ITEM 1. BUSINESS. --------
GENERAL
Applied Innovation Inc. ("Applied Innovation", "AI", or the "Company") develops, manufactures and markets network mediation and network bridging products and associated services to support the operation, maintenance, administration and provisioning of the internal data network that is used by telecommunications service providers to manage elements in their customer service network systems. Applied Innovation's customers include all of the Regional Bell Operating Companies, along with leading telecommunications, Internet, cable and other high technology companies. Applied Innovation's equipment is installed in over 20,000 locations ranging from remote facilities to Central Offices. Applied Innovation is an ISO 9001 certified organization and its products are compliant with the stringent Telcordia Network Element Building Standards ("NEBS") Level 3 requirements. The Company's LuxPath Networks division develops, manufactures and markets optical Ethernet access switching and transmission products for the Ethernet service delivery market.
The Company's predecessor was incorporated in 1983 and engaged primarily in development and preliminary testing activities until September 1984. In June 1986, the Company was formed as a Delaware corporation and the Company's predecessor, an Ohio corporation, was merged into the Company solely for the purpose of effecting a change in domicile. In 1995, the Company formed its wholly owned subsidiary, Applied Innovation International Inc., a U.S. Virgin Islands corporation, to act as a foreign sales corporation to market the Company's products outside of the United States.
The Company's executive offices and manufacturing facilities are located at 5800 Innovation Drive, Dublin, Ohio, 43016, telephone (614) 798-2000.
THE COMPANY'S MARKETS
The Company's products are designed to simplify telecommunications networks and accelerate time to market of new products and services. This provides improvements in
operational efficiency for existing network deployments, while simultaneously decreasing the cost of deploying the next generation network infrastructures required to meet the rapid acceleration in demand for broadband services. Applied Innovation offers a wide variety of solutions including Telecommunication's Data Communications Networking ("DCN"), Enhanced Services and Optical Broadband.
The Company's DCN product line provides the data communications infrastructure for the network management systems which enable remote access, fault management, security management, inventory, billing collection, provisioning and performance management. Telecommunications networks include a wide variety of Network Elements ("NE"), from a wide variety of vendors, using a wide variety of technologies and include both modem, state-of-the-art devices, and legacy equipment which has been installed for decades. Applied Innovation's DCN products enable modern Operation Support Systems ("OSSs") to interoperate with legacy network equipment, as well as allowing legacy OSSs to interoperate with modern, state-of-the-art network equipment. This is achieved by unifying the network interfaces presented to the OSS from the network elements using protocol mediation, physical interface translations, port and logical circuit concentration, application message translation and a variety of customized mediation functions designed to meet specific vendor requirements. This enables Applied Innovation to achieve the greatest amount of OSS and NE interoperability in the industry. This simplification of the network infrastructure extends the life of the existing capital equipment, reducing the need to "forklift" upgrades of the network as new services and equipment are deployed. The unified OSS interfaces also simplify the design of the DCN, eliminating the need for multiple OSS systems and parallel networks. This reduces overall cost, improves administration and management of the network, and allows for accelerated growth of the network to meet the ever increasing demand for bandwidth. The merger and acquisition trend in the telecommunications market increases the demand for network integration solutions as service providers struggle to consolidate OSS and management functions across the combined networks.
Applied Innovation's LuxPath Networks division delivers ideal solutions for deploying high-speed broadband to both metro edge and campus fiber networks addressing the rapidly growing demand for bandwidth to multi-dwelling units ("MDU"), multi-tenant units ("MTU"), corporate campuses and office parks. Using LuxConnect(TM), native Ethernet service providers can rapidly accelerate deployment of Gigabit Ethernet to remote sites, while lowering their maintenance and administration costs. This technology simplifies the delivery of high-speed optical broadband technology. LuxPath Network's targeted customer base is comprised of both emerging service providers, such as Building Local Exchange Carriers ("BLECs"), Ether Local Exchange Carriers ("ELECs"), Optical Local Exchange Carriers ("OLECs"), Data Local Exchange Carriers ("DLECs") and Competitive Local Exchange Carriers ("CLECs"), as well as established service providers, such as Inter eXchange Carriers ("IXCs") and Incumbant Local Exchange Carriers ("ILECs"), who wish to deploy higher bandwidth services to their existing customers.
Our Enhanced Services division provides turn-key solutions which include network planning and design, installation, systems integration and project management. The competitive
landscape of the telecommunications industry has created a shortage of the trained and skilled personnel required for rapid growth and deployment of new services. Utilizing Applied Innovation's expert staff, our existing customers can leverage their existing work force in order to facilitate rapid growth with lowered costs. New service providers can utilize Enhanced Services to provide the critical skills required to design and initiate their initial deployment, leveraging Applied Innovation's staff, capabilities and telecommunications experience to lower their cost, investment and risk in permanent staff, as well as improving their profitability.
The Company is expanding distribution for its products outside the United States. The Company has taken steps to establish a presence, through distributors, Original Equipment Manufacturer ("OEM") agreements, or otherwise, in Western Europe, Australia, Mexico, the Philippines, Taiwan, South Korea, South America and South Africa. The Company believes that countries currently building telecommunications infrastructures will require centralized network management and the supporting data communications capability supplied by its products as well as support for rapid deployment of Gigabit Ethernet Metropolitan Area Networks ("MANs").
The Company estimates that the Regional Bell Operating Companies ("RBOCs") control approximately half of the estimated 20,000 telecommunications Central Office locations and the estimated 200,000 Controlled Environment Vault ("CEVs") and huts in the United States. The remaining locations are controlled by a few large firms like GTE, Sprint, AT&T, MCIWorldcom, and over 1,000 smaller independent firms, CLECs and long distance companies. Because of their relative size, demand for product, and importance, the Company has concentrated its marketing efforts on the larger telecommunications service providers. The Company has historically received a large percentage of its annual net sales from RBOCs. However, in the most recent calendar year, the Company experienced rapid revenue growth in emerging service provider markets such as the IXC, CLEC and utilities markets. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Each telecommunications service provider has a finite number of Central Office facilities which limit their total capacity for the Company's products. To the extent that the Company achieves significant penetration with the Company's products into any single customer's Central Office facilities, it cannot anticipate substantial additional sales of those existing products to the customer. Future domestic sales growth to these customers depends on the development and acceptance of new products and new releases of existing products. Additional sales growth may be derived from additional sales to other RBOCs, CLECs and long distance phone companies. See "Business - Business Risks - Risks Associated with Customer Concentration; Dependence on Telecommunications Industry."
PRODUCTS
HARDWARE SOLUTIONS
AISWITCH(TM) - ------------
The AIswitch connects multiple generations of telecommunications network equipment to computers that monitor, control and analyze field conditions. The AIswitch incorporates the latest high speed microprocessor and programmable gate array technology to bridge the hardware and software gaps between old and new equipment, providing productivity gains and cost savings at both the customer's Central Office and the Operations Centers. Practically all vintages of telecommunications network equipment can be integrated with support systems through the use of the AIswitch.
The AIswitch provides connectivity and visibility among the diverse communication protocols and vendor equipment found in every telecommunications network. Within a typical telecommunications service region, there may be as many as 10,000 Network Elements to interface with a variety of equipment using various communications protocols. Communications protocols are standards which describe the way in which data is transmitted between computer systems. Replacing existing equipment and updating it to conform to newer standards takes place on extended schedules of up to twenty years, with successive introductions of new technologies. For this reason, many of the Central Office and local site locations utilize multiple generations of equipment from different vendors, each with unique operating conditions.
A unique capability of the AIswitch and the Company's technical organization is the ability to engineer custom interfaces for telecommunications equipment produced by a variety of different manufacturers for telecommunications service providers. Each AIswitch includes a wide variety of functions and options that are configured to fit client needs.
The key to the AIswitch integration capability is its flexible microprocessor controlled digital switching and protocol processing capabilities. The AIswitch permits the use of industry-standard, open architecture network building blocks to more easily connect different computers, Network Elements and other intelligent Central Office equipment with one or more network destinations. The Company transforms a complex multi-vendor environment into an easily managed seamless network to increase the total efficiency of Operations, Administration, Maintenance and Provisioning ("OAM&P") systems.
The AIswitch features NEBS Level 3 compliance, Hot Swap capability, software download and is Simple Network Management Protocol ("SNMP") manageable. It is a valuable tool to help enable service providers ensure 100% connectivity, 100% reliability and 100% availability from OS systems to Network Elements across any data communication network.
The Company has licensed technology from Cisco Systems, Inc. ("Cisco") which allows the Company to integrate a Cisco router into the AIswitch. Cisco's routing technology is the most widely used and allows the AIswitch to work smoothly with the routing technology already in use by most of the Company's customers. See "Business - Business Risks - Reliance on Suppliers."
AISCOUT(TM) - -----------
The AIscout is a self-contained, economical, mediation and concentration device providing versatile functionality and hardware connectivity for data communications networks. While designed for smaller Central Offices ("COs"), Controlled Environmental Vaults ("CEVS") and collocation sites, the AIscout offers many features to meet a broad range of network needs. It is ideal for protocol mediation and port concentration for transporting OAM&P data between Network Elements and Operational Support Systems. The AIscout offers remote software download capabilities, remote configuration, SNMP manageability, configuration backup, download and restore and local craft access. These management features contribute to more efficient allocation of customers' manpower. By integrating the AIflex (Fiber Local Area Network Extender - a Wave Division Multiplexer technology) within the AIscout, the OAM&P traffic may use the same fiber as the payload traffic. This eliminates the need for routers and channel service unit/data service unit ("CSU/DSUs"), which in turn flattens out the network and eliminates both the need for installing a dedicated circuit and the recurring monthly dedicated circuit costs.
AIFLEX(TM) - ----------
The AIflex enables telecom companies to use existing fiber connections from the Central Office to monitor and manage Controlled Environmental Vaults, huts and shelters. The AIflex uses Wave Division Multiplexer ("WDM") technology to enable telecommunication providers to manage remote locations as nodes on a Central Office-based local area network ("LAN"). Connecting directly to existing fiber without interfering with existing payload, AIflex transmits management data between remote sites and the central office without additional cost and delays associated with extra lines or routers. Utilizing existing fiber saves money, saves recurring circuit costs, frees a resource generating circuit and speeds deployment time.
AISPY(TM) - ---------
AIspy is a comprehensive system for managing small telecom sites such as Controlled Environmental Vaults, cell sites, huts, collocation sites, small central offices and remote and unmanned facilities. AIspy provides monitoring capabilities for the entire facility through a multitude of alarms and sensors. AIspy is built to telephone company standards and provides the customer with multiple management and communication path options. It has the capability to control and record access into the monitored site through either keypad or cellular phone ("DTMF") input.
NETWORK MANAGEMENT SYSTEMS
APPLIEDVIEW(TM) - ---------------
AppliedView is an element management system which allows the people and operations systems in a Network Operations Center to monitor the status of AIswitch units in remote locations such as Central Offices and Controlled Environmental Vaults. The program includes
software download and configuration backup for remote AIswitch units. AppliedView gives Network Operations Center technicians the same view as a technician standing in front of the switch. It provides centralized, constant and continuous surveillance and provisioning of the AIswitch network. Through a graphical user interface, this network manager reduces the cost and time required for upgrades and remote site maintenance.
NEWEB(TM) - ---------
NEWEB combines the AIswitch and Web technology for simple, secure access to Network Elements from anywhere, anytime. NEWEB simplifies the job of network management staff by providing a point-and-click interface, with configurable drop-down menus for provisioning, troubleshooting and secure remote access of Network Elements. By providing a wide variety of vendor specific network element databases, which incorporates the specific command sets for each element, it reduces training time for new staff and decreases the impact of personnel turnover greatly. Improved productivity translates into lower costs, greater flexibility and responsiveness, improved service quality and time-to-market. NEWEB provides users with a simple intuitive means to locate inventory and connect to specific network elements while providing a robust, yet flexible security model. NEWEB gives technicians direct access, with personal computers or workstations, to remote Network Elements. Users increase their productivity by eliminating unnecessary field service calls. NEWEB also enables users to diagnose and repair faults in less time while shortening their learning curve for Network Element provisioning and troubleshooting.
LUXPATH NETWORKS DIVISION
LUXCONNECT(TM) - --------------
The LuxConnect is a Gigabit Ethernet multiplexer that aggregates up to eight channels of Gigabit Ethernet into a single protected 10-Gbps optical signal. The LuxConnect is marketed through Applied Innovation's LuxPath Networks division. Aggregation into a 10-Gbps signal significantly improves fiber utilization and extends the reach for common Gigabit Ethernet optical interfaces. The LuxConnect is more economical than SONET-based solutions in terms of both equipment costs and operating expenses. While maintaining a lower total cost of ownership, the LuxConnect provides significant performance advantages as a native Ethernet transmission platform. By providing eight virtual pipes for Gigabit Ethernet services, the LuxConnect flattens data transport architectures, improving network administration and maintainability while enhancing total network scalability, and provides distinct time-to-market advantages in turning up new revenue-bearing services. Gigabit Ethernet interfaces utilize hot-swappable Giga-bit Integrated Circuit ("GBIC") modules which allow the user the flexibility to meet both existing and future optical and copper connectivity requirements.
Management options include SNMP Management, an embedded web server for monitoring, provisioning and performance management, as well as the standard async and Telnet based craft interfaces. An embedded web server utilizes internal exstensible markup language ("XML") databases to ensure future extensibility. Element management is provided using Applied Innovation's AppliedView(TM) system.
Ethernet is ubiquitous; it is estimated that there are over 300 million Ethernet ports in the US alone. LuxConnect is Ethernet-centric, leveraging the client's current knowledge base. As an Ethernet platform, the LuxConnect does not require the client to add or consume SONET and ATM expertise within their organization. This improves network maintainability, easing many of the data transport network's scalability issues and lowering the learning curve. This brings dramatic advances in time-to-market for new services. The LuxConnect makes it easier to deploy a data transport network.
ENHANCED SERVICES DIVISION
ENHANCED SERVICES - -----------------
Applied Innovation Services enable AI to provide value to our customers. Leveraging the knowledge AI possesses regarding Telecommunications, Enterprise Networking and Operational Support/Network Management Systems, AI provides a unique and fresh perspective to innovating the way today's service providers fulfill their business requirements. These services include project planning, project management, network engineering, installation, system integration and supplemental staffing.
MANUFACTURING AND OPERATIONS
All of the printed circuit boards used within the Company's products are proprietary designs of the Company. Printed circuit boards and power supplies used in each of the Company's products are contracted out to third party manufacturing firms for assembly. These subassemblies are then shipped to the Company for testing and final assembly. Procurement of materials is driven through an enterprise resource planning ("ERP") system with production forecasts supplied to contract firms for component ordering from sources supplied and approved by the Company. The Company maintains and controls all documentation and process requirements for products manufactured by the contract assembly firms. The Company utilizes multiple assembly firms and is, therefore, not dependent on any single third party manufacturer.
The Company performs multiple inspections on its products as well as various test procedures prior to shipment to customers. These processes are designed to assure product performance and reliability in the environments in which the products will be used. The Company has made and continues to make significant investments to attain quality assurance consistent with stringent industry standards. The Company develops and manufactures its products in accordance with NEBS and Generic Equipment Requirements guidelines. The Company is International Standards Organization 9001 ("ISO 9001") certified.
MARKETING, BUSINESS DEVELOPMENT, SALES AND SERVICES
The Company's products and services are sold primarily through its own sales force, except for independent sales agents in Western Europe, South Africa, Mexico, Australia, and South Korea. The Company is exploring alternative distribution channels to allow sales of the Company's products to markets that are not easily accessible nor cost effective for its own sales force. In addition to the Dublin, Ohio headquarters, the Company maintains sales offices in Atlanta, Chicago, Dallas, Denver, New York and Ontario, Canada.
The Company's marketing and business development staff consists of a Vice President of Marketing and Business Development, a Director of Product Line Management, a Director of Advanced Technology, a Director of Business Development, Product Line Managers and an administrative staff. The Company's sales department consists of a Senior Vice President, International Sales, a Vice President of Sales, a Director of Enhanced Services Sales, a Director of Sales Engineering, a Director of Emerging Markets (Sales), Regional Account Managers, Account Managers, Sales Engineers and an administrative staff. The Company's services division consists of a Vice President, Services Division, a Director of Services Operations, Installation, Detail Engineering, Project Management, Technical Support, Technical Training, and an administrative staff. Sales leads are currently generated through target marketing to telecommunications service providers, direct mail and trade shows. Sales leads are followed up by personal contact from the Company's sales and marketing staff. If sufficient interest exists, an on-site visit may be scheduled for the purpose of making a sales presentation, which may include a product demonstration.
The technical complexity of the Company's products and the relative large size of customers create a long sales cycle for the Company's products. The technical nature of the products and Central Office environment also mandates a very technical sales force. The Company's sales force receives incentive compensation based on increased levels of sales.
RESEARCH AND DEVELOPMENT
The Company's research and development ("R&D") activity is coordinated with product management and business development to create product development teams that focus on customer requirements. Enhancements to the AIswitch are focused on increasing its capacity and adapting to the wide variety of existing and emerging network element management interfaces. Investment is continuing in the area of leveraging the AIswitch technology in creating smaller, more highly integrated products, such as the AIscout and AIspy, which are appropriate for the smaller central office ("CO"), controlled environment vault ("CEV"), or Cabinet environment. Network Management/OSS products and services, such as NEWEB and future enhancements and Optical networking technology, such as the LuxConnect will continue to play a key position in the Company's R&D spending as we expand our presence into these emerging markets.
The Company spent $8,176,622, $7,479,496, and $11,979,875, on Company-sponsored R&D during the fiscal years ended December 31, 2000, 1999, and 1998, respectively. R&D expenditures represented approximately 7.0%, 15.1%, and 22.3%, of annual sales in fiscal 2000, 1999, and 1998, respectively. During 1998, the Company incurred $6,263,000 in R&D related to the terminated Access Products Group development activity. The Company expects to commit a substantial amount of resources and cash to its research and development efforts during 2001. See "Business - Business Risks - New Products and Rapid Technological Change; Need to Manage Product Transitions."
CUSTOMER SERVICE AND WARRANTY
The Company offers its customers a variety of services such as technical support, project management, training, detail engineering, installation and test and turn-up. Project managers interface between the Company and customers for installation of new products and services and upgrades of existing products. The project manager is also responsible for assuring that all possible circumstances are anticipated prior to certifying the system for full operation. Following installation, the project manager continues to monitor the customer's system to ensure proper satisfaction.
The Company designs training programs to educate the customer's system administration, operations and maintenance personnel to operate the system. Classes are available on line and at the customer's site or at the Company's headquarters. Additional training is also offered to the customer during system upgrades and for new operations personnel.
The Company's field service department provides custom design and installation services for telecommunications network equipment and software. The Company believes that its field service department complements and enhances the sale of its products.
The Company warrants its products for a minimum of one year and up to five years, as negotiated under contract. Customers may also purchase extended warranty contracts with guaranteed overnight factory replacement service for circuit boards or system modules in the event of equipment failure. Software revisions to the Company's products are also available as part of the extended warranty contracts, or may be purchased by the customer. In addition, for an additional charge, on-site spares are available for those customers who require immediate replacement. The Company also provides a 24-hour Service Hotline for instant access to its field service and support departments. A toll-free 800 number is also offered.
Warranty expense represented approximately 1.5%, 2.4%, and 4.5% of annual net sales in 2000, 1999, and 1998, respectively. See "Business - Business Risks - Risk of Product Defects."
COMPETITION
There are numerous manufacturers of data communications equipment. Manufacturers of these products frequently specialize their products for specific applications and could enter the Company's target markets. Significant competition exists from several well-established companies having resources superior to those of the Company and from relatively new but aggressive companies.
Competition for the Company's DCN products arises primarily from suppliers of telecommunications switching and transmission equipment. Competition comes from other data communications suppliers, such as Cisco Systems, Dantel, ACT Networks, Badger Technology, and IMCI Technologies. In some cases, newer products or redesigned older products from these suppliers compete with the Company's products. See "Business - Business Risks - Competition."
Competition for the Company's LuxPath division includes Nbase/Xyplex, Hitachi, Riverstone, Lucent, Nortel and Cisco Systems.
Competition for the Company's Enhanced Services division include EF&I, Lucent Netcare, Sprint North Supply and Marconi.
PERSONNEL
As of March 16, 2001, the Company had 310 full-time and part-time employees. The Company's employees are distributed among the following departments: Sales and Marketing (64); Research and Development (72); Customer Service (81); Manufacturing (55); and Operations (38). The Company anticipates that it will continue to increase the number of its employees as it grows.
BUSINESS RISKS
The Company desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. In addition to the other information in this report, readers should carefully consider that the following important factors, among others, in some cases have affected, and in the future could affect, the Company's actual results and could cause the Company's actual consolidated results of operations for the year ended December 31, 2000, and beyond, to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company.
Risks Associated with Customer Concentration; Dependence on Telecommunications Industry. A significant portion of the Company's revenues in each fiscal quarter since inception has been derived from substantial orders placed by large organizations, such as the RBOCs. As
a result, the Company's net sales often have been concentrated among a relatively small number of customers. In fiscal 2000, 1999, and 1998, net sales from the Company's two, two and five largest customers represented approximately 61%, 42%, and 75%, respectively, of the Company's total net sales. The Company expects that it will continue to be dependent upon a limited number of customers for a significant portion of its revenues in future periods. None of the Company's customers are contractually obligated to license or purchase additional products or services from the Company. As a result of this customer concentration, the Company's business, operating results and financial condition could be materially adversely affected by the failure of anticipated orders to materialize or by deferrals or cancellations of orders. In addition, there can be no assurance that revenue from customers that have accounted for significant net sales in past periods, individually or as a group, will continue, or if continued will reach or exceed historical levels in any future period. Furthermore, such customers are concentrated in the telecommunications industry. Accordingly, the Company's future success depends upon the capital spending patterns of such customers and the continued demand by such customers for the Company's products and services. Additionally, any future mergers and acquisitions among our customers could impact future orders from such customers. The Company's operating results may in the future be subject to substantial period-to-period fluctuations as a consequence of such customer concentration and factors affecting capital spending in the telecommunications industry.
Product Concentration. Revenue from the sale, service and support of the Company's DCN family of products has accounted for a substantial portion of the Company's net sales since inception. The Company believes that revenue from the sale, service and support of the DCN products will continue to account for a significant portion of the Company's net sales in fiscal 2001. Therefore, the Company's future operating results, particularly in the near term, are significantly dependent upon the continued market acceptance of the DCN products, improvements to the DCN product framework and new and enhanced development tools and network operations support. There can be no assurance that the AIswitch will continue to achieve market acceptance or that the Company will be successful in developing, introducing or marketing improvements to the AIswitch framework or new or enhanced development tools and applications. The life cycles of products, including development tools and applications, are difficult to estimate due in large part to the recent emergence of many of the Company's markets, the effect of future product enhancements and competition. A decline in the demand for DCN products as a result of competition, technological change or other factors would have a material adverse effect on the Company's business, operating results and financial condition.
New Products, Research and Development, and Rapid Technological Change; Need to Manage Product Transitions. The market for the Company's products is characterized by rapidly changing technologies, evolving industry standards, frequent new product introductions and rapid changes in customer requirements. The introduction of products embodying new technologies and the emergence of new industry standards and practices can render existing products obsolete and unmarketable. As a result, the life cycles of the Company's products are difficult to estimate. The Company's future success will depend on its ability to enhance its existing products and to develop and introduce, on a timely and cost-effective basis, new
products and product features that keep pace with technological developments and emerging industry standards and address the increasingly sophisticated needs of its customers. The Company is attempting to ensure future success by investing heavily in its research and development effort. However, there can be no assurance that the Company will be successful in developing and marketing new products or product features that respond to technological change or evolving industry standards, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products and features, or that its new products or product features will adequately meet the requirements of the marketplace and achieve market acceptance. If the Company is unable, for technological or other reasons, to develop and introduce enhancements of existing products or new products in a timely manner, the Company's business, operating results and financial condition will be materially adversely affected.
The introduction or announcement of products by the Company or one or more of its competitors embodying new technologies, or changes in industry standards or customer requirements, could render the Company's existing products obsolete or unmarketable. The introduction of new or enhanced versions of its products requires the Company to manage the transition from older products in order to minimize disruption in customer ordering. There can be no assurance that the introduction or announcement of new product offerings by the Company or one or more of its competitors will not cause customers to defer purchasing existing Company products. Such deferment of purchases could have a material adverse effect on the Company's business, operating results and financial condition.
Competition. Most of the Company's current and potential competitors have longer operating histories and significantly greater financial, technical, sales, customer support, marketing and other resources, as well as greater name recognition and a larger installed base of their products and technologies than the Company. There can be no assurance that the Company's current or potential competitors will not develop products comparable or superior to those developed by the Company or adapt more quickly than the Company to new technologies, evolving industry trends or changing customer requirements. There can be no assurance that the Company will be able to compete successfully against current and future competitors or that competitive pressures faced by the Company will not have a material adverse effect on its business, operating results and financial condition.
Dependence Upon Proprietary Technology; Risk of Third Party Claims of Infringement. The Company's success and ability to compete is dependent in part upon its proprietary software technology. The Company relies on a combination of trade secret, copyright and trademark laws, nondisclosure and other contractual agreements and technical measures to protect its proprietary rights. The Company currently has no patents or patent applications pending. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or to obtain and use information that the Company regards as proprietary. There can be no assurance that the steps taken by the Company to protect its proprietary technology will prevent misappropriation of such technology, and such protections may not preclude competitors from developing products with functionality or
features similar to the Company's products. In addition, effective copyright and trade secret protection may be unavailable or limited in certain foreign countries. While the Company believes that its products and trademarks do not infringe upon the proprietary rights of third parties, there can be no assurance that the Company will not receive future communications from third parties asserting that the Company's products infringe, or may infringe, the proprietary rights of third parties. The Company expects that software product developers will be increasingly subject to infringement claims as a number of products and competitors in the Company's industry segment grows and the functionality of products in different industry segments overlap. Any such claims, with or without merit, could be time-consuming, result in costly litigation and diversion of technical and management personnel, cause product shipment delays or require the Company to develop non-infringing technology or enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to the Company or at all. In the event of a successful claim of product infringement against the Company and failure or inability of the Company to develop non-infringing technology or license the infringed or similar technology, the Company's business, operating results and financial condition could be materially adversely affected.
The Company relies on certain software that it licenses from third parties, including software that is integrated with internally developed software and used in the Company's products to perform key functions. There can be no assurance that these third party software licenses will continue to be available to the Company on commercially reasonable terms or at all. Although the Company believes that alternative software is available from other third-party suppliers, the loss of or inability to maintain any of these software licenses or the inability of the third parties to timely and cost-effectively enhance their products in response to changing customer needs, industry standards or technological developments could result in delays or reductions in product shipments by the Company until equivalent software could be developed internally or identified, licensed and integrated, which would have a material adverse effect on the Company's business, operating results and financial condition.
Reliance on Suppliers. The Company purchases raw material and licenses technology from a number of domestic and foreign sources. The Company believes that currently there are acceptable alternatives to the suppliers of raw material and technology used in its products which could be substituted for over time, with the exception of network routing products supplied by Cisco Systems, Inc. The Company currently purchases network routing products and licenses technology regarding the same from Cisco Systems, Inc. pursuant to a Technology Agreement. The term of the Technology Agreement expires on December 31, 2001 and automatically renews for one year periods, unless either party elects not to renew. Additionally, the Technology Agreement may be terminated by either party for any reason upon six months notice. The Company believes that some of its customers place a high value on the incorporation of network routing products and technology from Cisco Systems, Inc. into the Company's products. While the Company believes that it could obtain similar quality network routing products and technology from other vendors, the termination of the Technology Agreement could materially adversely affect the acceptance of the Company's products, which could have a material adverse effect on the Company's business, financial condition and results of operations.
Future Capital Needs; Uncertainty of Additional Financing. The Company currently anticipates that its existing cash, cash equivalents, investments, cash to be generated from future operations, and funds which may be obtained from future financing activities will provide sufficient capital to meet the business needs of the Company. See "Management's Discussion and Analysis of Financial Condition and the Results of Operations - Liquidity and Capital Resources." The Company may need to raise additional funds through public or private debt or equity financings in order to take advantage of unanticipated opportunities, including more rapid expansion or acquisitions of complementary businesses or technologies, or to develop new or enhanced services and related products or otherwise respond to unanticipated competitive pressures. If additional funds are raised through the issuance of equity securities, the percentage ownership of the then current stockholders of the Company may be reduced and such equity securities may have rights, preferences or privileges senior to those of the holders of the Company's common stock. There can be no assurance that additional financing will be available on terms favorable to the Company, or at all. If adequate funds are not available or are not available on acceptable terms, the Company may not be able to take advantage of unanticipated opportunities, develop new or enhanced services and related products or otherwise respond to unanticipated competitive pressures and the Company's business, operating results and financial condition could be materially adversely affected.
Future Operating Results Uncertain. Although the Company has previously experienced growth in revenues and net income, the Company expects that historical growth rates are not sustainable and such growth rates should not be considered indicative of future growth, if any. There can be no assurance that the Company's revenues will grow or be sustained in future periods or that the Company will be profitable in any future period.
Risk of Product Defects. Products as complex as those offered by the Company may contain defects or failures when introduced or when new versions or enhancements are released. The Company has in the past discovered defects in certain of its products. Although the Company has remedied all known material defects in its products, there can be no assurance that, despite testing by the Company and its customers, errors will not be found in existing or new products or releases, resulting in delay or loss of revenue, loss of market share or failure to achieve market acceptance or substantial warranty expense. Any such occurrence could have a material adverse effect upon the Company's business, operating results and financial condition.
Potential Fluctuations in Quarterly Results; Seasonality. The Company's quarterly operating results have in the past and will in the future vary significantly depending on factors such as the timing of significant orders and shipments, capital spending patterns of the Company's customers, changes in pricing policies by the Company or its competitors, the lengthy sales cycle of the Company's products, increased competition, changes in operating expenses, mergers and acquisitions among customers, personnel changes, demand for the Company's products, the number, timing and significance of new product and product enhancement announcements by the Company and its competitors, the ability of the Company to develop, introduce and market new and enhanced versions of its products on a timely basis, the
mix of direct and indirect sales and general economic factors, among others. A significant portion of the Company's revenues have been, and will continue to be, derived from substantial orders placed by large organizations, such as the RBOCs, and the timing of such orders and their fulfillment has caused and will continue to cause material fluctuations in the Company's operating results, particularly on a quarterly basis. Due to the foregoing factors, quarterly net sales and operating results have been and will continue to be difficult to forecast. Revenues are also difficult to forecast because the Company's sales cycle, from initial evaluation to product shipment, varies substantially from customer to customer. For these and other reasons, the sales cycle associated with the purchase of the Company's products is typically lengthy and subject to a number of significant risks, including customers' budgetary constraints and internal acceptance reviews, over which the Company has little or no control. The Company's expense levels are based, in part, on its expectations as to future revenue levels. If revenue levels are below expectations, operating results are likely to be materially adversely affected. In particular, because only a small portion of the Company's expenses varies with net sales, net income (loss) may be disproportionately affected by a reduction in net sales. The Company's business has experienced and is expected to continue to experience significant seasonality, in part due to an increase in capital expenditures by customers in certain quarters. Based upon all of the foregoing, the Company believes that quarterly net sales and operating results are likely to vary significantly in the future and that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Further, it is likely that in some future quarter, the Company's net sales or operating results will be below the expectations of public market analysts and investors. In such event, the price of the Company's Common Stock could be materially adversely affected.
Dependence on Key Personnel. The Company's success depends to a significant degree upon the continuing contributions of its key management, sales, professional services, customer support and product development personnel. In particular, the Company would be materially adversely affected if it were to lose the services of Gerard B. Moersdorf, Jr., Chairman of the Board, who has provided significant leadership and direction to the Company since its inception. The Company has obtained key man life insurance on the life of Mr. Moersdorf in the amount of $10,000,000, payable to the Company. Additionally, the Company could also be materially affected were it to lose the services of Robert L. Smialek, Chief Executive Offcer and President. The loss of other key management or technical personnel could adversely affect the Company. The Company believes that its future success will depend in large part upon its ability to attract and retain highly-skilled managerial, sales, professional services, customer support and product development personnel. The Company has at times experienced and continues to experience difficulty in recruiting qualified personnel. Competition for qualified personnel is intense, and there can be no assurance that the Company will be successful in attracting and retaining such personnel. In addition, there are only a limited number of qualified professional services and customer support engineers, and competition for such individuals is especially intense. Furthermore, competitors have in the past and may in the future attempt to recruit the Company's employees. Failure to attract and retain key personnel could have a material adverse effect on the Company's business, operating results and financial condition.
Limited Market; Volatility of Stock Price. Although the Company is listed on the Nasdaq National Market, there can be no assurance that an active or liquid trading market in the Company's common stock will continue. The market price of the shares of the Company's common stock is likely to be highly volatile and may be significantly affected by factors such as actual or anticipated fluctuations in the Company's operating results, announcements of technological innovations, new products or new contracts by the Company or its competitors, developments with respect to copyrights or proprietary rights, general market conditions and other factors. In addition, the stock market has from time to time experienced significant price and volume fluctuations that have particularly affected the market prices for the common stocks of technology companies. These types of broad market fluctuations may adversely affect the market price of the Company's common stock. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been initiated against such company. Such litigation could result in substantial costs and a diversion of management's attention and resources, which could have a material adverse effect upon the Company's business, operating results and financial condition.
Anti-Takeover Provisions; Certain Provisions of Delaware Law; Certificate of Incorporation and By-Laws. Certain provisions of Delaware law and the Company's Certificate of Incorporation and By-Laws could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of the Company. The Company's By-Laws provide for the Board of Directors to be divided into three classes of directors serving staggered three-year terms. Such classification of the Board of Directors expands the time required to change the composition of a majority of directors and may tend to discourage a proxy contest or other takeover bid for the Company. Additionally, the directors, executive officers and existing principal stockholders of the Company and their affiliates beneficially own approximately 44.0% of the outstanding shares of the Company's Common Stock. Such concentration of ownership may have the effect of delaying or preventing a change in control of the Company.
Concentration of Stock Ownership. The present directors, executive officers and principal stockholders of the Company and their affiliates beneficially own approximately 44.0% of the outstanding shares of the Company's Common Stock. In particular, Gerard B. Moersdorf, Jr. and his spouse own approximately 41.1% of the outstanding shares of Common Stock. As a result, these stockholders are able to exercise significant influence over matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. Such concentration of ownership may have the effect of delaying or preventing a change in control of the Company.
Revenue Fluctuations due to Reseller Pass-Through. One time systems integration project opportunities may contribute to significant fluctuations in top line revenues on a non-recurring basis. These contributions are generally at lower margin than our core product line sales, and may affect quarterly margin performance. However, these projects do make significant contributions to our overall net profits, and do not affect long term profit growth for the Company.
ITEM 2.
ITEM 2. PROPERTIES. ----------
The Company headquarters is a 115,000 square foot modern corporate office and manufacturing facility in Dublin, Ohio. All of the Company's manufacturing, administrative and research and development activities and a substantial portion of its marketing activities are conducted at this location. The Company owns the building and the approximately 33 acres of land on which it is situated.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS. -----------------
Not applicable.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. ---------------------------------------------------
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. ---------------------------------------------------------------------
The Company's common stock has been traded in the over-the-counter market since 1986. The common stock was traded on the NASDAQ OTC Bulletin Board until May 18, 1993. From May 18, 1993 to November 26, 1993 the common stock was traded on the NASDAQ Small Cap Market. On November 29, 1993 the common stock began trading on the NASDAQ National Market. The following table sets forth, for the periods indicated, the high and low bid prices for the Company's common stock. The prices shown represent quotations between dealers, without adjustment for retail markups, markdowns or commissions and may not represent actual transactions.
2000 1999 ---- ----
High Low High Low
Q1 $14.56 $ 7.75 $5.19 $3.13
Q2 $12.13 $ 7.00 $5.75 $2.81
Q3 $27.06 $10.25 $4.94 $3.50
Q4 $16.50 $ 7.50 $9.00 $3.40 -----------------------------------------------------------------
At March 9, 2001, the Company had 531 stockholders of record.
The Company has not paid any cash dividends and presently anticipates that all of its future earnings will be retained for development of its business. The Company does not anticipate paying cash dividends on its common stock in the foreseeable future. The payment of any future dividends would be at the discretion of the Company's Board of Directors and would depend upon, among other things, future earnings, operations, capital requirements, the general financial condition of the Company and general business conditions. Although the Company's ability to pay dividends is not currently restricted by any of its financing agreements, the Company may be subject to such restrictions in the future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA. -----------------------
The information required by this item is included under the caption "Selected Consolidated Financial Data " in the Company's Annual Report to Stockholders and is incorporated herein by reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS ----------------------------------------------------------------------- OF OPERATIONS. --------------
The information required by this item is included under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's Annual Report to Stockholders and is incorporated herein by reference.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. ----------------------------------------------------------
The Company does not have any material exposure to interest rate changes, commodity price changes, foreign currency fluctuations, or similar market risks. Furthermore, the Company has not entered into any derivative contracts and the Company has no debt outstanding as of December 31, 2000.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. -------------------------------------------
The information required by this item is included under the caption "Consolidated Financial Statements" in the Company's Annual Report to Stockholders and is incorporated herein by reference, except that our Financial Statement Schedule and Independent Auditors' Report on Financial Statement Schedule are included in response to Item 14 below.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND --------------------------------------------------------------- FINANCIAL DISCLOSURE. ---------------------
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. --------------------------------------------------
The information appearing under the caption "ELECTION OF DIRECTORS" on pages 4 through 15 of the Company's Proxy Statement relating to the Company's Annual Meeting of Stockholders to be held on April 26, 2001 (the "Proxy Statement"), and the information appearing under the caption "SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE" on page 24 of the Proxy Statement is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION. ----------------------
The information appearing in the Proxy Statement under the caption "ELECTION OF DIRECTORS - Executive Compensation" on pages 8 through 15 of the Proxy Statement is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. --------------------------------------------------------------
The information appearing in the Proxy Statement under the caption "OWNERSHIP OF COMMON STOCK BY PRINCIPAL STOCKHOLDERS" on page 2, and under the caption "SECURITY OWNERSHIP OF MANAGEMENT" on page 3 of the Proxy Statement, is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. ----------------------------------------------
The information appearing in the Proxy Statement under the caption "ELECTION OF DIRECTORS - Related Party Transactions" on page 12 is incorporated herein by reference.
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. ----------------------------------------------------------------
(a)(1) The following documents are filed as part of this report:
Consolidated Balance Sheets as of December 31, 2000 and 1999.
Consolidated Statements of Operations for the years ended December 31, 2000, 1999 and 1998.
Consolidated Statements of Stockholders' Equity for the years ended December 31, 2000, 1999 and 1998.
Consolidated Statements of Cash Flows for the years ended December 31, 2000, 1999, and 1998.
Notes to Consolidated Financial Statements.
(a)(2) Schedule II (Valuation and Qualifying Accounts)
(a)(3) Exhibits: The following exhibits are filed as part of this report:
EXHIBIT NO. DESCRIPTION
3.1 Certificate of Incorporation of the Company. (Reference is made to Exhibit 3.1 to the Company's Registration Statement on Form 10-SB, filed with the Securities and Exchange Commission on March 10, 1993, and incorporated herein by reference).
3.2 By-laws of the Company, as amended. (Reference is made to Exhibit 3.2 to the Company's Registration Statement on Form 10-SB, filed with the Securities and Exchange Commission on March 10, 1993, and incorporated herein by reference).
10.1 Company's Amended and Restated 1986 Incentive Stock Option Plan, including form of Stock Option Agreement. (Reference is made to Exhibit 10.1 to the Company's Registration Statement on Form 10-SB, filed with the Securities and Exchange Commission on March 10, 1993, and incorporated herein by reference).
10.2 Company's 1986 Amended and Restated Non-Statutory Stock Option Plan, including form of Stock Option Agreement. (Reference is made to Exhibit 10.2 to the Company's Registration Statement on Form 10-SB, filed with the Securities and Exchange Commission on March 10, 1993, and incorporated herein by reference).
10.3 Form of Confidentiality, Assignment and Non-Competition Agreement between the Company and employee officers. (Reference is made to Exhibit 10.3 to the Company's Registration Statement on Form 10-SB, filed with the Securities and Exchange Commission on March 10, 1993, and incorporated herein by reference).
10.4 Technology Agreement, dated November 12, 1996, between the Company and Cisco Systems, Inc. (Reference is made to Exhibit 10.4 to the Company's Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 31, 1998, and incorporated herein by reference).
10.5 Employment Agreement between the Company and William J. Mrukowski. (Reference is made to Exhibit 10.7 to the Company's Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 31, 1998, and incorporated herein by reference).
10.6 Form of Indemnification Agreement between the Company and officers and directors. (Reference is made to Exhibit 10.8 to the Company's Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 31, 1994, and incorporated herein by reference).
10.7* Schedule of Indemnification Agreements.
10.8 Company's Amended and Restated 1996 Stock Option Plan. (Reference is made to Exhibit 10.11 to the Company's Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 30, 2000, and incorporated herein by reference).
10.9 Employment Agreement between the Company and Robert L. Smialek (Reference is made to Exhibit 10.1 to the Company's Quarterly Statement on Form 10-Q, filed with the Commission on November 14, 2000, and incorporated herein by reference).
10.10* Employment Agreement between the Company and Gerard B. Moersdorf, Jr.
10.11* Employment Agreement between the Company and Michael P. Keegan.
11* Statement re: computation of earnings per share
13* Portions of the Annual Report to Stockholders for year ended December 31, 2000
23* Consent of KPMG LLP
24* Powers of Attorney
99* Independent Auditors' Report
------------------------ * Filed herewith.
(b) None
(c) Exhibits - The exhibits to this report follow the signature page.
(d) Financial Statement Schedules - The financial statement schedule to this report follows the signature page and the independent auditors' report thereon is included in Exhibit 99 to this Report on Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
APPLIED INNOVATION INC.
Date: March 26, 2001 By: /s/ Robert L. Smialek ------------------------------------- Robert L. Smialek, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
APPLIED INNOVATION INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1998, 1999 AND 2000