current assessment, we may not identify and correct
all significant Year 2000 problems on a timely basis. Year 2000 compliance
efforts may involve significant time and expense and unremediated problems could
harm our business, financial condition and operating results. We currently do
not have any estimate of potential costs related to potential Year 2000
problems. We currently do not have plans to contact our material customers. We
currently have no contingency plans to address the risks associated with
unremediated Year 2000 problems. To date, we have not incurred any material
costs directly associated with Year 2000 compliance efforts, except for
compensation expense associated with salaried employees who have devoted some of
their time to Year 2000 assessment and remediation efforts. We do not expect the
total cost of Year 2000 problems to be material to our business, financial
condition or operating results. However, during the period prior to the century
change, we will continue to evaluate new versions of our products, new software
and information systems provided by third parties and any new infrastructure
systems that we acquire, to determine whether they are Year 2000 compliant.
Risks Related to Our Industry
If the market for applications using our host signal processing technology does
not grow as we anticipate, or if our products are not accepted in this market,
our revenues may stagnate and may decrease.
Our success depends on the growth of the market for applications using our
host signal processing technology. This market has only recently begun to
develop and may not develop at the growth rates that have been suggested by
industry estimates. Market demand for host signal processing technology depends
primarily upon the cost and performance benefits relative to other competing
solutions. For example, soft modems have only recently begun to gain acceptance
in the modem market. Although we have shipped a significant number of soft
modems since we began commercial sales of these products in October 1995, the
current level of demand for soft modems may not be
22
sustained or may not grow. If customers do not accept soft modems or the market
for soft modems does not grow, our revenues will decrease.
Further, we are in the process of developing next generation products and
applications which improve and extend upon our host signal processing
technology, such as a G.Lite modem solution, an external modem product and a
remote access solution. If these products are not accepted in our markets when
they are introduced, our revenues and profitability will be negatively affected.
Our industry is characterized by rapidly changing technologies. If we do not
adapt to these technologies, our products will become obsolete.
The connectivity product market is characterized by rapidly changing
technologies, limited product life cycles and frequent new product
introductions. To remain competitive in this market, we have been required to
introduce many products over a limited period of time. For example, we
introduced a 14.4 Kbps product in 1995, a 28.8 Kbps product in 1996, a 33.6 Kbps
product in late 1996, a non-International Telecommunications Union standard 56
Kbps modem in the second half of 1997 and a v.90 International
Telecommunications Union standard 56 Kbps modem in early 1998. The market for
high speed data transmission is also characterized by several competing
technologies that offer alternative broadband solutions which allow for higher
modem speeds and faster internet access. These competing broadband technologies
include x-digital subscriber line, wireless and cable. However, substantially
all of our current product revenue is derived from sales of analog modems, which
use a more conventional technology. We must continue to develop and introduce
technologically advanced products that support one or more of these competing
broadband technologies. If we are not successful in our response, our products
will become obsolete and we will not be able to compete effectively.
Changes in laws or regulations, in particular, future FCC regulations affecting
the broadband market, internet service providers, or the communications industry
could negatively affect our ability to develop new technologies or sell new
products and therefore, reduce our profitability.
The jurisdiction of the Federal Communications Commission, or FCC, extends
to the entire communications industry, including our customers and their
products and services that incorporate our products. Future FCC regulations
affecting the broadband access services industry, our customers or our products
may harm our business. For example, future FCC regulatory policies that affect
the availability of data and internet services may impede our customers'
penetration into their markets or affect the prices that they are able to
charge. In addition, international regulatory bodies are beginning to adopt
standards for the communications industry. Although our business has not been
hurt by any regulations to date, in the future, delays caused by our compliance
with regulatory requirements may result in order cancellations or postponements
of product purchases by our customers, which would reduce our profitability.
Risks Related to our Common Stock
Substantial future sales of our common stock in the public market may depress
our stock price.
Our current stockholders hold a substantial number of shares, which they
will be able to sell in the public market in the near future. Sales of a
substantial number of shares of our common stock could cause our stock price to
fall.
Provisions in our charter documents may inhibit a change of control or a change
of management which may cause the market price for our common stock to fall and
may inhibit a takeover or change in our control that a stockholder may consider
favorable.
Provisions in our charter documents could discourage potential acquisition
proposals and could delay or prevent a change in control transaction that our
stockholders may favor. These provisions could have the effect of discouraging
others from making tender offers for our shares, and as a result, these
provisions may prevent the market price of our common stock from reflecting the
effects of actual or rumored takeover attempts and may prevent stockholders from
reselling their shares at or above the price at which they purchased their
shares. These provisions may also prevent changes in our management that our
stockholders may favor. Our charter documents do not permit stockholders to act
by written consent, do not permit stockholders to call a stockholders meeting
and provide for a classified board of directors, which means stockholders can
only elect, or remove, a limited number of our directors in any given year.
23
Our board of directors has the authority to issue up to 5,000,000 shares of
preferred stock in one or more series. The board of directors can fix the price,
rights, preferences, privileges and restrictions of this preferred stock without
any further vote or action by our stockholders. The rights of the holders of our
common stock will be affected by, and may be adversely affected by, the rights
of the holders of any preferred stock that may be issued in the future. Further,
the issuance of shares of preferred stock may delay or prevent a change in
control transaction without further action by the our stockholders. As a result,
the market price of the our common stock may drop. The board of directors has
not elected to issue additional shares of preferred stock since the initial
public offering on October 19, 1999.
24
PC-Tel, Inc.
Item 3: Quantitative and Qualitative Disclosures about Market Risk
================================================================================
We are exposed to minimal market risks. We manage the sensitivity of our
results of operations to these risks by maintaining a conservative investment
portfolio, which is comprised solely of highly-rated, short-term investments. We
do not hold or issue derivative, derivative commodity instruments or other
financial instruments for trading purposes. We are exposed to currency
fluctuations, as we sell our products internationally. We manage the sensitivity
of our internationals sales by denominating all transactions in U.S. dollars.
We may be exposed to interest rate risks, as we may use additional
financing to fund additional acquisitions and fund other capital expenditures.
The interest rate that we may be able to obtain on financings will depend on
market conditions at that time and may differ from the rates we have secured in
the past.
25
PC-Tel, Inc.
Part II. Other Information
For the Three Months and Nine Months Ended: September 30, 1999
===============================================================================
Item 1 Legal Proceedings:
See Note 3 of Notes to the Consolidated Condensed Financial Statements.
Item 2 Changes in Securities and Use of Proceeds:
Upon the close of our initial public offering, each outstanding share of
preferred stock was converted into one share of common stock and the
Certificate of Incorporation was amended to remove all reference to
Series A, Series B or Series C preferred stock.
The effective date of the PC-Tel's first registration statement on Form
S-1 under the Securities and Exchange Act of 1933 (No. 333-84707) was
October 19, 1999, relating to our initial public offering of its common
stock. A total of 5,290,000 shares of our common stock were sold at a
price of $17.00 per share to an underwriting syndicate led by Banc of
America Securities LLC, Warburg Dillon Read LLC, and Needham & Company,
Inc. PC-Tel received aggregate gross proceeds of $89.9 million in
connection with its initial public offering. Of such amount,
approximately $6.3 million was paid to the underwriters in connection
with underwriting discounts, and approximately $1.8 million was paid by
PC-Tel in connection with offering expenses, including legal,
accounting, printing, filing and other fees. There were no direct or
indirect payments to directors or officers of PC-Tel or any other person
or entity. None of the offering proceeds have been used for the
construction of plant, buildings, or facilities or other purchase or
installation of machinery or equipment or for purchases of real estate
or the acquisition of other business. $15.5 million of the proceeds were
used to repay bank debt. PC-Tel is currently investing the net offering
proceeds for future use as additional working capital. Such remaining
net proceeds may be used for general corporate purposes, including
working capital, and for potential investments in and acquisitions of
complementary products, technologies or businesses.
Item 3 Defaults upon Senior Securities: None.
Item 4 Submission of Matters to a Vote of Security Holders:
In August 1999, we submitted several matters to a vote of its security
holders through an Action by Written Consent. The following is a brief
description of the matters voted upon at the meeting and a statement of
the number of votes cast for and against and the number of abstentions.
There were no broker non-votes with respect to any matter.
1. To approve an amendment and restatement of our Certificate of
Incorporation to provide that each share of each series of our
Preferred Stock shall automatically be converted into shares of
Common Stock at the then effective Conversion Price (as defined in
the amended Certificate of Incorporation) upon the closing of firm
commitment underwritten public offering pursuant to an effective
registration statement under the Securities Act of 1933, as amended,
covering the offer and sale of Common Stock to the public at an
aggregate gross offering price of not less than Fifteen Million
dollars ($15,000,000) and a price per share to the public equal to
or greater than Twelve Dollars ($12.00).
FOR: 8,046,418 AGAINST: 0 ABSTAIN: 2,955,600
2. To approve an amendment and restatement of our 1997 Stock Plan to
increase the authorized number of shares under such plan by
2,000,000 shares to a total of 5,500,000 shares of Common Stock,
plus an annual increase to be added on the first day of our fiscal
year beginning in 2000 equal to the lesser of (i) 700,000 (ii) 4% of
the outstanding shares on such date or (iii) a lesser amount
determined by the Board.
FOR: 8,046,418 AGAINST: 0 ABSTAIN: 2,955,600
3. To approve an amendment and restatement of our Certificate of
Incorporation concurrently with the Initial Public Offering to (i)
include provisions establishing certain defensive strategies for the
protection of stockholders' value (ii) deleting all reference to
series of Preferred Stock and authorizing
26
instead one class of undersigned Preferred Stock consisting of
5,000,000 shares and (iii) authorizing an increase in the authorized
number of shares of Common Stock to 100,000,000.
FOR: 8,046,418 AGAINST: 0 ABSTAIN: 2,955,600
Item 5 Other Information: None.
Item 6 Exhibits and reports on Form 8-K:
(a) Exhibits
10.16 Lease agreement dated September 17, 1999 between PC-Tel,
Inc. and Sun Microsystems, Inc. for an office building
located at 1331 California Circle, Milpitas, CA 95035
27.1 Financial Data Schedule
(b) No reports on Form 8-K were filed by the Registrant during the three
months ended September 30, 1999.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PC-Tel, Inc.
A Delaware Corporation
(Registrant)
November 17, 1999 /s/ Andrew Wahl
-----------------------------------
Andrew Wahl
Vice President, Finance and Chief Financial Officer
(principal financial and accounting officer)
EXHIBIT INDEX
10.16 Lease agreement dated September 17, 1999 between PC-Tel, Inc. and Sun
Microsystems, Inc. for an office building located at 1331 California
Circle, Milpitas, CA 95035.
27.1 Financial Data Schedule
29