10Q ..Part 2Glimpse.-Cont of 10Q......Net cash used in operations in the first nine months of 1998 was primarily the result of our net loss of $18,550,000.
Net cash used in investing activities was $8,994,000 and $2,860,000 during the first nine months of 1999 and 1998, respectively. Net cash used in investing activities for the first nine months of 1999 was primarily due to the purchase of short term investments in the amount of $8,991,000. Net cash used in investing activities for the first nine months of 1998, was primarily a result of the purchase of property and equipment of $3,818,000, partially offset by net proceeds from short term investments of $893,000. In the past, we have funded a substantial portion of our property and equipment expenditures from direct vendor leasing programs and third party commercial lease arrangements. At September 30, 1999, we did not have any material commitments for capital expenditures.
Net cash from financing activities was $18,052,000 for the first nine months of 1999 compared to a net use of cash of $311,000 for the first nine months of 1998. The increase was the result of the issuance in September 1999 of the convertible debentures in the principal amount of $18,101,000 referred to above.
At September 30, 1999, our liquidity consisted of cash and cash equivalents and short term investments of $17,125,000. We had no available line of credit or other source of borrowings or financing. Our principal indebtedness consists of the $18.1 million convertible debentures issued in September 1999 and a convertible debenture issued in April 1997 in the principal amount of $5.5 million (the "$5.5 Million Debenture").
RISKS RELATED TO THE YEAR 2000 ISSUE.
BACKGROUND. The "Year 2000 Issue" refers generally to the problems that some software, including firmware embedded in our products, may have in determining the correct century for the year. For example, software with date-sensitive functions that is not Year 2000 compliant may not be able to distinguish whether "00" means 1900 or 2000, which may result in failures or the creation of erroneous results.
OUR READINESS PLAN. We have developed a Year 2000 readiness plan for the current versions of our products. The plan includes development of corporate awareness, assessment, implementation (including remediation, upgrading and replacement of certain product versions), validation testing and contingency planning. We continue to respond to customer concerns about prior versions of our products on a case-by-case basis and we believe most products that could be affected have been withdrawn from service.
We have completed our plan, except for contingency planning, with respect to the current versions of all of our products to assure that they are Year 2000 compliant. As a result of our readiness plan all of the current versions of each of our products currently offered for sale are Year 2000 compliant (with the exception of final quality assurance and customer network testing), when configured and used in accordance with the related documentation, and provided that the underlying operating system of the host machine and any other software used with or in the host machine or our products are also Year 2000 compliant. In some cases, our products require an upgrade which is either sold as a complete substitute or as a kit for in-service systems to be Year 2000 Compliant. We consider our products to be Year 2000 compliant if they have the ability to: (i) correctly handle date information needed for the December 31, 1999 to January 1, 2000 date change; (ii) function according to the product documentation provided for this date change without changes in operation resulting from the advent of a new century, assuming correct configuration; (iii) where appropriate, respond to two-digit date input in a way that resolves the ambiguity as to century in a disclosed, defined, and predetermined manner; and (iv) recognize year 2000 as a leap year.
RISKS. Despite our testing and testing by our current customers, and any assurances from developers of products incorporated into our products, our products may contain undetected errors or defects associated with Year 2000 date functions. Also, certain prior versions of our products are not fully Year 2000 compliant and may remain in service. Known or unknown errors or defects in our products could result in delay or loss of revenue, diversion of development resources, damage to our reputation, or increased service and warranty costs, any of which could materially adversely affect our business.
We do not currently have any information concerning the Year 2000 compliance status of our customers. If our customers suspend or defer investments in system enhancements or new products to address Year 2000 compliance problems, our business could be materially adversely affected.
Some commentators have predicted significant litigation regarding Year 2000 compliance issues. Because this type of litigation lacks precedent, it is uncertain whether or to what extent we may be affected by it.
We have an ongoing program in an effort to prevent any adverse effects caused by the Year 2000 issue with regard to our mission critical internal information systems (including the third-party software for our management information systems, networks and desktop applications, and our hardware telecommunications technology). With respect to Mission Critical internal systems, we are currently 100% Year 2000 compliant.
COSTS. We have funded our Year 2000 efforts from operating cash. While we do not expect such costs to be material, additional costs will be incurred related to Year 2000 programs for administrative personnel to manage our readiness plans, technical support for our product engineering and customer satisfaction. Although we are currently not aware of any material operational issues or costs associated with preparing our internal information systems for the Year 2000, we may experience material unanticipated problems and costs caused by undetected errors or defects in the technology used in our information systems. We can give no assurance that other material problems and costs will not arise in connection with Year 2000 compliance or that these problems and costs will not adversely affect our business.
CONTINGENCY PLANNING. We have not developed a comprehensive contingency plan to address situations that may result if we are unable to achieve Year 2000 readiness of our critical operations. The cost of developing and implementing such a plan may itself be material. We are also subject to external forces that might generally affect industry and commerce, such as utility or transportation company Year 2000 compliance failures and related service interruptions. Were we to experience an unanticipated Year 2000 interruption, business operations could be seriously impaired for an indefinite period of time until remedial efforts could be achieved.
SEASONALITY AND INFLATION.
We do not believe that our business is seasonal or that it is impacted by inflation.
RISK FACTORS
AN INVESTMENT IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. YOU SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW AND THE OTHER INFORMATION IN THIS REPORT ON FORM 10-Q BEFORE INVESTING IN OUR COMMON STOCK. THE RISKS DESCRIBED BELOW ARE NOT THE ONLY ONES WE FACE. ADDITIONAL RISKS THAT WE ARE AWARE OF OR THAT WE CURRENTLY BELIEVE ARE IMMATERIAL MAY BECOME IMPORTANT FACTORS THAT AFFECT OUR BUSINESS. IF ANY OF THE FOLLOWING RISKS OCCUR, OR IF OTHERS OCCUR, OUR BUSINESS, OPERATING RESULTS AND FINANCIAL CONDITION COULD BE SERIOUSLY HARMED.
WE WILL NEED ADDITIONAL CAPITAL.
Although we raised over $35 million in net proceeds from our initial public offering in November 1997, our capital resources were virtually exhausted by September 1999. In September, we raised $18.1 million from the issuance and sale of convertible debentures. We anticipate that we will need to raise additional capital during 2000. Our ability to raise additional capital may be limited by a number of factors, including (i) Sprint's veto rights, right of first refusal and other substantial rights and privileges, (ii) our dependence upon Sprint's business (which is not assured) and, to a lesser extent, the business of a few other customers, (iii) possible continuing uncertainties and concerns as a result of our past financial reporting difficulties, class action litigation and related issues, (iv) our need to increase our work force quickly and effectively and to reduce the cost of our existing products and develop new products, (v) our Common Stock being delisted from the Nasdaq National Market and not traded on any other public market (except for sales on the Pink Sheets which have occurred without our consent), (vi) uncertainty regarding our financial condition and results of operations, (vii) our history of heavy losses and (viii) the other risk factors referred to herein. We can give no assurance that we will be able to raise the additional capital we will need in the future or that any financing we may be able to obtain will not be on terms that are detrimental to our business and our ability to raise additional capital.
WE ARE LARGELY DEPENDENT ON SPRINT
In September 1999, Sprint invested $11 million in purchasing convertible debentures from us and acquired warrants to purchase additional convertible debentures. The warrants are in consideration for a commitment by Sprint to purchase $10 million of our products by the end of 2000, but the terms of such purchases are subject to negotiation. Sprint is acquiring our principal wireless customers, and we expect that our future business will come primarily from wireless customers. Accordingly, our future business will probably be substantially dependent upon orders from Sprint or from companies selling to Sprint. Sprint is considering using our products in connection with its roll-out of wireless Internet access services, but it has made no commitment to do so and there can be no assurance that it will do so.
In connection with Sprint's investment in us, Sprint obtained substantial corporate governance rights. Two of our five directors are Sprint designees, and if Sprint exercised all its warrants and conversion privileges (and if no one else did so), Sprint would own approximately 39% of our Common Stock. Under the terms of our agreements with Sprint, we cannot issue any securities or, in most cases, take material corporate action without Sprint's approval. Sprint has other rights and privileges, including pre-emptive rights and a right of first refusal in the case of any proposed change of control transaction. (See Item 2 of Part II below.) As a result, Sprint will have a great deal of influence on us in the future. We have no assurance that Sprint will exercise this influence in our best interests, as Sprint's interests are in many respects different than ours (e.g., in deciding whether to purchase our products, in negotiating the terms of any such purchases and in deciding whether or not to support any future investment in us or any future strategic partnering or sale opportunity).
OUR LIMITED OPERATING HISTORY AND HEAVY LOSSES MAKE OUR BUSINESS DIFFICULT TO EVALUATE.
We were organized in 1990 and have had operating losses each year since then. Our accumulated deficit was $75,974,000 as of September 30, 1999 and $63,569,000 as of December 31, 1998. The revenue and profit potential of our business is unproven. The market for our products has only recently begun to develop, is rapidly changing, has an increasing number of competing technologies and competitors, and many of the competitors are significantly larger than we are. We have had negative gross margins in prior periods and the price pressures on sales of our products continues. We expect to incur losses for some time.
WE FACE LITIGATION RISKS.
Although the class action lawsuits have been settled, we continue to face litigation with Pacific Monolithics (referred to in Part II, Item 1 "Legal Proceedings"), and we are subject to an investigation by the SEC. It is difficult for us to evaluate what the outcome of the Pacific Monolithics litigation or the SEC investigation will be. Responding to the investigation has been, and probably will continue to be, expensive and time-consuming for us, and responding to the Pacific Monolithics litigation may be expensive as well. We do not know whether the results of the litigation or the investigation will be damaging for us.
It is possible that we may be exposed to further litigation in the future, particularly in light of the restatement of our financial statements, and the adverse developments that have occurred partly as a result of the restatement. In addition, litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of our patents or of the proprietary rights of others. Such litigation might result in substantial costs and diversion of resources and management attention. Furthermore, our business activities may infringe upon the proprietary rights of others, and in the past third parties have claimed, and may in the future claim, infringement by our software or products. Any such claims, with or without merit, could result in significant litigation costs and diversion of management attention, and could require us to enter into royalty and license agreements that may be disadvantageous to us or suffer other harm to our business. If litigation is successful against us, it could result in invalidation of our proprietary rights and liability for damages, which could have a harmful effect on our business. We initiated one patent infringement litigation to enforce our patent rights, and it resulted in a settlement in which we granted licenses to the defendants containing terms that are in some respects favorable to them, including a right of first refusal to purchase our patents that we granted to one defendant (Com21, Inc.) in the event that we propose in the future to sell our patents (whether separately or together with our other assets) to any third party. Nonetheless, we may find it necessary to institute further infringement litigation in the future in an effort to assert our patent rights, and third parties may bring litigation against us challenging our patents. Any such litigation could be time consuming and costly for us and could result in our patents being held invalid or unenforceable. Furthermore, even if the patents are upheld or are not challenged, third parties might be able to develop other technologies or products without infringing any such patents.
REDUCTION IN OUR EXPENDITURES AND IN THE NUMBER OF OUR EMPLOYEES HAVE HURT OUR BUSINESS. WE PLAN TO INCREASE EXPENDITURES IN THE FUTURE, BUT WE MIGHT NOT BE ABLE TO DO SO EFFECTIVELY.
Commencing in the latter part of 1998 and continuing through the first three quarters of 1999, we reduced our expenditures on research and development and on other aspects of our business. We also reduced the number of our employees. During the first quarter of 1999, we implemented a reduction in force that reduced the number of full-time employees to 32 as of March 31, 1999 compared to 87 full-time employees at December 31, 1998. At September 30, 1999, the number of full time employees had increased to 36. We used consultants heavily to supplement our workforce, and as of September 30, 1999 we had 15 consultants in various areas. While we believe these reductions were necessary to conserve our remaining capital resources, they have limited and delayed the enhancement of our products and our development of new products, and our sales and marketing efforts have been adversely affected. These limitations on our activities (together with the other factors referred to above and elsewhere herein) have hurt us competitively and may continue to harm our business in the future.
In September 1999, we raised $18.1 million and we are now attempting to hire additional personnel on an expedited basis in order to achieve our product development goals. We operate in an extremely competitive environment for technical and other qualified personnel, and there can be no assurance that we will be able to achieve our hiring and product development goals.
MARKET PRESSURE TO REDUCE PRICES MAY HURT OUR BUSINESS.
The market has historically demanded increasingly lower prices for our products, and we expect downward pressure on the prices of our products to continue. The list prices for our Series 2000 client modems currently range from approximately $320 to $480, depending upon features and volume. Customers wishing to purchase client modems generally must also purchase an Ethernet adapter for their computer. These prices make our products relatively expensive for the consumer electronics and the small office or home office markets. Market acceptance of our products, and our future success, will depend in significant part on reductions in the unit cost of our client modems. In a number of instances, the prices of our competitors' products are lower than ours. Our ability to reduce our prices has been limited by a number of factors, including our reliance on a single manufacturer of our modems and on single-sources for certain of the components of our products.
One of the principal objectives of our research and development efforts has been to reduce the cost of our products through design and engineering changes, although, as indicated above, we have recently had to reduce the scope of our research and development efforts due to lack of capital resources. We have no assurance that we will be able to redesign our products to achieve substantial cost reductions or that we will otherwise be able to reduce our manufacturing and other costs, or that any reductions in cost will be sufficient to improve our gross margins, which have been negative until this quarter and which must substantially improve in order for us to operate profitably.
We expect that the market price pressure to reduce the prices on our products will continue to exert downward pressure on our gross margins. Our gross margins are also affected by the sales mix of our headends and modems. Our single-user modems generally have lower margins than our multi-user modems, both of which have lower margins than our headends. We anticipate that, due to customer demand, the sales mix of our products may continue to be weighted toward lower-margin modems.
WE RELY ON A SINGLE MANUFACTURER FOR OUR MODEMS AND ON SINGLE-SOURCE COMPONENTS.
Our Series 2000 client modems are manufactured by Sharp Corporation through an agreement we have had since early 1997 with Sharp and its distributor, Itochu Corporation. We have not developed an alternative manufacturing source. Our inability to develop alternative manufacturing sources has adversely affected our ability to reduce the manufacturing costs of our modems despite competitive pressures that have caused us to reduce our selling prices. We expect downward pressure on the prices of our products to continue. In order for us to compete effectively in the sale of modems, we will need to reduce our prices, and the underlying costs, of our modems. As long as Sharp is the only manufacturing source of our modems, our ability to reduce the manufacturing costs of our modems may be limited.
We are dependent upon certain key suppliers for a number of the components for our 64QAM products. For example, we have only one vendor, BroadCom Corporation, for the 64QAM demodulator semiconductors that are used in our client modem products, and in past periods these semiconductors have been in short supply. In 1997, BroadCom announced a program whereby certain of its technological and product enhancements may be made available to certain of our competitors before making them available to us, thereby giving us a competitive disadvantage. Hitachi is the sole supplier of the processors used in certain of our modems. Stanford Telecom (now Intel), which is a competitor for at least one of our broadband wireless products, is currently the sole supplier for certain components used in our products. There can be no assurance that these and other si |
