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November 14, 1997
ASCEND COMMUNICATIONS INC (ASND)
Quarterly Report (SEC form 10-Q)
Management's Discussion and Analysis of Financial Condition and Results of Operations
ASCEND COMMUNICATIONS, INC.
This Report contains forward-looking statements which reflect the current views of the Company with respect to future events that will have an effect on its future financial performance. These statements include the words "expects," "believes," "estimates," and similar expressions. These forward-looking statements are subject to various risks and uncertainties, including those referred to under "Factors That May Affect Future Results" and elsewhere herein, that could cause actual future results to differ materially from historical results or those currently anticipated. Readers are cautioned not to place undue reliance on these forward-looking statements.
The information set forth below should be read in conjunction with the unaudited interim condensed consolidated financial statements and notes thereto included in Part 1 - Item 1 of this Quarterly Report and the audited financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 1996 contained in the Company's Registration Statement on Form S-4/A (No. 333-25287) filed on April 22, 1997 in connection with the acquisition of Cascade and the Company's and Cascade's 1996 Annual Reports on Form 10-K.
Results of Operations
The following table sets forth, for the periods indicated, the percentage of net sales represented by certain line items from the Company's Condensed Consolidated Statements of Operations for the quarter and nine months ended September 30, 1997 and 1996, respectively:
Quarter Ended Sept. 30, Nine Months Ended Sept. 30,
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1997 1996 1997 1996
---- ---- ---- ----
Net sales................................ 100% 100% 100% 100%
Cost of sales............................ 36 35 35 35
---- ---- ---- ----
Gross margin........................... 64 65 65 65
Operating expenses:
Research and development............... 15 10 13 11
Sales and marketing.................... 24 17 21 17
General and administrative............. 3 3 3 4
Purchased research and development..... - - 27 -
Cost of mergers........................ - 6 17 2
---- ---- ---- ----
Total operating expenses............. 42 36 81 34
---- ---- ---- ----
Operating income (loss).................. 22 29 (16) 31
Interest income, net..................... 2 2 2 2
---- ---- ---- ----
Income (loss) before income taxes........ 24 31 (14) 33
Provision for income taxes............... 9 13 6 13
---- ---- ---- ----
Net income(loss)......................... 15% 18% (20)% 20%
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See notes to condensed consolidated financial statements.
ASCEND COMMUNICATIONS, INC.
Net Sales
Net sales for the quarter ended September 30, 1997 were $270.4 million, an increase of 9% over net sales of $248.8 million for the third quarter of 1996. Net sales for the nine months ended September 30, 1997 were $874.8 million, an increase of 45% over net sales of $602.5 million for the nine months ended September 30, 1996. UUNET, an Internet service provider, accounted for approximately 15% and 10% of net sales for the quarters ended September 30, 1997 and 1996, respectively. UUNET accounted for approximately 16% of net sales for the nine months ended September 30, 1997. International sales accounted for approximately 29% of net sales for the quarter ended September 30, 1997 compared to 36% of net sales for the same period in 1996. International sales accounted for approximately 33% of net sales for the nine months ended September 30, 1997 compared to 34% of net sales for the same period in 1996. These decreases were principally due to decreased sales of the Company's products in Europe and Japan.
The following table provides a breakdown of net sales by business unit as a percentage of total Company net sales for the quarters and nine months ended September 30, 1997 and 1996, respectively:
Quarter Ended Sept. 30, Nine Months Ended Sept. 30,
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BUSINESS UNIT 1997 1996 1997 1996
------------------------ ---- ---- ---- ----
Access Concentrators........ 50% 49% 55% 47%
Core Switching.............. 36 36 33 37
Remote Access............... 5 7 5 8
Multimedia.................. 4 5 3 6
Other....................... 5 3 4 2
--- --- --- ---
Total Company............ 100% 100% 100% 100%
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Access Concentrators - The Access Concentrators business unit is composed of the MAX family of products. MAX products accounted for 50% and 49% of total Company net sales for the quarters ended September 30, 1997 and 1996, respectively. MAX products accounted for 55% and 47% of total Company net sales for the nine months ended September 30, 1997 and 1996, respectively. The increase in unit shipments of MAX products was primarily attributable to the growth in business from Internet service providers ("ISP's") and increased demand for corporate remote networking applications.
ASCEND COMMUNICATIONS, INC.
Net Sales (continued)
Core Switching The Core Switching business unit is composed of the BSTDX family of Frame Relay switches, the CBX500 family of ATM switches and the GRF family of Internet Protocol ("IP") switches. B-STDX products accounted for 25% and 31% of total Company net sales for the quarters ended September 30, 1997 and 1996, respectively. BSTDX products accounted for 25% and 34% of total Company net sales for the nine months ended September 30, 1997 and 1996, respectively. The decline in BSTDX sales as a percent of net sales was primarily attributable to the increase in the sales of the MAX family of products. CBX500 products accounted for 9% and 4% of total Company net sales for the quarters ended September 30, 1997 and 1996, respectively. CBX500 products accounted for 6% and 2% of total Company net sales for the nine months ended September 30, 1997 and 1996, respectively. GRF products, which were first shipped in volume in the first quarter of 1997, accounted for 2% of total Company net sales for both the quarter and the nine months ended September 30, 1997.
Remote Access The Remote Access business unit is composed of the Pipeline family of products. Pipeline products accounted for 5% and 7% of total Company net sales for the quarters ended September 30, 1997 and 1996, respectively. Pipeline products accounted for 5% and 8% of total Company net sales for the nine months ended September 30, 1997 and 1996, respectively. The decline of Pipeline net sales as a percent of total Company net sales was primarily attributable to the increase in the sales of the MAX family of products and price reductions of the Pipeline products due to increased competition.
Multimedia The Multimedia business unit is composed of the Multiband family of products and the MAX Video family of products. Multimedia products accounted for 4% and 5% of total Company net sales for the quarters ended September 30, 1997 and 1996, respectively. Multimedia products accounted for 3% and 6% of total Company net sales for the nine months ended September 30, 1997 and 1996, respectively. The decline of Multimedia net sales as a percent of total Company net sales was primarily attributable to the increase in the sales of the MAX family of products.
Gross Margin
Gross margin was 64% and 65% for the quarters ended September 30, 1997 and 1996, respectively. The decrease in gross margin for the quarter ended September 30, 1997 was primarily due to increased manufacturing period costs. Gross margin was 65% for both the nine months ended September 30, 1997 and 1996. In the future, the Company's gross margins may be affected by several factors, including the mix of products sold, the price of products sold, the introduction of new products with lower gross margins, the distribution channels used, price competition, increases in material costs and changes in other components of cost of sales.
ASCEND COMMUNICATIONS, INC.
Research and Development
Research and development expenses increased 61% to $40.7 million in the third quarter of 1997 from $25.3 million in the third quarter of 1996. Research and development expenses increased 80% to $115.6 million for the nine months ended September 30, 1997 from $64.1 million for the nine months ended September 30, 1996. Research and development expenses as a percent of net sales increased to 15% for the third quarter of 1997 compared to 10% for the same quarter of 1996. Research and development expenses as a percent of net sales increased to 13% for the first nine months of 1997 compared to 11% for the same period of 1996. These increases were primarily due to the addition of engineering personnel, payments for consulting services in connection with developing and enhancing the Company's existing and new products, payments for consulting services related to filing applications and product testing required to obtain governmental approvals to resell the Company's products outside of North America, addition of research and development laboratory equipment and material costs associated with new product prototypes. In addition, research and development expenses increased in part through the addition of engineering personnel and facilities as a result of the Company's merger and acquisition activities.
Sales and Marketing
Sales and marketing expenses increased 58% to $66.5 million for the third quarter of 1997 from $42.2 million for the third quarter of 1996. Sales and marketing expenses increased 71% to $179.6 million for the first nine months of 1997 from $105.3 million for the same period of 1996. Sales and marketing expenses as a percent of net sales increased to 24% for the third quarter of 1997 as compared to 17% for the same quarter of 1996. Sales and marketing expenses as a percent of net sales increased to 21% for the first nine months of 1997 as compared to 17% for the same period of 1996. These increases were primarily due to the addition of sales, marketing and technical support personnel, increased commissions, spending for marketing materials and trade shows, advertising and promotions, expenditures for demonstration and loaner equipment used by customers, and expenses associated with opening additional sales offices in North America, Europe and Asia and the Pacific Basin. The growth in sales, marketing and technical support personnel was primarily due to the need to manage the activities of an increased number of value-added resellers and distributors, end-user customers and new products.
General and Administrative
General and administrative expenses increased 11% to $8.5 million for the third quarter of 1997 from $7.7 million for the third quarter of 1996. General and administrative expenses increased 26% to $27.0 million for the first nine months of 1997 from $21.5 million for the first nine months of 1996. This increase was primarily due to the addition of finance, information systems and administrative personnel, accruals for performance bonuses, increased facilities costs and the cost of investor relations activities. General and administrative expenses as a percent of net sales were 3% for the quarters ended September 30, 1997 and 1996. General and administrative expenses as a percent of net sales decreased to 3% for the nine months ended September 30, 1997 from 4% for the same period of 1996. This decrease in general and administrative expenses as a percentage of net sales was due primarily to increased net sales.
ASCEND COMMUNICATIONS, INC.
Purchased Research and Development
Purchased research and development costs were $231.1 million for the first nine months of 1997. These costs were for the purchase of technology and related assets associated with the acquisitions of InterCon Systems Corporation and Sahara Networks, Inc. during the first quarter of 1997. These acquisitions provide technology and expertise that the Company is using to enhance and expand the breadth of its offerings to end-user markets.
Cost of Mergers
For the nine months ended September 30, 1997, the Company charged to operations one-time merger costs of approximately $150.3 million. These costs related to the acquisitions of Cascade Communications Corp. and Whitetree, Inc. and consist primarily of investment and professional fees and other direct costs associated with the merger. Of the $150.3 million in one-time merger costs, approximately $44.9 million are not deductible for tax purposes.
Interest Income, Net
Interest income (net) increased by approximately $1.8 million to $6.2 million (2% of net sales) for the third quarter of 1997 compared to $4.4 million for the same quarter of 1996. Interest income (net) increased by approximately $5.3 million to $17.7 million (2% of net sales) for the first nine months of 1997 compared to $12.4 million for same period of 1996. This increase in interest income (net) is due primarily to the investment of proceeds from the exercise of stock options and issuance of common stock in connection with the Company's employee and outside director stock plans and cash from operations.
Provision for Income Taxes
The Company's effective tax rate for the quarter and nine months ended September 30, 1997 was 37.0% and 37.6%, respectively, exclusive of the effect of one-time non-deductible in-process research and development expenses and certain merger related expenses. The effective tax rate for the quarter and nine months ended September 30, 1996 was 38.2% and 38.3%, respectively, exclusive of the effect of one time non-deductible merger related expenses. The lower effective tax rate for 1997 is primarily attributable to a larger benefit from the Company's Foreign Sales Corporation.
ASCEND COMMUNICATIONS, INC.
Liquidity and Capital Resources
At September 30, 1997, the Company's principal sources of liquidity included $593.1 million of cash and cash equivalents, short-term investments and investments, and an unsecured $15.0 million revolving line of credit which expires in November 1997. There were no borrowings under the line of credit during the nine months ended September 30, 1997. The decrease in cash and cash equivalents of $69.8 million for the period was principally due to $234.5 million of funds used in investing activities, partially offset by $81.9 million of proceeds from, and tax benefits related to, the exercise of stock options and issuance of common stock in connection with the Company's employee and outside director stock plans and by $82.8 million of funds provided by operations. The net cash provided by operating activities for the nine months ended September 30, 1997 was primarily due to increases in accrued liabilities, accrued compensation and accounts payable and increased net income adjusted for depreciation, purchased research and development, cost of mergers and deferred income taxes, partially offset by increases in accounts receivable and inventories.
Net cash used in investing activities of $234.5 million for the nine months ended September 30, 1997 related primarily to net purchases, maturities and sales of investments, expenditures for furniture, fixtures, and equipment and the effect of business combinations. Financing activities provided $81.9 million for the nine months ended September 30, 1997, primarily due to proceeds from, and tax benefits related to, the exercise of stock options and issuance of common stock in connection with the Company's employee and outside director stock plans.
At September 30, 1997, the Company had $699.7 million in working capital. The Company currently has no significant capital commitments other than commitments under facilities and operating leases. The Company believes that its available sources of funds and anticipated cash flow from operations will be adequate to finance current operations, anticipated investments and capital expenditures for at least the next twelve months.
Factors That May Affect Future Results
The Company's quarterly and annual operating results are affected by a wide variety of risks and uncertainties as discussed in the Company's Registration Statement on Form S-4/A (No. 333-25287) filed on April 22, 1997 in connection with the acquisition of Cascade and the Company's and Cascade's Annual Reports for the year ended December 31, 1996 on Form 10-K. This Report on Form 10-Q should be read in conjunction with such Forms S-4 and 10-K, particularly the section entitled "Risk Factors". These risks and uncertainties include but are not limited to competition, the mix of products sold, the mix of distribution channels employed, the Company's success in developing, introducing and shipping new products, the Company's success in integrating acquired operations, the Company's dependence on single or limited source suppliers for certain components used in its products, price reductions for the Company's products, risks inherent in international sales, changes in the levels of inventory held by third-party resellers, the timing of orders from and shipments to customers, seasonality and general economic conditions.
ASCEND COMMUNICATIONS, INC.
Factors That May Affect Future Results (continued)
In particular, a substantial portion of the Company's sales of MAX and Pipeline products is related to the Internet industry. In North America, the Company sells a substantial percentage of its products, particularly its MAX products, to ISPs. There can be no assurance that this industry and its infrastructure will continue to develop or that acceptance of the Company's products by
this industry will be sustained. The Company believes competition in the Internet industry will increase significantly in the future and could adversely affect the Company's business, results of operations and financial condition.
The Company has concluded the acquisition of four companies in 1996 and three companies in 1997. Achieving the anticipated benefits of these acquisitions or any other acquisitions the Company may undertake will depend in part upon whether the integration of the acquired companies' products and technologies, research and development activities, and sales, marketing and administrative organizations is accomplished in an efficient and effective manner, and there can be no assurance that this will occur. Moreover, the integration process may temporarily divert management attention from the day-to-day business of the Company. Failure to successfully accomplish the integration of the acquired companies could have a material adverse effect on the Company's business, financial condition and/or results of operations.
The Company expects that its gross margins could be adversely affected in future periods by price adjustments as a result of increased competition. In addition, increased sales of Pipeline products as a percentage of net sales may adversely affect the Company's gross margins in future periods as these products have lower gross margins than the Company's other products. In addition, the Company's use of third parties to distribute its products to other value-added resellers may adversely affect the Company's gross margins.
The Company expects that international sales will continue to account for a significant portion of the Company's net sales in future periods. International sales are subject to certain inherent risks, including unexpected changes in regulatory requirements and tariffs, difficulties in staffing and managing foreign operations, longer payment cycles, problems in collecting accounts receivable and potentially adverse tax consequences. The Company depends on third party resellers for a substantial portion of its international sales. Certain of these third party resellers also act as resellers for competitors of the Company that can devote greater effort and resources to marketing competitive products. The loss of certain of these third party resellers could have a material adverse effect on the Company's business and results of operations. Although the Company's sales are denominated in U.S. dollars, fluctuations in currency exchange rates could cause the Company's products to become relatively more expensive to customers in a particular country, leading to a reduction in sales and profitability in that country. Furthermore, future international activity may result in foreign currency denominated sales, and, in such event, gains and losses on the conversion to U.S. dollars of accounts receivable and accounts payable arising from international operations may contribute to fluctuations in the Company's results of operations. In addition, sales in Europe and certain other parts of the world typically are adversely affected in the third quarter of each calendar year as many customers reduce their business activities during the summer months. These seasonal factors may have an effect on the Company's business, results of operations and financial condition.
ASCEND COMMUNICATIONS, INC.
Factors That May Affect Future Results (continued)
The Company typically operates with a relatively small backlog. As a result, quarterly sales and operating results generally depend on the volume of, timing of and ability to fulfill orders received within the quarter, which are difficult to forecast. In the Company's most recent quarter, the sequential sales growth slowed from prior levels, and a disproportionate share of the sales occurred in the last month of the quarter. These occurrences are extremely difficult to predict and may happen in the future. The Company's ability to meet financial expectations could be hampered if the nonlinear sales pattern continues in future periods. Accordingly, the cancellation or delay of even a small percentage of customer purchases could adversely affect the Company's results of operations in the quarter. A significant portion of the Company's net sales in prior periods has been derived from relatively large sales to a limited number of customers, and therefore the failure of the Company to secure expected large sales may have a material adverse impact on results of operations. A significant portion of the Company's expense levels is relatively fixed in advance based in large part on the Company's forecasts of future sales. If sales are below expectations in any given quarter, the adverse impact of the shortfall on the Company's operating results may be magnified by the Company's inability to adjust spending to compensate for the shortfall. The Company may also increase spending in the future in response to competition or to pursue new market opportunities.
The market for the Company's products is characterized by rapidly changing technologies, evolving industry standards, frequent new product introductions and short product life cycles. The introduction of new products requires the Company to manage the transition from older products in order to minimize disruption in customer ordering patterns, avoid excessive levels of older product inventories and ensure that adequate supplies of new products can be delivered to meet customer demand. Furthermore, products such as those offered by the Company may contain undetected or unresolved hardware problems or software errors when they are first introduced or as new versions are released. There can be no assurance that, despite extensive testing by the Company, hardware problems or software errors will not be found in new products after commencement of commercial shipments, resulting in delay in or loss of market acceptance. Future delays in the introduction or shipment of new or enhanced products, the inability of such products to gain market acceptance or problems associated with new product transitions could adversely affect the Company's business, results of operations and financial condition.
The Company mainly competes in four segments of the data networking market : (i) wide area network ("WAN") and Internet access, (ii) WAN and Internet backbone switching, (iii) remote LAN access and Internet subscriber access, and (iv) videoconferencing and multimedia access. The Company competes in one or more of these market segments with Cisco Systems, Inc., 3Com Corporation, Bay Networks, Inc., Newbridge Networks, Inc., Shiva Corporation, Northern Telecom, Inc., Teleos Communications (a subsidiary of Madge Networks, Inc.), Adtran, Promptus Communications (a subsidiary of GTI) and many others. Some of these competitors have substantially greater financial, marketing and technical resources than the Company. The Company expects additional competition from existing competitors and from a number of other companies, some of which may have substantially greater financial, marketing and technical resources than the Company, that may enter the Company's existing and future markets. Increased competition could result in price reductions, reduced profit margins and loss of market share, each of which would adversely affect the Company's business, results of operations and financial condition.
ASCEND COMMUNICATIONS, INC.
Factors That May Affect Future Results (continued)
The Company's sales are, to a significant degree, made through telecommunications carriers, value-added resellers ("VARs") and distributors. Accordingly, the Company is dependent on the continued viability and financial stability of these companies. While the Company has contractual relationships with many telecommunications carriers, VARs and distributors, these agreements do not require these companies to purchase the Company's products and can be terminated by these companies at any time. There can be no assurance that any of the telecommunications carriers, VARs or distributors will continue to market the Company's products. The telecommunications carrier customers, to the extent they are resellers, VARs and distributors, generally offer products of several different companies, including products that are competitive with the Company's products. Accordingly, there is a risk that these companies may give higher priority to products of other suppliers, thus reducing their efforts to sell the Company's products. Any special distribution arrangement and product pricing arrangement that the Company may implement in one or more distribution channels for strategic purposes could adversely affect gross profit margins.
The Company's success depends to a significant degree upon the continuing contributions of its key management, sales, marketing and product development personnel. The Company does not have employment contracts with its key personnel and does not maintain any key person life insurance policies. The loss of key personnel could adversely affect the Company.
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