ITEM 1. BUSINESS.
Tekelec (the "Company") designs, manufactures and markets innovative network switching solutions and diagnostic systems for the global communications marketplace. Tekelec's products enable communications infrastructure suppliers and network providers to rapidly deliver advanced communications products and services. The Company's EAGLE(R) STP switching platform enables operators of wireline and wireless networks to deliver Intelligent Network (IN) and Advanced Intelligent Network (AIN) services such as Caller ID, voice messaging, personal number calling, Service Provider Local Number Portability and customized routing and billing as well as digital wireless services such as Personal Communications Systems (PCS) and Global Systems for Mobile (GSM). Tekelec's diagnostic systems are used in the design, installation and maintenance of a broad range of communications equipment and networks.
The Company's switching products have been sold primarily to U.S. independent telephone companies (ITCs), PCS and cellular operators, interexchange carriers (IXCs), competitive access providers (CAPs) and local exchange carriers. In 1997, the Company entered the Regional Bell Operating Company (RBOC) market with sales of its EAGLE STPs to NYNEX and to Bell Atlantic Corporation. The two companies subsequently merged into Bell Atlantic Corporation. Switching products have been sold primarily through the Company's direct sales force and also through distribution and marketing relationships with Daewoo Telecom, Ltd. (Daewoo), Lucent Technologies, Inc. (Lucent) and Stratus Computer, Inc. (Stratus). In 1997, Daewoo became the Company's exclusive Korean distributor of the EAGLE STP.
The Company sells its diagnostic systems worldwide to long distance carriers, telephone operating companies, communications equipment manufacturers, wireless and cellular network operators and government agencies.
INDUSTRY BACKGROUND
Deregulation and privatization worldwide have intensified competition among existing operators of public communications networks and encouraged the entrance of new service providers. At the same time, the convergence of telephony and computing is resulting in end users demanding new and enhanced high-quality communications services at lower cost. As a result, network operators are increasingly pressured to reduce the time and expense required to introduce such services. Together, these forces are creating the need for new equipment and infrastructure for both wireline and wireless networks.
Public Networks: Increased Competition and Complexity
In the U.S., long distance carriers, RBOCs and new competitive service providers that have entered the local and long-distance markets are competing with one another to offer enhanced products and services to their customers. The passage of the Telecommunications Act of 1996 and subsequent orders and rulings in 1997 continued their profound competitive impact on all domestic carriers. The rapid growth of cellular and wireless networks continues to further increase the number of communications alternatives offered to end users. For the first time, real local choice became available to consumers in most metropolitan areas. In response to this environment, operators of public networks are seeking to lower their costs and differentiate themselves by rapidly introducing new services. These include high-speed data services such as Asynchronous Transfer Mode (ATM) and Frame Relay, AIN services such as Caller ID, voice messaging, Service Provider Local Number Portability and customized routing and billing as well as digital wireless services such as PCS and GSM. Globally, state-owned Post Telephone and Telegraph Administrations (PTTs) are being liberalized and privatized, resulting in some of the industry's most deregulated and competitive marketplaces. The European Union, following the lead of the Federal Communications Commission (FCC), is establishing pan-European standards for Local Number Portability (LNP) based on Common Channel Signaling System No. 7 (SS7) with the objective of implementing such requirements by the year 2000.
While communications markets are becoming increasingly competitive, a proliferation of standards and protocols is making the design and operation of communications networks more complex. Demand for high-speed communications integrating voice, data and video is growing rapidly. Services based on emerging technologies, such as ATM, Frame Relay, xDSL, digital video and Fast Ethernet, are being deployed while Integrated Services Digital Network (ISDN) is increasingly available to provide end-user access to combined voice and data services, particularly for Internet services. With the explosive growth of the Internet comes the need for high-capacity, high-speed, flexible data products and services. In addition, network operators must also support these standards and protocols in an increasing number of Local Area Networks (LANs), Metropolitan Area Networks (MANs), Wide Area Networks (WANs) and Global Area Networks (GANs).
As a result, network operators have become more demanding of communications equipment suppliers to provide cost effective solutions that enable operators to increase the overall capabilities of their networks while maintaining the highest network integrity.
Intelligent Network and Advanced Intelligent Network Switching
The Intelligent Network (IN) utilizes a highly complex protocol called SS7 to provide the basis for virtually all new telecommunications services. The IN architecture uses two separate but parallel paths; one to handle the voice or data traffic and a second to carry the signaling
information for call set up and routing. Network operators utilize the IN architecture to increase the efficiency of their networks by offloading signaling traffic onto the SS7 network, thus freeing up trunk line capacity needed for revenue generating traffic.
A second generation Intelligent Network called the Advanced Intelligent Network (AIN) is used by carriers and service providers seeking to differentiate themselves by offering advanced voice and data communications services. The AIN is a network architecture and a set of standards designed to allow network operators to create, deploy and modify these services quickly and economically. AIN services represent the merging of telephony with database information through SS7 signaling. Such services include Caller ID, voice messaging, personal number calling, Service Provider Local Number Portability and customized routing and billing as well as digital wireless services such as PCS and GSM.
Network operators are increasingly using SS7 networks as a source of competitive advantage to introduce new services through software changes in IN elements rather than in central office switches. The key network elements in the IN and AIN architecture are as follows:
Signal Transfer Point (STP) - An STP is a switch that handles the signaling messages used to set up telephone calls, queries external databases for routing and processing information and dispatches call handling instructions.
Service Switching Point (SSP) - An SSP is a component of the central office switch that sets up trunk connections. When an SSP identifies an AIN call, it routes a signaling message to the STP and awaits further instructions for call processing.
Service Control Point (SCP) - An SCP is a computer database that is accessed by STPs for customer call routing and other special information required for AIN services.
Additional components of the AIN architecture include Service Creation Environments (SCE) used to create new software-based services and Service Management Systems (SMS) used for billing and administration.
While SS7 has been available since the 1980s, to date it has been used principally to support intelligent services such as call set-up, 800 number calling and calling card verification. AIN standards and services have only recently emerged and the number and complexity of these services continue to grow. Services such as Caller ID, voice messaging, personal number calling, Service Provider Local Number Portability and customized routing and billing as well as digital wireless services such as PCS and GSM all require SS7 networking technology. ISDN, driven by the growth of the Internet and telecommuting, is also increasing the need for SS7 to provide the signaling connectivity for ISDN applications.
The accelerating rate of introduction of these new enhanced services enabled by SS7 has placed increasing demand for functionality and capacity on the installed base of older generation STPs. These devices are, in most cases, modified central office digital switches that
fundamentally were not optimized for AIN purposes. In addition, the telecommunications industry is evolving towards an architecture of more intelligent distributed switching in which software will allow for third party developers to be involved in creating applications.
The FCC's June 1996 order requiring that Incumbent Local Exchange Carriers (ILECs) provide competitors with the ability to transition customers to their networks without changing the customer's existing telephone number (i.e., Service Provider Local Number Portability) is having a dramatic impact upon the SS7 network and all ILECs.
With competition among network operators accelerating the deployment of AIN services, the strategic and economic value of sophisticated switching equipment optimized for SS7 applications is rapidly increasing. In addition, the importance of SS7 network-to-network operators mandates extremely high reliability and fault tolerance from the equipment as well as higher throughput and scaleability to support the rapid and unpredictable growth in enhanced AIN services. Companies that offer SS7-based products that are built on scaleable, open distributed architectures and enable AIN applications can benefit from this industry shift.
Diagnostic Tools
The proliferation of standards and protocols, growth of the Internet and Intranet and the increasing complexity of communications equipment and networks are creating a need for new, more sophisticated diagnostic systems capable of simultaneously testing multiple existing and emerging technologies. Network operators use diagnostic tools to efficiently monitor network performance, simulate network services and test interoperability of equipment. In an increasingly competitive environment, network operators need diagnostic systems that can reduce time to market by shortening the testing cycles necessary to model and implement new services. In addition, network operators require advanced diagnostic solutions that verify reliability of network elements, offer flexibility to support new standards and protocols as they emerge and enable them to centralize the testing expertise within their organizations.
Equipment manufacturers use diagnostic tools to design and test their products, such as switches, hubs and routers, for conformance to new and existing standards and to simulate network operating conditions. Manufacturers seek diagnostic tools that enable them to shorten their product development cycles and reduce their testing costs as these elements are principal contributors to product development time and expense. Furthermore, diagnostic tools with a flexible architecture are necessary to accommodate the rapid changes in technology.
PRODUCTS
Network Switching Products
EAGLE STP. The Company introduced the EAGLE STP in early 1992. The EAGLE STP is designed to meet the demands of SS7 switching and features a fully distributed, standards-based open architecture. Its distributed open architecture, high capacity and throughput are tailored to the SS7 switching needs of common carriers, local exchange carriers and PCS and cellular operators. The EAGLE STP is economically scaleable in configurations from 2 to 500 links. Ongoing software releases provide continual product improvement to meet the evolving needs of end users. As is required in SS7 networks, the EAGLE is sold and deployed in pairs, for redundancy. The EAGLE has the following features:
Designed for SS7 Standards. The EAGLE STP is designed to exceed the requirements for STPs as defined by Bell Communications Research (Bellcore) and presently supports both American National Standards Institute (ANSI) and International Telephone and Telegraph Consultative Commission (CCITT) SS7 standards. Bellcore defines the standards used primarily by the RBOCs for equipment used in their networks. See "Sales, Marketing and Support."
Powerful, Distributed Architecture. The EAGLE STP features a fully distributed, open architecture, utilizing Intel x86 microprocessors. The performance of the product results from its uniquely distributed architecture and the elimination of central processors. In the EAGLE STP, all SS7 network intelligence, including SS7 routing information, is distributed among up to 250 signaling interface processors. Each interface is interconnected via a high-speed, redundant bus subsystem. The bus subsystem utilizes two counter-rotating 125 Mbps busses and features proprietary switching and buffering algorithms, which minimize collision and guarantee message delivery between all attached interfaces. All interfaces attached to the bus subsystem are hot-swappable, so that interface repair or replacement does not affect system operation.
Software Architecture. The EAGLE STP's software is fully modular and written entirely in industry-standard programming languages. All software is released in complete versions, eliminating the need for interim patching and minimizing the potential for errors. EAGLE STP software is optimized for the capacity and redundancy features of the host hardware.
Open Software Interfaces. Users of the EAGLE STP can rapidly add new functionality and value-added services to their network, utilizing the EAGLE STP's open software interfaces. Features enabling these open interfaces include: STP LAN, which allows users to attach inexpensive general purpose computers to the EAGLE for network analysis; Database Transport Access, which allows users to change the behavior of protocols in their network without relying on the vendor's development cycles; and X.25 to SS7/IS.41 Protocol Conversion which allows first-generation legacy cellular switches to interwork with the more advanced SS7 cellular network. A significant new capability enabling Service Provider Local Number Portability on
the EAGLE allows carriers to eliminate the need for significant numbers of dedicated Service Control Point (SCP) general purpose computers.
Ease of Operation and Maintenance. EAGLE STP installations generally do not require any enhancements to the central office's power supply, cooling system or flooring and require less than 36 square feet of space. An EAGLE STP can usually be installed in less than one week. No scheduled maintenance is required to support the EAGLE STP, eliminating the requirement for on-site personnel.
Prices for a pair of EAGLE STPs typically range from approximately $250,000 to $5,000,000, depending on configuration and associated software applications.
Network Diagnostics Products
Equipment manufacturers and network service providers utilize Tekelec's diagnostic products to perform a wide variety of test applications that simulate, monitor and analyze network communications infrastructures. The Company's proprietary simulation language enables the controlled imitation of communications devices and nodes in conjunction with variable traffic loads. Its analysis software packages support full-rate monitoring, selective capture and triggering of digitized pulses transmitted through a network. Uses of the Company's diagnostic products include the following:
- Designing Communications Equipment. By simulating existing and emerging communications devices and nodes (e.g., digital switches, STPs, SCPs, routers and intelligent hubs) and protocols (e.g., ATM, High-Speed Frame Relay, SS7, Fast Ethernet, SMDS, ISDN, FDDI, BERT and Token Ring), the Company's products enable engineers to quickly design communications devices that will transition seamlessly into emerging network infrastructures, minimizing potential breakdowns of network components deployed throughout the network.
- Ensuring Product Reliability. By simulating actual network conditions within an operating environment, including protocol errors and other network failures, the Company's products can help ensure that communications equipment manufacturers produce devices that will operate error-free, thus accelerating time to market and potentially reducing costly failures after installation.
- Verifying Certification. By executing conformance and performance test suites, network operators and manufacturers use the Company's products to rapidly verify that communication devices meet specified standards (e.g., ATM, Frame Relay, SS7, ISDN and BERT).
- Monitoring Networks. By collecting and analyzing traffic, the Company's products can monitor the health of networks on a continuous basis and provide advance notice of potential system failures, allowing quicker service restoration or even service failure prevention.
- Troubleshooting. By identifying the specific location and type of communication error, the Company's products can isolate which network device has failed (e.g., router, intelligent hub, switch port, edge switch). The Company's products help technicians and engineers repair devices and networks promptly and minimize expensive downtime associated with service failure.
The Company's principal intelligent network diagnostics product is the MGTS. The MGTS system is used primarily for SS7-based device simulation, load generation and network monitoring. In its fully configured form, the system includes Tekelec's proprietary programming tool, PASM, that can be used to design customized testing scenarios. The MGTS software runs on Sun Microsystems and Hewlett-Packard UNIX operating systems with an X-Windows, Motif graphical user interface. The MGTS system supports a number of protocols, including SS7, AIN, GSM, IS.41, CDMA and PCS. The system is scaleable and can support any number of links with multiple systems and can be networked over large geographic areas.
The Company's principal data network diagnostics products are:
Chameleon(R) Open. The Chameleon Open is a multiprotocol communications analyzer that features a flexible modular architecture, multiple LAN, MAN, WAN and GAN technologies and protocols, simultaneous interoperability between different technologies, and full bandwidth capabilities from low data transmission rates to high-speed optical interfaces. Technologies supported include ATM, SMDS, High-Speed Frame Relay, FDDI, ISDN, WAN DS-1/E1, Fast Ethernet, Ethernet, BERT and Token Ring. The Chameleon Open's user-friendly interface allows customers to quickly diagnose their network or switch performance and detect any upper layer violations within the protocol stack utilized within the network or switch fabric. The Chameleon Open's products are available in two configuration options: portable 6 slot test application (Chameleon Open) or the rack-mounted 12 slot test application (Chameleon Open-X). Each Chameleon Open operates with the same hardware and software packages, thus providing our customers with the most flexible test applications for portability and remote testing.
Chameleon 32+. The Chameleon 32+ protocol analyzer supports a variety of protocols and technologies including SS7, ISDN, IS-41, X.25/X.75, SNA and Frame Relay enabling network operators as well as equipment manufacturers to perform active network diagnostics, troubleshoot network or device problems on existing network equipment, and validate new equipment being developed. The Chameleon 32+ can be utilized for extensive monitoring and simulation testing for a wide-array of protocols and interfaces including: X.25, X.75, QLC, PSH, SNA, Async, Bisync, ISDN, SS7, IS-41, OSI, DPNSS, DASS 2, DMI, V.120, DDCMP, U Interface, Frame Relay, ASAI, SCAI, Digital Test Access and BERT.
List prices for the Company's principal diagnostic products range from approximately $14,000 to $150,000 depending on configuration.
Compliance with Industry Standards
The Company's products are designed to meet a significant number of standards and regulations, some of which are evolving as new technologies are deployed. In the United States, the Company's products must comply with various regulations defined by the FCC and Underwriters Laboratories as well as standards established by Bellcore and the ANSI. Internationally, the Company's products must comply with standards established by telecommunications authorities in various countries as well as with recommendations of the CCITT and the International Standards Organization (ISO). The failure of the Company's products to comply, or delays in compliance, with the various existing and evolving standards could have a material adverse effect on the Company's business and operating results.
PRODUCT DEVELOPMENT
The communications market is characterized by rapidly changing technology, evolving industry standards and frequent new product introductions. Standards for new services such as AIN, PCS and ATM are still evolving. As these standards and the demand for services and applications evolve, the Company intends to adapt its products or develop and support new products. The Company solicits product development input through discussions with users of the Company's products and participation in industry organizations and international standards committees, such as the Telecommunications Industry Association (TIA) and the ATM Forum, and by closely monitoring the activities of the ITU, ETSI, ISO and Bellcore.
The Company's network switching product development group is principally focused on the release of new software versions to incorporate enhancements desired by customers and compliance with standards to enable EAGLE to address additional domestic and international markets. In addition, the Company plans continued improvement of hardware components to improve performance and capabilities.
The Company's diagnostic product development activities are principally focused on expanding the capabilities of the MGTS and Chameleon products, including their interfaces, software modules and protocol capabilities for emerging technologies such as AIN and ATM, and adapting these products for the emerging network operations market. From time to time the Company engages in development projects for special applications for customers. The Company is usually free to use such technology in future products which are not competitive with the specific application for which the development work was performed.
The Company utilizes a common standards-based open architecture approach in the design of its products. This approach facilitates and accelerates the development of new applications and products and permits the Company to enhance existing products by substituting new hardware or software modules. This modular approach also helps to extend the life cycles of the Company's products, ensure compatibility among successive generations of products and simplify manufacturing.
The Company's success depends, to a substantial degree, upon its ability to respond rapidly to changes in technology, industry standards and customer requirements. This requires the timely selection, development and marketing of enhancements and new products on a cost-effective basis. The Company has invested and expects to continue to invest substantial resources in the development of new products and technology and product enhancements. There can be no assurance that the Company's product development efforts will result in commercially successful new or enhanced products or that the Company's products will not be rendered obsolete or noncompetitive by changing technology or new competitive products.
Products as complex as those offered by the Company may contain undetected errors or failures when first introduced or as new versions are released. Such errors have occurred in the past. Although the Company's products have not experienced any significant errors, such errors, particularly those that result in a failure of the Company's switching products, could have a material adverse effect on the Company's customer relationships, business and operating results. There can be no assurance that, despite thorough testing by the Company and by customers, errors will not be found in the Company's products.
Product development includes expenditures for research and development, new product design, enhancement of existing products and selective acquisition of technology. Research and development expenses amounted to approximately $21.0 million, $17.1 million and $15.1 million in 1997, 1996 and 1995, respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
The Company's development facilities are located in California, North Carolina and Japan. As of March 2, 1998, the Company had 170 persons engaged full time in product development. The Company believes that recruiting and retaining highly skilled engineering personnel is essential to its success. To the extent that the Company is not successful in attracting and retaining its technical staff, its business and operating results would be adversely affected.
SALES, MARKETING AND SUPPORT
The Company's sales and marketing strategy for its EAGLE switching product is to continue to focus on sales to the U.S. ITC, cellular and RBOC markets and to pursue new customer relationships and international opportunities. Current and future strategic alliances will continue to be an integral component of the strategy to reach broader markets and attain greater market presence. The network switching sales cycle typically ranges from three to 18 months depending on the complexity of a customer's planning, bidding and implementation requirements.
RBOCs and other large service providers require their suppliers to continuously participate in Bellcore Technical Auditing programs as new hardware and software features are introduced. Bellcore provides Technical Auditing Services ("technical audits") to suppliers of network equipment assessing the supplier's conformance to certain Bellcore standards which have been adopted by RBOCs and other service providers. Ongoing technical audits of the EAGLE STP are conducted by Bellcore and the results of these audits are available to the Company and its customers. Bellcore does not endorse or certify any product or service or guarantee its performance. Failure or delay in obtaining favorable technical audit results could have a material adverse effect on the Company's ability to sell its EAGLE STP to this large segment of the communications carrier market.
The Company's sales and marketing strategy for its diagnostic products is to initially target customers' research and development departments designing the next generation of communications equipment and then to target the manufacturing groups and ultimate users in network operations as equipment is manufactured, certified and installed. This strategy permits the Company to gain expertise in testing emerging technologies in the early stages of their life cycles.
Domestic Distribution. The Company sells its switching and diagnostic products in the U.S. principally through separate direct sales forces and, for the EAGLE STP, also through strategic relationships with Lucent and Stratus. The Company's direct sales forces operate out of the Company's headquarters in Calabasas, California and its regional offices located in Illinois, New Hampshire, New Jersey, North Carolina, Northern California and Texas.
International Distribution. The Company sells its switching products internationally through its direct sales force and a distributor in Korea. The Company sells its diagnostic products internationally through a network of 25 distributors and a wholly owned subsidiary in Japan. The Company's Japanese subsidiary, which presently sells only diagnostic products, generated approximately 13%, 22% and 22% of the Company's revenues for 1997, 1996 and 1995, respectively.
Tekelec-Airtronic, S.A., an affiliate of the Company, and its wholly owned subsidiaries are the distributors of the Company's diagnostic products in France, Italy, Germany, the Netherlands, Belgium, Luxembourg, Portugal, Spain and China. Nineteen additional independent companies distribute the Company's products in other Western European countries, the Far East (other than Japan), Australia, Mexico, Puerto Rico, New Zealand, Latin America, the Middle East and South Africa. Distributors typically purchase products directly from the Company pursuant to agreements that are exclusive for a particular territory and are cancelable by either party upon 90 days notice. Export sales through international distributors accounted for approximately 10%, 13% and 17% of revenues in 1997, 1996 and 1995, respectively.
The Company typically invoices export sales in U.S. dollars and its foreign subsidiary invoices sales in its local currency. International sales are subject to inherent risks, including longer payment cycles, unexpected changes in regulatory requirements and tariffs, difficulties in staffing and managing foreign operations and distributors, greater difficulty in accounts receivable collection and potentially adverse tax consequences. Additionally, exchange rate fluctuations on foreign currency transactions and translations arising from international operations may contribute to fluctuations in the Company's business and operating results. Fluctuations in exchange rates could also affect demand for the Company's products. In addition, due to the technical nature of the Company's products, certain of the Company's export sales must be licensed by the Office of Export Administration of the U.S. Department of Commerce. The Company's products are subject, in certain international jurisdictions, to reduced protection for the Company's copyrights and trademarks. See Notes A, E and N to consolidated financial statements.
Strategic Relationships. The Company believes that it can improve market penetration and acceptance for its EAGLE products through strategic relationships with leading communications equipment suppliers. These suppliers have long-standing relationships with public carriers and provide a broad range of services to these carriers through their existing sales and support networks. Tekelec seeks strategic relationships that (i) enhance the Company's presence in its target markets, (ii) offer products that complement the EAGLE to provide value-added networking solutions and (iii) leverage the Company's core technologies enabling the communications equipment suppliers to develop enhanced products with market differentiation that can be integrated with the EAGLE platform.
The Company has a non-exclusive distribution agreement with Lucent, an exclusive distribution agreement with Daewoo and a marketing agreement with Stratus for the EAGLE STP. The Company believes that these relationships demonstrate recognition of the technical advantages of the EAGLE STP. The Company believes that these agreements provide the Company with additional opportunities to penetrate the SS7 network switching marketplace. Through the Company's relationships with Lucent, Daewoo and Stratus, the Company has enhanced its market presence and its ability to access leading telephone companies. In general, these agreements can be terminated by either party on limited notice and,
except for Daewoo, do not require minimum purchases. Furthermore, Lucent is not precluded from selling products that are competitive with the Company's products. A termination of the Company's relationship with Lucent or the sale of competing products by Lucent could adversely affect the Company's business and operating results.
Advertising and Promotion. The Company uses advertising in trade journals, exhibitions at trade shows, a presence on the Internet via the World Wide Web and direct mail to promote awareness of the Company and its products. The Company has been most successful in generating sales through demonstrations of its products and, therefore, focuses its advertising and promotional activities on generating opportunities for demonstrations. The Company also provides extensive training for, and merchandising aids to, its direct sales force and distributors. These include sales brochures, demonstration systems and promotional product literature.
Services, Support and Warranty. The Company believes that customer service, support and training are important to building and maintaining strong customer relationships. The Company services, repairs and provides technical support for its products. The Company maintains an in-house repair facility and provides ongoing training and telephone assistance to customers and international distributors from its headquarters in Calabasas, California, certain U.S. regional offices and its Japanese subsidiary. The Company's Technical Assistance Center in Morrisville, North Carolina, supports the Company's switching products on a 24 hour-a-day, seven day-a-week basis. Support services include 24-hour technical support, remote access diagnostic and servicing capabilities, extended maintenance and support programs, comprehensive technical customer training, extensive customer documentation, field installation and emergency replacement. The Company typically warrants its products against defects in materials and workmanship for one year after the sale and thereafter offers extended service warranties. To date, warranty expenses have been within management's expectations.
CUSTOMERS
During 1997, the Company shipped approximately 45 pairs of EAGLE STPs to 25 customers worldwide and 900 units of its diagnostic products to over 220 customers worldwide. The Company's customers include end users and marketing intermediaries. End users for the Company's EAGLE STP consist primarily of U.S. ITCs, PCS and cellular operators, interexchange carriers, competitive access providers, local exchange carriers and RBOCs. End users for the Company's diagnostic products include long-distance carriers, telephone operating companies, communications equipment manufacturers, wireless and cellular network operators and government agencies. Sales to Bell Atlantic Corporation, which consisted primarily of switching products, accounted for 23% of the Company's 1997 revenues. No other customer accounted for more than 10% of the Company's revenues in 1997.
The Company's diagnostic business is substantially dependent on repeat business and, therefore, customer satisfaction and loyalty are crucial to its long-term success. Many of the
Company's largest customers in 1997 were purchasers of the Company's diagnostic systems in prior years.
Federal and state agencies, including the FCC, regulate many of the Company's domestic customers. The FCC and a majority of the states have enacted or are considering regulations based upon alternative pricing methods. Uncertainty regarding future pricing policies and the cost effectiveness of deploying public network services may affect demand for communications products, including the Company's products. However, the Company believes that deregulation of the telecommunications market and new methods of price regulation as evidenced by the passage of the Telecommunications Act of 1996 could increase the demand for products such as those offered by the Company which enhance the efficiency of the network or allow the expedited introduction of new revenue-producing services.
BACKLOG
Backlog for switching products typically consists of contracts or purchase orders for both product delivery scheduled within the next 12 months and EAGLE STP extended service warranty to be provided over the next five years. Orders for the Company's diagnostic products are usually placed by customers on an as-needed basis, and the Company has typically been able to ship these products in 15 to 30 days after the acceptance of the purchase order. Because of variations in the magnitude and duration of orders received by the Company, and customer delivery requirements, which may be subject to cancellation or rescheduling, the Company's backlog at any particular date may not be a meaningful indicator of future financial results. At December 31, 1997, the Company's backlog amounted to approximately $59.0 million, of which $28.7 million related to EAGLE STP service warranty. This compared to $28.0 million at December 31, 1996, of which $16.6 million related to EAGLE STP service warranty.
MANUFACTURING
The Company's manufacturing operations consist of the procurement and inspection of components, final assembly, burn-in, quality control testing and packaging. Printed circuit boards, chassis and most of the other major components used in the Company's products are subassembled to the Company's specifications by independent contractors with whom the Company generally has had long-standing working relationships. The assembled components are then delivered to the Company's production facilities for final assembly, quality control testing and product configuration, including software installation. The Company's products incorporate the Company's proprietary software as well as software licensed from third parties. The Company believes that its use of independent contractors for subassembly coupled with in-house final assembly improves production planning, increases efficiency, reduces costs and improves quality.
The Company has a computerized manufacturing inventory control system which integrates and monitors purchasing, inventory control and production. The Company's quality control process tests for reliability and conformance with product specifications and utilizes certain automated software test procedures. The Company received ISO 9002 certification from Bellcore in 1995, ISO 9001 certification from Bellcore for its network switching operation in 1996 and for its intelligent network diagnostics operation in 1997 and is currently undergoing the processes for ISO 9001 certification for its remaining operations.
The Company has obtained CE Mark registration for its principal diagnostic products to meet EC regulations for shipment of products into Europe. As new hardware and software features or new products are introduced, the Company routinely engages in the process of obtaining CE Mark registration as needed. Failure or delay in the Company's ability to obtain CE Mark registration for its products could have a material impact on future sales in Europe.
The Company generally uses industry standard components for its products which are available from multiple sources; however, a few key components, such as certain microprocessors, video displays and power supplies, are currently only available from single suppliers. Vendor supply agreements often include provisions requiring the vendor to maintain a specified level of key components. The Company believes that inventory levels of key components, including those maintained by vendors, are adequate. In addition, should any components become unavailable the Company believes that functionally similar, if not identical, components could be obtained, and any necessary internal redesign accomplished, without materially adversely impacting the Company. To date, the Company has not experienced any significant delays in obtaining components from its suppliers and independent contractors. However, the electronics industry is subject to rapid technological change. Components become obsolete and are discontinued by manufacturers as new succeeding generations are introduced. An inability to obtain essential components, if prolonged, could materially adversely affect the Company's business and operating results and damage customer relationships.
COMPETITION
Network Switching Products. The market for STPs is highly competitive and has been highly concentrated among a limited number of dominant suppliers. The Company expects competition to increase in the future from existing and new competitors. The Company presently competes with DSC Communications Corp. and to a lesser extent with a limited number of other manufacturers, all of which have significantly greater financial, marketing, manufacturing and other resources and larger installed customer bases than the Company. The Company believes that its long-term success will depend on its ability to further penetrate the major telephone companies, including the RBOCs, offer products with the best price/performance profile and be responsive to customers' needs for new features and services.
The Company believes that the principal competitive factors in the network switching products market are product price/performance characteristics and reliability, customer service and support and the supplier's financial resources, marketing and distribution capability. The Company anticipates that responsiveness in adding new features will become an increasingly important competitive factor. While the Company's competitors have greater financial resources, the Company believes it competes favorably in other respects. However, there can be no assurance that new entrants or established competitors with greater financial resources have not or will not offer products superior in performance, quality, service and support to, and/or lower in price than, those of the Company.
Diagnostic Products. The communications diagnostic market is intensely competitive and subject to rapid technological change and evolving industry standards. The Company primarily competes in the high performance segment of the market. Its principal competitor is Hewlett-Packard. The Company also competes with a number of other manufacturers, some of which have greater financial, marketing, manufacturing and technological resources than the Company. The Company believes that its long-term success will depend in part on its ability to be a leader in offering products that address new emerging industry standards and to offer a broad line of integrated applications.
The Company believes that the principal competitive factors in the communications diagnostic market in which the Company competes are product/price performance, functionality and reliability, timely introduction of new products, breadth of integrated product applications, marketing and distribution capability and customer service and support. The Company believes that it competes favorably, although there can be no assurance that new or established competitors will not offer products superior to or lower in price than those of the Company.
INTELLECTUAL PROPERTY
The Company relies on a combination of trade secret, copyright and trademark laws and contractual restrictions to establish and protect proprietary rights in its products. The Company generally does not hold patents with respect to its products. The Company has entered into confidentiality and invention assignment agreements with its employees, and enters into non-disclosure agreements with its suppliers, distributors and appropriate customers among others so as to limit access to and disclosure of its proprietary information. There can be no assurance that these statutory and contractual arrangements will prove sufficient to deter misappropriation of the Company's technologies or independent third-party development of similar technologies. The laws of certain foreign countries in which the Company's products are or may be developed, manufactured or sold may not protect the Company's products or intellectual property rights to the same extent as do the laws of the United States and thus make the possibility of piracy of the Company's technology and products more likely. The Company believes that, because of the rapid pace of technological change in the communications market, legal protections for its products are less significant factors in the Company's success than the
knowledge, ability and experience of the Company's employees, the frequency and timely introduction of product enhancements and the quality of support services provided by the Company.
The communications industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. From time to time, third parties may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies that are important to the Company. There are no currently pending material claims that the Company's products, trademarks or other proprietary rights infringe the proprietary rights of third parties. However, there can be no assurance that the Company will not receive communications from third parties in the future asserting that the Company's products infringe or may infringe the proprietary rights of third parties. In its distribution agreements and certain of its major customer agreements, the Company agrees to indemnify its customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. In the event of litigation to determine the validity of any third-party claims, such litigation, whether or not determined in favor of the Company, could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel from productive tasks. In the event of an adverse ruling in such litigation, the Company might be required to discontinue the use and sale of infringing products, expend significant resources to develop non-infringing technology or obtain licenses from third parties. There can be no assurance that licenses from third parties would be available on reasonable commercial terms, if at all. In the event of a successful claim against the Company and the failure of the Company to develop or license a substitute technology, the Company's business and operating results would be materially adversely affected.
EMPLOYEES
At March 2, 1998, the Company had 442 employees, comprising 156 in sales, marketing and support, 65 in manufacturing, 170 in research, development and engineering and 51 in management, administration and finance. The Company believes that its future success will depend in part on its ability to attract, motivate and retain highly qualified personnel. Most employees hold stock options and/or participate in an employee stock purchase plan. None of the Company's employees is represented by a labor union, and the Company has not experienced any work stoppages. The Company believes that its employee relations are excellent.
GLOSSARY
ITEM 2.
ITEM 2. PROPERTIES.
The Company's executive offices, as well as its principal manufacturing and data network diagnostics product engineering and marketing operations, are located in an approximate 58,000 square-foot facility in Calabasas, California, under a lease which expires in November 2004 with an option to extend for an additional five years.
The Company also occupies a 68,000 square-foot facility in Morrisville, North Carolina, under a lease expiring in March 2003, primarily for engineering, product development, customer support and regional sales activities for its network switching and intelligent network diagnostics products. The Company also has five regional sales offices occupying an aggregate of approximately 8,300 square feet under leases expiring between 1998 and 2000 in Campbell, California; Lombard, Illinois; Bedford, New Hampshire; Iselin, New Jersey and Irving, Texas. The Company's Japanese subsidiary occupies approximately 10,600 square feet in Tokyo under leases expiring between April 1998 and November 1998. The Company believes that its existing facilities will be adequate to meet its needs at least through 1998. The Company believes it will be able to obtain additional space when and as needed on acceptable terms.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
Inapplicable.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Inapplicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock is traded over-the-counter on the Nasdaq National Market System under the symbol TKLC. The following table sets forth the high and low closing sales prices for the Common Stock, as reported on the Nasdaq National Market System. As of March 2, 1998, there were 210 record holders and approximately 10,000 beneficial holders of the Company's Common Stock based on information provided by the Company's transfer agent and proxy solicitation agent.
The Company has never paid a cash dividend. It is the present policy of the Company to retain earnings to finance the growth and development of its business and, therefore, the Company does not anticipate paying cash dividends on its Common Stock in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
The statement of operations data included in the selected consolidated financial data set forth below for the years ended December 31, 1997, 1996 and 1995 and the balance sheet data set forth below as of December 31, 1997 and 1996 are derived from, and are qualified in their entirety by reference to, the Company's audited consolidated financial statements and notes thereto. The statement of operations data set forth below for the years ended December 31, 1994 and 1993 and the balance sheet data set forth below as of December 31, 1995, 1994 and 1993 are derived from audited consolidated financial statements of the Company which are not included herein.
FIVE-YEAR SELECTED FINANCIAL DATA
(1) Earnings (Loss) per share and weighted average number of shares outstanding have been retroactively adjusted to reflect the two-for-one stock splits effected August 22, 1997 and March 17, 1995, and have been computed under the provisions of SFAS No. 128 "Earnings Per Share." See Note M to consolidated financial statements.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion should be read in conjunction with, and is qualified in its entirety by, the consolidated financial statements and the notes thereto included in this Annual Report on Form 10-K. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods.
CORPORATE ORGANIZATION
The Company is organized into three divisions: Network Switching, Intelligent Network Diagnostics and Data Network Diagnostics.
The Network Switching Division develops and supplies the Company's EAGLE product, a high-capacity packet switching platform enabling wireline and wireless network operators to deliver intelligent network services.
The Intelligent Network Diagnostics Division and Data Network Diagnostics Division develop and supply diagnostic products for the communications marketplace. These products, principally the MGTS products for the Intelligent Network Diagnostics Division and the Chameleon family of products for the Data Network Diagnostics Division, have been the foundation of the Company's business and the source of the technology and expertise that has facilitated the Company's entry into other markets.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the percentages that statement of operations items bear to total revenues:
The following table sets forth, for the periods indicated, the revenues by principal product line as a percentage of total revenues:
The following table sets forth, for the periods indicated, the revenues by geographic territory as a percentage of total revenues:
1997 COMPARED WITH 1996
Revenues
The Company's revenues increased by $53.0 million, or 73%, during 1997 due to higher sales of switching products and intelligent network diagnostics products. Sales of data network diagnostics products decreased both in dollars and as a percentage of total sales.
Revenues from switching products increased by 173%, or $47.1 million, to $74.3 million due primarily to increased EAGLE STP market acceptance principally in the U.S., and the addition of sales of the Company's Local Number Portability (LNP) and related Local Service Management System (LSMS) features. Additionally, the EAGLE STP average selling price increased as a result of the Company's sales of larger systems to the Regional Bell Operating Company (RBOC) market. In 1997, 45 pairs of EAGLE STPs were sold compared with 26 in 1996.
Revenues from intelligent network diagnostics products increased by 40%, or $9.4 million, to $33.1 million. This increase was primarily driven by strong demand for the Company's MGTS products in all geographic markets, particularly North America.
Revenues from data network diagnostics products decreased by 16%, or $3.5 million, to $17.7 million primarily due to lower sales in all markets for both the Chameleon Open and the Company's older Chameleon products. The Company has taken steps to expand its Chameleon products' reach into the network operator market including the introduction of software applications addressing specific needs of this market which could provide additional sales opportunities, initially in the domestic market.
Revenues in North America increased by $49.5 million, or 118%, as a result of higher switching and MGTS product sales, partially offset by lower Chameleon product sales. Revenues in Japan increased by $638,000, or 4%, due primarily to higher sales of MGTS products partially offset by the impact of exchange rate fluctuations on currency translations in 1997. Other international revenues increased by $2.8 million, or 19%, primarily due to higher switching product sales in the rest of the world and higher MGTS product sales in Europe.
The impact of exchange rate fluctuations on currency translations, which consisted primarily of the translation of Japanese yen into U.S. dollars, decreased revenues by approximately $1.9 million, or 2%, and did not have a significant impact on net income.
The Company believes that its future revenue growth depends in large part upon a number of factors, including the continued market acceptance of the Company's products, particularly the EAGLE STP product, and new applications such as the Company's LNP and related LSMS features for its EAGLE STP. In 1997, the Company experienced significant revenue growth, particularly in its switching products, in part because of the initial success of its STP product in the RBOC market and the market acceptance of its LNP and LSMS solutions.
The Company expects that switching product sales will continue to grow in 1998 both in dollars and as a percentage of total revenues, although at a lower percentage rate of growth than in 1997.
Gross Profit
Gross profit as a percentage of revenues increased from 63% in 1996 to 67% in 1997, due primarily to the addition of sales of higher margin LNP and LSMS features and improved manufacturing efficiencies due to higher sales volumes. Changes in the following factors, among others, may affect gross profit: product and distribution channel mix, competition, customer discounts, supply and demand conditions in the electronic components industry, internal manufacturing capabilities and efficiencies, foreign currency fluctuations and general economic conditions.
Research and Development
Although research and development expenses increased by $3.9 million, or 23%, such expenses decreased as a percentage of revenues from 24% in 1996 to 17% in 1997. The dollar increase was attributable primarily to ongoing development expenses in the Network Switching Division with respect to the Company's LNP and LSMS features for the EAGLE STP product, and consisted principally of expenses incurred in connection with the hiring of additional personnel and higher depreciation expense resulting from equipment acquisitions. Additionally, research and development expenses increased as a result of the accrual of certain costs for performance-related award programs.
The Company intends to continue to make substantial investments in product and technology development and believes that its future success depends in large part upon its ability to continue to enhance existing products and develop new products that maintain its technological competitiveness.
Selling, General and Administrative
Although selling, general and administrative expenses increased by $5.1 million, or 17%, such expenses decreased as a percentage of revenues from 41% in 1996 to 28% in 1997. The increase in dollars was attributable primarily to increased infrastructure costs to meet the needs of the growing EAGLE installed base and to support higher sales levels of switching and intelligent network diagnostics products, and the accrual of certain costs for performance-related award programs.
Income Taxes
During 1997, the Company recorded a tax benefit of $9.0 million resulting from a reduction of its valuation allowance for deferred taxes. The reduction in the valuation allowance was based on the Company's improved income trend and management's assessment of various uncertainties related to the future realization of its deferred tax benefits. For the year ended December 31, 1997, excluding the one-time tax benefit, the Company had a tax provision of $9.7 million, resulting in an effective tax rate of 33%. Although the Company's 1996 pretax results showed a loss, the Company had a tax provision of $2.2 million, which consisted principally of
foreign taxes on the income of the Company's Japanese subsidiary and reflected the Company's then inability to recognize a benefit for its U.S. loss and credits carryforwards.
Interest, Net
Net interest income increased by $685,000 primarily as a result of higher average investment balances in 1997.
1996 COMPARED WITH 1995
Revenues
The Company's revenues decreased by $3.2 million, or 4%, during 1996 due to lower sales of data network diagnostics products, partially offset by higher sales of switching and intelligent network diagnostics products.
Revenues from data network diagnostics products decreased by 32%, or $9.8 million, to $21.2 million, primarily due to lower sales in all markets for both the Chameleon Open and the Company's older Chameleon products.
Revenues from intelligent network diagnostics products increased by 15%, or $3.1 million, to $23.7 million. This increase was primarily driven by strong demand for the Company's MGTS products in North America and Japan.
Revenues from switching products increased by 15%, or $3.5 million, to $27.2 million due primarily to increased EAGLE STP sales worldwide, particularly internationally. This increase was lower than anticipated principally due to delays in RBOC's SS7 network replacement and expansion. In 1996, 26 pairs of EAGLE STPs were sold compared with 28 in 1995. The increased revenues despite lower unit sales were due to larger average system sizes, combined with increased service revenues due to growth of the EAGLE installed base.
Revenues in North America decreased by $1.4 million, or 3%, as a result of lower Chameleon product sales, partially offset by higher MGTS and switching product sales. Revenues in Japan decreased by $938,000, or 6%, due to lower sales of Chameleon products and the impact of exchange rate fluctuations on currency translations in 1996, partially offset by strong MGTS product sales. Other international revenues decreased by $862,000, or 6%, primarily due to lower sales of both diagnostic product lines, partially offset by higher switching product sales.
The impact of exchange rate fluctuations on currency translations decreased revenues by approximately $2.4 million, or 3%, and increased net loss by $257,000, or 11%.
Gross Profit
Gross profit as a percentage of revenues decreased from 67% in 1995 to 63% in 1996, due primarily to increased competition in the EAGLE product market and lower sales of higher margin diagnostic products.
Research and Development
Research and development expenses increased by $2.0 million, or 13%, and represented 24% of revenues in 1996, compared to 20% in 1995. The increase was attributable primarily to the hiring of additional personnel in the Network Switching Division, expenses incurred in connection with the Bellcore technical audits of the Company's EAGLE product and higher depreciation expense as a result of equipment acquisitions for EAGLE research and development.
Selling, General and Administrative
Selling, general and administrative expenses increased by $2.2 million, or 8%, and represented 41% of revenues in 1996, compared to 37% in 1995. The increase was attributable primarily to severance charges, recruiting activity and relocation expenses incurred in connection with personnel changes.
Restructuring
During the third quarter of 1996, the Company recorded restructuring charges amounting to $327,000 which represent severance pay, benefit costs and other costs related to the consolidation of the Company's Ohio research facility into the Company's North Carolina facility. See Note F to consolidated financial statements.
Income Taxes
Although the Company's pretax results showed a loss in 1996, the Company had a tax provision of $2.2 million, compared to $2.1 million and an effective tax rate of 25% in 1995. The provisions for both periods were principally foreign taxes on the income of the Company's Japanese subsidiary. The 1996 provision was impacted by the Company's then inability to recognize a benefit for its U.S. loss and credits carryforwards, which remained available to reduce future U.S. taxes. In 1995, the Company was able to utilize a portion of its prior years' U.S. loss carryforwards, and consequently provided for taxes on its U.S. taxable income at the federal alternative minimum tax rate and applicable state tax rates.
Interest, Net
Net interest income increased by $554,000 primarily as a result of higher average investment balances in 1996.
LIQUIDITY AND CAPITAL RESOURCES
During 1997, cash and cash equivalents increased by $21.5 million to $38.7 million, after a net transfer of approximately $4.7 million to short-term and long-term investments. Operating activities, net of the effects of exchange rate changes on cash, provided $24.0 million, financing activities provided $8.8 million and $6.6 million was used for capital expenditures.
Accounts receivable, including amounts due from related parties, increased by 62% during 1997 due primarily to increased sales levels. Inventories increased by 39% during 1997 primarily to support the increased sales levels and the expanded breadth of the Company's products, particularly the new LNP and LSMS features for the EAGLE STP platform. Accrued payroll and related expenses increased by 70% due to the accrual of certain costs for performance-related award programs. Deferred revenues increased by 179% primarily as a result of increased extended warranty service revenues which are recognized ratably over the warranty period.
Capital expenditures were $6.6 million during 1997 and represented the planned acquisition of equipment principally for research and development, manufacturing operations and facility expansion. There are currently no significant commitments for capital expenditures; however, the Company expects capital expenditures will be at least at a comparable level in 1998, principally for the acquisition of equipment for research and development, sales demonstration and manufacturing operations.
Net cash provided by financing activities in 1997 was $8.8 million, which represented proceeds from the issuance of Common Stock upon the exercise of options and warrants.
The Company has a $10 million line of credit with a U.S. bank, collateralized by substantially all of the Company's assets and bearing interest at, or in some cases below, the U.S. prime rate (8.5% at December 31, 1997). There have been no borrowings under this credit facility, which expires June 30, 1998 if not renewed. Under the terms of this facility, the Company is required to maintain certain financial ratios and meet certain net worth and indebtedness tests for which the Company is in compliance.
The Company's Japanese subsidiary has collateralized yen-denominated lines of credit with Japan-based banks, primarily available for use in Japan, amounting to the equivalent of $2.7 million with interest at the Japanese prime rate (1.625% at December 31, 1997) plus 0.125% per annum which expire between August 5, 1998, and March 31, 1999, if not renewed. There have been no borrowings under these lines of credit.
Upon the expiration of the above-described credit facilities, the Company believes that, if necessary, it would be able to arrange for credit facilities on terms generally no less favorable than those described above.
There were no borrowings by the Company in 1997. The Company's weighted average short-term borrowing rate in 1996 was 11.6%.
The Company believes that existing working capital, funds generated from operations and its current bank lines of credit are sufficient to satisfy anticipated operating requirements at least through 1998. Nonetheless, the Company may seek additional sources of capital as necessary or appropriate to fund acquisitions or to otherwise finance the Company's growth or operations; however, there can be no assurance that such funds, if needed, will be available on favorable terms, if at all.
Foreign Exchange
International operations are subject to certain opportunities and risks, including currency fluctuations. In 1997, 1996 and 1995, the percentages by which weighted average exchange rates for the Japanese yen strengthened (weakened) against the U.S. dollar were (9%), (18%) and 9%, respectively.
The change in cumulative translation adjustments in 1997 was due primarily to the weakening of the Japanese yen against the U.S. dollar when comparing the exchange rate at December 31, 1997 to that of December 31, 1996. Realized exchange gains (losses) are recorded in the period when incurred, and amounted to $(273,000), $(180,000) and $(210,000) in 1997, 1996 and 1995, respectively. Exchange gains and losses include the remeasurement of certain currencies into functional currencies and the settlement of intercompany balances.
Statements of Financial Accounting Standards Not Yet Adopted
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." This statement establishes standards for the reporting and display of comprehensive income and its components in a full set of general purpose financial statements. Comprehensive income generally represents all changes in shareholders' equity during the period except those resulting from investments by, or distributions to, shareholders. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997 and requires restatement of earlier periods presented. The Company believes that comprehensive income in future periods will fluctuate as a result of changes in the cumulative translation account, which is a component of comprehensive income. Net unrealized gains and losses on the Company's available-for-sale securities, which have not been significant, are also a component of comprehensive income.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 establishes standards for public enterprises' reporting of information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997 and requires restatement of earlier periods presented. Management is currently evaluating the requirements of SFAS No. 131.
In October 1997, Statement of Position (SOP) 97-2, "Software Revenue Recognition" was issued, which addresses software revenue recognition under generally accepted accounting principles, and which is effective for fiscal years beginning after December 15, 1997. The Company believes it is currently in compliance with SOP 97-2 and does not anticipate any changes in the Company's revenue recognition practices.
Readiness for Year 2000
As the year 2000 approaches, a critical industrywide issue has emerged regarding how existing application software programs and operating systems can accommodate the year 2000 date value. The Company is currently in the preliminary stages of conducting a comprehensive review of its computer systems, products and significant vendors to identify the systems and products which could be affected by this issue. Based on the results of the review conducted to date, management does not anticipate that the Company will incur significant operating expenses or be required to invest heavily in computer system or product improvements to be year 2000 compliant. To the extent the Company's products or systems are not fully Year 2000 compliant, there can be no assurance that potential product failures, systems interruptions or the cost necessary to update software would not have a material adverse effect on the Company's business, financial condition, results of operations, cash flows and business prospects.
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
The statements which are not historical facts contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations and other sections of this Annual Report on Form 10-K are forward-looking statements that involve certain risks and uncertainties including, but not limited to, timing of significant orders and shipments, product mix, customer acceptance of the Company's products, capital spending patterns of customers, competition and pricing, new product introductions by the Company or its competitors, carrier deployment of intelligent network services, the timing of research and development expenditures, regulatory changes, general economic conditions and other risks described in this Annual Report on Form 10-K and in the Company's other Securities and Exchange Commission filings.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Inapplicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
See the consolidated financial statements of the Company and its subsidiaries included herein and listed in Item 14 (a) of this Annual Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
Inapplicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by this Item is incorporated by reference to the sections of the Company's definitive Proxy Statement for the Annual Meeting of Shareholders to be held on May 15, 1998, entitled "Election of Directors" and "Executive Officers" to be filed with the Commission.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this Item is incorporated by reference to the sections of the Company's definitive Proxy Statement for the Annual Meeting of Shareholders to be held on May 15, 1998, entitled "Election of Directors - Compensation of Directors," "Executive Compensation and Other Information," "Board of Directors and Compensation Committee Reports on Executive Compensation" and "Performance Graph," to be filed with the Commission.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this Item is incorporated by reference to the section of the Company's definitive Proxy Statement for the Annual Meeting of Shareholders to be held on May 15, 1998, entitled "Common Stock Ownership of Principal Shareholders and Management," to be filed with the Commission.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this Item is incorporated by reference to the section of the Company's definitive Proxy Statement for the Annual Meeting of Shareholders to be held on May 15, 1998, entitled "Certain Relationships and Related Transactions," to be filed with the Commission.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this Report:
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Schedules which are not listed above have been omitted because they are not applicable or the information required to be set forth therein is included in the consolidated financial statements or notes thereto.
LIST OF EXHIBITS
3.1 Amended and Restated Articles of Incorporation(1)
3.2 Bylaws, as amended(2)
4.1 Rights Agreement dated as of August 25, 1997 between the Registrant and U.S. Stock Transfer Corporation as Rights Agent(3)
10.1 Amended and Restated 1984 Stock Option Plan, including forms of stock option agreements(4)(5)
10.2 Amended and Restated Non-Employee Director Equity Incentive Plan, including forms of stock award certificate and nonstatutory stock option agreements(6), as amended February 21, 1996(5)(7)
10.3 1994 Stock Option Plan, including forms of stock option agreements(6), as amended February 4, 1995(8), March 3, 1995 (8), January 27, 1996(7), February 26, 1997(9), and March 19, 1997(5)(9)
10.4 Retirement Pension Rules of Tekelec Ltd.(5)(10)
10.5 Form of Indemnification Agreement between the Registrant and all directors of the Registrant(5)(11)
10.6 Lease dated as of February 8, 1988 between the Registrant and State Street Bank and Trust Company of California, N.A., not individually, but solely as an Ancillary Trustee for State Street Bank and Trust Company, a Massachusetts banking corporation, not individually, but solely as Trustee for the AT&T Master Pension Trust, covering the Company's principal facilities in Calabasas, California(12)
10.7 Form of International Distributor Agreement(13) and Schedule of Distributors
10.8 Officer Severance Plan, including form of Employment Separation Agreement(5)(14)
10.9 Agreement dated March 26, 1997 between the Registrant and Allan Toomer(2)(5)
10.10 Employee Stock Purchase Plan, including form of subscription agreement(5)(7)
10.11 Consulting Agreement dated August 1, 1996 between the Registrant and Howard Oringer, including forms of Warrant and Confidentiality Agreement(16), and Amendment No. 1 thereto dated November 30, 1996(2)
10.12 Credit Agreement dated October 22, 1996 between the Registrant and Imperial Bank, together with Promissory Note of the Registrant dated October 22, 1996(2)
10.13 General Security Agreement dated October 22, 1996 between the Registrant and Imperial Bank(2)
10.14 Agreement dated September 9, 1997 between the Registrant and Shigeru Suzuki(3), as amended by Agreement dated January 6, 1998(5)
10.15* Distribution and OEM Agreement dated as of June 1, 1997 between the Registrant and Daewoo Telecom, Ltd.(3)
10.16 Warrants issued to Allan Toomer to purchase 80,600 shares of the Company's Common Stock(5)(9)
10.17 Warrants to purchase shares of the Company's Common Stock and Schedule of Warrantholders(5)(17)
10.18 Description of the Company's Officer Bonus Plan for the year ended December 31, 1997(5)
10.19 Description of the Company's Officer Bonus Plan for the year ended December 31, 1998(5)
21.1 Subsidiaries of the Registrant
23.1 Consent of Coopers & Lybrand L.L.P.
27.1997 Financial Data Schedule for the year ended December 31, 1997
27.1996 Restated Financial Data Schedule for the year ended December 31, 1996
27.1995 Restated Financial Data Schedule for the year ended December 31, 1995
27.1997.1Q Restated Financial Data Schedule for the quarter ended March 31. 1997
27.1997.2Q Restated Financial Data Schedule for the quarter ended June 30, 1997
27.1997.3Q Restated Financial Data Schedule for the quarter ended September 30, 1997
27.1996.1Q Restated Financial Data Schedule for the quarter ended March 31, 1996
27.1996.2Q Restated Financial Data Schedule for the quarter ended June 30, 1996
27.1996.3Q Restated Financial Data Schedule for the quarter ended September 30, 1996
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* Confidential treatment has been granted with respect to portions of this exhibit, and such confidential portions have been deleted and filed with the Commission pursuant to Rule 24b-2 promulgated under the Securities Exchange Act of 1934.
(1) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q (File No. 0-15135) for the quarter ended June 30, 1997.
(2) Incorporated by reference to the Registrant's Annual Report on Form 10-K (File No. 0-15135) for the year ended December 31, 1996.
(3) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q (File No. 0-15135) for the quarter ended September 30, 1997.
(4) Incorporated by reference to the Registrant's Registration Statement on Form S-8 (Registration No. 33-48079) filed with the Commission on May 22, 1992.
(5) Constitutes a management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K.
(6) Incorporated by reference to the Registrant's Registration Statement on Form S-8 (Registration No. 33-82124) filed with the Commission on July 28, 1994.
(7) Incorporated by reference to the Registrant's Registration Statement on Form S-8 (Registration No. 333-05933) filed with the Commission on June 13, 1996.
(8) Incorporated by reference to the Registrant's Registration Statement on Form S-8 (Registration No. 33-60611) filed with the Commission on June 27, 1995.
(9) Incorporated by reference to the Registrant's Registration Statement on Form S-8 (Registration No. 333-28887) filed with the Commission on June 10, 1997.
(10) Incorporated by reference to the Registrant's Annual Report on Form 10-K (File No. 0-15135) for the year ended December 31, 1994.
(11) Incorporated by reference to the Registrant's Annual Report on Form 10-K (File No. 0-15135) for the year ended December 31, 1987.
(12) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q (File No. 0-15135) for the quarter ended June 30, 1988.
(13) Incorporated by reference to the Registrant's Registration Statement on Form S-1 (Registration No. 33-4123) filed with the Commission on March 19, 1986.
(14) Incorporated by reference to the Registrant's Annual Report on Form 10-K (File No. 0-15135) for the year ended December 31, 1993.
(15) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q (File No. 0-15135) for the quarter ended September 30, 1994.
(16) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q (File No. 0-15135) for the quarter ended September 30, 1996.
(17) Incorporated by reference to the Registrant's Registration Statement on Form S-8 (Registration No. 333-37843) filed with the Commission on October 14, 1997.
(B) REPORTS ON FORM 8-K
No reports on Form 8-K were filed or required to be filed by the Registrant during the quarter ended December 31, 1997.
(C) EXHIBITS
See the list of Exhibits under Item 14(a)3 of this Annual Report on Form 10-K.
(D) FINANCIAL STATEMENT SCHEDULES
See the Schedule under Item 14(a)2 of this Annual Report on Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
TEKELEC
By:/s/ Michael L. Margolis -------------------------- Michael L. Margolis, President and Chief Executive Officer Dated: March 31, 1998
Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
REPORT OF INDEPENDENT ACCOUNTANTS
TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF TEKELEC
We have audited the accompanying consolidated balance sheets of Tekelec and Subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, shareholders' equity, and cash flow, and the financial statement schedule for each of the three years in the period ended December 31, 1997. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Tekelec and Subsidiaries as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents, in all material respects, the information required to be included therein.
/s/ Coopers & Lybrand L.L.P. Woodland Hills, California February 5, 1998
TEKELEC CONSOLIDATED STATEMENTS OF OPERATIONS
(1)Earnings (Loss) per share and weighted average number of shares outstanding have been retroactively adjusted to reflect the two-for-one stock split effected August 22, 1997.
See notes to consolidated financial statements
TEKELEC CONSOLIDATED BALANCE SHEETS
(1)Number of shares outstanding have been retroactively adjusted to reflect the two-for-one stock split effected August 22, 1997.
See notes to consolidated financial statements
TEKELEC CONSOLIDATED STATEMENTS OF CASH FLOW
See notes to consolidated financial statements
TEKELEC CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(1)Number of shares of Common Stock have been retroactively adjusted to reflect the two-for-one stock split effected August 22, 1997.
See notes to consolidated financial statements
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION AND PRESENTATION
The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions are eliminated. Certain items shown in the December 31, 1996 and 1995 financial statements have been reclassified to conform with the current period presentation.
ESTIMATES
The preparation of financial statements 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 dates of the financial statements and revenues and expenses during the reporting periods. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.
INVENTORIES
Inventories are stated at the lower of cost (first in, first out) or market.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method. The estimated useful lives are:
Manufacturing and development equipment 3-5 years Furniture and office equipment 5 years Demonstration equipment 3 years Leasehold improvements The shorter of useful life or lease term
LONG-TERM ASSETS
The carrying value of long-term assets is periodically reviewed by management, and impairment losses, if any, are recognized when the expected nondiscounted future operating cash flows derived from such assets are less than their carrying value.
PRODUCT WARRANTY COSTS
The Company generally warrants its products for one year after sale and provides for estimated future warranty costs at the time revenue is recognized. At December 31, 1997 and 1996, accrued product warranty costs amounted to $1.2 million and $1.6 million, respectively, and are included in accrued expenses.
REVENUE RECOGNITION
Revenues from sales of diagnostic products are generally recognized when products are shipped. Revenues from sales of switching products are recognized upon shipment to the customer's final site and satisfaction of related significant Company obligations, if any. Revenues associated with installation are realized upon completion. Extended warranty service revenues are recognized ratably over the warranty period. Engineering service revenues are recognized on delivery or as the services are performed.
INCOME TAXES
Income tax expense is the tax payable for the period and the change during the period in non-capital-related deferred tax assets and liabilities. Deferred income taxes are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted rates in effect during the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.
ADVERTISING
Advertising costs are expensed as incurred and amounted to $669,000, $620,000 and $625,000 for 1997, 1996 and 1995, respectively.
TRANSLATION OF FOREIGN CURRENCIES
Translation of foreign currencies is accounted for using the local currency as the functional currency of the Company's foreign subsidiaries. All assets and liabilities are translated at current exchange rates while revenues and expenses are translated at average rates in effect for the period. The resulting gains and losses are included in a separate component of shareholders' equity. Realized gains (losses) on foreign currency transactions are reflected in net income (loss) and amounted to $(273,000), $(180,000) and $(210,000) for 1997, 1996 and 1995, respectively.
EARNINGS (LOSS) PER SHARE
In 1997, the Company adopted Statement of Financial Accounting Standards No. 128 "Earnings per Share" ("SFAS 128"). This statement requires dual presentation of newly defined basic and diluted earnings per share ("EPS"), which are computed using the weighted average number of shares outstanding and dilutive Common Stock equivalents (options and warrants), on the face of the income statement for all entities with complex capital structures. See note M.
STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS NOT YET ADOPTED
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." This statement establishes standards for the reporting and display of comprehensive income and its components in a full set of general purpose financial statements. Comprehensive income generally represents all changes in shareholders' equity during the period except those resulting from investments by, or distributions to, shareholders. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997 and requires restatement of earlier periods presented. The Company believes that comprehensive income in future periods will fluctuate as a result of changes in the cumulative translation account, which is a component of comprehensive income. Net unrealized gains and losses on the Company's available-for-sale securities, which have not been significant, are also a component of comprehensive income.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 establishes standards for public enterprises' reporting of information about operating segments in annual financial statements, and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997 and requires restatement of earlier periods presented. Management is currently evaluating the requirements of SFAS No. 131.
In October 1997, Statement of Position (SOP) 97-2, "Software Revenue Recognition" was issued, which addresses software revenue recognition under generally accepted accounting principles, and which is effective for fiscal years beginning after December 15, 1997. The Company believes it is currently in compliance with SOP 97-2 and does not anticipate any changes in the Company's revenue recognition practices.
NOTE B -- RESTRICTED CASH
At December 31, 1994, the Company's Japanese subsidiary had $1.0 million of restricted cash included in current assets, which represented cash on deposit at a bank in Japan as collateral for outstanding short-term borrowings in the U.S. under a $2.0 million line of credit. Upon expiration of this facility during 1995, the outstanding loan balance of $1.0 million was paid in full and the line of credit was not renewed.
NOTE C -- FAIR VALUE OF INVESTMENTS
The Company has short-term investments in corporate debt securities with original maturities of less than 90 days whose carrying amounts approximate their fair values because of their short maturities. These short-term investments are included in cash and cash equivalents, are classified as held-to-maturity securities and amounted to $25.3 million and $3.0 million at December 31, 1997 and December 31, 1996, respectively.
The Company also had investments classified as available-for-sale securities included in short-term and long-term investments, categorized as follows:
These available-for-sale securities are accounted for at their fair value, and unrealized gains and losses on these securities are reported as a separate component of shareholders' equity. At December 31, 1997 and 1996, net unrealized gains or losses on available-for-sale securities were not significant.
NOTE D -- BUSINESS AND CREDIT RISK
Financial instruments, which potentially subject the Company to concentration of credit risk, consist principally of cash, investments and trade receivables. The Company invests its excess cash in interest-bearing deposits with major banks, United States government securities, high-quality commercial paper and money market funds. At times the Company's cash balances may be in excess of the FDIC insurance limits. With respect to trade receivables, the Company sells network switching and communications diagnostic systems worldwide primarily to telephone operating companies, equipment manufacturers and corporations that use its systems to design, install, maintain, test and operate communications equipment and networks. Credit is extended based on an evaluation of each customer's financial condition, and generally collateral is not required. Credit losses, if any, have been provided for in the financial statements and to date have been within management's expectations.
NOTE E -- RELATED PARTY TRANSACTIONS
As of December 31, 1997, the Company's principal shareholder, a director and his family, and a foreign-affiliated company controlled by the director owned an aggregate of approximately 28% of the Company's outstanding stock.
The following is a summary of transactions and balances with these affiliates:
The amounts due from and to the affiliates are non-interest bearing.
In August 1996, the Company entered into a consulting agreement with a director, pursuant to which such director earned $30,000 and received a warrant to purchase 60,000 shares of the Company's Common Stock. This agreement terminated December 31, 1996. See Note Q.
NOTE F -- RESTRUCTURING
During the third quarter of 1996, the Company recorded restructuring charges amounting to $327,000 which represent severance pay and benefit costs for eight terminated employees in research and development and support functions, and other costs related to the consolidation of the Company's Ohio research facility into the Company's North Carolina facility. The costs consisted of the following:
At December 31, 1997, all identified employees had been terminated, and all severance costs and other accrued expenses had been paid.
NOTE G -- INCOME TAXES The provision for income taxes consists of the following:
The primary components of temporary differences which gave rise to deferred taxes at December 31, 1997 and 1996 are as follows:
The valuation allowance for deferred taxes decreased by approximately $12.7 million during the year ended December 31, 1997. The reduction in the valuation allowance is based on the Company's improved income trend and management's assessment of various uncertainties related to the future realization of its deferred tax benefits. The remaining valuation allowance of
$2.2 million is attributable to research and development and foreign tax credits carryforwards which may expire before the Company can utilize them.
Realization of the remaining net deferred tax assets of $10.3 million is dependent on the Company generating sufficient taxable income in the future. Although realization is not assured, the Company believes it is more likely than not that the deferred tax assets will be realized. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income are reduced.
The provision for income taxes differs from the amount obtained by applying the federal statutory income tax rate to income before provision for income taxes as follows:
At December 31, 1997, the Company had available federal net operating loss carryforwards of $9.4 million, foreign tax credit carryforwards of $247,000 and research and development credit carryforwards of $2.8 million which will generally expire beginning in the years 2009, 2003 and 2008, respectively.
The Company has not provided for federal income taxes on $11.8 million of undistributed earnings of its foreign subsidiaries which have been reinvested in their operations. If these earnings were distributed, net operating loss carryforwards and foreign tax credits available under current law would eliminate the resulting federal income tax liability.
NOTE H -- INVENTORIES The components of inventories are:
NOTE I -- PROPERTY AND EQUIPMENT Property and equipment consist of the following:
NOTE J -- BORROWINGS
The Company has a $10 million line of credit with a U.S. bank, collateralized by substantially all of the Company's assets and bearing interest at, or in some cases below, the U.S. prime rate (8.5% at December 31, 1997). There have been no borrowings under this credit facility, which expires June 30, 1998 if not renewed. Under the terms of this facility, the Company is required to maintain certain financial ratios and meet certain net worth and indebtedness tests for which the Company is in compliance.
The Company's Japanese subsidiary has collateralized yen-denominated lines of credit with Japan-based banks, primarily available for use in Japan, amounting to the equivalent of $2.7 million with interest at the Japanese prime rate (1.625% at December 31, 1997) plus 0.125% per annum which expire between August 5, 1998 and March 31, 1999, if not renewed. There have been no borrowings under these lines of credit.
There were no borrowings by the Company in 1997. The Company's weighted average short-term borrowing rate was 11.6% in 1996.
NOTE K -- COMMITMENTS AND CONTINGENCIES
The Company leases its office and manufacturing facilities together with certain office equipment under operating lease agreements. Lease terms generally range from one to ten years; certain building leases contain options for renewal for additional periods and are subject to increases up to 10% every 24 months.
Total rent expense was $2.5 million, $2.4 million and $2.4 million for 1997, 1996 and 1995, respectively.
Minimum annual noncancelable lease commitments at December 31, 1997 are:
NOTE L -- STOCK OPTIONS AND EMPLOYEE BENEFIT PLANS
The Company has various stock option plans with maximum terms of ten years under which 13.5 million shares of the Company's Common Stock have been issued or reserved for issuance. The terms of options granted under these option plans are determined at the time of grant, generally vest ratably over a three- to five-year period, and in any case the option price may not be less than the fair market value per share on the date of grant. Both incentive stock options and nonstatutory stock options can be issued under the Option Plans.
The Company also has Employee Stock Purchase Plans ("ESPP"), with maximum terms of ten years, the latest of which expires in the year 2006 and under which 400,000 shares of the Company's Common Stock have been authorized and reserved for issuance. Eligible employees may authorize payroll deductions of up to 10% of their compensation to purchase shares of Common Stock at 85% of the lower of the market price per share at the beginning or end of each six-month offering period.
Statement of Financial Accounting Standards No. 123 "Accounting for Stock-Based Compensation" ("SFAS 123") encourages but does not require companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, no compensation expense has been recognized for the Company's stock-based compensation plans. Had compensation costs for the
Company's stock option and purchase plans been determined based upon the methodology prescribed under SFAS 123, the Company's net income (loss) and diluted earnings (loss) per share would approximate the following pro forma amounts (in thousands except per-share data):
The effects of applying SFAS 123 in this pro forma disclosure are not indicative of future amounts. SFAS 123 does not apply to awards prior to 1995, and additional awards in future years are anticipated.
A summary of the status of the Company's stock options, as of December 31, 1997, 1996 and 1995, and the changes during the year ended on those dates is presented below (shares in thousands):
The following table summarizes information about stock options outstanding at December 31, 1997 (shares in thousands):
The fair value of options granted during 1997, 1996 and 1995 is estimated as $6.9 million, $3.6 million and $3.3 million, respectively, on the dates of grants using the Black-Scholes option-pricing model with the following assumptions: (i) dividend yield of 0%, (ii) expected volatility of 86%, 87% and 85%, respectively, for 1997, 1996 and 1995, (iii) weighted average risk-free interest rates of 6.4%, 6.2% and 6.9% for 1997, 1996 and 1995, respectively, (iv) weighted average expected life of 5.1 years, 4.8 years and 5.1 years for 1997, 1996 and 1995, respectively, and (v) assumed forfeiture rate of 58%, 64% and 64%, respectively, for 1997, 1996 and 1995.
During 1997, 1996 and 1995, approximately 80,000, 124,000 and 68,000 shares, respectively, were purchased under the Company's ESPP at weighted average exercise prices of $10.15, $4.80 and $5.48, respectively. At December 31, 1997, 1996 and 1995 there were approximately 265,000, 345,000 and 232,000 shares, respectively, available for future grants. The weighted average fair values of ESPP options granted in 1997, 1996 and 1995 were $4.47, $2.36 and $3.02 per share, respectively.
In 1997 and 1996, the Company granted warrants to purchase 261,000 and 60,000 shares of Common Stock, respectively. The grant date fair values of these warrants for 1997 and 1996 were $14.88 and $4.90 per share, respectively. See Note Q.
The Company has a 401(k) tax-deferred savings plan under which eligible employees may authorize from 2% to 12% of their compensation to be invested in employee-elected investment funds managed by an independent trustee. As determined annually by the Board of Directors, the Company may contribute matching funds of up to 50% of the employees' payroll deductions. During 1997, 1996 and 1995, the Company's contributions amounted to $401,000, $187,000 and $167,000, respectively.
NOTE M -- EARNINGS PER SHARE
In 1997, the Company adopted Statement of Financial Accounting Standards No. 128 "Earnings Per Share" ("SFAS 128"). This statement requires dual presentation of newly defined basic and diluted earnings per share ("EPS") on the face of the income statement for all entities with complex capital structures. The following table provides a reconciliation of the numerators and denominators of the basic and diluted per-share computations for the years ended December 31, 1997, 1996 and 1995:
The computation of diluted number of shares excludes unexercised stock options and warrants which are anti-dilutive. The number of such shares excluded were 44,000, 4,955,000 and 325,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
There were no transactions subsequent to December 31, 1997 which, had they occurred prior to December 31, 1997, would have changed materially the number of shares in the basic or diluted earnings per share computations.
NOTE N -- GEOGRAPHIC SEGMENTS AND FOREIGN OPERATIONS
The Company operates in one business segment. Transfers between geographic areas are made at prices reflecting market conditions. Geographic segment information including sales and transfers between geographic areas is presented below:
NOTE O -- MAJOR CUSTOMERS
Sales to Bell Atlantic Corporation amounted to 23% of revenues in 1997. Sales to Nippon Telegraph and Telephone amounted to 12% and 14% of revenues in 1996 and 1995, respectively, and sales to AT&T amounted to 12% of revenues in 1995.
NOTE P -- QUARTERLY FINANCIAL SUMMARY (UNAUDITED)
Tekelec typically operates with a limited backlog, and most of its revenues in each quarter result from orders received in that quarter. Further, Tekelec typically generates a significant portion of its revenues for each quarter in the last month of the quarter. Tekelec establishes its expenditure levels based on its expectations as to future revenues, and if revenue levels were to fall below expectations this would cause expenses to be disproportionately high. Therefore, a drop in near-term demand would significantly affect revenues, causing a disproportionate reduction in profits or even losses in a quarter. Tekelec's quarterly operating results may fluctuate as a result of a number of factors, including general economic and political conditions (such as recessions in the U.S. and Japan), capital spending patterns of Tekelec's customers, increased competition, variations in the mix of sales, fluctuation in proportion of foreign sales, and announcements of new products by Tekelec or its competitors.
NOTE Q -- COMMON STOCK
On August 22, 1997, the Company effected a two-for-one stock split. All references to number of shares and per-share amounts have been restated to reflect the stock split.
At December 31, 1997 and 1996, the Company had warrants outstanding to purchase an aggregate of 204,367 and 80,000 shares of its Common Stock, respectively, as more fully discussed as follows.
In July 1997, the Company issued warrants to purchase a total of 180,000 shares of its Common Stock to five directors and one corporate officer at $28.16 per share. These warrants vest and become exercisable in 12 equal quarterly installments beginning on September 30, 1997. During 1997, 2,500 of these warrants were exercised, and 177,500 were outstanding at December 31, 1997.
In January 1997, the Company issued warrants to a director and corporate officer to purchase 80,600 shares of its Common Stock at $9.31 per share, all of which vested in 1997. During 1997, 53,733 of these warrants were exercised, and 26,867 were outstanding at December 31, 1997.
In August 1996, pursuant to a consulting agreement between the Company and a director, the Company issued warrants to purchase 60,000 shares of its Common Stock at $4.75 per share to such director. These warrants vested during 1996, and were all outstanding at December 31, 1996. During 1997, all of these warrants were exercised.
In 1992, the Company issued warrants to purchase a total of 40,000 shares of its Common Stock to two directors at $3.78 per share. These warrants were repriced to $1.80 per share in 1993, and were exercisable in full at any time prior to January 17, 1997. At December 31, 1996, 20,000 of these warrants were outstanding. During 1997, the remaining 20,000 warrants were exercised.
On August 25, 1997, the Company adopted a shareholder rights plan to protect shareholders against unsolicited attempts to acquire control of the Company which do not offer what the Company believes to be an adequate price to all shareholders. Under the plan, a dividend distribution of one right for each outstanding share of Tekelec Common Stock was made to shareholders of record on September 5, 1997, and such rights expire on September 5, 2007. Each right entitles the registered holder to purchase from the Company one share of Common Stock at a price of $180 per share, subject to adjustment (the "Purchase Price").
The rights will be exercisable only if a person or group (except for certain exempted persons or groups, including those shareholders of the Company who at the time of adoption of the Plan beneficially owned more than 15% of Tekelec Common Stock) acquires 15% or more of Tekelec's Common Stock or announces a tender offer which would result in ownership of 15% or more of the Common Stock.
Under the plan, if any person or group (other than the Company, any subsidiary of the Company or any employee benefit plan of the Company or any exempted person or group) acquires 15% or more of the Company's outstanding voting stock without the prior written consent of the Company's Board of Directors, each right, except those held by such acquiring persons or group, would entitle each holder of a right to acquire such number of shares of the Company's Common Stock as equals the result obtained by multiplying the then current Purchase Price by the number of shares of Common Stock for which a right is then exercisable and dividing the product by 50% of the then current per-share market price of the Company's Common Stock.
The Company may redeem the rights at $0.01 per right at any time until ten business days after a person or group acquires 15% or more of the Company's outstanding shares. The Company also may, at any time after a person or group acquires 15% or more, but less than 50%, of the Company's shares, exchange each right for one share of Common Stock.
TEKELEC VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
S-1 SCHEDULE II
EXHIBIT INDEX
Sequentially Exhibit Numbered Number Description Page - ------- ----------- ------------
10.7 Schedule of Distributors........................
10.18 Description of the Company's Officer Bonus Plan for the year ended December 31, 1997............
10.19 Description of the Company's Officer Bonus Plan for the year ended December 31, 1998............
21.1 Subsidiaries of the Registrant..................
23.1 Consent of Coopers & Lybrand L.L.P. ............
27.1997 Financial Data Schedule for the year ended December 31, 1997...............................
27.1996 Restated Financial Data Schedule for the year ended December 31, 1996.........................
27.1995 Restated Financial Data Schedule for the year ended December 31, 1995.........................
27.1997.1Q Restated Financial Data Schedule for the quarter ended March 31, 1997............................
27.1997.2Q Restated Financial Data Schedule for the quarter ended June 30, 1997.............................
27.1997.3Q Restated Financial Data Schedule for the quarter ended September 30, 1997........................
27.1996.1Q Restated Financial Data Schedule for the quarter ended March 31, 1996............................
27.1996.2Q Restated Financial Data Schedule for the quarter ended June 30, 1996.............................
27.1996.3Q Restated Financial Data Schedule for the quarter ended September 30, 1996........................