10-Q 1 p15925_10q.txt QUARTERLY REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 Commission File No. 0-27742 CYLINK CORPORATION (Exact name of registrant as specified in its charter) California 95-3891600 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 3131 Jay Street Santa Clara, California 95054 (Address of principal executive offices) (408) 855-6000 (Registrant's telephone number, including area code) 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 ___ As of August 13, 2002, there were 32,986,000 shares of the Registrant's common stock outstanding. CYLINK CORPORATION FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2002 INDEX Page PART I FINANCIAL INFORMATION Item 1 Financial Statements a) Condensed Consolidated Balance Sheets at June 30, 2002 and December 31, 2001 1 b) Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2002 and July 1, 2001 2 c) Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and July 1, 2001 3 d) Notes to Condensed Consolidated Financial Statements 4 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 9 Item 3 Quantitative and Qualitative Disclosures about Market Risk 21 PART II OTHER INFORMATION 22 Item 1. Legal Proceedings 22 Item 2. Changes in Securities and Use of Proceeds 22 Item 3. Defaults upon Senior Securities 22 Item 4. Submission of Matters to a Vote of the Security Holders 22 Item 5. Other information 23 Item 6. Exhibits and Reports on Form 8-K 23 Signature 24 PART I. FINANCIAL INFORMATION Item 1. Financial Statements CYLINK CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands, except share and par value data; unaudited)

See accompanying notes to condensed consolidated financial statements. 1 CYLINK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data; unaudited)

See accompanying notes to condensed consolidated financial statements. 2 CYLINK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands; unaudited)

See accompanying notes to condensed consolidated financial statements. 3 CYLINK CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) 1. Basis of Presentation The unaudited condensed consolidated financial statements included herein contain all adjustments, consisting only of normal recurring adjustments, which, in the opinion of management, are necessary to state fairly the consolidated financial position, results of operations and cash flows of Cylink Corporation ("Cylink" or "the Company") for the periods presented. These financial statements should be read in conjunction with the Company's audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. Interim results of operations are not necessarily indicative of the results to be expected for the full year. The accompanying condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. The condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in the Company's consolidated financial statements, the Company has experienced declining annual revenues and has incurred losses from continuing operations of $8.6 million in the first half of 2002, $20.1 million in 2001 and $35.4 million in 2000. These factors, among others indicate that the Company may be unable to continue as a going concern for a reasonable period of time. The condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. To address these issues, the Company has effected significant cost cutting measures beginning in the fourth quarter of 2000 and continuing into 2002, including staff reductions and field office consolidations, divestiture of unprofitable operations and has planned to sublease a portion of its corporate headquarters facility. Management believes that the Company will be able to continue operations through the successful implementation of its plan to increase revenues, continued reduction of its cost structure and ultimate attainment of profitable operations. In addition, the Company may seek debt or equity financing if required; however, no assurances can be given that the Company will attain profitable operations or that additional financing will be available. Certain 2001 financial statement amounts were reclassified to conform with 2002 classifications. These reclassifications had no effect on net loss or shareholders' equity as previously reported. 2. Recent Accounting Pronouncements In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations", which was effective for business combinations initiated after June 30, 2001. In October 2001, the FASB issued SFAS 144, "Impairment or Disposal of Long-Lived Assets", which is effective for fiscal years beginning after December 15, 2001. In June 2001, the FASB issued SFAS 143, "Accounting for Retirement Obligations," which is effective for the Company's fiscal year beginning January 1, 2003. We have not yet assessed the impact that the adoption of FAS 143 will have on our financial condition or results of operations. The adoption of SFAS 141 and SFAS 144 did not have a material effect on our financial condition or results of operations. Accounting for Business Combinations, Goodwill and Intangible Assets: In June 2001, the FASB issued SFAS 142, "Goodwill and Other Intangible Assets". SFAS 142 requires that goodwill is no longer amortized, but tested for impairment at least annually, or more frequently if certain indications arise. The Company adopted SFAS 142 effective January 1, 2002. Cylink completed its initial goodwill impairment tests on March 31, 2002 and determined that no impairment of goodwill had occurred as of that date. The Company further determined that no circumstances or events occurred in the quarter ended June 30, 2002 that would require it to conduct an impairment test between annual tests. Subsequent impairment losses, if any, will be reflected in operating expense in the consolidated statement of operations. The Company is not able to predict at this time whether the determination of fair value under SFAS 142 will result in an impairment of goodwill at a future date. Given the $15.7 million net carrying value of the Company's goodwill and intangibles at June 30, 2002, an impairment determination could have a material 4 impact on Cylink's financial position and results of operations. Had the Company been accounting for its goodwill under SFAS 142 for all periods presented, the Company's net loss and net loss per share would have been as follows: Three months ended: Six months ended: -------------------- -------------------- June 30, July 1, June 30, July 1, 2002 2001 2002 2001 -------------------- -------------------- (in thousands (in thousands except per share data) except per share data) Reported net loss $ (4,665) $ (7,418) $ (8,561) $(14,550) Add back goodwill amortization, net of income taxes -- 307 -- 659 -------- -------- -------- -------- Proforma adjusted net loss $ (4,665) $ (7,111) $ (8,561) $(13,891) ======== ======== ======== ======== Proforma adjusted net loss per share $ (0.14) $ (0.22) $ (0.26) $ (0.43) ======== ======== ======== ======== In June 2002, the FASB issued SFAS 146, "Accounting for Costs Associated with Exit or Disposal Activities," which addresses accounting for restructuring and similar costs. SFAS 146 supersedes previous accounting guidance, principally Emerging Issues Task Force Issue No. 94-3. The Company will adopt the provisions of SFAS 146 for the restructuring activities initiated after December 31, 2002. SFAS 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost was recognized at the date of the Company's commitment to an exit plan. SFAS 146 also established that the liability should initially be measured and recorded at fair value. Accordingly, SFAS 146 may affect the timing of recognizing future restructuring costs as well as the amounts recognized. 3. Inventories Inventories are stated at the lower of standard costs (which approximates actual costs on a first-in, first-out basis) or market and consist of: June 30, December 31, 2002 2001 ------ ------ (in thousands) Inventories: Raw materials $1,852 $2,482 Work in process and subassemblies 1,821 1,171 Finished goods 595 1,179 ------ ------ $4,268 $4,832 ====== ====== 4. Loss Per Share Basic loss per share is based on the weighted-average number of common shares outstanding, excluding shares in escrow. Diluted loss per share is based on the weighted-average number of shares outstanding and dilutive potential common shares outstanding, excluding contingent shares held in escrow. The Company's only potentially dilutive securities are stock options. As of June 30, 2002 and July 1, 2001, the Company had 6,754,000 and 7,135,000 stock options outstanding with a weighted-average exercise price of $3.63 and $5.59, respectively. These options expire on various dates through 2008. All potentially dilutive securities have been excluded from the computation of diluted loss per share, as their effect is anti-dilutive on the net loss for the periods presented. 5 5. Comprehensive Loss The components of comprehensive loss, consisting of the Company's reported net loss and unrealized gains or losses in the translation of foreign currencies, are as follows: Three months ended: Six months ended: -------------------- -------------------- June 30, July 1, June 30, July 1, 2002 2001 2002 2001 -------- -------- -------- -------- (in thousands) (in thousands) Net loss $ (4,665) $ (7,418) $ (8,561) $(14,550) Other comprehensive income (loss) (15) (28) 14 57 -------- -------- -------- -------- Total comprehensive loss $ (4,680) $ (7,446) $ (8,547) $(14,493) ======== ======== ======== ======== 6. Commitments and Contingencies Cylink is currently engaged in litigation. See Part II, Item 1. "Legal Proceedings." 7. Restructuring Charge In the fourth quarter of 2001, the Company recorded a $1.4 million charge to accrue a reserve for losses relative to the estimated costs of excess leased facilities and related furniture and equipment, net of estimated proceeds from planned subleasing of excess office space in Santa Clara. In the second quarter of 2002, the Company increased its estimate by an additional $1.2 million based on a continued weak sublease market. In addition, the Company recorded as expense $0.7 million in restructuring charges during the second quarter of 2002 related to severance payments to 36 former employees affected by the workforce reduction. Approximately $0.2 million of the reserves have been utilized through June 30, 2002. The reserves will be utilized for excess lease costs associated with the Company's headquarters in future periods. The following table summarizes the activity representing the restructuring charge liability in the condensed consolidated balance sheet for the periods presented: Current Long-term Total ------- --------- ----- (in millions) Balance at December 31, 2001 $ 0.5 $ 0.9 $ 1.4 Additions 0.3 0.9 1.2 Utilization (0.1) (0.1) (0.2) Reclassification from Long-term to Current 0.2 (0.2) -- ------ ------ ------ Balance at June 30, 2002 $ 0.9 $ 1.5 $ 2.4 ====== ====== ====== 8. Goodwill & Other Intangible Assets Changes in the carrying amount of goodwill for the six months ended June 30, 2002 are as follows (in thousands): Balance as of December 31, 2001 $ 6,222 Write-off of Cylink-Belguim (29) ------- Balance as of June 30, 2002 $ 6,193 ======= In connection with the adoption of SFAS No. 142, the Company performed a transitional impairment test on goodwill as of March 31, 2002 and determined that no impairment of the Company's goodwill had occurred and that no further impairment test was necessary during this quarter. See Note 2. 6 Information regarding the Company's other intangible assets is as follows (in thousands):

Amortization expense of other intangible assets was $444,000, and $953,000 for the three months and the six months ended June 30, 2002, respectively. The estimated amortization for each of the five fiscal years subsequent to December 31, 2001 is as follows: Year Ended Amortization December 31, Expense ------------ ------- 2002 $ 1,908 2003 1,908 2004 1,908 2005 1,842 2006 1,728 Thereafter 179 ------- Total $ 9,473 ======= 9. Working Capital Loan The Company's $7.5 million revolving working capital loan facility matured on June 27, 2002, and was extended by the bank as described below. This loan is secured by all of Cylink's tangible assets and contains a covenant to maintain a minimum tangible net worth. The Company fell out of compliance with its covenant in February 2002 and remained out of compliance as of June 30, 2002. The bank has waived the Company's compliance with these covenants, pending renewal of this credit facility. The Company is working with the bank to renew this credit facility for one year at $5.0 million and the bank has extended the maturity date for $5.0 million of this loan facility through August 27, 2002 pending its renewal. There have been no borrowings under the loan since its inception. 10. Contingent Liability The Company is obligated under its Master Lease on its Santa Clara headquarters facility to assume responsibility for and begin paying rent at a pre-determined rental rate on approximately 24,600 sq. ft. currently leased by the landlord to a third party tenant, when and if that space becomes available. In June 2002, the landlord notified the Company that this tenant was in default as to a portion of the rent due. Subsequently, the landlord notified the Company that this tenant had entered into an assignment for the benefit of creditors with the intent of winding up its operations. The third party tenant has subleased the facility to a third party subtenant through August 2004 and it is uncertain at this date what are the rights and obligations of this subtenant. Should the space become available sooner than the termination of the sublease, the Company would be obligated to assume occupancy under the Master Lease and pay rent at the current rate of $55,400 per month subject to 3% annual escalations through the September 2009 termination of its Master Lease. No accrual has been recorded in the accompanying financial statements for this contingent liability because the event that would trigger the obligation has not occurred and therefore, the obligation is not reasonably estimable. 7 11. NASDAQ Listing Notice On June 27, 2002, the Company received a notice from the staff of the NASDAQ National Market that its Common Stock had failed to maintain the minimum bid price of $1.00 over the prior 30 trading days as required for continued listing on the NASDAQ National Market. The notice stated that, if during the 90 days following the date of the notice the bid price of Cylink Common Stock failed to close at or above $1.00 for at least 10 consecutive trading days, Cylink Common Stock could be delisted. 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements within the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. All statements included or incorporated by reference in this Quarterly Report, other than statements that are purely historical, are forward-looking statements. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates" and similar expressions also identify forward-looking statements. Forward-looking statements in this Report include, without limitation, statements regarding: revisions to the Company's financial plan and implementation by the Company of the plan and additional cost cutting measures in the third quarter; failure of the Company to meet covenants in its loan documents, renewal of the credit facility, and the Company's need to seek additional funds to support working capital requirements; failure to raise additional funds as needed; plans to continue cost reducing measures in 2002; the sufficiency of the Company's existing cash balances and available borrowing to fund operations through 2002; and the belief that the Company has meritorious defenses and adequate insurance for the damages claimed in shareholder litigation actions and the Company's intentions to defend itself vigorously. These forward-looking statements and any expectations based on such forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements. Any of Cylink's actual results could differ materially from those included in such forward-looking statements. The above forward-looking statements are subject to the risks and uncertainties further discussed under "Risk Factors That May Affect Future Results" beginning on page 13. All forward-looking statements included in this document are based on information available to Cylink on the date hereof, and Cylink assumes no obligation to update any such forward-looking statements. Shareholders are cautioned not to place undue reliance on such statements, which speak only as of the date of this Report. The reader should also consult the cautionary statements and risk factors listed from time to time in Cylink's Reports on Forms 10-Q, 8-K, 10-K and its Annual Reports to Shareholders for other trends, risks or uncertainties which could cause the Company's results to differ from those expressed in such forward looking statements. The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included in Part I Item 1 of this Report on Form 10-Q and the audited consolidated financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations included in the Company's Report on Form 10-K for the year ended December 31, 2001. Critical Accounting Policies and Estimates Cylink's discussion and analysis of its financial condition and results of operations are based upon the Company's condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires Cylink to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an ongoing basis, Cylink evaluates its estimates, including those related to allowance for doubtful accounts, inventories, investments, deferred tax assets, intangible assets, income taxes, warranty obligations, restructuring, and contingencies and litigation. Cylink bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. A description of those accounting policies that Cylink believes are critical is contained in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. 9 RESULTS OF OPERATIONS The following table sets forth certain consolidated statement of operations data as a percentage of revenue for the periods indicated:

Revenue. Revenue decreased 46% from $13.6 million for the three months ended July 1, 2001 to $7.4 million for the three months ended June 30, 2002, and decreased 45% from $26.2 million for the six months ended July 1, 2001 to $14.5 million for the six months ended June 30, 2002. The decrease is primarily due to lower unit volumes resulting from the market slowdown generally and the divestiture of our Israeli subsidiary, Algorithmic Research, Limited (ARL) . International revenue comprised 32% and 36% of total revenue for the second quarter of 2001 and 2002, respectively. The increase in international revenues in the second quarter of 2002 as a percentage of total revenue from the prior year second quarter was due to a smaller decline in international revenues over domestic revenues in a weakened global environment. Gross Profit. Gross profit decreased from $7.6 million for the three months ended July 1, 2001 to $4.7 million for the three months ended June 30, 2002, and decreased from $15.9 million for the six months ended July 1, 2001 to $9.2 million for the six months ended June 30, 2002. This decrease in dollars primarily was a result of the overall decrease in revenue for the same period. As a percentage of sales, gross profit was approximately 56% and 64% for the quarters ended July 1, 2001 and June 30, 2002, respectively, and 61% and 64% for the six months ended July 1, 2001 and June 30, 2002, respectively. The increase in gross profit as a percentage of revenue was due to higher service revenue margins due to benefits realized from cost reduction programs implemented by the Company in 2002, reduced excess and obsolete inventory and warranty adjustments, offset by lower product margins resulting from the spread of fixed manufacturing and facility costs over a much lower revenue base. Research and Development. Research and development expenses consist primarily of salaries and other personnel related expenses, depreciation of development equipment, facilities and supplies. Research and development expenses decreased 43% from $5.2 million for the three months ended July 1, 2001 to $3.0 million for 10 the three months ended June 30, 2002 and decreased 47% from $11.1 million for the six months ended July 1, 2001 to $5.9 million for the six months ended June 30, 2002. Research and development expenses as a percentage of revenue were 38% for the second quarter of 2001 and 40% for the second quarter 2002, and 43% for the first six months of 2001 and 41% for the first six months of 2002. The dollar decrease in research and development expenses was a result of reduced project spending and headcount, due to cost savings initiatives implemented by the Company, and the divestiture of ARL. The increase in expense as a percentage of revenue for the second quarter of each period was due to a greater decline in revenues than the reduction in product development expenditures. The decrease in expense as a percentage of revenue for the first six months of each period is due to revenue increases in the second quarter of each period when compared to the dollar decrease in expenses for reasons mentioned above. Selling and Marketing. Selling and marketing expenses consist primarily of personnel expenses, including sales commissions and bonuses, and expenses for public relations, seminars and trade shows. Selling and marketing expenses decreased 45% from $5.0 million for the three months ended July 1, 2001 to $2.8 million for the three months ended June 30, 2002 and decreased 46% from $10.8 million for the six months ended July 1, 2001 to $5.8 million for the six months ended June 30, 2002. Selling and marketing expenses as a percentage of revenue were 37% for the second quarter of 2001 and 38% for the second quarter of 2002, and 41% for the first six months of 2001 and 40% for the first six months of 2002. The dollar decrease in selling and marketing expenses was a result of lower commission spending due to decreased revenues, lower headcount spending driven by the reduction in workforce actions taken during 2002, and lower marketing and bonus spending due to the implementation of cost savings initiatives by the Company. The increase in expense as a percentage of revenue for the second quarter of each period was due to a greater decline in revenues than the reduction in selling and marketing expenditures. For the first six months of each period, the percentages were essentially comparable. General and Administrative. General and administrative expenses consist primarily of personnel and related costs, information systems costs, and audit, legal and other professional service fees. General and administrative expenses decreased 47% from $2.7 million for the three months ended July 1, 2001 to $1.4 million for the three months ended June 30, 2002 and decreased 40% from $5.7 million for the six months ended July 1, 2001 to $3.5 million for the six months ended June 30, 2002. General and administrative expenses as a percentage of revenue were 20% for the second quarter of 2001 and 19% for the second quarter 2002, and 22% for the first six months of 2001 and 24% for the first six months of 2002. The dollar decrease in general and administrative expenses was due to lower headcount spending driven by the reduction in workforce actions taken during 2002, and lower bonus spending due to the implementation of cost savings initiatives by the Company. The decrease in expense as a percentage of revenue for the second quarter of each period was due to a greater decline in expenditures than the reduction in revenues. The increase in expense as a percentage of revenues for the first six months of each period was due to a faster decline in revenues than expenses could be adjusted. Restructuring Charges. Restructuring charges consist of severance expenses due or paid to former employees and the estimated cost of excess leased facilities and related furniture and equipment, net of estimated proceeds from planned subleasing of excess office space. In the second quarter of 2002, the Company eliminated 36 positions incurring a pre-tax severance charge of $0.7 million. In light of the workforce reduction, and the continued weak demand for vacant office space in Santa Clara, CA, the Company increased its estimate of the loss from excess leased facilities by $1.2 million. Amortization of Acquired Intangibles. Amortization of intangible assets declined from $0.8 million for the three months ended July 1, 2001 to $0.4 million for the three months ended June 30, 2002 and declined from $1.7 million for the six months ended July 1, 2001 to $1.0 million for the three months ended June 30, 2002. Pursuant to the adoption of SFAS 142, "Goodwill and Other Intangibles," on January 1, 2002, Cylink ceased amortizing its goodwill. Other Income (Expense), Net. Other income (expense), net consists primarily of interest income and interest expense, foreign exchange gains or losses, royalty income, and impairment losses from investments in non-operating companies. Other income, net increased from $39 thousand for the quarter ended July 1, 2001 to $170 thousand for the quarter ended June 30, 2002, principally due to foreign exchange gains in the current period versus losses in the prior period. Other income, net decreased from income of $210 thousand for the six months ended July 1, 2001 to a loss of $92 thousand for the six months ended June 30, 2002, principally due to the write-down of our investment in an unaffiliated company in 2002. 11 Provision for Income Taxes. A charge for state taxes paid was recognized in the quarter ended June 30, 2002. Cylink recognized a tax benefit of $1.2 million for the quarter ended July 1, 2001 representing the partial recognition of the Company's net operating loss for income tax purposes. LIQUIDITY AND CAPITAL RESOURCES At June 30, 2002, the Company had working capital of $10.2 million (including cash and cash equivalents of $10.5 million) and $2.6 million of long-term obligations. For the six months ended June 30, 2002, the Company recorded a net loss of $8.6 million. Net cash provided by operating activities for the first six months of 2002 was $0.2 million, consisting primarily of the loss from operations, offset by $2.4 million of non-cash depreciation and amortization and a net decrease in working capital. The decrease in working capital included a decrease in accounts receivable of $5.7 million, an increase in deferred revenue of $0.4 million, a decrease in inventories of $0.6 million, an increase in restructuring accruals of $1.2 million, partially offset by a decrease in accounts payable and accrued liabilities of $0.8 million, an increase in income tax receivables of $0.4 million, and an increase in other assets of $0.2 million. The decrease in accounts receivable was due to lower shipments during the second quarter of 2002, and improved collection activities. The decrease in inventories and accounts payable was due to continued strict purchasing controls. The decrease in accrued liabilities was due principally to decreased commission and bonus liabilities, along with decreased employment liabilities resulting from reduced headcount. Net cash used in operating activities for the first half of 2001 was $3.0 million consisting primarily of the loss from operations of $14.6 million, partially offset by a decrease in working capital which included a decrease in accounts receivable of $4.0 million, a decrease in inventories of $3.1 million, an increase in deferred revenue of $1.7 million, partially offset by a decrease in accounts payable and accrued liabilities of $3.1 million, an increase in income tax receivables of $0.4 million, and an increase in other assets of $0.6 million. The decrease in accounts receivable was due to lower than average shipments during the quarter supported by improved collection activities. The decrease in inventories and the decrease in accounts payable were the result of stricter purchasing controls. The decrease in accrued liabilities was due principally to decreased commission, bonus, and legal liabilities. Cash provided by investing activities was $0.7 million for the six months ended June 30, 2002 as compared to cash used by investing activities of $0.6 million for the six months ended July 1, 2001. Cash provided by investing activities for the first six months of 2002 resulted from the collection of a $1.0 million note receivable, and the write-down of an investment in an unaffiliated company, partially offset by the acquisition of $0.5 million of property, plant and equipment. Cash used in investing activities for the first six months of 2001 consisted primarily of the acquisition of $0.5 million of property, plant and equipment. Cash provided by (used in) financing activities for the six months ended June 30, 2002 and July 1, 2001, respectively, was not material in both periods. On June 27, 2001, the Company entered into a loan and security agreement with a bank under which it may borrow up to $7.5 million by way of revolving advances. This loan matured on June 27, 2002. The loan is secured by all of Cylink's tangible assets and contains a covenant to maintain a minimum tangible net worth. The Company fell out of compliance with its covenant in February 2002 and remains not in compliance with said covenant as of June 30, 2002. The bank has waived the Company's compliance with said covenant, pending renewal of this credit facility. The Company is working with the bank to renew this credit facility for one year at $5.0 million and the bank has extended the maturity date for $5.0 million of this loan facility through August 27, 2002 pending its renewal. There have been no borrowings under the loan since its inception. In conjunction with the acquisition of Celotek Corporation in August 2000, Cylink assumed an equipment loan with an outstanding balance of $0.3 million. This loan matures December 1, 2002 and bears interest at the prime rate plus 1%. As of June 30, 2002, the outstanding balance under the equipment line was $0.1 million. The equipment line requires the Company to maintain certain liquidity and profitability covenants, with which the Company was not in compliance as of June 30, 2002. 12 As of the date of filing of this Quarterly Report on Form 10Q, the Company's revenue to date for 2002 is significantly below the revenue anticipated under its current financial plan. Under the Company's financial plan for 2002, the Company had projected a positive operating cashflow for the 2002 fiscal year. Due to the decrease in the Company's revenues below the amounts anticipated by the Company under its financial plan, the Company undertook a workforce reduction in June 2002 and is prepared to undertake certain additional cost cutting actions predicated on actual revenue performance during the third quarter. However, there can be no assurance that the Company will be able to implement or achieve a revised plan, that such a revised plan, if implemented, would be sufficient for the Company to achieve profitability, or that the Company's existing cash balances and available borrowing will be sufficient to fund operations through 2002. In the event the Company's financial plan is unsuccessful, the Company may require additional funds in the near term to support working capital requirements or for other purposes and may seek to raise such additional funds through public or private equity or debt financing, sales of assets, or from other sources. No assurance can be given that additional financing will be available or that, if available, will be on terms favorable to the Company or its shareholders. If Cylink is unsuccessful in implementing it's revised financial plan, and cannot raise additional funds, the Company may not have the resources to maintain its operations. On June 27, 2002, the Company received a notice from the staff of the NASDAQ National Market that its Common Stock had failed to maintain the minimum bid price of $1.00 over the prior 30 trading days as required for continued listing on the NASDAQ National Market. The notice stated that if during the 90 days following the date of the notice the bid price of Cylink Common Stock failed to close at or above $1.00 for at least 10 consecutive trading days, then Cylink Common Stock could be delisted. RISK FACTORS THAT MAY AFFECT FUTURE RESULTS We have a history of losses, and may not be able to meet our needs for working capital. We incurred significant net losses in 2001 and in prior years. We had an accumulated deficit of $127.3 million as of June 30, 2002. Our prior losses may also adversely impact our ability to raise additional capital if required to sustain our operations. As of the date of filing of this Quarterly Report on Form 10-Q, our revenue to date for 2002 is significantly below the revenue anticipated under our current financial plan. Under our financial plan for 2002, we had projected a positive operating cash flow for the 2002 fiscal year. Due to the decrease in the Company's revenues below the amounts anticipated by the Company under its financial plan, we undertook a workforce reduction in June 2002 and are prepared to undertake certain additional cost cutting actions predicated on actual revenue performance during the third quarter. However, there can be no assurance that we will be able to implement or achieve our revised plan, that such a revised plan, if implemented, would be sufficient for the Company to achieve profitability, or that our principal sources of liquidity, which include cash and cash equivalents of $10.5 million as of June 30, 2002, will satisfy our current anticipated working capital and capital expenditure requirements through at least the next twelve months. Our previous credit line expired in June 2002 and it undergoing the renewal process. In February 2002, we breached certain financial covenants contained in the loan agreement for such credit line. The bank has waived compliance with the covenants pending renewal of the loan. There is no guarantee that we will satisfy the renewal covenants or other covenants in the loan agreement in the future, and there is no guarantee that the bank will renew the credit line after its extended expiration in August 2002. If we fail to meet our financial covenants or if the bank does not renew the facility, the line of credit will not be available to fund our operations if it is needed. In 2001, we began to realize the benefits of the actions taken in the fourth quarter of 2000, and throughout 2001 to reduce operating costs in our core business. We plan to continue such cost reducing measures in 2002. However, there can be no assurance that we will be able to continue reducing costs at a pace that reflects further reduction in revenues, or that we will not need to raise additional capital to fund operations within this period or that additional financing can be obtained on acceptable terms, or at all. If additional funds are raised by issuing equity securities, dilution to shareholders may result. If adequate funds are not available, we, our business, and the price of our Common Stock will be adversely affected. Our quarterly operating results may vary in the future, which could cause our stock price to drop. 13 We have historically experienced significant fluctuations in our operating results on a quarterly basis and could experience such fluctuations in the future. Our revenues and operating results could be affected by a number of factors outside of our control, including the following: o our inability to accurately forecast revenues and respond in a timely manner to changes in revenue levels; o the timing of the introduction by us or by our competitors of new or enhanced products; o market acceptance of our new products and those of our competitors; o the timing, cancellation or delay of customer orders, including cancellation or delay in anticipation of new product introductions or enhancements; o changes in our pricing policies or those of our competitors; o changes in operating costs and expenses, including those resulting from changes in available production capacity of independent foundries and other suppliers and the availability of raw materials; o changes in the revenue mix from products or services sold; o changes in the percentage of products sold through our direct sales force; o loss of an important customer; o failure to grow our customer base in accordance with market expectations; o customer discounts and credits; o our limited ability to reduce expenses to offset any unexpected shortfall in revenue growth or decrease in revenue; o delays in manufacturing due to shortages in components or unanticipated revisions in product design; o expenses incurred in seeking to enforce or defend claims with respect to intellectual property rights; o changes in the economy that affect the purchasing decisions of our customers; o defaults by existing subtenants under our long term lease for leasehold space may increase our net costs in a deteriorating office rental market; and o disruption in our operations caused by reductions in our workforce. Many of these factors are outside of our control. Unforeseen reductions in revenue can materially and adversely affect our ability to raise capital or sustain ongoing operations. We are currently involved in litigation. Several securities class action complaints have been filed against us and certain of our current and former directors and officers in federal courts in California. These complaints allege, among other things, that our previously issued financial statements were materially false and misleading and that the defendants knew or should have known that these financial statements caused our common stock price to rise artificially and allege violations of Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder, and Section 20 of the Exchange Act. The securities class action lawsuits have been ordered consolidated into a single action pending in the United States District Court for the Northern District of California, captioned In Re Cylink Securities Litigation, No. C98-4292 (VRW). For more information on this lawsuit, see Part II, Item 1. "Legal Proceedings." Although we believe we have meritorious defenses and adequate insurance for the damages claimed in these actions, it is not feasible to predict or determine the final outcome of these proceedings, and if the outcome were to be unfavorable and exceed our applicable insurance, our business, financial condition, cash flows and results of operations could be materially adversely affected. Our sales cycles are long and unpredictable, which makes period-to-period revenues difficult to predict. 14 Sales of our products generally involve a significant commitment of capital by customers, with the attendant delays frequently associated with large capital expenditures. For these and other reasons, the sales cycle associated with our products is typically lengthy and subject to a number of significant risks over which we have little or no control. We are often required to ship products shortly after we receive orders. Consequently, order backlog at the beginning of any period has, at times in the past, represented only a small portion of that period's expected revenue. Furthermore, increases in backlog from quarter to quarter may be due to placement of orders calling for delivery dates extended over a much longer period of time into future periods. Consequently, our order backlog becomes more vulnerable to customer cancellations. As a result of these fluctuations in our sales cycle and order backlog, product revenue in any period has been and will continue to be substantially dependent on orders booked and shipped in that period. We typically plan our production and inventory levels based on internal forecasts of customer demand, which are highly unpredictable and can fluctuate substantially. In particular, market forces beyond our control, including recession, and limits or changes in government spending may have a material affect on customer demand for our products. If revenue falls significantly below anticipated levels, as it has at times in the past, our financial condition and results of operations would be materially and adversely affected. In addition, our operating expenses are based on anticipated revenue levels and a high percentage of our expenses are generally fixed in the short term. Based on these factors, a small fluctuation in the timing of sales can cause operating results to vary significantly from period to period. It is possible that in the future our operating results will again be below the expectations of securities analysts and investors. In such an event, or in the event that adverse conditions prevail or are perceived to prevail generally or with respect to our business, or the market sector in which we operate, the price of our Common Stock would likely be adversely affected. These factors make it difficult to predict our financial performance. As our quarterly results fluctuate, they may fall below the expectations of public market analysts or investors. If this occurs, the price of our Common Stock may drop. The overall economic climate continues to be weak. Our products typically represent substantial capital commitments by customers, involving a potentially long sales cycle. As a result, customer purchase decisions may be significantly affected by a variety of factors including trends in capital spending for communication networks, market competition, and the availability or announcement of alternative technologies. Continued recent weakness in general economic conditions has resulted in many of our customers delaying and/or reducing their capital spending related to information systems. If the economy continues to be weak, demand for our products could decrease, resulting in lower revenues and a decline in the overall rate of our revenue growth. We are dependent on recently introduced and new network security products. Our future results of operations will be highly dependent on the successful marketing and manufacture of the NetHawk product, as well as successful marketing and manufacture of the Cylink Link Encryptors, PrivaCy Manager, Cylink ATM, and Cylink Frame Encryptor products. Through the second quarter of 2002, we have made only limited commercial shipments of our NetHawk product, which began shipping in mid-year 2000. This product requires additional development work, enhancement, and testing to achieve widespread commercial success. If this or other new or recently introduced products have performance, reliability, quality or other shortcomings, such products could fail to achieve adequate market acceptance. The failure of our new or existing products to achieve or enjoy market acceptance, whether for these or other reasons, could cause us to experience reduced orders, higher manufacturing costs, delays in collecting accounts receivable and additional warranty and service expenses, which in each case could have a material adverse effect on our business, financial condition and results of operations. Due to insufficient market acceptance of stand alone public key infrastructure ("PKI") products, such as our Net Authority and similar products of our competitors, we revised our marketing approach in the second half of 2001 by discontinuing efforts to sell Net Authority as a stand alone product and focused our efforts on potential customers seeking to embed our PKI as part of their application or service. In addition, on February 8, 2002, we received notice from the United States Postal Service ("USPS") that it was terminating its license to Cylink's Net Authority product as of March 17, 2002, noting that its decision was "not a reflection of the quality of work performance provided by Cylink" but was due to "USPS' immediate need to reduce cost" and downsize its non core businesses following the anthrax attack on its operations in October of 2001. After granting USPS a continuation of its license, at its request, through May 30, 2002, this license and all further revenue earned under Cylink's contract with the USPS finally expired in the second quarter of 2002. Revenue for the second quarter of 2002, and the first six months of 2002 resulting from USPS was $0.2 million, and $0.5 million, respectively. We discontinued all further development of our PKI technology in July 2002. 15 We face significant competition from other providers of network security systems Competition is intense among providers of network security systems, and we expect such competition to increase in the future. Significant competitive factors in these markets include: o the development of new products and features; o product quality and performance; o customer perception regarding the adequacy of security provided by existing software and routers; o adoption of embedded security solutions in other vendors' hardware and software products; o the quality and experience of our sales, marketing and service organizations; o product price; o name recognition; and o perception of our stability and long-term viability. Many of these competitive factors are beyond our control. Our competitors in the information security markets, including companies that offer products similar to, or are perceived as an alternative to, our products, are Checkpoint Software Technologies, Ltd., Network Associates, Inc., SafeNet, Inc., Secure Computing Corporation, RSA Security, Inc., Symantec Corporation, and Thales e-Security, Inc. Our NetHawk VPN appliance competes with numerous other products, including those offered or under development by Cisco Systems, Inc., Newbridge Networks Corporation, Netscreen Technologies, Inc., Nokia Corp, and Sonic Wall, Inc. A number of significant vendors, including Microsoft Corporation, and Cisco Systems, Inc. have embedded security solutions in their software. To the extent that these embedded or optional security capabilities provide all or a portion of the functionality provided by our products, our products may no longer be required by customers to attain network security. Many of our competitors have substantially greater financial, technical, marketing, distribution and other resources, greater name recognition and longer standing relationships with customers than we possess. Competitors with greater financial resources are better able to engage in more aggressive marketing campaigns and sustained price reductions in order to gain market share. Any period of sustained price reductions would have a material adverse effect on our financial condition and results of operations. We may not be able to compete successfully in the future and competitive pressures may result in price reductions, loss of market share or otherwise have a material adverse effect on our financial condition and results of operations. We face the risks from tort and warranty claims that may be made against us. We face the risks from tort and warranty claims that may be made against us. Customers rely on our network security products to prevent unauthorized access to their networks and data transmissions. A malfunction or the inadequate design of our products could result in tort or warranty claims. A breach of a customer's network by an unauthorized party, which is attributable to an alleged defect in our products, may cause substantial damages due to loss or compromise of the customer's valuable information. Furthermore, there is inadequate legal precedent for allocating responsibility for such losses caused by the wrongful acts of third parties. Although we attempt to reduce the risk of such losses through warranty disclaimers and liability limitation clauses in our sales and license agreements and by maintaining product liability insurance, there can be no assurance that such measures will be effective in limiting our liability for any such damages. Any liability for damages resulting from security breaches or other product defects could be substantial and could have a material adverse effect on our business, financial condition and results of operations. In addition, a well-publicized actual or perceived security breach could adversely affect the market's perception of security products in general, or our products in particular, regardless of whether such breach is attributable to our products. This could result in a decline in demand for our products, which would have a material adverse effect on our business, financial condition and results of operations. 16 On August 2, 2001, Cylink determined that a hardware design could cause a premature failure of the backup battery on its Cylink Frame Encryptor (CFE) product. Shortly thereafter, Cylink announced a program to give its customers the option of updating their CFE units by returning them to the factory, or receiving an extended warranty covering the battery through the end of December 2002. Cylink accrued approximately $1.0 million in warranty costs during the second quarter of 2001 associated with this program. While we believe this reserve was based on reasonable estimates based on information available to us at the time, actual costs could exceed these reserves. Since announcing this program, two of our major customers stated their intention to submit substantial claims related to their costs of avoiding product failures. Although we believe such claims may be barred or significantly reduced by the limitations and exclusions in the governing contracts of sale, there can be no assurance that we will be found free from liability and any obligation to reimburse customers may have a material effect on our operations. We may be unable to retain our executive officers and key personnel that are critical to our business. Our future success will depend in large part on the abilities of our executive officers, key management and technical personnel and our ability to retain qualified and competent individuals following our reductions in the employee workforce. There is no guarantee that our present executive management and technical staff will remain with the Company, particularly if our performance is not up to expectations, and particularly if general economic recovery leads to expanded alternative opportunities for such employees. The loss of the services of one or more of our executive officers or key personnel, or the inability to attract and retain additional executives and other qualified personnel, could delay product development cycles or otherwise have a material adverse effect on our business and operating results. We may not be able to hire and retain sufficient technical, marketing and management personnel that we need to succeed because these people are limited in number and are in high demand. We may not be able to hire and retain sufficient technical, marketing and management personnel that we need to succeed because we have limited resources to expand our work force. We recently experienced, and may continue to experience, substantial fluctuations in the number of employees and the scope of our operations in the network security business, resulting in increased responsibilities for management. To manage our business effectively, we will need to continue to improve our operational, financial and management information systems and to retain, motivate and manage our employees. In the recent past, competition has been intense for qualified technical, marketing and management personnel. Furthermore, the recent reductions in our workforce, and fluctuation in our stock price, may create greater uncertainty amongst our existing employees, who may decide not to continue employment with the Company. There can be no assurance that we will be able effectively to achieve or manage any future growth, and our failure to do so could delay product development cycles or otherwise have a material adverse effect on our financial condition and results of operations. Any inability to protect our intellectual property could reduce our competitive advantage, divert management attention, and require additional intellectual property to be developed or cause us to incur expenses to enforce our rights. We rely on patents, trademarks, copyrights, licenses and trade secret law to establish and preserve our intellectual property rights. We own a number of U.S. patents covering certain features of our network security product designs, and have additional U.S. patent applications pending. There can be no assurance that any patent, trademark, copyright or license owned or held by us will not be invalidated, circumvented or challenged, that the rights granted thereunder will provide competitive advantages to us or that any of our pending or future patent applications will be issued with the scope of the claims sought by us, if at all. Further, there can be no assurance that others will not develop technologies that are similar or superior to our technology, duplicate our technology, misappropriate our trade secrets, or design around the patents owned by us. Resorting to the courts to protect our intellectual property would require significant financial and management resources. In addition, the laws of certain countries in which our products are or may be developed, manufactured or sold may not protect our products and intellectual property rights to the same extent as the laws of the United States. Our inability to protect our intellectual property adequately could have a material adverse effect on our financial condition and results of operations. The computer, communications, software and network security industries are characterized by substantial litigation regarding patent and other intellectual property rights. In the past, we have received communications from third parties asserting that our patents, features or content of certain of our products infringe upon the intellectual 17 property rights held by third parties, and we may receive such communications in the future. There can be no assurance that third parties will not assert claims against us that result in litigation. Any litigation, whether or not determined in our favor, could result in significant expense to us and could divert management and other resources. In the event of an adverse ruling in any litigation involving intellectual property, we might be required to discontinue the use of certain processes, cease the manufacture, use and sale of infringing products, expend significant resources to develop non-infringing technology or obtain licenses to the infringing technology and we may suffer significant monetary damages, which could include treble damages. There can be no assurance that under such circumstances a license would be available to us on reasonable terms or at all. In the event of a successful claim against us and our failure to develop or license a substitute technology on commercially reasonable terms, our financial condition and results of operations would be adversely affected. There can be no assurance that existing claims or any other assertions (or claims for indemnity from customers resulting from infringement claims) will not materially and adversely affect our financial condition and results of operations. If we are unable to adapt our services to rapidly changing technology, or if the market for our network security products fails to grow, our business and operating results could suffer. The market for our network security products is characterized by rapidly changing technology, emerging industry standards, new product introductions and changes in customer requirements and preferences. Our future success will depend in part upon end users' demand for network security products in general, and upon our ability to enhance our existing products and to develop and introduce new products and technologies that meet customer requirements. We face continuing challenges to educate customers as to the value of our security products. We believe that many potential customers do not appreciate the need for our security products unless and until they have faced a major security breach. Many potential customers prefer not to disclose significant security breaches of their networks or are reluctant to invest in the development of a professional security architecture to protect their networks. This market resistance is compounded by our limited resources to invest in marketing campaigns for our products and services. If we are unable successfully to educate potential customers as to the value of, and thereby obtain broad market acceptance for, our products and services, we will continue to rely primarily on selling new and existing products to our base of existing customers, which will significantly limit any opportunity for growth. In addition, any significant advance in technologies for attacking cryptographic systems could render some or all of our existing and new products obsolete or unmarketable. To the extent that a specific method other than ours is adopted as the standard for implementing network security in any segment of the network security market, sales of our existing and planned products in that market segment may be adversely impacted, which could have a material adverse effect on our business, financial condition and results of operations. The National Institute of Standards and Technology has announced a new Advanced Encryption Standard, or AES, which we expect to integrate into our products. Our ability to timely implement the AES into our products may materially affect our development costs and ability to timely market our solutions. Network security-related products or technologies developed by others may adversely affect our competitive position or render our products or technologies noncompetitive or obsolete. In addition, a portion of the sales of our network security products will depend upon a robust industry and infrastructure for providing access to public switched networks, such as the Internet. The infrastructure or complementary products necessary to turn these networks into viable commercial marketplaces may not be fully developed, and once developed, these networks may not become viable commercial marketplaces. If our research and development activities are unsuccessful, we will not be able to market new products and services and our business operations and financial results could be harmed. The markets for our products are characterized by rapidly changing technologies, extensive research and new product introductions. We believe that our future success will depend in part upon our ability to continue to enhance our existing products and to develop, manufacture and market new products. As a result, we expect to continue to make a significant investment in engineering, research and development. We may not be able to develop and introduce new products or enhancements to our existing products in a timely manner that satisfy customer needs, achieve market acceptance or address technological changes in our target markets. If we fail to develop products and introduce them successfully and in a timely manner, this could adversely affect our competitive position, financial condition and results of operations. We face risks associated with our international operations. 18 We plan to continue to maintain our foreign sales channels, which require significant management attention and financial resources. International sales are subject to a number of risks, including unexpected changes in regulatory requirements, export control laws, tariffs and other trade barriers, political and economic instability in foreign markets, difficulties in the staffing, management and integration of foreign operations, longer payment cycles, greater difficulty in collecting accounts receivable, currency fluctuations and potentially adverse tax consequences. Since most of our foreign sales are denominated in U.S. dollars, our products become less price competitive in countries in which local currencies decline in value relative to the U.S. dollar. The uncertainties of monetary exchange values have caused, and may in the future cause, some foreign customers to delay new orders or delay payment for existing orders. The long-term impact of such devaluation, including any possible effect on the business outlook in other developing countries, cannot be predicted. Our ability to compete successfully in foreign countries is dependent in part on our ability to obtain and retain reliable and experienced in-country distributors and other strategic partners. We do not have long-term contracts with most of our value added resellers and distributors and, therefore, have no assurance of a continuing relationship within a given market. Due to U.S. government regulations restricting the export of cryptographic devices and software, including our network security products to non-civilian agencies of foreign governments, we are often at a disadvantage in competing for international sales compared to companies located outside the United States that are not subject to such restrictions. Furthermore, in certain foreign countries, our distributors are required to secure licenses or formal permission before encryption products can be imported. Although the Department of Commerce continues to relax the export control laws as they apply to sales of our products to our commercial customers, we still face export controls on sales to certain foreign governments and transfers of our technology to foreign partners. To date, we have been able to secure the necessary export and import licenses to compete effectively in the international market. However, we may not be able to secure such licenses in a timely manner in the future, or at all. We face risks from our dependence on third party subcontractors and suppliers. Our ability to deliver our products in a timely manner is dependent upon the availability of quality components and subsystems used in these products. We depend in part upon subcontractors to manufacture, assemble and deliver certain items in a timely and satisfactory manner. We obtain certain components and subsystems from a single, or a limited number of, sources. A significant delay in obtaining a source of supply for components selected by our design engineers or interruption in the delivery of such items could have a material adverse effect on our financial condition and results of operations. On February 14, 2002, we notified our OEM supplier of our ISDN encryption products, Biodata Information Technology AG ("Biodata") of our decision to terminate our development and supply agreement following Biodata's declaration of insolvency. Due to Biodata's financial failure, and that of the previous supplier of our ISDN encryption products, Dica, in the first half of 2001, we have discontinued all further sales and support for this product line. Although we attempted to disclaim all liability for Biodata and Dica's failure in our supply contract with our principal customer for ISDN encryption products, there can be no assurance that the suppliers' failure, and our discontinuance of this ISDN product line, will not cause claims for breach of warranty and support by our customer and end users. We face risks of additional losses from excess leased facilities. In the fourth quarter of 2001, we recorded a $1.4 million charge to accrue a reserve for losses relative to the estimated costs of excess leased facilities in Santa Clara and related furniture and equipment, net of estimated proceeds from planned subleasing of excess office space. In the second quarter of 2002, the Company increased its estimate by an additional $1.2 million based on a continued weak sublease market. These losses reflect decreased space utilization from our reduced workforce along with estimates of sublease income and the time to market that excess space for sublease. The Company is obligated to assume occupancy and pay rent on space covered by its Master Lease on its Santa Clara facility, currently leased by its landlord to a third party tenant through August 2004. Various events might require additional increases in our reserves for potential losses due to excess leased facilities, including additional workforce reductions, further deterioration in the market for sublease space, or early termination of existing subleases. If any of these events occur, we would incur additional losses form excess leased facilities, which would have a material adverse affect on our financial position and results of operations. 19 Cylink Common Stock could be delisted from the NASDAQ National Market, which could adversely affect Cylink and its shareholders. On June 27, 2002, the Company received a notice from the staff of the NASDAQ National Market that its Common Stock had failed to maintain the minimum bid price of $1.00 over the prior 30 trading days as required for continued listing on the NASDAQ National Market. The notice stated that if during the 90 days following the date of the notice the bid price of Cylink Common Stock failed to close at or above $1.00 for at least 10 consecutive trading days, then Cylink Common Stock could be delisted. If Cylink Common Stock were to be delisted from the NASDAQ National Market, we could apply for listing on the NASDAQ SmallCap Market, the OTC Bulletin Board or another quotation system or exchange for which we could qualify. We cannot guarantee, however, that we could apply for listing on another quotation system or exchange if we are delisted from the NASDAQ National Market or that if we do apply for listing that we will be eligible initially for such listing or that if we do become listed, that we will be able to maintain eligibility. Listing on another quotation system or exchange may negatively affect the price of our Common Stock because stocks trading on over-the-counter markets are typically less liquid and trade with larger variations between the bid and ask prices. In addition, the delisting of our Common Stock from the NASDAQ National Market would adversely affect or limit or restrict our ability to raise funds through stock issuances. If the market price for our Common Stock remains below $1.00 per share and we are no longer listed on the NASDAQ National Market, our Common Stock will be deemed to be penny stock. If our Common Stock were considered penny stock, it would be subject to rules that impose additional sales practices on broker-dealers who sell our securities. For example, broker-dealers must make a special suitability determination for the purchaser and have received the purchaser's written consent to the transaction prior to sale. Also, a disclosure schedule must be prepared prior to any transaction involving a penny stock and disclosure is required about sales commissions payable to both the broker-dealer and the registered representative and current quotations for the securities. Monthly statements are also required to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stock. Because of these additional obligations, some brokers may be unwilling to effect transactions in penny stocks. This could have an adverse effect on the liquidity of our Common Stock under those circumstances. Terrorist attacks may negatively impact all aspects of our operations, revenues, costs and stock price. Recent terrorist attacks in the United States, as well as future events occurring in response or connection to them, including, without limitation, future terrorist attacks against United States targets, rumors or threats of war, actual conflicts involving the United States or its allies or military or trade disruptions impacting our domestic or foreign suppliers of merchandise, may impact our operations, including, among other things, causing delays or losses in the delivery of goods and supplies to us and decreased sales of the products we carry. More generally, any of these events may have affected, and may continue to affect, the general economy and customers' demand for capital equipment. Any of these occurrences could have a significant impact on our operating results, revenues and costs, may result in the volatility of the market price for our Common Stock, and have an adverse impact on the future price of our Common Stock. Recent accounting pronouncements may impact our financial position and results of operations. We have adopted recent changes in financial accounting standards. In June 2001, the FASB issued SFAS 142, "Goodwill and Other Intangible Assets". The valuation of the Company's goodwill and intangible assets under SFAS 142 depends on certain factors outside of our control, including our stock price, and we may be required to write down some or all of the $15.7 million net carrying value of our investment in intangibles reported as of June 30, 2002. Any determination under SFAS 142 of an impairment of our investment in intangibles could have a material impact on Cylink's financial position and results of operations. In June, July and August, 2001, the FASB also issued SFAS 141 "Business Combinations", SFAS 143, "Accounting for Asset Retirement Obligations", and SFAS 144,"Impairment or Disposal of Long-Lived Assets", respectively, which are effective for fiscal years beginning after December 15, 2001. The adoption of these statements did not have a material effect on our financial condition or results of operations. There can be no assurances, however, that the issuance by FASB of additional statements of financial accounting standards would not materially adversely affect our business, financial condition, and results of operations if such are required to be adopted by us in the future. 20 In June 2002, the FASB issued SFAS 146, "Accounting for Costs Associated with Exit or Disposal Activities," which addresses accounting for restructuring and similar costs. SFAS 146 supersedes previous accounting guidance, principally Emerging Issues Task Force Issue No. 94-3. The Company will adopt the provisions of SFAS 146 for the restructuring activities initiated after December 31, 2002. SFAS 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost was recognized at the date of the Company's commitment to an exit plan. SFAS 146 also established that the liability should initially be measured and recorded at fair value. Accordingly, SFAS 146 may affect the timing of recognizing future restructuring costs as well as the amounts recognized. Item 3. Quantitative and Qualitative Disclosures about Market Risk As of June 30, 2002, we held a total of $10.5 million of cash and cash equivalents. These securities consist primarily of money market funds and high-grade, short-term corporate obligations. Certain of these securities are subject to interest rate risk and will decline in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels as of June 30, 2002, the decline in fair value of the portfolio would not be material. We transact substantially all of our revenues and costs in U.S. dollars and our results of operations would not be materially affected by fluctuations in foreign exchange rates. Accordingly, to date, we have not used material amounts of derivative financial instruments. As of June 30, 2002, we had no fixed rate obligations except for an equipment loan with a balance of approximately $69,000. As such, the fair value of our fixed rate obligations is not subject to a material adverse impact from changes in interest rates. 21 PART II. OTHER INFORMATION Item 1. Legal Proceedings Securities Class Action. In 1998, we filed amended Forms 10-Q for the first and second quarters of 1998 and an amended Form 10-K for 1997, reflecting restated financial results for those quarters, and for the fourth quarter of 1997. Between November 6, 1998 and December 14, 1998, several securities class action complaints were filed against us and certain of our current and former directors and officers in federal courts in California. These complaints allege, among other things, that our previously issued financial statements were materially false and misleading and that the defendants knew or should have known that these financial statements caused our common stock price to rise artificially. The actions variously allege violations of Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), as amended, and SEC Rule 10b-5 promulgated thereunder, and Section 20 of the Exchange Act. The securities class action lawsuits have been ordered consolidated into a single action pending in the United States District Court for the Northern District of California, captioned In Re Cylink Securities Litigation, No. C98-4292 (VRW). The action is currently pending before the Court. We believe we have meritorious defenses and adequate insurance for the damages claimed in these actions and we intend to defend the Company vigorously. However, it is not feasible to predict or determine the final outcome of these proceedings, and if the outcome were to be unfavorable and exceed our applicable insurance, our business, financial condition, cash flows and results of operations could be materially adversely affected. Other Litigation In addition, in the normal course of business, we, from time to time, receive inquiries or other communication with regard to possible infringement of third party intellectual property rights by our patents, or the features or content of certain of our products. We believe it is unlikely that the outcome of these infringement inquiries will have a material adverse effect on our financial position or results of operations, however if litigation results from any of these inquires and the outcome is unfavorable to us, it could have a material adverse effect on our cash flows, results of operations and financial condition. There has been substantial litigation regarding patent and other intellectual property rights in the software and network security related industries. Further commercialization of our products could provoke claims of infringement from third parties. In the future, litigation may be necessary to enforce our patents, to protect our trade secrets or know-how or to defend against claimed infringement of the rights of others and to determine the scope and validity of the proprietary rights of others. Any such litigation could result in substantial cost and diversion of our efforts, which by itself could have a material adverse effect on our financial condition and operating results. Further, adverse determinations in such litigation could result in loss of proprietary rights, subject us to significant liabilities to third parties, require us to seek licenses from third parties or prevent us from manufacturing or selling our products, any of which could have a material adverse effect on our business, financial condition or results of operations. Item 2. Changes in Securities and Use of Proceeds Not applicable Item 3. Defaults upon Senior Securities Not applicable Item 4. Submission of Matters to a Vote of Security Holders (a) The Registrant's Annual Meeting of Shareholders was held May 15, 2002. The vote of the holders of record of 33,035,017 shares of Cylink's common stock outstanding at the close of business on March 29, 2002 was solicited by proxy pursuant to Regulation 14A under the Securities Act of 1934. 22 (b) The following persons were elected Directors of Cylink at the Annual Meeting: Votes Votes Name of Director For Against ---------------- ------- ------- Mr. Paul Gauvreau 21,825,592 111,004 Mr. Regis McKenna 21,612,948 323,648 (c) The shareholders ratified the appointment of Deloitte & Touche LLP as Cylink's independent auditor for the fiscal year ending December 31, 2002. Votes Votes Votes For Against Withheld --- ------- -------- 21,860,396 56,585 19,615 (d) There were no other matters voted on at the meeting. Item 5. Other Information. Notice was received June 27, 2002 from the NASDAQ National Market indicating possible delisting for failure to meet NASDAQ's minimum bid requirements. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: None (b) Reports on Form 8-K: None 23 SIGNATURE Pursuant to the requirements 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. Date: August 13, 2002 CYLINK CORPORATION By: /s/ R. Christopher Chillingworth ------------------------------------- R. Christopher Chillingworth Vice President of Finance and Chief Financial Officer (Duly Authorized Officer and Principal Financial Officer) 24

CYLINK CORP /CA/ 10-Q