ITEM 1. BUSINESS. - ------------------
PairGain Technologies, Inc. ("PairGain" or the "Company") is a leading provider of telecommunications products based on xDSL technology. The Company designs, manufactures, markets and supports products that allow telecommunications carriers and private network owners to expand the capabilities of copper cable and more efficiently provide high-speed digital services to end users over the large existing infrastructure of unconditioned copper wires. These services enable high-speed data transmission for applications such as T1/E1, POTS, high-speed Internet access, telecommuting, local and wide area networking and video conferencing.
RISK FACTORS
Except for the historical information contained herein, the matters discussed in this Annual Report are forward-looking statements which involve risk and uncertainties, including but not limited to economic, competitive, governmental and technological factors affecting the Company's operations, markets, products, services and prices and other factors discussed in the Company's filings with the Securities and Exchange Commission.
Average Sales Price Reductions
Commencing in mid-1993, the Company began reducing the average sales prices of its HiGain(R) products in an effort to increase market demand for its products and in anticipation of expected price competition. These reductions have been significant, representing a reduction of as much as 30% during 1997, 17% during 1996 and 21% during 1995. The Company expects to continue to reduce the average sales prices of its products, including its HiGain products, in future periods. Accordingly, the Company's ability to maintain or increase revenues will depend in part upon its ability to increase unit sales volumes of HiGain products and to introduce and sell new products at rates sufficient to compensate for the reduced revenue effect of such continuing reductions in the average sales prices of the Company's HiGain products. Declining average sales prices may also adversely affect gross margins on the Company's HiGain products if the Company is unable to fully offset such reductions in average sales prices by reductions in the Company's per unit costs. There can be no assurance that the Company will be able to increase the unit sales volumes of its HiGain products, introduce and sell new products, reduce its per unit costs or maintain or increase revenues or margins attributable to such products. See "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Business--Products" and "--Competition."
Product Concentration
Revenues from HiGain products represented approximately 67% of the Company's total revenues in 1997 and 76% of the Company's total revenues in both 1996 and 1995. The Company expects that revenues from HiGain products will continue to account for a majority of the Company's revenues for the foreseeable future, although there can be no assurance that the Company will be able to sustain recent levels of HiGain product sales. A decline in demand for HiGain products, whether as a result of competition, deployment of fiber cable, technological change or otherwise, could have a material adverse effect on the Company's operating results. See "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Business--Products."
Future Operating Results Subject to Fluctuation; Lack of Backlog
The Company's operating results may fluctuate in the future as a result of a number of factors, including the timing of orders from, and shipments to, major customers, the timing of new product announcements by the Company or its competitors, variations in the Company's sales channels or the mix of products it sells, changes in pricing policies by the Company's suppliers, the availability and cost of key components, the timing of personnel hirings, the market acceptance of new and enhanced versions of the Company's products and the timing of final product approvals from any of the RBOCs.
Because the Company generally ships products within a short period after receipt of an order, the Company typically does not have a material backlog of unfilled orders, and revenues in any quarter are substantially dependent on orders booked in that quarter. Further, the Company's expense levels are based in part on expectations of future revenues and are relatively fixed in the short-term. The Company has been significantly increasing and intends to continue to significantly increase operating expenditures and to increase inventories as it expands its levels of operations. Therefore, the Company may be unable to adjust spending in a timely manner to compensate for any unexpected shortfall of orders. Accordingly, any significant shortfall of demand in relation to the Company's expectations or any material delay of customer orders in any quarter would have an almost immediate adverse impact on the Company's business and results of operations for that quarter, and, potentially, on results in future quarters.
Competition
Competition in the Company's markets is intense, and the Company expects that competition will increase. Many of the Company's potential competitors have substantially greater name recognition and technical, financial and marketing resources than the Company. There can be no assurance that the Company will have the financial resources, technical expertise or marketing, distribution and support capabilities to compete successfully in the future. Competitive pressures could reduce demand for the Company's products, cause the Company to further reduce prices on its existing products, increase expenses or cause delays or cancellations of customer orders, any one of which could adversely affect the Company's business and results of operations.
All manufacturers of products based on HDSL technology face competition from fiber optic and conventional repeatered systems as alternate solutions for the delivery of T1, E1 and other high-bandwidth services to end users. As telephone companies continue to install fiber cable and conventional repeatered T1 systems to provide high-bandwidth service in local subscriber loops, the demand for HDSL products may decline. Further, the deployment of fiber to replace existing HDSL installations will result in the availability of those existing HDSL systems for installation elsewhere and may adversely affect future demand for HDSL products.
The Company is investing heavily in xDSL developments. The market for xDSL-based products is emerging and will change dramatically over a very short time. There can be no assurance that the products the Company develops will be commercially successful. See "Business--Industry Background" and "--Competition."
Dependence on Suppliers and Subcontractors
Certain components used in the Company's HDSL products are currently purchased from a single source (including the Company's SPAROW II chip) and others are available from a limited number of sources. In the past, the Company has experienced delays in the receipt of certain of its key components, which have resulted in delays in product deliveries. There can be no assurance that delays in key component and product deliveries will not occur in the future. The inability to obtain sufficient key components as required, or to develop alternative sources if and as required in the future, could result in delays or reductions in product shipments to the Company's customers. Any such delays or reductions could have a material adverse effect on the Company's reputation and customer relationships which could, in turn, have a material adverse effect on the Company's business and results of operations. In addition, the Company uses third-party subcontractors for the manufacture of its products. This reliance on third-party subcontractors involves several risks, including the potential absence of adequate capacity, the unavailability of or interruptions in access to certain process technologies and reduced control over product quality, delivery schedules, manufacturing yields and costs.
Shortage of raw materials or production capacity constraints at the Company's subcontractors could negatively affect the Company's ability to meet its production obligations and result in increased prices for affected parts. Any such reduction may result in delays in shipments of the Company's products or increases in the price of components, either of which could have a material adverse impact on the Company. See "Business--Manufacturing."
Customer Concentrations
Aggregate sales to local telephone companies affiliated with the five RBOCs accounted for approximately 57%, 62% and 65% of the Company's total revenues for 1997, 1996 and 1995, respectively. As a result of the Company's dependence on its largest customers, the Company's future success will significantly depend upon the timeliness and size of future purchase orders, if any, from its largest customers, the product requirements of such customers, the financial and operational success of such customers, and in particular, the success of such customers' services deployed using the Company's products. The Company's sales to its largest customers have in the past fluctuated and may in the future fluctuate significantly from quarter-to-quarter and year-to-year. The loss of any such customer or the occurrence of any such sales fluctuations could have a material adverse effect on the Company's business and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations," and "Business--Customers."
Dependence on New Markets and Technologies
The Company is evaluating new applications of high-speed copper transmission technologies, is investing significant corporate resources in the development of ADSL technology and expects to devote significant additional resources to the development of other new technologies in the future. In addition, the Company does not expect to generate significant revenues from ADSL products until 1999, and there can be no assurance that the Company will ever generate significant revenues from ADSL products. There can be no assurance that such technologies will be viable or that markets for such technologies will develop. Any failure in the development of new markets and technologies could have a material adverse effect on the Company's business. "Business--Company Strategy" and "--Product Development."
Rapid Technological Change and Dependence on New Products
The market for the Company's products is characterized by rapid technological advances, evolving industry standards, changes in end user requirements and frequent new product introductions and enhancements. The introduction of xDSL products involving superior technologies or the emergence of alternative technologies or new industry standards could render the Company's existing products, as well as products currently under development, obsolete and unmarketable. The Company believes its future success will depend in part upon its ability to continue, on a cost-effective and timely basis, to enhance its xDSL products, develop and introduce new products for the xDSL market and other markets, meet changing customer needs and achieve broad market acceptance for its products. There can be no assurance that the Company will be able to respond effectively to technological changes or new product announcements, that the Company will be able to successfully develop and market new products or product enhancements or that such products or enhancement will achieve market acceptance. Any failure by the Company to anticipate or respond on a cost effective and timely basis to technological developments, changes in industry standards or end user requirements, or any significant delays in product development or introduction, could have a material adverse effect on the Company's business. Further, there are physical limits to the speed at which transmissions can travel over copper wire, and the Company's copper-based xDSL products will not be a viable solution for customers requiring service at performance levels beyond the limits of copper wire. See "Business--Company Strategy" and "--Product Development."
Need to Generate International Sales
To date, sales of the Company's products outside of the United States and Canada have been limited. The Company's ability to meet its objectives will require it to generate significant international sales in 1998 and beyond. International business is subject to risks in addition to those inherent in the Company's North American business including substantially different regulatory requirements in different jurisdictions, varying technical standards, tariffs and trade barriers, political and economic instability, reduced protection for intellectual property rights in certain countries, difficulties in staffing and maintaining foreign operations, difficulties in managing distributors, potentially adverse tax consequences, foreign currency exchange fluctuations, the burden of complying with a wide variety of complex foreign laws and treaties and the possibility of difficulties in collecting accounts receivable and increased days sales outstanding. There can be no assurance that the Company will be able to generate significant international sales, or establish new strategic marketing relationships in the future. In addition, in the event the Company is successful in doing business outside of North America, the Company may also face
economic, political and foreign currency situations that are substantially more volatile than those commonly experienced in the United States and other international markets. There can be no assurance that any of these factors will not have a material adverse effect on the Company's business and results of operations.
Proprietary Technology
The Company's success and future revenue growth will depend, in part, on its ability to protect trade secrets, obtain or license patents and operate without infringing on the rights of others. Although the Company regards its technology as proprietary, it has limited patents on such technology. The Company relies on a combination of technical leadership, trade secrets, copyright and trademark law and nondisclosure agreements to protect its unpatented proprietary know-how. However, there can be no assurance that such measures will provide meaningful protection for the Company's trade secrets or other proprietary information. Moreover, in the absence of patent protection, the Company's business may be adversely affected by competitors who independently develop substantially equivalent technology. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the United States. The Company is also subject to the risk of adverse claims and litigation alleging infringement of the intellectual property rights of others. From time to time the Company has received claims of infringement of other parties' proprietary rights, although the Company is not party to any pending intellectual property litigation. There can be no assurance that third parties will not assert infringement claims against the Company in the future or that any such claims will not result in costly litigation or require the Company to obtain a license to intellectual property rights of such parties, regardless of the merit of such claims. No assurance can be given that any necessary licenses will be available or that, if available, such licenses can be obtained on commercially reasonable terms. See "Business--Proprietary Rights."
Dependence on Key Personnel
The success of the Company is dependent in large part on two of its founders, Howard S. Flagg and Benedict A. Itri, on its Chairman and Chief Executive Officer, Charles S. Strauch, and on other key management and technical personnel, the loss of one or more of whom could adversely affect the Company's business. The Company does not have employment contracts with any of its executive officers. In addition, the Company believes that its future success will depend in large part upon its continued ability to attract, retain and motivate highly skilled employees, who are in great demand. There can be no assurance that the Company will be able to do so.
Management of Expanding Operations
The Company has experienced a period of significantly expanding operations and headcount, which has placed, and will continue to place, a significant strain on the Company's personnel and other resources. The Company's ability to manage any future increases in the scope of its operations or headcount, should they occur, will depend on significant expansion of its manufacturing, research and development, marketing and sales, management and financial and administrative capabilities. The failure of the Company's management to effectively manage any expansion in its business could have a material adverse effect on the Company's business and results of operations.
Reliance on Primary Manufacturing Facilities
The Company historically conducted virtually all final assembly and final test functions at its manufacturing facility in Tustin, California. In 1996, the Company entered into an agreement to have its small subscriber products manufactured, on a turnkey basis, by Jabil Circuits at Jabil's St. Petersburg, Florida facility. Any extended interruption of operations at either of these facilities could have a material adverse effect on the Company's business and results of operations.
Possible Volatility of Stock Price
The market price of the Company's Common Stock has increased significantly since the Company's initial public offering in September 1993, and has experienced fluctuations during this period. The market price of the Company's Common Stock has been volatile and may continue to be volatile in the future. The trading price of the Company's Common Stock could be subject to wide fluctuations in response to quarter-to-quarter variations in
operating results, changes in revenue and earnings estimates by analysts, announcements of technological innovations or new products by the Company or its competitors, developments in the Company's relationships with its suppliers or customers, challenges associated with integration of businesses and other events or factors. In addition, the stock market has from time to time experienced extreme price and volume fluctuations which have particularly affected the market price for many high technology companies, often without regard to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock.
Capital Requirements
The Company's capital requirements will depend on many factors, including the levels at which the Company maintains inventory, the continued market acceptance of the Company's products, growth in unit sales volume of HiGain products, the extent to which the Company invests in new technology and improvements to its existing xDSL technology, the marketing expenditures associated with launching new products and maintaining a competitive position in the marketplace and the response of competitors to products based on the Company's technology. To the extent that the Company's existing resources, together with future earnings, are insufficient to fund the Company's future activities, the Company may need to raise additional funds through public or private financings. No assurance can be given that additional financing will be available or that, if available, it can be obtained on terms favorable to the Company and its stockholders.
INDUSTRY BACKGROUND
In recent years, demands on the telephone infrastructure have prompted telephone companies to improve the reliability and increase the speed of transmission over telephone networks. Telephone networks have evolved from systems based entirely on low speed analog communication over copper wires to fiber optic backbones running throughout the interexchange carrier and local exchange carrier networks. These fiber optic backbones permit digital communication of much greater volumes of data with greatly enhanced reliability and increased speed throughout the interexchange network and among the local carriers. However, the "last mile," the local subscriber loop through which telephone services are delivered from local carriers to end users, continues to be predominantly characterized by low speed analog transmission over copper wires.
The quality of telephone service to end users is determined by the least reliable and slowest link in the network, and the traditional analog infrastructure was not designed to provide high-speed, high-data capacity service to end users. However, end users are increasingly demanding higher speed data transmission for applications such as Internet access, telecommuting, remote LAN access, video conferencing and wide area networking, which includes communications among computers and telephone systems. Telephone service carriers are therefore facing increasing pressure to install digital telecommunications services in the "last mile." Digital transmission has distinct advantages over analog transmission, including increased speed, higher reliability, lower costs, ease of installation and better quality. Installing digital service facilities also provides telephone companies worldwide with the foundation to offer their customers high-speed video and multimedia services. In addition, international carriers, especially those in developing countries where the copper wire infrastructure is less extensive, are facing a growing demand for digital service and are deploying it to provide multiple voice circuits (telephone lines) rather than the high-speed services requested in the United States.
Competitive pressure from alternate carriers has further accelerated the telephone companies' deployment of digital service in the "last mile." Unlike public telephone companies, these alternate carriers are not required to provide universal service and instead may choose to serve only those customers with high demand for digital services, an important market targeted by the telephone companies due to the higher rates and increased usage associated with these services. By installing primarily fiber cable, these alternate carriers have provided short delivery intervals and high quality service, which has enabled them to compete effectively with the local telephone companies for these high demand customers. In addition, telephone companies are facing competition from cable companies that offer high-speed cable modem service. As a result of this competitive pressure, the telephone companies face an increased need to provide digital service approaching the quality of fiber optic cable quickly and efficiently.
T1/E1 Access
The basic building blocks of today's high-speed digital telecommunications networks in North America are T1 lines, which transmit data at 1.544 Mbps, the equivalent of 24 voice circuits for simple telephone service. E1 lines, the international functional equivalent of T1 lines, operate at 2.048 Mbps. Telephone companies are seeking cost effective methods of providing T1 service to meet customer demands for high-speed digital transmission. By providing T1 service, telephone companies can provide the means for increased customer usage which, in turn, expands the revenue base for these telephone companies. One way that telephone companies have installed T1 service has been to deploy fiber cable. However, deploying fiber cable in the "last mile" is capital and labor intensive, so it is only cost efficient if a number of T1 lines are requested in the particular subscriber loop. A fiber system may be capable of transporting from four to over one hundred T1 lines. The equipment required at a customer's premises alone can cost a few thousand dollars for a T1 fiber optic system with four lines to tens of thousands of dollars for higher capacity systems. In either case, significant additional costs are involved in installing fiber cable in existing conduit or burying new cable. Installing fiber cable in the "last mile" is also time consuming, often taking a carrier weeks or months to complete, depending on the location to which the fiber is deployed, the timeliness of the carrier's success in obtaining the necessary rights of way and the extent to which the existing conduit is obstructed or damaged.
As an alternative to fiber deployment, telephone companies use repeatered T1 lines, which require them to "condition" the existing copper wires to meet T1 or E1 standards. Conditioning copper wires is accomplished through a time consuming, capital and labor intensive installation process, which involves the removal of bridged taps and the installation of repeaters. Repeaters are devices required about every 3,000 to 5,000 feet to regenerate the signal as it passes along the line. To condition existing copper wires, telephone company engineers must (i) identify which copper wires are to be used (only three to four pairs of wires in a single cable can be used due to "crosstalk," or interference, from other pairs of wires in the same cable), (ii) define where repeaters must be installed, (iii) allocate space in repeater housings and manholes for the necessary equipment and (iv) locate bridged taps (wire leads from previously disconnected lines) for removal. Technicians, following the design of the engineers, must then go to each location to remove the bridged taps, install the repeaters and add new repeater housings when needed. Next, each repeater span must be measured by the engineers to ensure that the intent of the design is achieved. The cost of installing a repeatered T1 line varies widely depending on the amount of conditioning that the copper wires require, including the number of repeaters that need to be installed. Generally, the cost of installing a repeatered T1 line on up to 12,000 feet of unconditioned copper wire can range from approximately $2,500 to $8,000. While often deployed as an alternative to fiber, the transmission error rates on repeatered T1 lines are significantly higher than fiber, which is particularly detrimental for certain data and video transmissions.
In the late 1980s, Bellcore, the research and development entity jointly created and funded by the RBOCs for the development of new technologies, developed the parameters for HDSL technology as a high quality, but lower cost and more efficient method for installing T1 lines in the "last mile" on copper. HDSL utilizes high-speed digital signal processing technology to create a mathematical model of copper wire that allows the receiver to precisely compensate for the predictable distortion that the wire imparts on the digital signal sent from the distant end.
A cost and performance comparison of a two-mile connection for the three types of T1 deployment follows:
- -------------------------- BER 10 to the minus 10 = one bit error every week in a constant transmission versus BER 10 to the minus 7 which is one bit error every 6 to 7 seconds
The following diagram depicts a comparison of a conventional repeatered T1 line with an HDSL circuit:
[DIAGRAM]
The Company believes that HDSL technology offers a significant opportunity to meet end user demand for high-speed digital telecommunications services in the local subscriber loop. HDSL technology has a number of advantages over both fiber cable and conventional repeatered T1 systems, including lower installation costs and faster deployment time. Because HDSL technology utilizes the existing copper wire infrastructure, it can be deployed in one or two days instead of weeks or months. HDSL systems operate over copper wire without the removal of bridged taps and can tolerate crosstalk, resulting in reduced engineering design time and lower costs. HDSL systems also eliminate the need for repeaters, thereby reducing a carrier's initial capital expenditures and its subsequent maintenance costs for trouble shooting. HDSL provides higher quality digital transmission than repeatered copper and approaches the low error rate of fiber optic cable. There are, however, certain situations in which HDSL technology is disadvantaged relative to these alternative solutions. For example, if a number of T1 lines are requested at a single location, fiber cable may be more cost effective to deploy.
Subscriber Carrier Systems
Subscriber carrier systems use HDSL technology allowing for rapid deployment of new telephone service, cable capacity transmission and full-featured services over existing copper lines. The systems increase the channel capacity of copper lines in the local loop. Subscriber carrier systems can be used to satisfy additional line demand from businesses, apartment complexes, hotels, etc. In addition, some subscriber carrier systems can provide access through a digital loop carrier.
Megabit Access
Various telecommuting, Internet access and remote LAN access applications are driving the need for new higher-speed access technologies. T1 lines are not feasible for use by small businesses and residential customers. Solutions for these customers have historically been limited to ISDN or analog, voice grade circuits, which when equipped with 28.8 modems offer some minimally useful capacities.
Megabit access products go beyond modem and ISDN capabilities, offering high-speed data services to business and residential customers. These services include high-speed Internet and Intranet access, remote LAN access, advanced services such as pay-per-view movies, telemedicine, distance learning, interactive video games, educational video and many other on-demand services. The following chart shows the relative efficiency of the various transmission methodologies.
Desired and acceptable response time is less than 3.0 seconds.
PAIRGAIN STRATEGY
The Company pioneered the development of a VLSI implementation of HDSL technology and is currently a leading provider of telecommunications products based on xDSL technology. The Company's strategy for expanding the market for its products consists of three primary elements:
o Maintain Technology Leadership. The Company believes that it is a leader in xDSL technology and systems. The Company intends to be able to offer clients whatever form of xDSL they desire. The Company's engineering organization includes a core development team focused on applying DSP techniques to telecommunications products. The Company leverages this core DSP expertise with an in-house VLSI design group that designs advanced VLSI components. The Company's in-house VLSI design group was the first to deliver an HDSL transceiver on a single chip (the SPAROW I chip). The Company believes that the close coordination between its VLSI design and product development teams enables it to reduce its time to market for new products. The engineering organization places the highest priority on maintaining the cost and feature competitiveness of the Company's HDSL product line through aggressive cost reduction and introduction of new products that provide high-speed transmission over copper wire. In addition to providing HDSL-based products, the Company plans to provide products that use ADSL technology. The Company has recently released its Falcon(TM) DMT ADSL chip, which will support DMT ADSL and "splitterless" ADSL, or G.lite. The Company believes that maintaining its leadership in technology for high-speed digital transmission over copper wire is critical to its ability to build and maintain strong relationships with the RBOCs and other customers and to achieve leadership in new markets.
o Leverage Core Technologies Into New Applications. The Company has developed its Campus product line and its PG-Plus(TM) and PG-Flex(TM) products based upon the same core HDSL technology utilized in the Company's HiGain products. The Company markets its Campus products to private network users such as universities, hospitals, military bases, corporate complexes and other campus environments. In addition,
potential demand for the delivery of advanced communication services to residential and business customers, including high-speed Internet access, advanced video services such as pay-per-view movies, interactive video games, educational video and many other on-demand services, may present a significant new market opportunity for products incorporating the Company's DSP and copper transmission expertise by using ADSL technologies. See "-- Products" and "-- Product Development."
o Subscriber Carrier Systems. Due to a shortage in copper lines, the Company's subscriber carrier systems, PG-Flex and PG-Plus, represent an enormous potential market as carriers look to offer competitive local access and to provision second and third lines quickly and cost-effectively. The systems increase the channel capacity of copper cables in the local loop, allowing service providers to maximize the utility of the lines.
o Develop OEM Opportunities. The Company will continue to pursue opportunities to provide products and chipsets to manufacturers of telecommunications and data communications equipment. The Company believes that it can provide added value to third-party products through higher levels of integration with other elements of wide area networking infrastructures, such as bridges, routers and multiplexers. The Company also believes an opportunity exists to utilize its xDSL technology to connect local wireless communication systems to local central offices.
o Create Development Partnerships and Alliances. The Company has and will continue to establish partnerships with industry leaders in an effort to pursue new market opportunities. The Company is currently collaborating with leading telecommunications companies to develop a new standard for second generation HDSL technology, known as HDSL2. The purpose of setting a standard is to move the industry toward interoperability. In addition, the Company is a member of the Universal ADSL Working Group ("UAWG") aimed at accelerating the adoption and availability of high-speed Internet access for the mass market by creating an open interoperable International Telecommunication Union ("ITU") standard.
PRODUCTS
Core Technology
The core technology for the Company's HiGain, Campus, PG-Flex and PG-Plus product lines is based on HDSL and was developed from the Company's dual core competencies in digital signal processing and microelectronics. HDSL allows the symmetric transmission and receipt of digital data at T1 rates (1.544 Mbps) over two twisted pair of copper wires or at 768 kbps over a single twisted pair of copper wire. HDSL permits the delivery of an outbound signal on the same pair of wires on which the return signal is received. The transmitted signal is canceled by the receiver by precisely predicting the amount of signal "echo" and subtracting it from the overall input signal. HDSL-based products tolerate crosstalk and operate not only on continuous unobstructed pairs of wires, but also on cables with mixed wire gauges and bridged taps.
The Company's unique implementation of HDSL technology stems from its development of a special purpose digital signal processing integrated circuit. This VLSI device, the SPAROW (Signal Processing Adaptive Receiver On Wire) chip, operates at a speed of 250 million instructions per second, enabling it to perform the extremely heavy numerical calculations required for the transmission of signals at HDSL rates. The SPAROW chip has enabled the Company to significantly reduce the physical size of its HDSL-based products. Two SPAROW chips are used in each of the Company's HDSL-based products, one for each twisted pair of copper wires entering the unit. The SPAROW I chip was replaced by the Company's SPAROW II chip which provides all of the features of the original SPAROW I chip, costs less to produce and consumes less power. Currently under development is the Company's SPAROW III chip which will be specially designed to handle pure data transport and include a built-in timing function to enhance RADSL products and a new interface to use a lower cost analog chip. In addition, the SPAROW III chip will use less power, cost less to produce and run faster than the SPAROW II chip. The SPAROW III chip also conforms to the requirements of the European Telecommunication Standards Institute ("ETSI").
The Company's microelectronics team has design and development capabilities that include silicon compilers which allow the Company to develop chips that are at performance and complexity levels beyond what is
achievable on standard ASIC design systems. The Company has also leveraged its microelectronics product capabilities into the HiGain and Campus product lines. The Company is currently focusing its resources on further cost and performance improvements in HDSL including an HDSL2 standard that will let service providers deliver full T1 performance over a single twisted pair cable with the same reach, robustness and spectral compatibility of today's two-pair HDSL. Additionally, significant effort is being placed on new ADSL technology such as the newly released Falcon chip, which is capable of transferring data, voice and video at rates over 8 Mbps downstream and 1 Mbps upstream over a single copper telephone line, and the RADSL product series, which allow for consumer and business internet access, transparent LAN access and telecommuting applications.
The Company is a supporter and contributor in the UAWG. The goal of the UAWG is to accelerate the adoption and availability of high-speed digital Internet access for the mass market by proposing a simplified version of ADSL which will deliver to consumers high-speed modem communications over existing phone lines based on an open, interoperable ITU standard. The UAWG is led by PC, semiconductor and telecommunications industry leaders. The ADSL specification is expected to be delivered to the ITU in 1998 for worldwide deployment.
By utilizing its HDSL and ADSL technology in different forms, the Company offers products for different markets and varied applications.
T1/E1 Access
HIGAIN SYSTEMS
The Company's HiGain systems are used by telephone companies to (i) provide a T1 or fractional T1 link between the central office and a carrier's remote hub and (ii) provide T1 or fractional T1 service in the local subscriber loop between the central office or remote hub and the customer. A HiGain system consists of two units: a circuit plug-in unit that mounts in a shelf located in the central office or in a shelf in a remote hub and a unit that mounts at or near the customer's location. The circuit plug-in unit mounts in standard telephone company shelves alongside conventional transmission equipment, making it easily deployable in almost every central office and remote hub.
HiGain systems are capable of providing T1 service over two twisted pairs of copper wire of up to 12,000 feet in length over 24-gauge copper wire and up to 9,000 feet over 26-gauge wire without the repeaters or complicated engineering design required with repeatered T1 systems. According to Bellcore and the RBOCs, approximately 85% of the business subscriber loops nationwide are within these distances from the local central office. Each HiGain system provides a single end user with the service of one T1 line, which is the equivalent of 24 voice circuits for simple telephone service. An end user requiring the capacity of multiple T1 lines will require an equivalent number of HiGain systems.
The Company also provides HiGain systems in different forms to address variances in customer installation and configuration requirements. The Company's doubler product regenerates the HDSL signal at the end of a wire to a HiGain remote unit located a similar distance further on, allowing telephone companies to increase the distance range of HDSL from 12,000 feet to 24,000 feet and satisfy T1 demands by its more isolated customers. In addition, the Company has also introduced a product which provides a T1 connection over shorter distances requiring only one pair instead of two pairs of wire. The Company recently introduced a comprehensive range of HDSL-based HiGain products designed specifically to be deployed in digital loop carrier ("DLC") feeder environments where multiple T1s are used to link remote DLC systems to telephone company central offices.
To ensure flexibility of installation, the Company's HiGain units are available with a variety of shelf and mounting hardware, weather resistant housings and connecting hardware. In addition, all HiGain remote units provide self-diagnostic testing to detect failures and interface with the central office alarm system. The Company first shipped units of its HiGain system to customers in June 1992. As of December 31, 1997, the Company had shipped approximately 612,000 HiGain units.
ILLUSTRATION OF HIGAIN SYSTEM
[ILLUSTRATION]
ETSI HIGAIN SYSTEMS
In order to provide digital E1 solutions to the Company's customers outside of North America, including public carriers and private network operators, the Company introduced the HiGain ETSI Global Access product line. These products apply HDSL-based technology in compliance with ETSI requirements. They allow service providers to rapidly establish E1 connections between central offices and the customer. The equipment transfers data at rates of 2.048 kbps over four-wire circuits. Its applications include LAN and PBX networking, WAN connections, high-speed Internet access and videoconferencing. The Company's ETSI HiGain systems were recently approved by the British Approvals Board for Telecommunications for use with unconditioned, two-wire and four-wire circuits from British Telecommunications. This will allow service providers to link their private circuit networks into British Telecom's public network over unconditioned copper telephone lines.
Subscriber Carrier Systems
PG-2
PG-2 was the Company's first commercial product and was delivered to customers beginning in 1989. The PG-2 system allows telephone companies to establish two analog transmission lines over a single twisted pair of copper wires, where traditional technology only allowed the establishment of one line over a single twisted pair of copper wires. PG-2 systems are used by telephone companies to provide emergency service and additional line service to residences and small businesses. The Company's PG-2 system can also be used to convert a degraded analog copper pair to high-speed digital transmission. In the international marketplace, where the copper infrastructure is less extensive, these digital subscriber systems allow PTTs to expand telephone service without laying more copper lines.
The Company's PG-2 products compete worldwide with products from a number of telecommunications equipment manufacturers. The Company considers itself to be at a competitive disadvantage in the international market for the two channel digital subscriber carrier business served by its PG-2 system because it lacks a local manufacturing presence, which results in price disadvantages caused by import duties.
PG-FLEX SYSTEMS
PG-Flex is a small subscriber carrier product. PG-Flex employs HDSL technology to provide a system for delivering up to 32 standard phone lines on two pairs of wire over an operating range of up to 12,000 feet. The PG-Flex system operates in the local loop at carrier service area distances. The remote terminals are powered from the central office which enables virtually uninterrupted service during local power outages. The Company markets the PG-Flex product to both international and domestic telephone companies and expects significant competition in
both markets. The Company began production shipments of PG-Flex systems in 1996. PG-Flex has received numerous approvals from RBOCs and independent telcos.
ILLUSTRATION OF PG-FLEX SYSTEM
[ILLUSTRATION]
PG-PLUS
In 1997, the Company introduced PG-Plus, a small subscriber carrier system based on HDSL technology. The PG-Plus system can be configured to support four or six channels for POTS or ISDN over one unconditioned copper telephone line at distances up to 21,000 feet. PG-Plus can be deployed rapidly and is intended to offer low cost solutions to business and residential users who require additional voice, fax or data lines, or in emergency situations for temporary voice communications. The PG-Plus system consists of central office terminal and remote terminal equipment along with the alarm unit which is the central point of communication within the PG-Plus system.
Campus Systems
The Company's Campus systems are xDSL transmission products designed by the Company to meet the digital communications needs of organizations operating their own private networks. Campus systems are reconfigured versions of the HiGain product and provide high-speed digital connectivity over one or two twisted pairs of copper wires between user premises in campus environments. Examples of these environments include universities, hospitals, utility plants, military bases, industrial parks and corporate complexes. The Campus systems enable the interconnection of LANs, video conferencing, Internet and Intranet access, PBX extensions and many other applications.
A Campus system consists of two base units that operate at T1, E1, 768 kbps or 384 kbps speeds and are compatible with a number of standard data communications interfaces. These interfaces allow Campus systems to connect directly to LAN bridges, routers, T1 multiplexers, PBXs, video conferencing systems and other high-speed networking devices. The Company first shipped Campus systems to customers in June 1993.
CAMPUS STAR(TM)
The Company enhanced the Campus family of products in late 1994 with the Campus-Star access platform. The Campus-Star is a rack mountable module that incorporates power supplies and SNMP network management capabilities along with slots for up to 14 Campus unit equivalents. The use of the Campus-Star platform is driven by the needs of data communications managers to incorporate network management capabilities into their network components. PairGain has further enhanced the Campus-Star to provide Ethernet bridging interfaces and other high
bandwidth interfaces. The Campus-Star is being positioned to provide flexibility in supporting a broad range of access interfaces and is designed to be a core element of the networking strategy of Campus data communications managers.
CAMPUS-REX(TM)
The Company continued to enhance the Campus family of products with the introduction of the Campus-REX(TM) (Remote Ethernet eXpress), a full bandwidth Ethernet remote bridge, providing transparent connectivity between LANs without repeaters at a distance of up to five miles. It provides a 10BASE-T port, one serial port, an embedded SNMP agent and IEEE 802. 1d transparent MAC level bridging with Spanning Tree protocol support.
PAIRGAIN CAMPUS PRODUCT APPLICATIONS (Campus Area Network)
[NETWORK DIAGRAM]
OEM Products
The Company has formed an OEM sales group to establish relationships with manufacturers to integrate PairGain's xDSL technologies into their own products. Recent opportunities for relationships have centered around DLC manufacturers. The Company currently has relationships with DSC Communications and Advanced Fibre Communications.
Megabit Access Products
The Company's megabit access products offer high-speed solutions for a wide range of consumer and business applications, including Internet and remote LAN access. Megabit access products are designed for local exchange carriers, ISPs and private network owners.
MEGABIT MODEM(TM)
The Company's Megabit Modem products provide high-speed access to the Internet or corporate LANs at speeds up to 768 kbps in each direction. Megabit Modems may also be installed at remote office sites to extend high-speed services across wide area networks. It operates over a single copper telephone line and outperforms ISDN, cable modems and dial-up modems.
MEGABIT MODEM CRA(TM)
The Megabit Modem CRA are RADSL modems that have been designed to support a variety of applications in residential and business environments. The modems automatically adjust transmission speeds to the highest rate possible according to distance, traffic, line quality and other factors. The Megabit Modem CRA transfers data at speeds up to 3.2 Mbps downstream (to the subscriber) and 1 Mbps upstream to distances as far as 25,000 feet. With the addition of a S1 NID ADSL Splitter, both digital and analog signals can be transmitted simultaneously. The network management function for the RADSL products can be integrated with other xDSL products, consolidating network management functions for all network elements into one system. RADSL modems are easy to install and require no end user configuration.
ETHERPHONE(TM)
The Company's EtherPhone products provide both an Ethernet network connection and an analog POTS voice connection over a single telephone line. The unit mounts on the outside of a residence or small office, and does not require any end user configuration. The EtherPhone provides a 64 kbps voice channel and transmits data at speeds up to 704 kbps in each direction. EtherPhone products facilitate telecommuting applications and allow high-speed Internet access.
ADSL CHIPS
The Company recently introduced its Falcon DMT ADSL chip which is the industry's first single-chip DMT ADSL processor. The Falcon chip will support DMT ADSL and "splitterless ADSL," or G.lite, a standard currently under development by the ITU to simplify modem deployment by eliminating customer premises splitter installation for simultaneous data and analog voice connections. Although telephone companies have focused on deploying fiber and hybrid fiber and coaxial cable networks for delivering these advanced services, the Company believes the high cost and long implementation periods that will be involved in setting up these networks will provide a window of opportunity for equipment that can deliver similar capabilities on ordinary telephone wires.
CONSUMER APPLICATIONS
[GRAPHIC]
PRODUCTS UNDER DEVELOPMENT
HDSL2
The Company is currently collaborating with leading telecommunications companies to develop a new standard for second generation HDSL technology, known as HDSL2. The purpose of setting a standard is to move the industry toward interoperability. HDSL2 is being developed to deliver full T1 performance over a single twisted pair cable, with the same reach, robustness and spectral compatibility of current two-pair HDSL technology.
ADSL Modules
The Company is developing products that will use the Falcon chip to support DMT ADSL and "splitterless ADSL," or G.lite.
DSLAM
The Company is also providing resources to develop ATM-based Digital Subscriber Line Access Multiplexer ("DSLAM") products at its Tustin, California and Wallingford, Connecticut facilities.
CUSTOMERS
The Company sells its HiGain, PG-2, PG-Flex, PG-Plus and megabit access products primarily into the public network market and its Campus products primarily into the private network market. The Company uses its direct sales force to market its products to the public network market in the United States and Canada. The Company markets its domestic Campus products and all international products through both direct sales and distributors.
Public Networks
The public network market consists of the five RBOCs and their local telephone company affiliates, as well as independent telephone companies, CLECs, ISPs and international carriers.
RBOCs. Prior to selling products in volume to a local telephone company affiliated with an RBOC, a vendor must first receive approval of its product from the RBOC. Although the approval process for a new product varies somewhat among the five RBOCs, the process generally consists of the following three phases:
o Laboratory Evaluation. The product's functions and performance are tested against all relevant industry standards. This process can take from two weeks to three months, or longer, depending on a variety of factors.
o Field Trial. A number of actual telephone lines are equipped with the product for live operation in a field trial lasting from three weeks to three months, or longer. These field trials are for evaluating performance, assessing the ease of installation and establishing troubleshooting procedures. The RBOCs grant conditional approval upon successful completion of a new product's field trial, enabling field personnel to order limited quantities of the product under one-time approvals.
o Final Approval and Contract. Prior to final approval, which may take from one to four months, or longer, the RBOC develops and implements a variety of procedures that cover ordering, stocking, installation, maintenance, returns and all other activities associated with use of the product.
All five U.S. RBOCs and Bell Canada have approved the Company's HiGain products. In addition, several carriers have approved the Company's small subscriber carrier systems: two RBOCs and Bell Canada have approved the Company's PG-2 system, four RBOCs have approved the PG-Flex system and one RBOC has approved the PG-Plus system. Sales in the aggregate to local telephone companies affiliated with the five RBOCs accounted for approximately 57% of the Company's total revenues in 1997. See Note 3 of Notes to Consolidated Financial Statements contained in a separate section of this Annual Report on Form 10-K commencing on page.
Independent Telephone Companies. There are approximately 1,500 telephone companies in the United States that are unaffiliated with any of the RBOCs. The Company has targeted approximately 50 of the largest independent telephone companies as potential customers for its carrier products. Although the independent telephone company market does not present as large an opportunity as the RBOC market, the Company's experience has been that the independent telephone companies are often more receptive to new technology. As a result, the approval process for new technology is often less time consuming. Several of the large and small independent telephone companies have approved and deployed the Company's HiGain system. One large independent telephone company has approved the Company's PG-Flex and PG-2 small subscriber carrier systems.
CLECs and ISPs. There are numerous competitive local exchange carriers and Internet service providers throughout North America. These providers supply Internet access, T1, long distance and other residential services to consumers or businesses. In many cases, CLECs will lease unbundled network elements from the local exchange carrier to deliver digital services using their own transmission equipment. Most CLECs are focused on new types of data or voice services and are potential customers for the Company's products. The CLEC market is relatively new (since the 1996 Telecom Act), and it is unknown at this point how CLECs will evolve.
International Carriers. In most international markets there is one telephone company per country; there are no alternate carriers and no independents. Typically these PTTs are highly regulated, government-owned agencies that have an even more rigorous approval process for new technology than the RBOCs. While the international carrier network systems are architecturally similar to the domestic public networks, E1 service is not deployed as extensively in local subscriber loops internationally as T1 service is in local loops domestically. The demand for E1 service has grown, however, and international carriers are deploying it primarily to provide multiple voice circuits rather than the high-speed service requested in the United States. The Company's products have been successfully deployed in over 95 countries, and in 1997, sales outside of North America comprised approximately 9% of total revenues.
Private Networks
Customers for the Company's Campus products, first introduced in 1993, include universities, hospitals, military bases and other government installations, corporate complexes and other campus-like environments with private network systems.
SALES, MARKETING AND CUSTOMER SUPPORT
Sales and Marketing
The Company's direct sales force markets its products to the RBOCs and their local telephone company affiliates and to the larger independent telephone companies by working closely with the planning, switching and
transmission departments of such customers. The Company sells to other independent carriers, CLECs and owners of private networks through direct sales, telesales and distributors.
The Company's North American sales personnel are located in the following areas: California, Florida, Georgia, Utah, Texas, Washington, New Hampshire, Illinois, New Jersey, New York, North Carolina, Oregon, Massachusetts, Maryland, Missouri, Kansas, Colorado, Pennsylvania, Virginia, Washington, DC, and in the provinces of Alberta and Quebec. The Company sells its products outside of North America through its own sales force based in the United States, Switzerland, Brazil, Hong Kong and China, and a network of international data communications equipment distributors.
In addition to the specific sales efforts directed at its public and private network customers, the Company's marketing activities include participation in industry trade shows and conferences, distribution of sales and product literature, media relations, advertising in trade journals, direct mail and ongoing communications with its customers and industry analysts.
Customer Support
Service, repair and technical support of the Company's products are performed primarily in-house, however, the Company also uses an independent third party repair service. The Company's field service personnel are located in California, New York, Maryland, Georgia, Florida, Illinois, Texas, Missouri, Colorado, Virginia, Massachusetts, and Ontario, Canada, Sao Paulo, Brazil, Mexico City, Mexico, Dubai, U.A.E. and Guangzhou, China. The Company offers technical support to its customers on a 24-hours-a-day, 7-days-a-week basis via an 800 hotline and through paging systems for all support personnel. The Company's products are sold with a five year warranty.
PRODUCT DEVELOPMENT
The Company believes that its future success depends on its ability to maintain its technological leadership through enhancements of its existing products and development of new products that meet a wide range of customer needs. Accordingly, the Company intends to continue to make substantial investments in product development.
The Company's engineering efforts consist of microelectronics, software development and hardware development. Within the microelectronics group, a substantial majority of the Company's efforts are devoted to the development of ADSL, the enhancement of microelectronics used in the Company's HiGain and Campus product lines and the development of microelectronics products based on the Company's existing products. Within the software development group, the Company's efforts are devoted to the development and enhancement of network management software and protocol compliance for its products and the development of firmware for products such as PG-Flex, PG-Plus and ETSI.
The remainder of the Company's research and development is devoted to the development, improvement and enhancement of new and existing hardware products and is directed at the following:
o Cost Reduction. The Company continuously reviews the design and manufacturing process of its products to determine areas of product cost savings or enhanced product quality. This review includes, among other things, an examination of the product design to determine if further improvements can be made in the VLSI components.
o Product Line Extensions. The Company seeks to extend its existing product lines through product modifications and enhancements in order to meet the needs of its different customers and their applications. Products resulting from the Company's product line extension efforts include the PairGain Management System for management of HiGain products, long range 384 kbps Campus systems, single pair T1 systems and the HiGain doubler product.
o New Technology. The Company explores new transmission technologies to determine whether they represent an opportunity for products incorporating the Company's DSP and copper transmission expertise.
During 1997, 1996 and 1995, research and development expenses were approximately $32.0 million, $19.5 million and $10.7 million, respectively. All of the Company's research and development expenses were charged to operations as incurred.
MANUFACTURING
The Company's manufacturing operations consist primarily of final assembly, burn-in, full system test, packaging and shipping. The Company uses domestic independent third-party contract assembly companies on a consignment basis for circuit board assembly, including in-circuit and functional testing, for many of its products. The Company conducts final assembly and final test functions for those products at its facility in Tustin, California. In addition, the Company performs extensive burn-in, testing and inspection of all of its products prior to shipping them to customers. Product quality and reliability are the Company's prime concerns in all phases of the manufacturing process. Quality control is maintained through incoming inspection of components and subassemblies, auditing of consignment and turnkey contractors, in-house final assembly and test functions, plus a final shipping inspection of all products. During 1996, the Company entered into an agreement to have its PG-2 and PG-Plus products manufactured, on a turnkey basis, by Jabil Circuits at Jabil's St. Petersburg, Florida facility. Under the terms of this agreement, Jabil manufactures, tests, packages and ships these products directly to the Company's customers.
In April 1996 the Company achieved ISO 9001 certification for its manufacturing operations located in Tustin, California. ISO 9000 Quality Standards were developed by the International Organization for Standardization. It is a quality system standard for ensuring a total quality management system in engineering and manufacturing and is becoming an accepted prerequisite for international trade. ISO 9001 is the most comprehensive standard, covering design and development as well as production, installation and service.
The Company currently procures all of its components from outside suppliers, either directly from manufacturers or distributors or through its consignment and turnkey contractors. The Company generally purchases and stores the more expensive components at its location and allows its assembly and test subcontractors to purchase and store other necessary components. In procuring components, the Company and its subcontractors rely upon a number of suppliers that are the sole source for certain of the components. One such sole supplier part is the SPAROW II chip. Although the Company has utilized its VLSI expertise to design its SPAROW II chip in a manner that will facilitate transition to multiple sources of supply, such a transition could result in delays or reductions in product shipments which, in turn, could have a material adverse effect on the Company's customer relationships and operating results.
The Company's backlog at December 31, 1997 was approximately $10.4 million. The Company includes in backlog all firm purchase orders for products regardless of their ship date. Because of the quick turnaround that the Company's customers expect on their orders, and because of the possibility of customer changes in delivery schedules or cancellation of orders, the Company's backlog as of any particular date may not be indicative of actual revenues expected for any future period.
The Company's products are subject to FCC regulations regarding emission of electromagnetic energy, which may interfere with other equipment. All of the Company's currently commercially available products have been tested and comply with the relevant FCC regulations. The Company's commercially available products that are sold for use at the end user's premises, such as the HiGain remote unit and the Campus products, also comply with all required UL safety specifications.
COMPETITION
Competition in the Company's markets is intense, and the Company expects that competition will increase. Many of the Company's potential competitors have substantially greater name recognition and technical, financial and marketing resources than the Company. There can be no assurance that the Company will have the financial resources, technical expertise or marketing, distribution and support capabilities to compete successfully in the future. Competitive pressures could reduce demand for the Company's products, cause the Company to further reduce prices on its existing products, increase expenses or cause delays or cancellations of customer orders, any one of which could adversely affect the Company's business and results of operations.
Some companies that offer competitive products in PairGain's primary revenue segments are listed below:
All manufacturers of products based on HDSL technology face competition from fiber optic and conventional repeatered systems as alternate solutions for the delivery of T1, E1 and other high-bandwidth services to end users. As telephone companies continue to install fiber cable and conventional repeatered T1 systems to provide high-bandwidth service in local subscriber loops, the demand for HDSL products may decline. Further, the deployment of fiber to replace existing HDSL installations will result in the availability of those existing HDSL systems for installation elsewhere and may adversely affect future demand for HDSL products.
The Company is investing heavily in xDSL developments. The market for xDSL-based products is emerging and will change dramatically over a very short time. There can be no assurance that the products the Company develops will be commercially successful.
PROPRIETARY RIGHTS
The Company relies on a combination of technical leadership, trade secret, patent, copyright and trademark law and nondisclosure agreements to establish and protect its proprietary rights in its products. Currently, the Company holds two United States patents and has an application pending for one additional patent. The Company also has certain registered and other trademarks. The Company believes that, because of the rapid pace of technological change in the networking industry, patent and copyright protection are less significant to the Company's competitive position than factors such as the knowledge, ability and experience of the Company's personnel, new product development, market recognition and ongoing product maintenance and support.
EMPLOYEES
As of December 31, 1997, the Company employed 640 persons, including 227 in manufacturing, 99 in sales and marketing, 20 in customer service, 241 in engineering and 53 in finance and administration. The Company also employs a number of temporary and contract employees. During the last quarter of fiscal 1997, the Company employed between 94 and 100 temporary employees, mostly in manufacturing. None of the Company's employees is represented by a labor union and the Company has experienced no work stoppages. The Company does not have any employment contracts with any of its executive officers.
ITEM 2.
ITEM 2. PROPERTIES. - --------------------
The Company has several property leases, as detailed below:
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS. - ---------------------------
In January 1996, the Company received a copy of a complaint, filed derivatively by a Company stockholder on behalf of the Company, naming as defendants the Company's directors and certain officers, as well as Mr. S. Jay Goldinger and Capital Insight, Inc., a third party investment advisor. This suit arose out of losses incurred by the Company in 1995 of approximately $15.8 million in connection with unauthorized trading of investments made by Mr. Goldinger and Capital Insight on the Company's behalf. The derivative complaint alleged causes of action for breach of fiduciary duty, abuse of control, constructive fraud, gross mismanagement and waste of corporate assets. The complaint sought in excess of $15.8 million in damages and legal fees and expenses in connection with the loss by the Company of the funds it provided to Mr. Goldinger and Capital Insight. The suit was filed in Superior Court of the State of California, County of Orange. Additionally, the same stockholder filed a separate, related complaint, brought derivatively on behalf of the Company, in the Orange County Superior Court, against a brokerage firm involved in the Capital Insight matter.
In September 1996, the Company and other parties to the derivative suits described above executed definitive settlement agreements to settle and dismiss the derivative suits. The Court approved the settlement on November 19, 1996. Under the terms of the settlement, the Company received $2.5 million from a brokerage firm involved in processing the investments for Capital Insight, and paid plaintiff's attorneys fees of $450,000. The impact of the settlement was recorded in the Company's financial statements for the year ended December 31, 1996.
In January 1996, the Company filed suit in Los Angeles federal court against Mr. S. Jay Goldinger and Capital Insight, Inc. charging unauthorized trading, fraudulent misrepresentation, violation of federal securities laws and breach of fiduciary duties. The suit seeks $15.8 million in damages by reason of the losses incurred by the Company, as well as punitive damages and legal fees.
As previously reported, the U.S. Attorney's office and the Securities and Exchange Commission have been investigating S. Jay Goldinger and Capital Insight, Inc. in connection with their loss of nearly $100 million of their clients' funds, including $15.8 million of PairGain's funds. The U.S. Attorney and the SEC are also investigating whether PairGain and some of its past and present officers and employees engaged in any wrongdoing with respect to PairGain's investment of its excess cash with Capital Insight, the disclosure of such investments and the disclosure of losses incurred.
See Notes 15 and 16 of Notes to Consolidated Financial Statements contained in a separate section of this Annual Report on Form 10-K commencing on page.
The Company does not maintain Directors and Officers liability insurance. However, under the terms of its certificate of incorporation, the Company indemnifies its directors and officers for damages and legal fees arising from litigation matters.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. - -------------------------------------------------------------------------------
The Company's Common Stock is traded on The Nasdaq Stock Market(SM) under the symbol PAIR. As of January 30, 1998, there were 69,361,762 shares of the Company's Common Stock issued and outstanding. The number of stockholders of record at that date was 637. This number does not account for Common Stock registered in street name. Accordingly, the actual number of holders of record of the Company's Common Stock may be significantly greater than the number indicated above. The following table sets forth, for the fiscal periods indicated, the high and low sale prices for the Common Stock as reported on the Nasdaq Stock Market(SM). The market quotations set forth below reflect inter-dealer prices, without retail markup, markdown or commissions, and may not necessarily represent actual transactions. The Company has never paid cash dividends and has no present intention of declaring a cash dividend for the foreseeable future.
On January 30, 1998, the last reported sales price for the Company's stock was $18.38.
* 1996 share prices have been adjusted for the June 18, 1996 and December 18, 1996 two-for-one stock splits.
USE OF PROCEEDS FROM REGISTERED SECURITIES
The effective date of the Company's first registration statement (the "Registration Statement") filed on Form S-1 (Registration No. 33-66680) under the Securities Act of 1993, as amended, was September 13, 1993. The class of securities registered was Common Stock. The offering commenced on September 15, 1993 and all securities were sold in the offering. The managing underwriters for the offering were Lehman Brothers, Inc. and Hambrecht & Quist, Inc.
Pursuant to the Registration Statement, the Company sold 4,140,000 shares of its Common Stock for an aggregate offering price of $58.0 million, and certain selling shareholders sold 632,500 shares of the Common Stock of the Company for an aggregate offering price of $8.9 million.
The Company incurred expenses of $4.7 million of which $4.1 million represented underwriting discounts and commissions and $573,000 represented other expenses. All such expenses were direct or indirect payments to others. The net offering proceeds to the Company after total expenses was $53.3 million.
Of the net proceeds from the offering, $5.3 million was used to pay off indebtedness in 1993 and $48.0 million has been invested in short-term investments. In 1995, the Company realized a $15.8 million unauthorized trading loss. See Notes 15 and 16 of Notes to Consolidated Financial Statements contained in a separate section of this Annual Report on Form 10-K commencing on page.
The use of the proceeds from the offering does not represent a material change in the use of the proceeds described in the prospectus which is part of the Registration Statement.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA. - ---------------------------------
SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data of the Company as of December 31, 1997 and 1996 and for the years ended December 31, 1997, 1996 and 1995 is derived from audited consolidated financial statements of the Company included elsewhere in this Annual Report. The selected consolidated financial data of the Company as of December 31, 1995, 1994 and 1993 and for the years ended December 31, 1994 and 1993 are derived from audited consolidated financial statements of the Company not included in this Annual Report. The following information should be read in conjunction with the Consolidated Financial Statements of the Company and the related notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in separate sections of this Annual Report.
The Company paid no dividends on its Common Stock during any of the periods presented.
(1) Financial data for 1996 reflect the February 27, 1997 business combination between PairGain and Avidia Systems, Inc. accounted for on a pooling-of-interests basis. Avidia was formed in December 1995 and had no significant transactions prior to January 1, 1996. See Notes 1 and 2 of Notes to the Consolidated Financial Statements contained in a separate section of this Annual Report on Form 10-K commencing on page.
(2) All share and per share amounts have been adjusted for the June 18, 1996 and December 18, 1996 two-for-one stock splits and have been restated to reflect the adoption of SFAS No. 128, "Earnings Per Share" ("SFAS No. 128").
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 the consolidated financial statements and related notes included elsewhere herein as well as the section entitled "Risk Factors" in Item 1 of this Annual Report. The Company's future operating results may be affected by various trends and factors which are beyond the Company's control. These include, among other factors, economic, competitive, governmental and technological factors affecting the Company's operations, markets, products, services and prices. Accordingly, past results and trends should not be used by investors to anticipate future results or trends.
Except for the historical information contained herein, the matters discussed in this Annual Report are forward-looking statements which involve risk and uncertainties. A number of important factors including those contained in the section entitled "Risk Factors," as well as factors discussed elsewhere in this report and in the Company's other reports filed with the Securities and Exchange Commission, could affect the Company's actual results and cause actual results to differ materially from those in the forward-looking statements.
OVERVIEW
PairGain Technologies, Inc. ("PairGain" or the "Company") is a leading provider of telecommunications products based on high-speed Digital Subscriber Line ("xDSL") technology. The Company designs, manufactures, markets and supports products that allow telecommunications carriers and private network owners to expand the capabilities of copper cable and more efficiently provide high-speed digital services to end users over the large existing infrastructure of unconditioned copper wires. These services enable high-speed data transmission for applications such as T1/E1, high-speed Internet access, telecommuting, local and wide area networking and video conferencing.
The Company's first product was PG-2, a two-channel digital subscriber carrier system, which was initially shipped in late 1989. In 1991, the Company undertook the development of its HiGain products, which were first shipped in June 1992. In June 1993, the Company introduced its Campus line of products, and in 1996, began shipping its PG-Flex product, a small subscriber carrier system for delivering up to 32 voice channels over two pair of copper wires. In the first quarter of 1997, the Company commenced shipments of its PG-Plus and ETSI products. Revenues from HiGain products represented approximately 67% the Company's total revenues in 1997 and 76% of the Company's total revenues in both 1996 and 1995. Although revenues from sales of the Company's HiGain products have historically represented a substantial majority of the Company's total revenues and are expected to continue to account for a majority of its revenues for the foreseeable future, the Company believes that revenues from sales of its Campus, PG-Flex, PG-Plus and other products will continue to increase as a percentage of total revenues in the future.
Commencing in mid-1993, the Company began reducing the average sales prices of its HiGain products in an effort to increase market demand for its products and in anticipation of expected price competition. These reductions have been significant, representing reductions of then current prices of as much as 16% in 1997, 14% in 1996 and 23% in 1995. Although future effects of price competition and other competitive pressures inherent in the Company's business are uncertain, the Company expects to continue to reduce the average sales prices of its HiGain and other products. Accordingly, the Company's ability to maintain or increase revenues will depend in part upon its ability to increase unit sales volumes of existing products and to introduce and sell new products at rates sufficient to compensate for the reduced revenue effect of such continuing reductions in the average sales prices of the Company's existing products. Declining average sales prices may also adversely affect gross margins on the Company's existing products if the Company is unable to fully offset such reductions in average sales prices by reductions in the Company's per unit costs. During 1997, 1996 and 1995 the Company's continuing effort toward cost reduction through engineering design changes, reduced prices for components, increased manufacturing efficiencies and increases in volume resulted in gross margins of 49% in 1997 and 48% in 1996 and 1995. However, there can be no assurance that the Company will be able to continue to increase unit sales volumes, introduce and sell new products or further reduce its per unit costs in the future.
RESULTS OF OPERATIONS
The results of operations discussed below are comprised of two sections. The first section compares 1997 to 1996 for all items noted on the Consolidated Statements of Income contained in a separate section of this Annual Report on Form 10-K commencing on page. The second section compares 1996 to 1995 for the same items.
All share and per share amounts have been adjusted to reflect the two-for-one stock splits effective June 18, 1996 and December 18, 1996 and have been restated to reflect the adoption of SFAS No. 128, for all periods presented.
The following table sets forth, for the periods indicated, certain operating data as a percentage of total revenues.
1997 Compared to 1996
REVENUES
Revenues increased 37% to $282.3 million in 1997 compared with $205.5 million in 1996. This increase was primarily due to a 39% increase in unit sales volume of the Company's HiGain products and, to a lesser extent, a 57% and 41% increase in unit sales volume of the Company's Campus and PG-2 products, respectively. These increases were partially offset by declines in the average sales prices of HiGain and Campus products of 16% and 13%, respectively. In addition, revenues from the Company's PG-Flex, PG-Plus and megabit access products increased to 7% of total revenues in 1997 compared to 2% in 1996. Revenue per average employee increased to $432,000 in 1997, compared to $399,000 in 1996.
Aggregate sales to local telephone companies affiliated with the five RBOCs accounted for approximately 57% and 62% of the Company's total revenues for 1997 and 1996, respectively.
GROSS PROFIT
Gross profit represents total revenues for a period, including royalty income, less the cost of revenues for such period. Cost of revenues represents primarily product costs, together with associated overhead expenditures and provisions for inventory and warranty reserves. In 1997, the Company's gross profit as a percentage of total revenues increased to 49% from 48% in 1996 despite decreases in average sales prices and increases in overhead spending and provisions for inventory and warranty reserves. The Company's continuing effort toward cost reduction through engineering design changes, reduced prices for components, increased manufacturing efficiencies and increases in volume was the primary reason for the Company's ability to increase gross margin to 49% of revenues in 1997.
OPERATING EXPENSES
Operating expenses, excluding merger expenses, increased 38% to $65.4 million in 1997 from $47.5 million in 1996. As a percentage of revenue, operating expenses, excluding merger expenses in 1997, were 23% for 1997 and 1996. The majority of the increase in absolute operating expense levels was in the area of research and development with the remainder of the increase coming from selling and marketing expenses. The Company plans to increase its relative spending in engineering and field sales support in an effort to continue to develop and market new products and technologies such as the small subscriber and megabit access product lines and the newly released Falcon(TM) DMT ADSL chip.
Research and development expense increased 64% to $32.0 million in 1997 from $19.5 million in 1996. Research and development expense was 11% of total revenues in 1997 compared to 9% in 1996. The increase in expenses was primarily due to the addition of personnel for the development of new products, specifically, development programs for PG-Flex, PG-Plus, Falcon chip technology and megabit access products, and sustaining, enhancement and cost reduction programs for HiGain and Campus products. Costs for prototype expenditures as new products were tested in the lab and payments to consultants where specific resources were needed in the development process also increased in 1997 over the prior year. The Company anticipates that research and development expenses will continue to increase as new products are further developed and other xDSL technologies and applications are pursued.
Selling and marketing expense increased 30% to $22.8 million in 1997 from $17.6 million in 1996. Selling and marketing expense as a percentage of total revenues was 8% in 1997 and 9% in 1996. The increase in absolute expense levels was primarily due to the addition of personnel and the associated increase in salaries, benefits and travel expenses, and additional advertising and trade show expenditures designed to market the Company's new products and technology. In addition, costs related to the expansion of the Company's presence in the international market more than doubled over the prior year. The Company anticipates higher selling and marketing spending levels in the future in order to maintain its leadership position in the xDSL market and to secure market share in the small subscriber and megabit access markets.
General and administrative expense increased to $10.6 million in 1997 from $10.4 million in 1996. Increases in personnel-associated costs and expenditures for computer equipment, software maintenance and consulting fees related to upgrading the Company's information system capabilities were offset by decreases in legal fees and provisions for bad debts. General and administrative expense as a percentage of total revenues was 4% in 1997 compared to 5% in 1996.
MERGER EXPENSES
Expenses related to the acquisition of Avidia Systems, Inc. aggregating approximately $2.6 million were charged against the operations of the Company in the quarter ended March 31, 1997. These expenses consisted of $1.8 million in investment banking fees, $588,000 in legal fees, $120,000 in accounting fees and $121,000 in other expenses.
INTEREST INCOME, NET
Net interest income was $6.9 million in 1997 and $3.7 million in 1996. The increase in interest income was the result of increased average cash balances.
GAINS ON SALES OF SHORT-TERM INVESTMENTS
Realized gains on sales of short-term investments were $23,000 in 1997. There were no realized gains on sales of short-term investments in 1996 and there were no realized losses on sales of short-term investments in 1997 or 1996.
LOSS ON NOTE RECEIVABLE AND LONG-TERM INVESTMENT
In July 1995, the Company entered into certain agreements with Sourcecom Corporation of Westlake, California ("Sourcecom"). The agreements provided for the incorporation of Sourcecom's networking technology into the Company's current and future transmission products. Under the terms of the agreements, the Company loaned Sourcecom $2.7 million and had rights to purchase a minority ownership position. The note bore interest at the prime rate less one percent, payable monthly, with the principal balance due July 1999.
In April 1996, the Company purchased approximately 150,000 shares of Sourcecom's Series A Preferred Stock for an aggregate of $273,000. In September 1996, the Company purchased approximately 321,000 shares of Sourcecom's Common Stock for an aggregate of $271,000. Shares purchased have been adjusted to reflect Sourcecom's two-for-one stock split, effective September 24, 1996.
In the third quarter of 1997, Sourcecom filed for protection from creditors under the U.S. Bankruptcy Act. Accordingly, the Company recorded a valuation adjustment of $544,000 during the third quarter of 1997 to reflect an impairment in its investment in Sourcecom. In December 1997, Sourcecom and the Company reached an agreement for a mutual release of all claims. Under the terms of the release, Sourcecom paid $2.6 million to the Company to settle the loan made under the original agreements. In the fourth quarter of 1997, the Company wrote-off the balance of the note and associated legal fees aggregating $200,000.
SETTLEMENT INCOME RELATED TO UNAUTHORIZED TRADING OF INVESTMENTS BY THIRD PARTIES
As described in Notes 15 and 16 of Notes to the Consolidated Financial Statements, the Company incurred a loss of $15.8 million from unauthorized and inappropriate trading of investments by third parties in 1995.
In January 1996, the Company received copies of complaints filed derivatively by a Company stockholder on behalf of the Company, naming as defendants the Company's directors and certain officers, as well as Capital Insight and Mr. S. Jay Goldinger, its president, and a brokerage firm used in executing and clearing transactions authorized by Mr. Goldinger. The derivative complaint stated causes of action for breach of fiduciary duty, abuse of control, constructive fraud, gross mismanagement and waste of corporate assets. The suit sought an award in the amount of all damages sustained by the Company including the losses of $15.8 million and legal fees and expenses.
In September 1996, the Company and other parties to the derivative suits described above executed definitive settlement agreements to settle and dismiss the derivative suits. The Court approved the settlement on November 19, 1996. Under the terms of the settlement, the Company received $2.5 million from a brokerage firm involved in processing the investments for Capital Insight, and the Company paid plaintiff's attorneys fees of $450,000. The impact of the settlement was recorded in the Company's financial statements for the year ended December 31, 1996.
PROVISION FOR INCOME TAXES
The Company's provision for income taxes increased to $30.3 million in 1997, compared to $22.8 million in 1996. The effective tax rate during 1997 was 39%. The effective tax rate during 1996 was 40%.
Excluding non-deductible merger expenses, the 1997 effective tax rate was 38%. The primary reason for the reduction in the Company's effective tax rate was due to additional research and development tax credits.
NET INCOME AND EARNINGS PER SHARE
Net income for the year ended December 31, 1997 was $47.6 million or $0.70 per share, compared to $34.9 million or $0.54 per share, for the year ended December 31, 1996. The weighted average number of common shares outstanding were 68.0 million and 64.2 million for the years ended December 31, 1997 and 1996, respectively. This increase in common shares was attributable to the exercise of stock options and warrants and the issuance of shares under the Employee Stock Purchase Plan.
Earnings per share, taking into account the dilutive effects of common stock options and warrants, were $0.63 per share and $0.47 per share for the year ended December 31, 1997 and 1996, respectively. The weighted average number of common and common equivalent shares outstanding were 75.2 million in 1997 and 73.8 million in 1996.
1996 Compared to 1995
REVENUES
Revenues increased 92% to $205.5 million in 1996 compared with $107.2 million in 1995. This increase was primarily due to a 106% increase in unit sales volume of the Company's HiGain products and, to a lesser extent, a 90% and 64% increase in unit sales volume of the Company's Campus and PG-2 products, respectively. These increases were somewhat offset by declines in the average sales prices of HiGain and Campus products of 14% and 7%. Revenue per average employee increased 46% to $399,000 in 1996, compared to $274,000 in 1995.
Aggregate sales to local telephone companies affiliated with the five RBOCs accounted for approximately 62% and 65% of the Company's total revenues for 1996 and 1995, respectively. In addition, included in revenues for 1995 was royalty income totaling $1.1 million. These royalties were paid to the Company primarily in connection with technology licensing agreements entered into with Alcatel and ADC Telecommunications, Inc. In 1995, the agreement between the Company and Alcatel was renegotiated. As a result, royalty income from these licensing agreements will be minimal in future periods.
GROSS PROFIT
In 1996, the Company's gross profit as a percentage of total revenues continued at the 1995 rate of 48% in spite of decreases in average sales prices, a decline in royalty income and increases in overhead spending and provisions for inventory and warranty reserves. The Company's continuing effort toward cost reduction through engineering design changes, reduced prices for components, increased manufacturing efficiencies and increases in volume, was the primary reason for the Company's ability to maintain gross margin at 48% of revenues.
OPERATING EXPENSES
Research and development expense increased to $19.5 million in 1996 from $10.7 million in 1995. Research and development expense was 9% of total revenues in 1996 compared to 10% in 1995. The increase in absolute expense levels was primarily due to the addition of personnel for the development of new products, specifically, development programs for PG-Flex, PG-Plus, Falcon chip technology and megabit access products, and sustaining, enhancement and cost reduction programs for HiGain and Campus products. Costs for prototype expenditures as new products were tested in the lab and payments to consultants where specific resources were needed in the development process also increased in 1996 over the prior year. In addition, the Company's research and development facility in Raleigh, North Carolina, which was established in the second half of 1995, and its research facility in Wallingford, Connecticut, which was established in December 1995, were expanded significantly during 1996.
Selling and marketing expense increased to $17.6 million in 1996 from $9.9 million in 1995. This increase in expense levels was primarily due to the addition of personnel and the associated increase in salaries, commission and travel expenses, and additional advertising and trade show expenditures. Selling and marketing expense as a percentage of total revenues was 9% in both 1996 and 1995.
General and administrative expense increased to $10.4 million in 1996 from $6.8 million in 1995. This increase was primarily due to the addition of personnel, payments to outside consultants related to the implementation of an information systems upgrade, legal and accounting fees related to the unusual trading losses and subsequent settlement and an overall increase in spending commensurate with the Company's increase in headcount and operating activities. General and administrative expense as a percentage of total revenues was 5% in 1996 compared to 6% in 1995.
INTEREST INCOME, NET
Net interest income was $3.7 million in 1996 and $2.1 million in 1995. The increase in interest income was the result of increased average cash balances.
GAINS ON SALES OF SHORT-TERM INVESTMENTS
There were no realized gains or losses on sales of investments in 1996. Realized gains on sales of short-term investments were $415,000 in 1995.
UNUSUAL LOSS / SETTLEMENT INCOME RELATED TO UNAUTHORIZED TRADING OF INVESTMENTS BY THIRD PARTIES
As described in Notes 15 and 16 of Notes to the Consolidated Financial Statements, the Company incurred a loss of $15.8 million from unauthorized and inappropriate trading of investments by third parties in 1995.
In January 1996, the Company received copies of complaints filed derivatively by a Company stockholder on behalf of the Company, naming as defendants the Company's directors and certain officers, as well as Capital Insight and Mr. S. Jay Goldinger, its president, and a brokerage firm used in executing and clearing transactions authorized by Mr. Goldinger. The derivative complaint stated causes of action for breach of fiduciary duty, abuse of control, constructive fraud, gross mismanagement and waste of corporate assets. The suit sought an award in the amount of all damages sustained by the Company including the losses of $15.8 million and legal fees and expenses.
In September 1996, the Company and other parties to the derivative suits described above executed definitive settlement agreements to settle and dismiss the derivative suits. The Court approved the settlement on November 19, 1996. Under the terms of the settlement, the Company received $2.5 million from a brokerage firm involved in processing the investments for Capital Insight, and the Company paid plaintiff's attorneys fees of $450,000. The impact of the settlement was recorded in the Company's financial statements for the year ended December 31, 1996.
PROVISION FOR INCOME TAXES
The Company's provision for income taxes increased to $22.8 million in 1996, compared to $9.2 million in 1995. The effective tax rate during 1996 was 40%. The effective tax rate during 1995 was 90%, since the Company did not record any tax benefit on the unusual trading losses in that year.
Excluding the $15.8 million unusual loss, the Company's effective tax rate in 1995 was 37%. The increased effective tax rate in 1996 over 1995 was principally attributed to tax-free interest income representing a smaller proportion of total pre-tax income as a result of the earnings growth. Additionally, the Company did not record any tax benefit related to Avidia Systems net operating losses and research and development tax credits for pre-acquisition periods due to the uncertainty of their realization as a result of separate return limitation year rules.
NET INCOME AND EARNINGS PER SHARE
Net income for the year ended December 31, 1996 was $34.9 million or $0.54 per share, compared to $1.1 million or $0.02 per share, for the year ended December 31, 1995. Excluding the impact of the unauthorized trading loss, 1995 net income was $16.5 million or $0.28 per share. The weighted average number of common shares outstanding were 64.2 million and 58.2 million for the years ended December 31, 1996 and 1995, respectively. This increase in common shares was attributable to the exercise of stock options, the issuance of stock under the Employee Stock Purchase Plan and the issuance of Common Stock by Avidia prior to its acquisition by the Company.
Earnings per share, taking into account the dilutive effects of common stock options and warrants, were $0.47 per share and $0.02 per share for the year ended December 31, 1996 and 1995, respectively. Excluding the impact of the unauthorized trading loss, 1995 diluted earnings per share were $0.24. The weighted average number of common and common equivalent shares outstanding were 73.8 million in 1996 and 67.2 million in 1995.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 1997, the Company had $176.6 million in cash, cash equivalents and short-term investments and $214.7 million in working capital, compared to $114.2 million in cash, cash equivalents and short-term investments and $140.7 million in working capital in 1996. These figures represent an increase of $62.4 million in cash, cash equivalents and short-term investments and $74.0 million in working capital over December 31, 1996. These increases were primarily attributable to cash generated from operations of $66.3 million and $8.1 million in cash generated from the issuance of Common Stock resulting from exercises of options and warrants and Common Stock sold under the Employee Stock Purchase Plan, offset by capital expenditures of $13.5 million. In 1996, the Company had cash flow from operations of $60.2 million. In addition, $10.4 million in cash was generated from the issuance of stock, including $7.4 million resulting from the exercises of common stock options and Common Stock sold under the Employee Stock Purchase Plan and $3.0 million from the issuance of stock by Avidia prior to its acquisition by the Company.
Accounts receivable increased to $35.4 million at December 31, 1997, compared to $23.9 million at December 31, 1996. Gross inventories increased $9.8 million to $50.6 million at December 31, 1997 compared to $40.8 million at December 31, 1996, due to increased stocking levels to support future shipments. Reserves for inventory obsolescence, excess quantities, cost reductions and test and evaluation inventories increased to $20.1 million at December 31, 1997 compared to $14.7 million at December 31, 1996. The primary reasons for the increase in these reserves were: (a) an increase in components, materials and sub-assemblies to support production builds; (b) an increase in excess and obsolete inventories; (c) valuation reductions due to product cost reduction programs; and (d) an increase in test and evaluation inventories of new products on trial with customers. The Company's net inventory turns increased to 4.7 times in 1997 from 4.1 times in 1996.
Capital expenditures were $13.5 million, $7.6 million and $5.9 million for the years ended December 31, 1997, 1996 and 1995, respectively. Included in these amounts were approximately $3.5 million, $450,000 and $750,000 in 1997, 1996 and 1995, respectively, of software and equipment purchased to upgrade the Company's information system capabilities. Additional expenditures in 1997 included $1.2 million for a manufacturing and material handling system, $1.8 million in improvements to the Company's new engineering and production facility adjacent to its main Tustin facility and $4.8 million for test equipment primarily related to new products. Expenditures in 1996 also included $251,000 in leasehold improvements at two of the Company's Tustin facilities and $158,000 in leasehold improvements at the Company's Raleigh, North Carolina research and development center. Included in the 1995 additions is $1.0 million in leasehold improvements at the Company's Tustin, California manufacturing, engineering and administrative headquarters.
During 1996, the Company made investments in Sourcecom and E/O Networks ("E/O") of $544,000 and $3.0 million, respectively. Both investments were made with internally generated funds. In the third quarter of 1997, Sourcecom filed for protection from creditors under the U.S. Bankruptcy Act. The Company recorded a valuation adjustment to its investment of $544,000 during the third quarter of 1997 to reflect an impairment in its investment in Sourcecom. A mutual release of all claims between Sourcecom and the Company was reached in
December 1997. Under the terms of the release, Sourcecom paid $2.6 million to the Company to offset the $2.7 million loan made to Sourcecom in 1995. Accordingly, in the fourth quarter of 1997, the Company wrote off the balance of the loan and associated legal fees aggregating $200,000.
The Company maintains an unsecured line of credit with a bank. The line allows maximum borrowings of $5,000,000, including the issuance of letters of credit and foreign exchange contracts. The line bears interest at the prime rate (8.5% at December 31, 1997). At December 31, 1997, the Company had no outstanding borrowings under this line of credit. The debt agreement specifies certain financial and other covenants. The Company was in compliance with the financial and other covenants at December 31, 1997. The agreement expires May 1, 1998. The Company typically renews the line upon expiration.
The Company has no other material near-term commitments for its funds. The Company believes that the current cash and short-term investment balances and internally generated cash flow will be sufficient to meet its working capital and capital expenditure requirements through 1998. To the extent that the Company's existing resources, together with future earnings, are insufficient to fund the Company's future activities, the Company may need to raise additional funds through public or private financings.
YEAR 2000 ISSUE
Many of the world's computer systems currently record years in a two-digit format. Such computer systems will be unable to properly interpret dates beyond the year 1999, which could lead to business disruptions in the U.S. and internationally (the "Year 2000" issue). The potential costs and uncertainties associated with the Year 2000 issue will depend on a number of factors, including software, hardware and the nature of the industry in which a company operates. Additionally, companies must coordinate with other entities with which they electronically interact, such as customers, creditors and borrowers.
In 1997, the Company began a review of its computer systems to assess the potential costs and scope of the Year 2000 issue. In January 1998, the Company began a project to upgrade its core business applications which support sales and customer service, manufacturing, distribution and finance and accounting, with an implementation target of October 1998. Additional areas that require conversion are expected to be identified by the end of the first quarter of 1998, with a goal of completing all relevant internal software remediation and testing by the end of 1998. Year 2000 compliance efforts and testing will continue through 1999.
The Company will utilize both internal and external resources to reprogram, or replace, and test its software for Year 2000 modifications. The total cost to the Company of these Year 2000 issue activities has not been and is not anticipated to be material to its financial position or results of operations in any given year. Purchased hardware and software will be capitalized in accordance with normal policy. Personnel and all other costs related to the project are being expensed as incurred. Costs incurred related to the Year 2000 issue are being funded through operating cash flows.
An assessment of the readiness of external entities with which the Company interfaces, such as vendors, counterparties, customers, payment systems and others, is ongoing. The Company has initiated formal communications with all of its significant suppliers and large customers to determine the extent to which the Company's interface systems are vulnerable to those third parties' failure to remedy their own Year 2000 issue. There can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted and would not have an adverse effect on the Company's systems.
The above was based upon management's best estimates, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, the nature and amount of programming required to upgrade or replace each of the affected programs, the rate and magnitude of related labor and consulting costs and the success of the Company's external customers and suppliers in addressing the Year 2000 issue.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"). SFAS No. 130 discusses how to report and display comprehensive income and its components in a full set of general-purpose financial statements. Also in June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires those enterprises to report selected information about operating segments in interim financial reports issued to shareholders. SFAS No. 130 and SFAS No. 131 must be implemented by PairGain in 1998. The Company has not completed its evaluation of these statements, but does not anticipate a material impact on the consolidated financial statements from the adoption of the additional disclosure requirements of these accounting standards.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. - ---------------------------------------------------------------------
At December 31, 1997, the Company had an investment portfolio of fixed income securities, including those classified as cash equivalents, of $155.6 million. These securities are subject to interest rate fluctuations. An increase in interest rates could adversely affect the market value of the Company's fixed income securities.
A sensitivity analysis was performed on the Company's investment portfolio as of December 31, 1997. This sensitivity analysis is based on a modeling technique that measures the hypothetical market value changes that would result from a parallel shift in the yield curve of plus 50, plus 100 or plus 150 basis points over a 12-month time horizon. The market value changes for a 50, 100 or 150 basis point increase in short-term treasury security yields were not material due to the overall short-term maturity of the Company's portfolio. As of December 31, 1997, the weighted average maturity of the Company's portfolio is 187 days.
The Company limits its exposure to interest rate and credit risk by establishing and strictly monitoring clear policies and guidelines for its fixed income portfolios. At the present time, the maximum average maturity of the Company's overall investment portfolio is limited by policy to 36 months. The guidelines also establish credit quality standards, limits on exposure to one issue, issuer, as well as the type of instrument. Due to the limited duration and credit risk criteria established in the Company's guidelines, the exposure to market and credit risk is not expected to be material. The Company does not use derivative financial instruments in its investment portfolio to manage interest rate risk.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. - -----------------------------------------------------
The Company's consolidated financial statements and schedule appear in a separate section of this Annual Report on Form 10-K beginning on page and S-1, respectively.
SUPPLEMENTARY FINANCIAL DATA ----------------------------
- -------------------------- (1) All share and per share amounts have been adjusted for the June 18, 1996 and December 18, 1996 two-for-one stock splits and have been restated to reflect the adoption of SFAS No. 128.
(2) Financial data for 1996 reflect the February 27, 1997 business combination between PairGain and Avidia Systems, Inc. accounted for on a pooling-of-interests basis. Avidia was formed in December 1995 and had no significant transactions prior to January 1, 1996. See Notes 1 and 2 of Notes to the Consolidated Financial Statements contained in a separate section of this Annual Report on Form 10-K commencing on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------------------------------------------------------------------------ FINANCIAL DISCLOSURE. - ---------------------
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. - -------------------------------------------------------------
The sections tilted "Directors and Nominees" and "Compliance with Section 16(a) of the Exchange Act" appearing in the Company's Proxy Statement for the 1998 Annual Meeting of Stockholders is incorporated herein by reference.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information concerning the Executive Officers and Directors of the Company.
- -------------------------- (1) Member of the Audit Committee (2) Member of the Compensation Committee
Mr. Strauch became a director of the Company in October 1991, Chairman of the Board of Directors of the Company in November 1991 and Chief Executive Officer of the Company in April 1992. Prior to his employment with the Company, Mr. Strauch held executive management positions and directorships with various publicly traded companies including Chief Executive Officer of MSI Data Corporation, a manufacturer of hand-held data collection devices (AMEX); Chief Executive Officer of Magnuson Computer Systems, a manufacturer of main frame computers (Nasdaq); and President/Chief Operating Officer of Memorex, a manufacturer of computer peripherals (NYSE). Mr. Strauch has also held several directorships including Symbol Technologies, EECO Inc. and BMC Industries.
Mr. Flagg, a founder of the Company, has been President and a director of the Company since November 1991. He served as Chief Executive Officer from November 1991 to April 1992 and as Vice President, Research and Development from February 1988 to November 1991. Prior to founding the Company, Mr. Flagg founded and served as a principal of Advanced Telecommunications, Inc., an aerospace telecommunications consulting firm.
Mr. Itri, a founder of the Company, was named Chief Technical Officer in April 1996. Previously, Mr. Itri was Vice President, Engineering of the Company since its inception in February 1988 and has been a director of the Company since November 1991. Prior to founding the Company, Mr. Itri founded and served as a principal of Advanced Telecommunications, Inc.
Mr. McBrayer was named Senior Vice President and Chief Financial Officer in February 1998. Mr. McBrayer joined the Company in March 1995 as Vice President, Finance and Administration and Chief Financial Officer. Mr. McBrayer served as Vice President, Finance and Chief Financial Officer for Triconex Corporation, a publicly held corporation (Nasdaq), from 1986 to March 1995 and was named to the Board of Directors of Triconex in January 1994.
Mr. Young was named Senior Vice President, Operations and Product Line Management in February 1998. Mr. Young joined the Company in September 1993 as Director, European Operations and assumed the position of Vice President, Operations in December 1994. From 1985 to 1993, Mr. Young served as Managing Director of Talley (UK) Ltd. and EECO (UK) Ltd. These companies designed, manufactured and marketed both consumer and industrial products throughout the United Kingdom, Europe and certain world markets.
Mr. Kimble was named Vice President, T1 Access in February 1998. Mr. Kimble joined the Company in September 1993 as Project Manager and later assumed the position of Director of Engineering. He was named Vice President, Engineering in April 1996. From 1991 to 1993, Mr. Kimble was a Product Line Manager at Cable and Computer Technology, Inc., a military computer systems manufacturer. From 1985 to 1991, Mr. Kimble was President and owner of Semaphore Corporation, a telemetry equipment and DSP consulting firm.
Mr. Reynolds joined the Company in October 1996 as Senior Vice President, Sales, Customer Service and Field Marketing. Mr. Reynolds was employed by Motorola Information Systems Group from 1990 to 1996 where he served in various senior management positions in sales and marketing. From 1983 to 1990, Mr. Reynolds held field sales management positions at Hewlett-Packard and Harris Corporation, manufacturers of workstation and data communications products.
Mr. Hawk became a director of the Company in November 1992. Mr. Hawk is President of Hawk Communications and recently retired as President and CEO of U S WEST Multimedia Communications, Inc. From 1988 until 1996, Mr. Hawk served as President of the Carrier Division of U S WEST Communications, Inc. Prior to that time, Mr. Hawk served as Vice President, Marketing and Strategic Planning for CXC Corporation and as Director, Advanced Systems Development for AT&T/American Bell. Mr. Hawk also serves as a director of Premisys Communications (Nasdaq), Xylan Corporation (Nasdaq), Concord Communications (Nasdaq) and privately-held Radcom.
Mr. Hoff became a director of the Company in February 1989. Mr. Hoff has been a general partner of Crosspoint Venture Partners, a private venture capital investment company, since September 1983. Mr. Hoff also serves as a director of privately-held Com21 Incorporated, Efficient Networks, Sonoma Systems and Accredited Home Lenders and publicly-held Onyx Acceptance Corporation (Nasdaq) and US Web Corporation (Nasdaq).
Mr. Lay became a director of the Company in February 1989. Mr. Lay has been a general partner of Southern California Ventures, a private venture capital investment partnership, since May 1983. Mr. Lay serves as a director of privately-held Physical Optics Corporation and Waveband, Inc. and of publicly-held ViaSat, Inc. (Nasdaq), Kofax Imaging Corporation (Nasdaq) and Helisys, Inc. (Nasdaq).
Mr. Bubb became a director of the Company in December 1997. Mr. Bubb has been President and CEO of Dialogic Corporation since June 1993. From July 1991 through June 1993, Mr. Bubb was an Executive Vice President of Dialogic. Mr. Bubb has served as director for Dialogic since 1994. Mr. Bubb joined Dialogic from Lexar's Telenova subsidiary where he was senior vice president and general manager. Mr. Bubb also held senior management positions at United Technologies, Memorex and Telex corporations.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION. - ---------------------------------
The section titled "Executive Compensation and Related Information" appearing in the Company's Proxy Statement for the 1998 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. - -------------------------------------------------------------------------
The section titled "Principal Stockholders" appearing in the Company's Proxy Statement for the 1998 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. - ---------------------------------------------------------
The section titled "Certain Transactions" appearing in the Company's Proxy Statement for the 1998 Annual Meeting of Stockholders is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. - ---------------------------------------------------------------------------
(A)(1) FINANCIAL STATEMENTS:
The following financial statements are included in a separate section of this Annual Report on Form 10-K commencing on page:
Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements
(2) FINANCIAL STATEMENT SCHEDULE:
The following financial schedule for the years 1997, 1996 and 1995 is included in a separate section of this Annual Report on Form 10-K commencing on page S-1:
Schedule II - Valuation and Qualifying Accounts.
All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
(3) EXHIBITS:
- -------------------- (a) Incorporated herein by reference to the same Exhibit number to the Company's Registration Statement on Form S-1 (Registration No. 33-66680) declared effective by the Commission on September 14, 1993, as amended.
(b) Incorporated herein by reference to the same Exhibit number to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1994, as filed with the Commission on February 22, 1995.
(c) Incorporated herein by reference to the same Exhibit number to the Company's Quarterly Report on Form 10-Q for the second quarter ended June 30, 1995, as filed with the Commission on August 10, 1995.
(d) Incorporated herein by reference to the same Exhibit number to the Company's Quarterly Report on Form 10-Q for the third quarter ended September 30, 1995, as filed with the Commission on November 6, 1995.
(e) Incorporated herein by reference to the same Exhibit number to the Company's Quarterly Report on Form 10-Q for the second quarter ended June 30, 1996, as filed with the Commission on August 13, 1996.
(f) Incorporated herein by reference to Exhibit number 99-1 of Form S-8 Registration Statement as filed with the Commission on July 23, 1996.
(g) Incorporated herein by reference to Appendix A of Proxy Statement for the Annual Meeting of Stockholders to be held June 12, 1996 as filed with the Commission on May 9, 1996.
(h) Incorporated herein by reference to the same Exhibit number to the Company's Quarterly Report on Form 10-Q for the third quarter ended September 30, 1996, as filed with the Commission on November 8, 1996.
(i) Incorporated herein by reference to Appendix A of Proxy Statement for the Special Meeting of Stockholders to be held December 10, 1996 as filed with the Commission on November 12, 1996.
(j) Incorporated herein by reference to the same Exhibit number to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1996, as filed with the Commission on March 19, 1997.
(k) Incorporated herein by reference to Exhibit number 99.1 to the Company's Registration Statement on Form S-8, as filed with the Commission on May 7, 1997.
(l) Incorporated herein by reference to Exhibit number 99.1 to the Company's Registration Statement on Form S-8, as filed with the Commission on August 15, 1997.
(B) REPORTS ON FORM 8-K:
None.
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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K is signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
PAIRGAIN TECHNOLOGIES, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
CONTENTS
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders PairGain Technologies, Inc. Tustin, California
We have audited the accompanying consolidated balance sheets of PairGain Technologies, Inc. and subsidiaries (the "Company") as of December 31, 1997 and 1996, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedule listed in the index at Item 14 (a)(2). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule 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, such consolidated financial statements present fairly, in all material respects, the financial position of PairGain Technologies, Inc. and subsidiaries as of December 31, 1997 and 1996, and the 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. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
Costa Mesa, California January 29, 1998
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
See notes to consolidated financial statements.
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF INCOME
See notes to consolidated financial statements.
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
See notes to consolidated financial statements.
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY AND SIGNIFICANT ACCOUNTING POLICIES
PairGain Technologies, Inc. ("PairGain" or the "Company") designs, manufactures, markets and supports a comprehensive line of digital telecommunications products that allow telecommunications carriers and private network owners to more efficiently provide high-speed digital services to end users over the large infrastructure of unconditioned copper wires. These services enable high-speed data transmission for applications such as T1/E1, high-speed Internet access, telecommuting, wide area networking and video conferencing.
The accompanying consolidated financial statements reflect the February 27, 1997 business combination between PairGain and Avidia Systems, Inc. ("Avidia") accounted for on a pooling-of-interests basis. Avidia was formed in December 1995 and had no significant transactions prior to January 1, 1996. (See Note 2)
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
TRANSLATION OF FOREIGN CURRENCIES
Foreign subsidiary financial statements are translated into U.S. dollars in accordance with Statement of Financial Accounting Standards ("SFAS") No. 52, "Foreign Currency Translations." The functional currency of the Company's Canadian and Swiss subsidiaries is the U.S. dollar; therefore, translation gains and losses are included in results of operations. Transaction and translation gains and losses were not significant in 1997, 1996 or 1995.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform with the current year presentation.
FAIR VALUE OF FINANCIAL INSTRUMENTS
Pursuant to SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," the Company is required to estimate the fair value of all financial instruments included on its balance sheets at December 31, 1997 and December 31, 1996. The Company considers the carrying value of such amounts in the financial statements to approximate their fair value due to the relatively short period of time between origination of the instruments and their expected realization or the overall immateriality of the amounts.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments with maturities at the date of purchase of less than three months to be cash equivalents.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SHORT-TERM INVESTMENTS
Short-term investments are accounted for in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Management determines the appropriate classification of such securities at the time of purchase and reevaluates such classification as of each balance sheet date. Based on its intent, the Company's investments are classified as available-for-sale and are carried at fair value, with unrealized gains and losses, net of tax, reported as a separate component of stockholders' equity. The investments are adjusted for amortization of premiums and discounts to maturity and such amortization is included in interest income. Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in the consolidated statements of income.
INVENTORIES
Inventories are stated at lower of cost (determined on a first-in, first-out basis) or market. The Company maintains allowances for estimated obsolete and excess inventories based upon projected sales levels.
PROPERTY AND EQUIPMENT
Property and equipment are carried at cost. The Company provides for depreciation and amortization using the straight-line method. Equipment is depreciated over an estimated useful life of three years. Leasehold improvements are amortized over the lesser of five years or the life of the lease.
WARRANTY RESERVE
The Company accrues warranty reserves, which are charged against cost of goods sold, based upon historical rates and estimated future costs.
REVENUE RECOGNITION
Revenue from product sales is recognized at the time of shipment. Provision is made currently for estimated product returns which historically have been insignificant. Royalty income is recognized when earned.
RESEARCH AND DEVELOPMENT COSTS
Research and development costs are expensed as incurred.
PER SHARE INFORMATION
In February 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings Per Share," ("SFAS No. 128"). This statement is effective for periods ending after December 15, 1997 and requires restatement of all prior periods. The Statement redefines earnings per share ("EPS") under generally accepted accounting principles, making EPS comparable to international standards. SFAS No. 128 requires dual presentation of "Basic" and "Diluted" EPS, by entities with complex capital structures, replacing "Primary" and "Fully diluted" EPS under Accounting Principles Board ("APB") Opinion No. 15.
Basic EPS excludes dilution from common stock equivalents and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution from common stock equivalents, similar to fully diluted EPS, but uses only the average stock price during the period as part of the computation.
The Company has adopted the provisions of SFAS No. 128 in the accompanying 1997 consolidated financial statements and has restated prior periods to reflect the adoption of SFAS No. 128.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following table reconciles the weighted average shares outstanding for basic and diluted earnings per share for the periods presented.
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income," ("SFAS No. 130"). This statement establishes standards for the reporting of comprehensive income and its components in a financial statement that is displayed with the same prominence as other financial statements. Comprehensive income, as defined, includes all changes in equity (net assets) during a period from non-owner sources. Examples of items to be included in comprehensive income, which are excluded from net income, include foreign currency translation adjustments and unrealized gain/loss on available-for-sale securities. The disclosures prescribed by SFAS No. 130 are effective beginning with the first quarter of calendar 1998.
In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," ("SFAS No. 131"). This statement establishes standards for the way companies report information about operating segments in annual financial statements. It also establishes standards for related disclosure about products and services, geographic areas and major customer. The Company has not yet determined the impact, if any, of adopting this new standard. The disclosures prescribed by SFAS No. 131 are effective for fiscal years beginning after December 15, 1997.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
STOCK SPLITS
All share and per share amounts have been adjusted to reflect the two-for-one stock splits, effective June 18, 1996 and December 18, 1996, for all periods presented. (See Note 12)
ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees." (See Note 13)
STATEMENT OF CASH FLOWS
Significant noncash transactions in 1997, 1996 and 1995 affecting the Company's accounts consisted of tax benefits from exercises of common stock options of $22.1 million, $18.2 million and $2.1 million, respectively, and $285,000 in deferred compensation related to stock options issued in 1996.
2. ACQUISITION OF AVIDIA
On February 27, 1997, the Company acquired Avidia pursuant to an Agreement and Plan of Reorganization (the "Merger Agreement") among Avidia and others, with Avidia surviving as a wholly-owned subsidiary of the Company (the "Acquisition") in a transaction accounted for as a pooling-of-interests. Pursuant to the Merger Agreement, the Company issued 2,235,697 shares of PairGain Common Stock to Avidia stockholders in exchange for all outstanding Avidia Common Stock, Preferred Stock and vested warrants to purchase Avidia Common Stock. In addition, outstanding options and unvested warrants to purchase Avidia Common Stock were exchanged for options and warrants to purchase 232,521 and 131,168 shares, respectively, of the Company's Common Stock. Merger expenses of $2.6 million, which consisted of investment banking, legal, accounting and other costs, were charged to expense upon the closing of the Acquisition. The Company's historical consolidated financial statements have been restated to reflect the financial position and results of operations of Avidia.
3. CONCENTRATION OF CREDIT RISK, MAJOR CUSTOMERS, PRODUCTS AND MARKET DATA
The Company markets its products principally to telephone companies in the United States and Canada. Credit is extended based on an evaluation of the customer's financial condition and collateral is not required. Credit losses are provided for in the financial statements and consistently have been minimal. Sales to major customers as a percentage of total product revenue were as follows:
A decision by a significant customer to substantially decrease or delay purchases from the Company or the Company's inability to collect receivables from these customers could have a material adverse effect on the Company's financial condition and results of operations.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Revenues from HiGain products represented approximately 67% of the Company's total revenues in 1997 and 76% of the Company's total revenues in both 1996 and 1995. A significant decline in demand or average sales price for HiGain products, whether as a result of competition, deployment of fiber cable, technological change or otherwise, could have a material adverse effect on the Company's financial condition and results of operations.
Export sales represented 17%, 13% and 9% of product revenue during 1997, 1996 and 1995, respectively. Product sales by geographical region is summarized as follows:
4. SHORT-TERM INVESTMENTS
Short-term investments as of December 31, 1997 and 1996 are summarized as follows:
For the year ended December 31, 1997 there was a realized gain of $23,000. There were no realized gains or losses for the year ended December 31, 1996. Unrealized gains on short-term investments, net of tax, included as a separate component of stockholders' equity were $82,000 and $71,000 in 1997 and 1996, respectively.
The amortized cost and estimated fair value of investments at December 31, 1997 by contractual maturity are shown below. Actual maturities may differ from contractual maturities because the issuer of the securities may have the right to repurchase such securities. The Company classifies short-term investments as current assets as all such investments are available for current operations.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. INVENTORIES
Inventories consist of:
6. PROPERTY AND EQUIPMENT
Property and equipment consist of:
7. NOTE RECEIVABLE AND LONG-TERM INVESTMENTS
In July 1995, the Company entered into certain agreements with Sourcecom Corporation of Westlake, California ("Sourcecom"). The agreements provided for the incorporation of Sourcecom's networking technology into the Company's current and future transmission products. Under the terms of the agreements, the Company loaned Sourcecom $2.7 million and had rights to purchase a minority ownership position. The note bore interest at the prime rate less one percent, payable monthly, with the principal balance due July 1999.
In April 1996, the Company purchased approximately 150,000 shares of Sourcecom's Series A Preferred Stock for an aggregate of $273,000. In September 1996, the Company purchased approximately 321,000 shares of Sourcecom's Common Stock for an aggregate of $271,000. Shares purchased have been adjusted to reflect Sourcecom's two-for-one stock split, effective September 24, 1996.
In the third quarter of 1997, Sourcecom filed for protection from creditors under the U.S. Bankruptcy Act. In addition, Sourcecom sold all of its assets to an unrelated third party for $8.0 million. Based upon the information available, the Company recorded a valuation adjustment of $544,000 during the third quarter of 1997 to reflect an impairment in its investment in Sourcecom. A mutual release of all claims between Sourcecom and the Company was reached in December 1997. Under the terms of the release, Sourcecom paid $2.6 million to the Company to offset the loan made under the original agreements. In the fourth quarter of 1997, the Company wrote off the balance of the note and associated legal fees aggregating $200,000.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In June 1996, the Company made a minority investment in E/O Networks of Hayward, California ("E/O"). E/O supplies low-density fiber optic access equipment to public carriers both domestically and internationally. The Company purchased approximately 545,000 shares of E/O's Series D Preferred Stock for an aggregate of $3.0 million.
The Company accounts for long-term investments using the cost method. However, when it is determined that an investment is permanently impaired, the Company records a valuation adjustment.
8. BANK LINE OF CREDIT
The Company maintains an unsecured line of credit with a bank. The line allows maximum borrowings of $5,000,000, including the issuance of letters of credit and foreign exchange contracts. The line bears interest at the prime rate (8.5% at December 31, 1997). At December 31, 1997, the Company had no outstanding borrowings under this line of credit. The debt agreement specifies certain financial and other covenants. The Company was in compliance with the financial and other covenants at December 31, 1997. The agreement expires May 1, 1998.
9. ACCRUED EXPENSES
Accrued expenses consist of:
10. INCOME TAXES
The components of the provision for income taxes are as follows:
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The provision for income taxes for the years ended December 31, 1997, 1996, and 1995 differs from the U.S. federal statutory tax expense for the years as follows:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets are as follows:
At December 31, 1997, the Company had federal and state capital loss carryforwards for income tax purposes of approximately $721,000 which will begin expiring in 2002. The Company also had net operating loss carryforwards and research and development credit carryforwards of $1.6 million and $36,000, respectively, which will expire beginning in 2011 and 2012. The net operating loss and tax credit carryforwards are subject to separate return limitation year ("SRLY") rules related to the Company's acquisition of Avidia. The Company has established a valuation allowance of $1,037,000 related to these carryforwards and $157,000 related to non-California state deferred tax assets since the realization of the benefit from these items is not reasonably assured at the end of 1997.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. COMMITMENTS
The Company has entered into several operating leases for its facilities with varying terms and escalation clauses. Future annual minimum lease payments under non-cancelable operating leases are as follows:
Rent expense for the years ended December 31, 1997, 1996 and 1995 aggregated $1.3 million, $747,000 and $424,000, respectively.
12. STOCKHOLDERS' EQUITY
STOCK SPLITS
In June 1996, the Company's stockholders approved an amendment to the Company's Certificate of Incorporation (the "Amendment") to increase the authorized Common Stock of the Company from 30 million shares, par value $.001, to 60 million shares, par value $.0005, and to effect a two-for-one stock split (the "Stock Split").
In December 1996, the Company's stockholders approved an amendment to the Company's Amended and Restated Certificate of Incorporation (the "Second Amendment") to increase the authorized Common Stock of the Company from 60 million shares, par value $.0005, to 175 million shares, par value $.0005. The Second Amendment was proposed to facilitate a two-for-one stock split (the "Second Stock Split") which was effected in the form of a 100% stock dividend.
All references in the accompanying consolidated financial statements related to Common Stock, common stock options, common stock warrants and earnings per share have been adjusted to reflect both stock splits.
STOCK OFFERINGS
In a series of private placements during 1996, Avidia sold common and preferred shares which converted in the Merger into 2,235,697 of the Company's shares. The net proceeds raised were approximately $3,015,000.
In March 1995, the Company completed a secondary public offering and sold 2,000,000 shares of its Common Stock at a price of $5.91 per share. The net proceeds raised by the Company were approximately $10,970,000. In connection with the offering, certain outstanding warrants were exercised to purchase 5,750,620 shares of Common Stock at an aggregate exercise price of $2,717,000.
WARRANTS
In 1996, Avidia granted warrants to certain stockholders which converted in the Merger into the right to purchase 131,168 shares of the Company's Common Stock at an aggregate exercise price of $495,000. Such warrants were exercised in February 1997.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In 1995, the Company granted warrants for the purchase of 40,000 shares of its Common Stock at exercise prices of $5.00 to $6.25 per share in exchange for services. Such warrants were outstanding at December 31, 1997 and expire beginning in May 1998 through September 1999.
13. STOCK OPTION PLANS
1993 EMPLOYEE STOCK OPTION PLAN
Under the Company's 1993 Stock Option/Stock Issuance Plan ("the Plan"), which is the successor plan to its 1990 Stock Option Plan ("the 1990 Plan"), a Committee consisting of non-employee members of its Board of Directors, is authorized to grant stock options or issue Common Stock to officers, key employees, members of the Board of Directors and certain consultants or other independent contractors of the Company. In addition, the Plan also provides for the purchase of the Company's Common Stock by eligible individuals at a price per share not less than 85% of the fair market value at the time of issuance. No shares have been issued under the purchase provisions. Incentive options are granted at a price equal to 100% of the fair market value at the date of grant (at least 85% of the fair market value for non-qualified options) and vested options are exercisable for a period determined by the Committee that is not to exceed ten years from the date of grant. Options issued under the 1990 Plan are exercisable immediately upon grant and shares issued related to options exercised but not vested are subject to repurchase by the Company at the exercise price of such options. At the discretion of the Committee, the Plan provides option holders stock appreciation rights which allow the holder to exercise such options in exchange for the payment of the difference between the fair market value and option price of the underlying shares in the form of cash or shares of Common Stock. Under certain circumstances in the event of a merger, sale or other significant transaction involving the Company, the options and stock issued may become fully vested and exercisable.
In January 1995, the Company's Board of Directors approved an increase in the number of common shares reserved and available for issuance under the Plan from 14,800,000 shares to 18,800,000 shares. In January 1997, the Company's Board of Directors approved an increase in the number of common shares reserved and available for issuance under the Plan from 18,800,000 shares to 21,800,000 shares.
1996 NON-EMPLOYEE DIRECTORS STOCK OPTION PLAN
In June 1996, the Company's stockholders approved the 1996 Non-Employee Directors Stock Option Plan (the "Directors Plan"). Under the terms of the Directors Plan, 400,000 shares of Common Stock have been reserved for issuance to non-employee members of the Board. Following the 1996 Annual Meeting, initial options to purchase 40,000 shares of the Company's Common Stock were granted to each non-employee director who had not previously received any stock option grants from the Company. On an annual basis beginning with the 1997 Annual Meeting, an option to purchase an additional 20,000 shares of Common Stock will be granted to each individual who is to continue to serve as a non-employee Board member. There is no limit to the number of such annual 20,000-share option grants any one non-employee Board member may receive over his or her period of continued Board service during the term of the Directors Plan. Each option will have an exercise price per share equal to 100% of the fair market value per share of Common Stock on the option grant date and a maximum term of ten years measured from the option grant date. Each option will be immediately exercisable for all the option shares, but any purchased shares will be subject to repurchase by the Company, at the exercise price paid per share, upon the optionee's cessation of Board service. Each initial option grant will vest (and the Company's repurchase rights will lapse) in four successive equal annual installments over the optionee's period of Board service, with the first such installment to vest upon the completion of one year of Board service measured from the option grant date. Additional option grants will vest (and the Company's repurchase rights will lapse) upon the completion of one year of Board service measured from the option grant date. The term of the Directors Plan is ten years.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
AVIDIA STOCK OPTION AND INCENTIVE AWARD PLAN
In 1996, Avidia established the 1996 Stock Option and Incentive Award Plan (the "Avidia Plan") which provides for the grant of any or all of the following types of awards: (1) stock options, including incentive stock options and non-qualified stock options, and (2) performance share awards. Under the terms of the Avidia Plan, 232,521 shares of Common Stock have been reserved for issuance to directors, employees, consultants, advisors and vendors of Avidia and any related corporations. The majority of the stock options vest over a four-year period, with 25% of the shares becoming exercisable on each of the first four anniversaries of the grant date. The Board of Directors at its discretion may grant accelerated vesting. The options expire ten years from the date of the grant. During 1996, all of the options under the Avidia Plan were granted at less than market value, which resulted in total compensation of $285,000. This compensation is being amortized over a period of four years, and has resulted in charges to earnings of $76,000 and $48,000 in 1997 and 1996, respectively.
Option activity under the plans is as follows:
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The outstanding stock options primarily vest ratably over a four year period. Stock options outstanding at December 31, 1997 are summarized as follows:
At December 31, 1997, 2,898,853 and 260,000 shares were available for future grants under the 1993 Employee Stock Option Plan and 1996 Non-Employee Directors Stock Option Plan, respectively.
EMPLOYEE STOCK PURCHASE PLAN
Under the Company's Employee Stock Purchase Plan, (the "Purchase Plan"), eligible employees are permitted to have salary withholdings to purchase shares of Common Stock at a price equal to 85% of the lower of the market value of the stock at the beginning or end of each six-month offer period, subject to an annual limitation. Activity under the Purchase Plan is summarized as follows:
At December 31, 1997, 787,850 shares were reserved for future issuances under the Purchase Plan.
ADDITIONAL STOCK PLAN INFORMATION (SFAS NO. 123)
As discussed in Note 1, the Company accounts for its stock-based awards using the intrinsic value method in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees," and its related interpretations.
SFAS No. 123, "Accounting for Stock-Based Compensation," requires the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method as of the beginning of fiscal 1995. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company's stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions:
The Company's calculations are based on a single option valuation approach and forfeitures are recognized as they occur. The computed fair values for options awards are $19.4 million, $34.4 million and $14.7 million in 1997, 1996 and 1995, respectively. If the fair values of the awards had been amortized to expense over the vesting period of the awards, results would have been as follows:
The impact of stock options granted prior to 1995 has been excluded from the pro forma calculation; accordingly, the 1997, 1996 and 1995 pro forma adjustments may not be indicative of future period pro forma adjustments, when the calculation will be applicable to all stock options.
14. EMPLOYEE BENEFIT PLANS
401 (K) MATCHING CONTRIBUTION
The Company sponsors a defined contribution 401(K) Savings and Investment Plan, which was established in 1993, covering substantially all of the Company's employees subject to certain eligibility requirements. At its discretion, the Company may make contributions to the plan. In April 1996, the Board approved a resolution to match employee contributions provided that a threshold earnings per share level was reached. Employee deferrals during 1997 and from April 28, 1996 through December 31, 1996 were eligible for a matching contribution equal to fifty percent (50%) of the employee's salary deferral, not to exceed $500 per employee. Matching contributions vest over a period of four years of service. The aggregate expense related to the contributions was $221,000 in 1997 and $145,000 in 1996.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
PROFIT SHARING
In October 1996, the Company established a company-wide Profit Sharing Plan for fiscal years beginning after December 31, 1996. Under the terms of the Profit Sharing Plan, a pool equal to 2.5% of pre-tax income was established for payments to be made on a pro rata basis, based on the amount of each participant's base compensation. Plan participants include all employees in the Company except those on an incentive compensation or sales commission plan who are employed as of the date of the Profit Sharing payment. Payment is subject to achieving a predetermined threshold earnings per share level as established by the Board of Directors and is to take place approximately one month after the end of the year for which the Profit Sharing applies. The aggregate accrual for the Profit Sharing pool included in the accompanying consolidated balance sheet as of December 31, 1997 was $2.0 million.
MANAGEMENT DEFERRED COMPENSATION PLAN
The Company established a Management Deferred Compensation Plan in 1996. The purpose of the plan is to provide a tax deferred capital accumulation opportunity to senior management. Employees whose annual base salary is $85,000 or greater are eligible to participate. The minimum deferral is $5,000 per Plan year (January 1 to December 31) and can be satisfied from salary, commission and/or incentive compensation payments. Deferrals may be increased, decreased or terminated for any subsequent years by filing an election by December 1 of the prior year. The Company may make discretionary Company contributions at any time as approved by the Compensation Committee of the Board of Directors. To date, no Company contributions have been made to the Deferred Compensation Plan.
15. UNUSUAL LOSS DUE TO UNAUTHORIZED TRADING OF INVESTMENTS BY THIRD PARTIES
In 1993 and 1994, the Company invested a portion of its excess cash with Capital Insight, Inc. ("Capital Insight"), a financial advisor and broker based in Beverly Hills, California. The Company had no funds invested with Capital Insight at either December 31, 1993 or December 31, 1994, as all such invested funds were returned to the Company prior to the end of each of those years.
In early 1995, the Company again invested a portion of its excess cash with Capital Insight, with instructions that the funds be invested solely in U.S. Treasury securities with maturities of one year or less. These instructions were consistent with the investment guidelines which had been approved by the Company's Board of Directors in October 1994. However, these instructions were violated and the funds were used to engage in unauthorized trading in options and futures. In November 1995, the Company confirmed that it had incurred non-recurring losses of $15.8 million resulting from these inappropriate and unauthorized trading activities.
The Company's outside directors retained independent legal counsel and forensic accountants to determine the facts and circumstances surrounding this matter. This investigation revealed no improper involvement by any Company director, officer or employee in the unauthorized trading. Additionally, the investigation found that the Company was provided with fictitious statements by Capital Insight, and the Company had actually incurred substantial losses in the second quarter of 1995. During the third and fourth quarters of 1995, the unauthorized trading generated significant gains resulting in net trading losses of $15.8 million for the year. Furthermore, it was determined that the 1994 statements provided by this advisor and relied upon by the Company for its quarterly reporting were also incorrect. Although total financial results for 1994 were not impacted by these false statements, previously reported 1994 quarterly financial statements did not reflect the proper periods in which the trading gains and losses occurred. Based on the results of the investigation, the Company amended its quarterly statements for both 1994 and 1995 to reflect the proper reporting of the trading gains and losses.
PAIRGAIN TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In January 1996, the Company filed suit in Los Angeles federal court against Mr. S. Jay Goldinger and Capital Insight, Inc. charging unauthorized trading, fraudulent misrepresentation, violation of federal securities laws and breach of fiduciary duties. The suit seeks $15.8 million in damages by reason of the losses incurred by the Company, as well as punitive damages and legal fees.
16. SETTLEMENT INCOME RELATED TO UNAUTHORIZED TRADING OF INVESTMENTS BY THIRD PARTIES
In January 1996, the Company received a copy of a complaint, filed derivatively by a Company stockholder on behalf of the Company, naming as defendants the Company's directors and certain officers, as well as Capital Insight and Mr. S. Jay Goldinger, its president. The derivative complaint stated causes of action for breach of fiduciary duty, abuse of control, constructive fraud, gross mismanagement and waste of corporate assets by reason of unusual losses incurred by the Company as a result unauthorized trading of investment by third parties (See Note 15). The suit sought an award in the amount of all damages sustained by the Company including the losses of $15.8 million and legal fees and expenses.
In September 1996, the Company and other parties to the derivative suits described above executed definitive settlement agreements to settle and dismiss the derivative suits. The Court approved the settlement in November 1996. Under the terms of the settlement, the Company received $2.5 million from a brokerage firm involved in processing the investments for Capital Insight, and paid plaintiff's attorneys fees of $450,000. The impact of the settlement has been recorded in the Company's financial statements for the year ended December 31, 1996.
PAIRGAIN TECHNOLOGIES, INC.
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
S-1