-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Gn3TMPywwkbVuO/pJmXIRXBfGHcG7wwGCmUXzlu4vohnxirqTOPDh1FlPI3m3lj2 XdZhMJ+ZOomnG7kA6eIGjw== 0000950172-99-000594.txt : 19990520 0000950172-99-000594.hdr.sgml : 19990520 ACCESSION NUMBER: 0000950172-99-000594 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990519 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ASCEND COMMUNICATIONS INC CENTRAL INDEX KEY: 0000921146 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER COMMUNICATIONS EQUIPMENT [3576] IRS NUMBER: 943092033 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: SEC FILE NUMBER: 000-23774 FILM NUMBER: 99630732 BUSINESS ADDRESS: STREET 1: 1701 HARBOR BAY PKWY CITY: ALAMEDA STATE: CA ZIP: 94502 BUSINESS PHONE: 5107696001 MAIL ADDRESS: STREET 1: ONE ASCEND PLAZA STREET 2: 1701 HARBOR BAY PARKWAY CITY: ALAMEDA STATE: CA ZIP: 94502 10-K/A 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K/A AMENDMENT NO. 1 ( X ) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ________ TO ________ Commission File Number: 000-23774 ASCEND COMMUNICATIONS, INC. (Exact name of registrant as specified in its charter) Delaware 94-3092033 ---------------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1701 Harbor Bay Parkway, Alameda, CA 94502 ---------------------------------------- -------------------- (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code: (510) 769-6001 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: common stock, $0.001 Par Value Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No___ --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] As of December 31, 1998 the approximate aggregate market value of voting stock held by non-affiliates of the Registrant was $11,672,400,250 (based upon the closing price for shares of the Registrant's common stock as reported by the Nasdaq National Market on that date). Shares of common stock held by each officer, director and holder of 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. The determination of affiliate status is not necessarily a conclusive determination for other purposes. As of February 28, 1999, 222,250,267 shares of the Registrant's common stock were outstanding. DOCUMENTS INCORPORATED BY REFERENCE Not applicable. PORTIONS AMENDED The Registrant hereby amends and restates Items 3 and 7 of this Report on Form 10-K and Footnotes 3, 8 and 9 to the Registrant's Consolidated Financial Statements set forth in this Report on Form 10-K, in each case as set forth below. ITEM 3. LEGAL PROCEEDINGS On January 13, 1999, four purported class action complaints challenging the proposed merger between Ascend and Lucent were filed in the Delaware Court of Chancery by individuals who claim to be stockholders of Ascend. The complaints name the Company, its directors and certain former directors of Cascade Communications Corp. as defendants. One of the complaints also names Lucent as a defendant. The complaints allege, among other things, that the defendants have resolved to wrongfully allow Lucent to obtain the assets of Ascend at a bargain price, that the defendants have breached their fiduciary duties to the class, that action by the defendants will prevent Ascend's stockholders from receiving a fair price for their shares, that Ascend's directors failed to make an informed decision in recommending Lucent's offer, and that the terms of the proposed merger fail to include appropriate mechanisms to protect Ascend's stockholders against a decline in the price of Lucent's or Ascend's stock. The complaint naming Lucent alleges that it aided and abetted the breaches of fiduciary duty by the other defendants. The plaintiffs seek, among other things, (i) a declaration that the proposed transaction is unfair, unjust and inequitable; (ii) preliminary and permanent injunctive relief against the consummation or closing of the proposed transaction; (iii) rescission of the transaction in the event it is consummated; (iv) damages, (v) allowance for plaintiffs' attorneys' fees and expenses; and, (vi) other relief as the Court may deem just and proper. These actions are in the early stages of proceedings and the Company is currently investigating the allegations. Based on its current information, the Company believes the suits to be without merit and intends to defend itself and the named defendants vigorously. Although it is reasonably possible the Company may incur a loss upon the conclusion of these claims, an estimate of any loss or range of loss cannot be made. No provision for any liability that may result upon adjudication has been made in the consolidated financial statements. In the opinion of management, resolution of this matter is not expected to have a material adverse effect on the financial position of the Company. However, depending on the amount and timing, an unfavorable resolution of this matter could materially affect the Company's financial position, future results of operations or cash flows in a particular period. The Company and various of its current and former officers and directors are defendants in a number of consolidated class action lawsuits pending in the United Stated District Courts for the Central District of California, which have been filed on behalf of all persons who purchased or acquired the Company's stock (excluding the defendants and parties related to them) for the period November 5, 1996 to September 30, 1997 ("federal securities actions"). In addition, the Company and one of its officers are defendants in a securities action filed in the Superior Court of Alameda County, California ("state securities action"). The state securities action purports to be brought in behalf of all purchasers of the Company's stock between July 15, 1997 and September 29, 1997 (excluding the defendants and parties related to them). The lawsuits allege that the defendants violated the federal or state securities laws by engaging in a scheme to artificially inflate and maintain the Company's stock price by disseminating materially false and misleading information concerning its business and earnings and the development, efficiency, introduction and deployment of its digital modems based on 56K-bps technology. On August 17, 1998, the Court certified the federal securities actions as a class action and appointed four plaintiffs to serve as class representatives. On September 4, 1998, plaintiffs filed a second Amended and Consolidated Complaint. On February 2, 1999, the Court issued an Order granting the motion to dismiss and allowing plaintiffs to file an amended complaint. The state securities action has been stayed pending resolution of the motion to dismiss in the federal securities action. These actions are in the early stages of proceedings and the Company is currently investigating the allegations. Based on its current information, the Company believes the suits to be without merit and intends to defend itself and its officers and directors vigorously. Although it is reasonably possible the Company may incur a loss upon the conclusion of these claims, an estimate of any loss or range of loss cannot be made. No provision for any liability that may result upon adjudication has been made in the consolidated financial statements. In the opinion of management, resolution of this matter is not expected to have a material adverse effect on the financial position of the Company. However, depending on the amount and timing, an unfavorable resolution of this matter could materially affect the Company's financial position, future results of operations or cash flows in a particular period. In connection with these legal proceedings, the Company expects to incur substantial legal and other expenses. Shareholder suits of this kind are highly complex and can extend for a protracted period of time, which can substantially increase the cost of such litigation and divert the attention of the Company's management. In April 1997, a civil action was filed against Sahara, its three founders and ten employees of Sahara by General Datacomm Industries, Inc. in the Superior Court for the State of Connecticut. The complaint alleges several causes of action, including: breach of contract; tortious interference with contractual relations; misappropriation of trade secrets; unfair competition and violation of the Connecticut Unfair Trade Practices Act. The plaintiff seeks relief of unspecified monetary damages, costs and injunctive relief. The Company has not yet engaged in substantive discovery and the ultimate outcome of this matter cannot yet be determined. The Company plans to vigorously defend this lawsuit. Although it is reasonably possible the Company may incur a loss upon the conclusion of these claims, an estimate of any loss or range of loss cannot be made. No provision for any liability that may result from the action has been recognized in the consolidated financial statements. In the opinion of management, resolution of this litigation is not expected to have a material adverse effect on the financial position of the Company. However, depending on the amount and timing, an unfavorable resolution of this matter could materially affect the Company's future results or cash flows in a particular period. The Company is a party as a defendant in various other lawsuits, contractual disputes and other legal claims arising in the ordinary course of business, the results of which are not presently determinable. Although it is reasonably possible the Company may incur a loss upon the conclusion of these claims, an estimate of any loss or range of loss cannot be made. No provision for any liability that may result from these claims has been recognized in the consolidated financial statements. However, in the opinion of management, after consultation with legal counsel, the amount of losses that might be sustained, if any, from these lawsuits would not materially affect the Company's financial position. However, depending on the amount and timing, an unfavorable resolution of some or all of these matters could materially affect the Company's future results of operations or cash flows in a particular period. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Ascend develops, manufactures and sells wide area networking solutions for telecommunications carriers, ISPs and corporate customers worldwide which enable them to build: (i) Internet access systems consisting of POP equipment for ISPs and remote site Internet access equipment for Internet subscribers; (ii) telecommunications carrier and ISP backbone networks utilizing high speed Frame Relay, ATM and IP switches; (iii) extensions and enhancements to corporate backbone networks that facilitate access by remote offices, telecommuters and mobile computer users; (iv) non-stop computing platforms and Intelligent Networking ("IN") solutions for enhanced voice services in telephony networks; and (v) videoconferencing and multimedia access solutions. The Company's products support existing digital and analog networks. In January 1999, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement") with Lucent, pursuant to which each outstanding share of Ascend common stock will be exchanged for 0.825 shares of Lucent common stock, and each outstanding option or warrant to purchase Ascend common stock will be converted into an option or warrant to purchase Lucent common stock (adjusted for the exchange ratio). The merger is expected to be accounted for as a pooling of interests, is subject to standard regulatory approvals and is expected to close during the second quarter of 1999. In February 1999, Lucent announced a two-for-one stock split, payable on April 1, 1999 to shareholders of record as of March 5, 1999. Under the terms of the Merger Agreement the exchange ratio will be adjusted for the effect of this stock split and any similar changes in the capitalization of Lucent. In October 1998, the Company purchased Stratus, a manufacturer of fault-tolerant computer systems, and announced its intention to divest the non-telecommunications business units of Stratus prior to the consummation of the acquisition. In June 1997, the Company acquired Cascade, a developer and manufacturer of wide area network switches. In April 1997, the Company acquired Whitetree, a developer and manufacturer of high-speed ATM switching products. In February 1997, the Company purchased InterCon, a developer of remote access client software products. In January 1997, Cascade acquired Sahara, a privately held developer of scaleable high-speed broadband access products. Results of Operations The following table summarizes the percentage of net sales represented by certain line items from the Company's consolidated statements of operations:
YEAR ENDED DECEMBER 31, ----------------------------------------- 1998 1997 1996 ---------- ----------- ---------- Net sales................................................ 100% 100% 100% Cost of sales............................................ 37 35 35 ---------- ----------- ---------- Gross profit........................................... 63 65 65 Operating expenses: Research and development............................... 15 14 10 Sales and marketing.................................... 20 21 18 General and administrative............................. 5 3 3 Purchased in-process research and development.......... 18 20 - Costs of mergers....................................... (1) 13 2 --------- ----------- ---------- Total operating expenses............................ 57 71 33 --------- ----------- ---------- Operating income (loss) ................................. 6 (6) 32 Interest income, net..................................... 2 2 2 --------- ----------- ---------- Income (loss) before income taxes........................ 8 (4) 34 Provision for income taxes............................... 9 7 13 --------- ----------- ---------- Net income (loss)........................................ (1)% (11)% 21% ========= =========== ==========
Years Ended December 31, 1998, 1997 and 1996 Net Sales. Net sales for 1998 increased 27% to $1.479 billion as compared to $1.167 billion in 1997, which increased 31% from $890.3 million in 1996. International sales (sales outside of North America) increased to $427.5 million in 1998 as compared to $362.3 million in 1997 and to $313.3 million in 1996 and accounted for 29%, 31% and 35% of net sales in 1998, 1997 and 1996, respectively. Substantially all of the increase in sales in each period was attributable to increases in unit shipments of the Company's products. The following table provides a breakdown of net sales by business unit as a percentage of total Company net sales for 1998, 1997 and 1996, respectively: YEAR ENDED DECEMBER 31, -------------------------------- BUSINESS UNIT 1998 1997 1996 - --------------------------------------- -------- -------- -------- Core Systems........................... 47 % 35 % 36 % Access Switching....................... 41 52 48 Enterprise Access...................... 7 9 13 Other.................................. 5 4 3 -------- -------- -------- Total Company..................... 100 % 100 % 100 % ======== ======== ======== Core Systems - The Core Systems business unit consists of the B-STDX family of Frame Relay switches, the CBX500 and GX 550 ATM switches, the SA family of broadband access products, the Carrier Signaling Group of products acquired from Stratus and the GRF family of IP switches. Core Systems products accounted for 47%, 35% and 36% of total Company net sales for 1998, 1997 and 1996, respectively. The increase in Core Systems sales as a percentage of net sales in 1998 was primarily attributable to significant growth in sales of ATM switches. Incremental revenues from the acquisition of Stratus also contributed to the increase, to a lesser extent. The decline in Core Systems revenues as a percent of net sales in 1997 was primarily attributable to the increase in sales of the MAX family of Access Switching products. Access Switching - The Access Switching business unit consists of the MAX family of products, which accounted for 41%, 52% and 48% of total Company net sales for 1998, 1997 and 1996, respectively. Access Switching revenues were relatively flat year-over-year from 1997 to 1998, but declined as a percentage of total sales due to the increase in total revenues. The increase in Access Switching revenues as percent of net sales in 1997 was primarily attributable to increased shipments of MAX products, due to increased demand for corporate remote networking applications. Enterprise Access - The Enterprise Access business unit consists of the Pipeline family of remote access equipment as well as the Multiband MAX family of inverse multiplexing equipment. Enterprise Access products accounted for 7%, 9% and 13% of total Company net sales for 1998, 1997 and 1996, respectively. Enterprise Access revenues were relatively flat year-over-year from 1997 to 1998, but declined as a percentage of total sales due to the increase in total revenues. The decline in Enterprise revenues as a percent of net sales in 1996 was primarily attributable to price reductions of the Pipeline family of products due to increased competition. Gross Margin. Gross margin was 63% for 1998 and 65% for both 1997 and 1996. The decrease in gross margin in 1998 was primarily due to decreases in the average selling prices of the Company's products. To a lesser extent, the acquisition of Stratus contributed to the decrease in gross margin, as gross margins for products sold by Stratus were lower than the Company's gross margins. In the future, the Company's gross margin may be affected by several factors, including the mix of products sold, the price of products sold, the introduction of new products with lower gross margins, the distribution channels used, price competition, increases in material costs and changes in other components of cost of sales. Research and Development. Research and development expenses increased to $216.2 million in 1998 as compared to $156.0 million in 1997 and $93.7 million in 1996. These increases were primarily due to the addition of engineering personnel, expenses related to the development and enhancement of the Company's existing and new products, expenses related to applications and product testing required to enter new markets, addition of development laboratory equipment, and material costs associated with new product prototypes. In addition, research and development expenses have increased in part through the addition of engineering personnel as a result of the Company's mergers and acquisitions. Research and development expenses as a percent of net sales increased to 15% in 1998 from 14% in 1997 and 10% in 1996. The Company expects that spending for research and development will increase in absolute dollars in 1999 but may continue to vary as a percentage of net sales. Sales and Marketing. Sales and marketing expenses increased to $302.0 million in 1998 compared to $249.1 million in 1997 and $156.3 million in 1996. These increases were primarily due to the addition of sales, marketing and technical support personnel and related commissions, and expenses associated with opening additional sales offices in North America, Europe and Asia and the Pacific Basin. Approximately 50% of the total increase in sales and marketing expenses in 1998 were attributable to each of the factors listed above, respectively. The growth in sales, marketing and technical support personnel was primarily due to the need to manage the activities of an increasing number of customers and products. Sales and marketing expenses as a percent of net sales decreased slightly to 20% in 1998 from 21% in 1997, which increased from 18% in 1996. The Company expects that sales and marketing expenses will increase in absolute dollars in 1999 but may continue to vary as a percentage of net sales. General and Administrative. General and administrative expenses increased to $78.9 million in 1998 as compared to $35.3 million in 1997 and $29.9 million in 1996. The increase in 1998 was partially due to the effect of special charges totaling $27.5 million related to the settlement of a patent issue, the settlement of an outstanding receivable from a contract manufacturer and the establishment of reserves against certain customers afforded working capital loans. In addition, the increases in absolute dollars in both years were due to the addition of finance and administrative personnel, bonus compensation paid to the Company's employees, and increased costs for insurance and contract personnel associated with information systems service and support. For 1998, excluding the impact of the $27.5 million in special charges, approximately 20%, 35% and 45% of the total increase in general and administrative expenses were attributable to each of the factors listed above, respectively. General and administrative expenses as a percent of net sales were 5% in 1998 compared to 3% in both 1997 and 1996. Excluding the effect of the special charges discussed above, general and administrative expenses were 3% of net sales in 1998. The Company expects that spending for general and administrative activities will increase in absolute dollars in 1999 but may continue to vary as a percentage of net sales. Purchased In-Process Research and Development. Purchased in-process research and development costs were $267.0 million for 1998 and $231.1 million for 1997. These costs were related to the acquisition of Stratus during the fourth quarter of 1998, and the acquisitions of InterCon and Sahara during the first quarter of 1997. These acquisitions provide technology and expertise that the Company is using to enhance and expand the breadth of its product offerings to end-user markets. In connection with the acquisition of Stratus, purchased in-process research and development totaling $267.0 million was written off as a non-recurring charge at the date of acquisition because the purchased in-process research and development had not yet reached technological feasibility and had no future alternative use. A total of $133.5 million was allocated to existing technology ($130.0 million) and the assembled work force ($3.5 million), with these amounts being amortized over periods of ten years and three years, respectively. The purchased in-process research and development acquired in 1998 is expected to facilitate the development of products which will enable carriers and network service providers to more effectively integrate their existing voice and data networks. As a result, the Company expects to be able to target markets that have historically been served by traditional telecommunications equipment suppliers. The Company is using the purchased in-process research and development to create new products that will become part of the Core Systems business unit product suite, with anticipated product release dates throughout 1999 and 2000. Although the Company expects that the purchased in-process research and development will be successfully developed, there can be no assurance that commercial viability of these products will be achieved. The nature of the efforts required to develop the purchased in-process research and development into commercially viable products principally relates to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish whether the product will be able to meet its design specifications, including functions, features and technical performance requirements. The estimated cost to develop the in-process research and development was approximately $48 million, the majority of which is expected to be incurred in 1999. Brief descriptions of the relevant hardware and software technologies are as follows: Hardware FTX: FTX is an implementation of a UNIX system V operating system for Stratus' line of fault-tolerant computers. When run on FTX, UNIX applications can take advantage of Stratus' single-processor or multiprocessor fault- tolerant architecture that provides continuous system availability and a high level of data protection. FTX was classified as a core/developed technology for purposes of the valuation. HP-UX: Stratus licenses Hewlett-Packard Company's HP-UX UNIX operating system and has enabled the operating system to run on the Continuum family of fault tolerant systems. Applications that run on HP platforms will run unaltered in the Stratus Continuum fault-tolerant environment. These applications include mainstream products from companies such as Oracle, Sybase, and Informix, as well as other solutions and tools listed in the HP-UX operating system product catalog. HP-UX was classified as an in-process technology that is estimated to be released during the first quarter of 1999. Stratus management estimated that 10 months had been spent on the development of this technology prior to the acquisition and approximately 4 months were required post-close to complete this technology. Continuum 1248: Continuum 1248 replaces Continuum 1228 at the high-end of the Continuum product line. The high-end systems offer the growth path and expandability users demand for large online transaction processing applications. The Continuum family combines Reduced Instruction Set Computing based, symmetric multiprocessing technology with Stratus' proven continuous availability architecture to provide customers with robust, continuously available open systems. Continuum 1248 is available on the FTX operating system and the Stratus Virtual Operating System, which is Stratus' fault- tolerant proprietary multiprocessing operating system. Continuum 1248 was classified as an in-process technology, and revenues are not expected until fiscal year 2000. Stratus' management estimated that 2 months had been spent on the development of this technology prior to the transaction and approximately 14 months were required post-close to complete this technology. Continuum 448: Continuum 448 gives customers continuous availability in an entry-level system at the lowest cost in the marketplace. Continuum 448 is available on the FTX and HP-UX operating systems. Continuum 448 was classified as an in-process technology, and revenues are not expected until the fourth quarter of fiscal year 1999. Stratus' management estimated that 2 months had been spent on the development of this technology prior to the transaction and approximately 12 months were required post-close to complete this technology. As of the acquisition date, the remaining risk to development was that the I/O subsystem may not be sufficient to support 4-way scaling in some applications. M708: M708 is a memory board which will support 1 GB - 4 GB. M708 was classified as an in-process technology, and revenues are not expected until the second quarter of fiscal year 1999. Stratus' management estimated that 11 months had been spent on the development of this technology prior to the transaction and approximately 6 months were required post-close to complete this technology. SPHINX: SPHINX provides scalable software fault tolerance for clustered or networked environments. Through SPHINX, distributed applications can be made robust to hardware, network and operating system faults, and many application software faults. The technology can be applied across a broad range of environments from high speed cluster interconnects to wide area networks. SPHINX combines replication for fault tolerance with load balancing for scalability. These capabilities are built on a foundation of fault-tolerant multicast. SPHINX was classified as an in-process technology, that is estimated to be released during the first quarter of fiscal year 1999 and will start generating revenue at this time. Stratus' management estimated that 15 months had been spent on the development of this technology prior to the acquisition and approximately 3 months were required post-close to complete this technology. Other Continuum Systems: Stratus offers three ranges of hardware fault- tolerant systems including the Continuum 400 Series (entry-level systems), the Continuum 600 Series (mid-range systems), and the Continuum 1200 Series (high- end systems). The six developed Continuum 400 Series models are entry-level systems. The five developed Continuum 600 Series models are mid-range systems that provide open continuously available computing. The seven developed Continuum 1200 Series models are the family's high-end systems for the expandability and growth path customers need for large online transaction processing applications. All 400 Series Continuum products can be ordered with the FTX or HP-UX operating systems. These Continuum products were classified as developed technologies. HARMONY: HARMONY is the first product offering of the Continuum II series, or the follow on product line from the Continuum I series (i.e., Continuum 1248 and Continuum 448). HARMONY is a mid-range fault-tolerant computer based on the Intel 64-bit architecture. Migrating to a 64-bit processor architecture will give Continuum II improved scalability and performance over previous Continuum products. HARMONY supports HP-UX, FTX, and Windows NT operating system platforms. HARMONY was classified as an in-process technology. HARMONY is anticipated to begin generating revenue during fiscal year 2000. Stratus management estimated that 18 months had been spent on the development of this technology prior to the acquisition and approximately 18 months were required post-close to complete this technology. Software LNP: Local Number Portability ("LNP") software gives both wireline and wireless carriers performance-tested solutions for managing and provisioning LNP services, and for communicating with regional Number Portability Administration Centers. LNP products run on HP-UX on the Stratus Continuum Series platform. Uninterrupted availability, a prime requisite for LNP, is ensured by Stratus' fault tolerant technology. LNP was classified as an in- process technology that is expected to begin generating revenue during the first quarter of fiscal year 1999. Stratus' management estimated that 12 months had been spent on the development of this technology prior to the acquisition and approximately 3 months were required post-close to complete this technology. CORE IN: CORE IN is Stratus' performance-tested mobile number portability solution. The CORE IN solution implements an advanced intelligent signaling relay architecture for mobile porting. In this design, standard messages used to locate the mobile in order to route calls are transparently redirected to the ported subscriber's network. Ported calls can then be handled in a manner similar to ordinary roaming calls. CORE IN was classified as an in-process technology that is expected to begin generating revenue during the second quarter of fiscal year 1999. Stratus' management estimated that 12 months had been spent on the development of this technology prior to the acquisition and approximately 5 months were required post-close to complete this technology. PN: Personal Number ("PN") portability. PN is included in the CORE IN solution. PN was classified as an in-process technology that is expected to begin generating revenue during the first quarter of fiscal year 1999. Stratus' management estimated that 9 months had been spent on the development of this technology prior to the acquisition and approximately 4 months were required post-close to complete this technology. Signaling System 7 ("SS7") Gateway and Internet Gateway: Stratus' SS7 Gateway and Internet Gateway offer a new solution for telecommunications service providers and Internet service providers who need to meet fast-growing demand for Internet connections at an affordable cost. The gateways are used to transfer data traffic between the Internet and the public switched telephone network, or PSTN. The solution acts as a virtual switch to offload Internet traffic from switching equipment and Inter-Machine Trunks in the PSTN. The SS7 and Internet Gateway solution allows the user to gain an immediate way to expand Internet connection capacity, enhance service levels, improve network manageability, and control spiraling costs. The SS7 Gateway allows phone companies to provide reliability as well as value-added services like credit card verification, caller identification, call forwarding and 800 calling. SS7 Gateway was classified as core/developed technology and Internet Gateway was classified as in-process technology which is estimated to be released during the first quarter of fiscal year 1999. Stratus' management estimated that 16 months had been spent on the development of this technology prior to the acquisition and approximately 1 month was required post-close to complete this technology. The fair value of the in-process research and development projects was estimated at $267.0 million (after the pro-rata allocation of the excess purchase price to the long-term assets acquired). The estimated costs to complete these technologies were $11.2 million in 1998, $28.7 million in 1999 and $8.0 million in 2000. Material risks affecting the timely completion and commercialization of the in-process research and development projects include the risk that development schedules may be delayed, the Company may not be able to retain key personnel involved in the development efforts, integration issues between the hardware and software components may not be resolved on a timely basis, and that the anticipated market demand for the products to be developed based on the in-process technology may not materialize. The nature of the efforts required to develop the purchased in-process research and development into commercially viable products principally relates to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish whether the product will be able to meet its design specifications, including functions, features and technical performance requirements. The value of the purchased in-process research and development from the Stratus acquisition was determined by estimating the projected net cash flows related to such products, including costs to complete the development of the technology and the future revenues to be earned upon commercialization of the products. These cash flows were discounted back to their net present value. The resulting projected net cash flows from such projects were based on management's estimates of revenues and operating profits related to such projects. These estimates were based on several assumptions, including those summarized below. If these projects to develop commercial products based on the purchased in-process research and development are not successfully completed, the Company's operating results may be adversely affected in future periods. Revenues and operating profit attributable to the in-process research and development were estimated to total $5.1 billion and $2.3 billion, respectively, over an eleven-year projection period. The resulting projected net cash flows were discounted to their present value using a discount rate of 35%, which was calculated based on the weighted average cost of capital, adjusted for the technology risk associated with the purchased in-process research and development, which was considered to be significant due to the rapid pace of technological change in the telecommunications industry. The resulting valuation of $370.8 million was subsequently reduced to $267.0 million due to the pro-rata allocation of the excess of the estimated fair value of the net assets acquired over the purchase price. For projected cash flows attributable to existing technology, a discount rate of 30% was used, which reflects the weighted average cost of capital, adjusted for the technology risk associated with these technologies. The primary purchased in-process research and development in 1997 was the Broadband access technology acquired through the January 1997 acquisition of Sahara by Cascade, which was subsequently acquired by the Company. In connection with the acquisition of Sahara, purchased in-process research and development totaling $213.0 million was written off as a non-recurring charge at the date of acquisition because the purchased technology had not yet reached technological feasibility and had no future alternative use. At the acquisition date, Sahara had no revenues or commercially available products. The Company's revenues attributable to the Broadband access technology were not significant in either 1998 or 1997. Cost of Mergers. In 1998, the Company reversed accrued merger costs of $18.3 million, which related to the estimated costs charged to operations in 1997 of approximately $150.3 million. These costs principally related to the acquisition of Cascade and consisted primarily of investment banking fees, professional fees, reserves for redundant assets, redundant products and employee severance packages. In 1996, the Company charged to operations merger costs of approximately $13.9 million. These costs principally related to the acquisition of NetStar, Inc. and consisted primarily of investment banking fees, professional fees and other direct costs associated with the merger. There were no remaining merger related accruals at September 30, 1998. In conjunction with the acquisition of Stratus in the fourth quarter of 1998, the Company recorded, as part of the purchase price, accrued merger costs of $49.3 million, which consist of $7.6 million of merger transaction costs and $41.7 million of integration expenses. Integration expenses consist of $2.4 million for severance and outplacement costs, $34.8 million for costs associated with the divestiture of the non-telecommunications business units, and $4.5 million of other merger related costs. The $2.4 million of severance and outplacement costs relates to approximately 150 employees involved in duplicate functions, including manufacturing and logistics, sales and marketing, and finance and administration. The $34.8 million of costs associated with the divestiture of the non-telecommunications business units consists of the following major components: (1) $22.2 million of costs associated with termination of lease agreements and relocation of the non- telecommunication business units, (2) $8.6 million of investment banker and professional fees related to the divestitures, and (3) $4.0 million of other miscellaneous expenses. At December 31, 1998, the accrued merger costs for Stratus were $49.3 million, with such costs expected to be paid during the first three quarters of 1999. Substantially all of the accrued merger costs represent anticipated cash expenditures. Interest Income. Interest income increased to $28.1 million in 1998 compared to $23.0 million in 1997 and $17.2 million in 1996. The increase in interest income during 1998 and 1997 was primarily due to increases in cash and investments balances, which were primarily attributable to cash generated from operations, and proceeds received from the exercise of stock options. Provision for Income Taxes. The provision for income taxes for 1998 was $136.6 million compared to $79.4 million for 1997 and $118.1 million in 1996. The Company's tax expense for 1998 and 1997 was impacted by non-deductible costs associated with the Company's business combinations. Excluding the effects of these non-deductible charges, the Company's effective tax rate was 35.6% for 1998 and 37.3% for 1997, which approximates the effective statutory federal and state income tax rates adjusted for the impact of tax exempt interest, the benefits associated with the Company's Foreign Sales Corporation and the utilization of various tax credits. The decrease in the Company's effective tax rate from 1997 to 1998 was primarily attributable to the utilization of various tax credits. Excluding the effects of non-deductible one-time charges, the Company's effective tax rate was 38.2% for 1996. Liquidity and Capital Resources At December 31, 1998, the Company's principal sources of liquidity included cash and cash equivalents, short-term investments and investments totaling $1.137 billion and an unsecured $25.0 million revolving line of credit which expires in June 1999. There were no borrowings or amounts outstanding under the line of credit as of December 31, 1998. The increase in cash and cash equivalents of $201.8 million for 1998 was attributable to $281.9 million of cash provided by operations and $203.8 million of cash provided by financing activities, offset by $283.9 million of cash used in investing activities. The net cash provided by operating activities for 1998 was primarily due to the net loss, adjusted for the effects of purchased research and development and depreciation and amortization, offset by changes in working capital assets. Net cash used in investing activities of $283.9 million for 1998 related primarily to net purchases of investments of $362.9 million and expenditures for property and equipment of $157.5 million, offset by cash acquired in conjunction with the acquisition of Stratus of $269.4 million. Financing activities provided $203.8 million in 1998, due to proceeds from the exercise of stock options and issuance of common stock in connection with the Company's stock option and stock purchase plans. At December 31, 1998, the Company had $1.051 billion in working capital. The Company currently has no significant capital commitments other than commitments under facilities and operating leases. The Company believes that its available sources of funds and anticipated cash flow from operations will be adequate to finance current operations, anticipated investments and capital expenditures for at least the next twelve months. Factors which may affect future results The Company's quarterly and annual operating results are affected by a wide variety of risks and uncertainties as discussed below and in the Company's Registration Statement on Form S-4/A (No. 333-62281) filed on September 9, 1998 in connection with the acquisition of Stratus. This Report on Form 10-K should be read in conjunction with such Form S-4/A, particularly the section entitled "Risk Factors". Merger Agreement with Lucent On January 12, 1999, the Company and Lucent executed a definitive merger agreement pursuant to which Dasher Merger Inc., a Delaware corporation and a wholly owned subsidiary of Lucent, will merge, subject to certain conditions, with and into the Company and the Company will become a wholly owned subsidiary of Lucent. Under the terms of the merger, each outstanding share of common stock of the Company will be exchanged for 0.825 shares of common stock of Lucent, subject to adjustment for changes in Lucent's capitalization, including the two-for-one stock split announced by Lucent in February 1999. The announcement of the merger could have an impact on the ability of the Company to market its products and services to its customers, possibly causing operating results to vary from those expected. The merger is subject to approval by the Company's stockholders and various regulatory agencies, including the Department of Justice, and there can be no assurance that the merger will be successfully completed. In the event that the merger is not successfully completed, the Company's results of operations and common stock price could be materially adversely affected. If the merger is successfully completed, holders of the Company's common stock will become holders of Lucent common stock. Lucent's business is different from that of the Company, and Lucent's results of operations, as well as the price of Lucent common stock, may be affected by factors different than those affecting the Company's results of operations and the price of the Company's common stock. For a discussion of Lucent's business and certain factors to consider in connection with such business, see Lucent's Annual Report on Form 10-K for the fiscal year ended September 30, 1998. Dependence on the Internet Access and Telecommunications Markets A substantial portion of the Company's sales of its MAX and Pipeline products is related to the Internet industry. In North America, the Company sells a substantial percentage of its products, particularly its MAX products, to ISPs. Additionally, a substantial portion of the Company's sales of its core systems products is related to the telecommunications carrier industry. In North America, the Company sells a substantial percentage of its core systems products to public carriers. There can be no assurance that these industries and their infrastructure will continue to develop or that acceptance of the Company's products by these industries will be sustained. The Company believes competition in the Internet and public carrier industry will increase significantly in the future and could have a material adverse effect on the Company's business, results of operations or financial condition. Integration of Acquisitions The Company concluded the acquisition of one company in 1998 and four companies in 1997. Achieving the anticipated benefits of these acquisitions or any other acquisitions the Company may undertake will depend in part upon whether the integration of the acquired companies' products and technologies, research and development activities, and sales, marketing and administrative organizations is accomplished in an efficient and effective manner. There can be no assurance that this will occur. Moreover, the integration process may temporarily divert management attention from the day-to-day business of the Company. Failure to successfully accomplish the integration of acquired companies could have a material adverse effect on the Company's business, financial condition or results of operations. International Sales The Company expects that international sales will continue to account for a significant portion of the Company's net sales in future periods. International sales are subject to certain inherent risks, including unexpected changes in regulatory requirements and tariffs, political and economic instability, difficulties in staffing and managing foreign operations, longer payment cycles, problems in collecting accounts receivable and potentially adverse tax consequences. The Company depends on third party resellers for a substantial portion of its international sales. Certain of these third party resellers also act as resellers for competitors of the Company that can devote greater effort and resources to marketing competitive products. The loss of certain of these third party resellers could have a material adverse effect on the Company's business, financial condition or results of operations. Although substantially all of the Company's sales are denominated in U.S. dollars, fluctuations in currency exchange rates could cause the Company's products to become relatively more expensive to customers in a particular country, leading to a reduction in sales and profitability in that country. Furthermore, future international activity may result in foreign currency denominated sales, and, in such event, gains and losses on the conversion to U.S. dollars of accounts receivable and accounts payable arising from international operations may contribute to fluctuations in the Company's results of operations. In addition, sales in Europe and certain other parts of the world typically are adversely affected in the third quarter of each calendar year as many customers reduce their business activities during the summer months. These seasonal factors may have a material adverse effect on the Company's business, results of operations and financial condition. Fluctuations in Quarterly Operating Results The Company typically operates with a relatively small backlog. As a result, quarterly sales and operating results generally depend on the volume of, timing of and ability to fulfill orders received within the quarter, all of which are difficult to forecast. In the Company's most recent quarters, the sequential sales growth has fluctuated significantly, and a disproportionate share of the sales occurred in the last month of the quarter. These occurrences are extremely difficult to predict and may happen in the future. The Company's ability to meet financial expectations could be hampered if the nonlinear sales pattern continues in future periods. Accordingly, the cancellation or delay of even a small percentage of customer purchases could materially adversely affect the Company's results of operations in the quarter. A significant portion of the Company's net sales in prior periods has been derived from relatively large sales to a limited number of customers, and therefore the failure of the Company to secure expected large sales may have a material adverse impact on results of operations. A significant portion of the Company's expenses are fixed in advance based in large part on the Company's forecasts of future sales. If sales are below expectations in any given quarter, the adverse impact of the sales shortfall on the Company's operating results may be magnified by the Company's inability to adjust spending to compensate for the shortfall. Rapidly Changing Technologies The market for the Company's products is characterized by rapidly changing technologies, evolving industry standards, frequent new product introductions and short product life cycles. The introduction of new products requires the Company to manage the transition from older products in order to minimize disruption in customer ordering patterns, avoid excessive levels of older product inventories and ensure that adequate supplies of new products can be delivered to meet customer demand. Furthermore, products such as those offered by the Company may contain undetected or unresolved hardware problems or software errors when they are first introduced or as new versions are released. There can be no assurance that, despite extensive testing by the Company, hardware problems or software errors will not be found in new products after commencement of commercial shipments, resulting in delay in or loss of market acceptance. Future delays in the introduction or shipment of new or enhanced products, the inability of such products to gain market acceptance or problems associated with new product transitions could have a material adverse effect on the Company's business, results of operations or financial condition. Competition The Company mainly competes in four segments of the data networking market: (i) WAN and Internet access, (ii) WAN and Internet backbone switching, (iii) remote LAN access and Internet subscriber access, and (iv) videoconferencing and multimedia access. The Company competes in one or more of these market segments with Cisco, 3Com, Newbridge, Nortel and many others. Some of these competitors have substantially greater financial, marketing and technical resources than the Company. The Company expects additional competition from existing competitors and from a number of other companies, some of which may have substantially greater financial, marketing and technical resources than the Company, that may enter the Company's existing and future markets. Increased competition could result in price reductions, reduced profit margins and loss of market share, each of which would have a material adverse effect on the Company's business, results of operations and financial condition. The Company expects that its gross margins could be adversely affected in future periods by price changes resulting from increased competition. In addition, increased sales of Pipeline products as a percentage of net sales may materially adversely affect the Company's gross margins in future periods as these products have lower gross margins than the Company's other products. Reliance on Third Party Telecommunications Carriers, Value-Added Resellers and Distributors The Company's use of third parties to distribute its products to VARs may adversely affect the Company's gross margins. The Company's sales are, to a significant degree, made through telecommunications carriers, VARs and distributors. Accordingly, the Company is dependent on the continued viability and financial stability of these companies. While the Company has contractual relationships with many telecommunications carriers, VARs and distributors, these agreements do not require these companies to purchase the Company's products and can be terminated by these companies at any time. There can be no assurance that any of the telecommunications carriers, VARs or distributors will continue to market the Company's products. The telecommunications carrier customers, to the extent they are resellers, VARs and distributors, generally offer products of several different companies, including products that are competitive with the Company's products. Accordingly, there is a risk that these companies may give higher priority to products of other suppliers, thus reducing their efforts to sell the Company's products. Any special distribution arrangement or product pricing arrangement that the Company may implement in one or more distribution channels for strategic purposes could materially adversely affect gross profit margins. Dependence on Key Personnel The Company's success depends to a significant degree upon the continuing contributions of its key management, sales, marketing and product development personnel. The Company typically does not have employment contracts with its key personnel and does not maintain any key person life insurance policies. The loss of key personnel could materially adversely affect the Company. Management of Growth The Company is currently experiencing rapid growth and expansion, which has placed, and will continue to place, a significant strain on its administrative, operational and financial resources and increased demands on its systems and controls. This growth has resulted in a continuing increase in the level of responsibility for both existing and new management personnel. The Company anticipates that its continued growth will require it to recruit and hire a substantial number of new engineering, sales, marketing and managerial personnel. There can be no assurance that the Company will be successful at hiring or retaining these personnel. The Company's ability to manage its growth successfully will also require the Company to continue to expand and improve its operational, management and financial systems and controls and to expand its manufacturing capacity. If the Company's management is unable to manage growth effectively, the Company's business, results of operations and financial condition may be materially and adversely affected. Proprietary Rights The Company relies on a combination of patents, copyright, and trade secret laws and non-disclosure agreements to protect its proprietary technology. However, there can be no assurance that any of the Company's proprietary technology rights will not be challenged, invalidated or circumvented, or that any such rights will provide significant competitive advantage. From time to time, the Company receives notices from third parties regarding patent or copyright claims. Any such claims, with or without merit, could be time consuming to defend, result in costly litigation, divert management's attention and resources and cause the Company to incur significant expenses. The Company is currently involved in patent disputes the results of which are not presently determinable. Such disputes could result in significant expenses to the Company and divert the efforts of the Company's technical management personnel. Dependence on Contract Manufacturers and Single-Source Suppliers Although the Company generally uses standard parts and components for its products, certain components, including certain key microprocessors and integrated circuits, are presently available only from a single source or from limited sources. The Company has no supply commitments from its vendors and generally purchases components on a purchase order basis as opposed to entering into long term procurement agreements with vendors. The Company has generally been able to obtain adequate supplies of components in a timely manner from current vendors or, when necessary to meet production needs, from alternate vendors. The Company believes that, in most cases, alternate vendors can be identified if current vendors are unable to fulfill needs. However, delays or failure to identify alternate vendors, if required, or a reduction or interruption in supply, or a significant increase in the price of components could materially adversely affect the Company's revenues and financial results and could impact customer relations. Ascend Year 2000 Readiness Disclosure The Year 2000 computer issue creates a risk for Ascend and therefore the Company makes the following Year 2000 readiness disclosure. If computer systems do not correctly recognize date information when the year changes to 2000, there could be a materially adverse impact on the Company's operations. The risk for the Company exists in four areas: systems used by the Company to run its business, systems used by the Company's suppliers, potential warranty or other claims from the Company's customers, and the potential reduced spending by other companies on networking solutions as a result of significant information systems spending on Year 2000 remediation. The Company is currently evaluating its exposure in all of these areas and expects to complete such evaluation no later than June 30, 1999. Internal Systems. The Company has almost completed a comprehensive assessment and evaluation of its systems, equipment and facilities. The Company has a number of projects underway to test and replace or upgrade systems, equipment and facilities that are known to be Year 2000 non-compliant. The Company expects Year 2000 internal testing to be complete by June 1999. The Company has not identified alternative remediation plans if upgrade or replacement is not feasible. The Company will consider the need for such remediation plans as it continues to assess the Year 2000 risk. For the Year 2000 non-compliance issues identified to date, the cost of upgrade or remediation is not expected to be material to the Company's operating results. If implementation of replacement systems is delayed, or if significant new non-compliance issues are identified, the Company's results of operations or financial condition could be materially adversely affected. Suppliers. The Company is also in the process of contacting its critical suppliers to determine whether the suppliers' operations and the products and services they provide are Year 2000 compliant. The Company's process for assessing such compliance includes obtaining supplier certifications, supplier follow-up meetings and external testing, if required. Supplier certifications, supplier follow-up meetings and external testing, if required, are expected to be completed by June 1999. In the event that suppliers are not Year 2000 compliant, the Company will seek alternative sources of supplies. However, such failures remain a possibility and could have a materially adverse impact on the Company's results of operations or financial condition. Additionally, litigation may arise from situations in which the Company has minimum purchase commitment contracts with suppliers that are not Year 2000 compliant. Warranty. On the basis of product designs and quality assurance tests, the Company believes the majority of its current products are Year 2000 compliant; however, some of the products sold by the Company in the past may not be Year 2000 compliant. The Company currently identifies the products that are certified as Y2K compliant through its Year 2000 readiness disclosure to customers, and for other products, does not have any obligation to upgrade these products. However, the Company's products are sometimes bundled or marketed with, or used by customers with, third party products which may not always be Year 2000 compliant. For these reasons, the Company may experience an increase in warranty and other claims as a result of the Year 2000 transition and such claims could have a material adverse impact on the Company's results of operations or financial condition. In addition, in the event that a significant number of the Company's customers experience Year 2000-related problems, whether or not due to the Company's products, demand for technical support and assistance may increase substantially. In such case, the Company's costs for providing technical support may rise and the quality of such technical support or the Company's ability to manage incoming requests may be impaired. Sales Impact. Year 2000 compliance is an issue for almost all businesses, whose computer systems and applications may require significant hardware and software upgrades or modifications. Companies owning and operating such systems may plan to devote a substantial portion of their information systems' spending to fund such upgrades and modifications and divert spending away from networking solutions. Such changes in customers' spending patterns could have a material adverse impact on the Company's sales, operating results or financial condition. General. In order to evaluate the risks outlined above and to implement Year 2000 compliance solutions, Ascend has established a company wide team coupled with outside consultants. The internal Ascend Year 2000 compliance team consists of representatives from various functional areas, including risk management, finance, engineering, purchasing, and legal. The external Year 2000 compliance team includes various national Year 2000 compliance consultants. The team has established an overall Year 2000 compliance goal, incremental milestones and meets regularly to assess progress on its milestones. Currently, the Company is establishing contingency plans to address the impact to the Company in the event its suppliers, products and internal systems are not Year 2000 compliant. Costs incurred to date on the Company's Year 2000 compliance project are approximately $11.5 million. Total costs of the project and compliance are estimated to be $20.0 million to $24.0 million and should be substantially incurred by June 30, 1999. However, there can be no assurance that these costs will not be greater than anticipated, or that corrective actions undertaken will be completed before any Year 2000 compliance problems occur. The Company's Year 2000 compliance criteria comply with the requirements established by the US Government as stated in The Final GSA - Year 2000 Compliance. Volatility of Stock Price The Company's common stock has experienced significant price volatility, and such volatility may occur in the future, particularly as a result of quarter-to-quarter variations in the actual or anticipated financial results of the Company or other companies in the networking industry, announcements by the Company or competitors regarding new product introductions or other developments affecting the Company or changes in financial estimates by public market analysts. In addition, the market has experienced extreme price and volume fluctuations that have affected the market price of many technology companies' stocks and that have been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations may materially adversely affect the market price of the Company's common stock. Recent periods of volatility in the market price of the Company's securities resulted in securities class action litigation against the Company and various officers and directors. Such litigation could result in substantial costs and a diversion of management's attention and resources, which would have a material adverse effect on the operating results and financial condition of the Company. In consideration of these factors, there can be no assurance that the Company will be able to sustain growth in revenues or profitability, particularly on a period-to-period basis. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is experiencing a greater proportion of its sales activity through its partners in two-tier distribution channels. Such partners tend to have access to more limited financial resources than other resellers and end-user customers and therefore represent potential sources of increased credit risk. Additionally, the Company is experiencing increased demands for customer financing and leasing solutions. The Company also continues to monitor increased credit exposures because of the weakened financial conditions in Asia and South America and the impact that such conditions may have on the worldwide economy. Although the Company has not experienced significant losses due to customer default to date, such losses, if incurred, may have a material adverse impact on the Company's business, operating results, and financial position. The Company maintains investment portfolio holdings of various issuers, types, and maturities. These securities are generally classified as available for sale. The Company also has certain real estate lease commitments with payments tied to short-term interest rates. At any time, a sharp rise in interest rates could have a material adverse impact on the fair value of the Company's investment portfolio while increasing the costs associated with its lease commitments. Conversely, declines in interest rates could have a material impact on interest earnings for the Company's investment portfolio. The Company does not currently hedge these interest rate exposures. The following table presents the hypothetical changes in fair values in the financial instruments held by the Company at December 31, 1998 that are sensitive to changes in interest rates. These instruments are not leveraged and are held for purposes other than trading. The modeling technique used measures the change in fair values arising from selected potential changes in interest rates. Market changes reflect immediate hypothetical parallel shifts in the yield curve of plus or minus 50 basis points ("BPS"), 100BPS, and 150BPS over a twelve-month time horizon. Beginning fair values represent the market principal plus accrued interest and dividends for investments at December 31, 1998, which consist entirely of obligations of states and political subdivisions. Ending fair values comprise the market principal plus accrued interest, dividends, and reinvestment income at a twelve-month time horizon. This table estimates the fair value of the portfolio at a twelve-month time horizon (in thousands):
Valuation of securities No change Valuation of securities given an interest rate in interest given an interest rate decrease of X basis points rates increase of X basis points -------------------------- ----------- -------------------------- (150 BPS) (100 BPS) (50 BPS) 50 BPS 100 BPS 150 BPS - --------- --------- -------- ------ ------- ------- $708,723 $703,999 $699,293 $694,717 $690,092 $685,534 $680,958
A 50BPS move in the Federal Funds Rate has occurred in 9 of the last 10 years; a 100BPS move in the Federal Funds Rate has occurred in 6 of the last 10 years; and a 150BPS move in the Federal Funds Rate has occurred in 3 of the last 10 years. The Company also is exposed to interest rate risk associated with a lease on its facilities whose payments are tied to the London Interbank Offered Rate (LIBOR), and has evaluated the hypothetical change in lease obligations held at December 31, 1998 due to changes in the LIBOR rate. Market changes reflected immediate hypothetical parallel shifts in the LIBOR curve of plus or minus 50BPS, 100BPS, and 150BPS over a twelve-month period. The results of this analysis were not material to the Company's financial results. The Company also maintains investments in various privately held companies totaling $37.0 million at December 31, 1998, and may acquire additional investments in the future. The carrying value of these investments is subject to potential declines in value, depending on the financial performance of the privately held companies in which the investments are maintained. Although the Company believes that the investments are fairly valued at cost at December 31, 1998, there can be no assurance that unanticipated declines in value will not occur, the results of which could have a material adverse effect on the Company's financial position and results of operations. Prior to the acquisition of Stratus in the fourth quarter of 1998, substantially all of the Company's sales were denominated in US dollars. With the acquisition of Stratus, nondollar-denominated sales have increased to some extent. Accordingly, the Company has entered into forward foreign exchange contracts to offset the impact of currency fluctuations on certain nonfunctional currency assets and liabilities, primarily denominated in certain European, Japanese, Asian, and Australian currencies. The forward currency contracts generally have original maturities of one to three months, with none having a maturity greater than one year in length. The total notional values of forward contracts purchased and forward contracts sold were not material at December 31, 1998, and management does not expect gains or losses on these contracts to have a material impact on the Company's financial position and results of operations. As a global concern, the Company faces exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse impact on the Company's financial results. Currently, the Company's primary exposures relate to nondollar-denominated sales in Europe, Japan, the rest of Asia, and Australia and nondollar-denominated operating expenses in Europe and Asia. The introduction of the Euro as a common currency for members of the European Monetary Union has not had a material effect on the Company. At the present time, the Company hedges only those currency exposures associated with certain known assets and liabilities, denominated in nonfunctional currencies, and does not hedge anticipated foreign currency cash flows. The hedging activity of the Company is intended to offset the impact of currency fluctuations on certain nonfunctional currency assets and liabilities. The success of this activity depends upon estimation of balances denominated in various currencies, primarily certain European, Japanese and Australian currencies. To the extent that these estimates are over- or understated during periods of currency volatility, the Company could experience unanticipated currency gains or losses. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Business Combinations Pooling of Interests Combinations Business combinations which were accounted for as pooling of interests are summarized as follows (in millions): CASCADE WHITETREE NETSTAR Acquisition date June 1997 April 1997 August 1996 Shares of common stock issued............ 66.3 1.3 3.9 Stock options and warrants assumed....... 8.5 0.1 0.7 Cascade Communications Corp. ("Cascade") was a developer and manufacturer of wide area network switches. Whitetree, Inc. ("Whitetree") was a developer and manufacturer of high-speed ATM switching products. NetStar, Inc. ("NetStar") was a developer and manufacturer of high performance, high-speed IP network routers. The Company's historical financial results were restated for each pooling of interest business combination, except in the case of Whitetree, where the results of the acquired entity were not material to the Company's consolidated results. Purchase Combinations Business combinations which were accounted for as a purchase are summarized as follows (in millions):
STRATUS INTERCON SAHARA ------- -------- ------ Acquisition date.......................................... October 1998 February 1997 January 1997 Purchase price ........................................... $ 916.7 $ 21.6 $ 219.0 Consideration Shares of common stock issued........................... 18.1 - 2.4 Fair value of common stock issued....................... $ 808.7 $ - $ 196.8 Fair value of common stock options assumed.............. $ 27.7 $ - $ 22.2 Cash paid............................................... $ - $ 12.0 $ - Liabilities assumed..................................... $ 80.3 $ 9.6 $ - Allocation of purchase price Net tangible assets..................................... $ 400.2 $ 0.6 $ 6.0 Assets held for sale.................................... $ 116.0 $ - $ - Purchased in-process research and development........... $ 267.0 $ 18.0 $ 213.0 Existing technology..................................... $ 130.0 $ 3.0 $ - Assembled work force.................................... $ 3.5 $ - $ - Amortization period - existing technology (years)....... 10 3 - Amortization period - assembled work force (years)...... 3 - -
Stratus Computer, Inc. ("Stratus") was a manufacturer of fault-tolerant computer systems. InterCon Systems Corporation ("InterCon") was a developer of remote access client software products. Sahara Networks, Inc. ("Sahara") was a privately held developer of scaleable high-speed broadband access products. Sahara was acquired by Cascade, which was subsequently acquired by the Company. For business combinations accounted for as a purchase, the Company's consolidated financial statements include the operating results from the date of acquisition. The amounts allocated to purchased in-process research and development were determined using the discounted cash flow method and were expensed upon acquisition because technological feasibility had not been established and no future alternative uses existed. Prior to the consummation of the acquisition of Stratus, the Company announced its intention to divest the non-telecommunication business units of Stratus, which consist of the Enterprise computer business unit, two business units comprised of financial and enterprise software (TCAM and S2), and a software joint venture interest (Astria). Accordingly, these business units were recorded at their estimated fair value upon acquisition and are classified as assets held for sale at December 31, 1998. The estimated fair value was based on discussions with independent third parties that expressed interest in acquiring these business units. Based on these discussions, the fair value of these business units was estimated to range from $132.0 million to $175.0 million. The assets held for sale were recorded within this range. This amount was subsequently reduced by operating cash outflows totaling $21.6 million, partially offset by operating income of $5.6 million, both of which were excluded from the Company's consolidated results of operations and cash flows, for an adjusted book value of $116.0 million at December 31, 1998. In January and February 1999, the Company entered into definitive agreements to divest each of these business units, for a combined total of approximately $165 million, subject to potential adjustments under certain circumstances. To the extent that the sales proceeds of the business units exceed the original estimate, or the accrued costs to divest the business units is less than expected, the Company will reduce its original charge for purchased in-process research and development and reduce the amount of the purchase price allocated to non-current assets on a pro-rata basis. The following summary of the unaudited pro forma combined results of Ascend and Stratus (as if the acquisition had occurred on January 1, 1997) excludes the results of operations for the acquired business units held for sale (thousands, except per share data): YEAR ENDED DECEMBER 31, -------------------------------------- 1998 1997 ----------------- ---------------- (UNAUDITED) (UNAUDITED) Net sales................................. $ 1,647,075 $ 1,470,152 Operating income (loss)................... 74,684 (45,556) Net loss.................................. (20,337) (102,637) Net loss per share - basic and diluted.... (0.10) (0.50) Included in the liabilities assumed are $49.3 million of accrued merger costs, which consist of $7.6 million of merger transaction costs and $41.7 million of integration expenses. Integration expenses consist of $2.4 million for severance and outplacement costs, $34.8 million for costs associated with the divestiture of the non-telecommunications business units, and $4.5 million of other merger related costs. The $2.4 million of severance and outplacement costs relates to approximately 150 employees involved in duplicate functions, including manufacturing and logistics, sales and marketing, and finance and administration. The $34.8 million of costs associated with the divestiture of the non-telecommunications business units consists of the following major components: (1) $22.2 million of costs associated with termination of lease agreements and relocation of the non-telecommunication business units, (2) $8.6 million of investment banker and other professional fees related to the divestitures, and (3) $4.0 million of other miscellaneous expenses. The purchase price allocation for the Stratus acquisition is tentative and will be adjusted based on certain factors, including the value received for the business units held for sale. Accordingly, the purchase price allocation will be adjusted during the first or second quarter of 1999. 8. Litigation On January 13, 1999, four purported class action complaints challenging the proposed merger between Ascend and Lucent were filed in the Delaware Court of Chancery by individuals who claim to be stockholders of Ascend. The complaints name the Company, its directors and certain former directors of Cascade Communications Corp. as defendants. One of the complaints also names Lucent as a defendant. The complaints allege, among other things, that the defendants have resolved to wrongfully allow Lucent to obtain the assets of Ascend at a bargain price, that the defendants have breached their fiduciary duties to the class, that action by the defendants will prevent Ascend's stockholders from receiving a fair price for their shares, that Ascend's directors failed to make an informed decision in recommending Lucent's offer, and that the terms of the proposed merger fail to include appropriate mechanisms to protect Ascend's stockholders against a decline in the price of Lucent's or Ascend's stock. The complaint naming Lucent alleges that it aided and abetted the breaches of fiduciary duty by the other defendants. The plaintiffs seek, among other things, (i) a declaration that the proposed transaction is unfair, unjust and inequitable; (ii) preliminary and permanent injunctive relief against the consummation or closing of the proposed transaction; (iii) rescission of the transaction in the event it is consummated; (iv) damages, (v) allowance for plaintiffs' attorneys' fees and expenses; and, (vi) other relief as the Court may deem just and proper. These actions are in the early stages of proceedings and the Company is currently investigating the allegations. Based on its current information, the Company believes the suits to be without merit and intends to defend itself and the named defendants vigorously. Although it is reasonably possible the Company may incur a loss upon the conclusion of these claims, an estimate of any loss or range of loss cannot be made. No provision for any liability that may result upon adjudication has been made in the consolidated financial statements. In the opinion of management, resolution of this matter is not expected to have a material adverse effect on the financial position of the Company. However, depending on the amount and timing, an unfavorable resolution of this matter could materially affect the Company's financial position, future results of operations or cash flows in a particular period. The Company and various of its current and former officers and directors are defendants in a number of consolidated class action lawsuits pending in the United Stated District Courts for the Central District of California, which have been filed on behalf of all persons who purchased or acquired the Company's stock (excluding the defendants and parties related to them) for the period November 5, 1996 to September 30, 1997 ("federal securities actions"). In addition, the Company and one of its officers are defendants in a securities action filed in the Superior Court of Alameda County, California ("state securities action"). The state securities action purports to be brought in behalf of all purchasers of the Company's stock between July 15, 1997 and September 29, 1997 (excluding the defendants and parties related to them). The lawsuits allege that the defendants violated the federal or state securities laws by engaging in a scheme to artificially inflate and maintain the Company's stock price by disseminating materially false and misleading information concerning its business and earnings and the development, efficiency, introduction and deployment of its digital modems based on 56K-bps technology. On August 17, 1998, the Court certified the federal securities actions as a class action and appointed four plaintiffs to serve as class representatives. On September 4, 1998, plaintiffs filed a second Amended and Consolidated Complaint. On February 2, 1999, the Court issued an Order granting the motion to dismiss and allowing plaintiffs to file an amended complaint. The state securities action has been stayed pending resolution of the motion to dismiss in the federal securities action. These actions are in the early stages of proceedings and the Company is currently investigating the allegations. Based on its current information, the Company believes the suits to be without merit and intends to defend itself and its officers and directors vigorously. Although it is reasonably possible the Company may incur a loss upon the conclusion of these claims, an estimate of any loss or range of loss cannot be made. No provision for any liability that may result upon adjudication has been made in the consolidated financial statements. In the opinion of management, resolution of this matter is not expected to have a material adverse effect on the financial position of the Company. However, depending on the amount and timing, an unfavorable resolution of this matter could materially affect the Company's financial position, future results of operations or cash flows in a particular period. In connection with these legal proceedings, the Company expects to incur substantial legal and other expenses. Shareholder suits of this kind are highly complex and can extend for a protracted period of time, which can substantially increase the cost of such litigation and divert the attention of the Company's management. In April 1997, a civil action was filed against Sahara, its three founders and ten employees of Sahara by General Datacomm Industries, Inc. in the Superior Court for the State of Connecticut. The complaint alleges several causes of action, including: breach of contract; tortious interference with contractual relations; misappropriation of trade secrets; unfair competition and violation of the Connecticut Unfair Trade Practices Act. The plaintiff seeks relief of unspecified monetary damages, costs and injunctive relief. The Company has not yet engaged in substantive discovery and the ultimate outcome of this matter cannot yet be determined. The Company plans to vigorously defend this lawsuit. Although it is reasonably possible the Company may incur a loss upon the conclusion of these claims, an estimate of any loss or range of loss cannot be made. No provision for any liability that may result from the action has been recognized in the consolidated financial statements. In the opinion of management, resolution of this litigation is not expected to have a material adverse effect on the financial position of the Company. However, depending on the amount and timing, an unfavorable resolution of this matter could materially affect the Company's future results or cash flows in a particular period. The Company is a party as a defendant in various other lawsuits, contractual disputes and other legal claims arising in the ordinary course of business, the results of which are not presently determinable. Although it is reasonably possible the Company may incur a loss upon the conclusion of these claims, an estimate of any loss or range of loss cannot be made. No provision for any liability that may result from these claims has been recognized in the consolidated financial statements. However, in the opinion of management, after consultation with legal counsel, the amount of losses that might be sustained, if any, from these lawsuits would not materially affect the Company's financial position. However, depending on the amount and timing, an unfavorable resolution of some or all of these matters could materially affect the Company's future results of operations or cash flows in a particular period. 9. Segment and Geographical Information Segment Disclosures -- The Company operates in one business segment, which is the global communications networking industry. For management purposes, the Company is divided into three primary business units, Core Systems, Access Switching and Enterprise Access. Each of these groups has a vice president who reports directly to the Chief Executive Officer ("CEO"), who is the Chief Operating Decision Maker as defined by SFAS 131. The measures of profitability reviewed by the CEO consist of revenues, gross profit and contribution margin. The majority of the Company's operating expenses are not allocated to the business units, but are treated as corporate expenses. Revenues attributable to each business unit are as follows: YEAR ENDED DECEMBER 31, ------------------------------------ 1998 1997 1996 ----------- ------------ ---------- Core Systems......................... $ 688,889 $ 410,144 $320,498 Access Switching..................... 603,523 605,906 427,331 Enterprise Access.................... 103,135 100,291 115,735 Other................................ 83,135 51,011 26,709 ----------- ------------ ---------- $1,478,682 $1,167,352 $890,273 =========== ============ ========== For financial reporting purposes, the Core Systems and Access Switching business units (which total approximately 87%, 87% and 84% of total revenues in 1998, 1997 and 1996, respectively) are combined into a single industry segment, because the nature of the products and services, the production processes, types of customers, distribution method and gross margins for these business units are similar. No other business units meet the revenue, profit/loss or assets criteria for reportable segments as defined by SFAS 131. Major Customers and Revenues by Geographic Area -- One customer accounted for 13% and 17% of net sales in 1998 and 1997, respectively. No customer accounted for more than 10% of net sales in 1996. Net sales were derived from customers based in the following geographic areas (in thousands): YEAR ENDED DECEMBER 31, ------------------------------------------ 1998 1997 1996 ----------- ----------- ---------- North America...................... $1,051,160 $ 805,012 $ 576,996 Europe............................. 184,128 157,960 129,126 Asia and Pacific Basin............. 212,184 189,675 170,747 Latin and South America............ 31,210 14,705 13,404 ------------ ----------- ---------- $1,478,682 $1,167,352 $ 890,273 ============ =========== ========== Substantially all of the Company's identifiable assets at December 31, 1998 and 1997 were attributable to North American operations. 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. ASCEND COMMUNICATIONS, INC. Date May 19, 1999 by /s/ Mory Ejabat ------------ ------------------------------ Mory Ejabat President, Chief Executive Officer and Director -----END PRIVACY-ENHANCED MESSAGE-----