10-Q 1 a10-q.txt 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the quarterly period ended JUNE 30, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____ TO _____ COMMISSION FILE NUMBER 000-21171 SPLASH TECHNOLOGY HOLDINGS, INC. (Exact name of registrant as specified in its charter) DELAWARE 77-0418472 (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 555 DEL REY AVENUE, SUNNYVALE, CA 94086 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (408) 328-6300 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 [ ] The number of shares outstanding of the Registrant's Common Stock. $.001 par value, as of July 31, 2000 was 14,321,111 shares. SPLASH TECHNOLOGY HOLDINGS, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

The accompanying notes are an integral part of these consolidated financial statements. 2 SPLASH TECHNOLOGY HOLDINGS, INC. CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)

The accompanying notes are an integral part of these consolidated financial statements. 3 SPLASH TECHNOLOGY HOLDINGS, INC. CONSOLIDATED STATEMENTS CASH FLOWS (IN THOUSANDS) (UNAUDITED)

The accompanying notes are an integral part of these consolidated financial statements. 4 SPLASH TECHNOLOGY HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. REORGANIZATION AND BASIS OF PRESENTATION Splash Technology Holdings, Inc. (the "Company"), through its wholly-owned subsidiaries, develops, produces and markets color servers, which consist of computer hardware and software systems that provide an integrated link between desktop computers and digital color copiers and enable such copiers to provide high speed and quality networked color printing and scanning. The Company sells, through its wholly owned subsidiaries substantially all of its color servers through two original equipment manufacturers ("OEMs") which integrate the Company's color servers into connected digital color photocopier systems, which are sold to end users in North and South America, Europe, Asia, Australia, Japan, New Zealand, Africa and the Middle East. The Company operates in one business segment. The accompanying unaudited consolidated financial information has been prepared by the Company in accordance with accounting principles generally accepted in the United States for interim financial statements and pursuant to the rules of the Securities and Exchange Commission on Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The December 31, 1999 balance sheet was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States. In the opinion of management, the accompanying consolidated financial statements contain all normal, recurring adjustments necessary to present fairly the Company's consolidated financial position as of June 30, 2000, and the results of operations for the three and six months ended June 30, 2000 and cash flows for the six months ended June 30, 2000, which results are not necessarily indicative of results on an annual basis. The consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes contained in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1999. 2. BALANCE SHEET DETAIL (IN THOUSANDS):

3. COMPUTATION OF NET INCOME PER SHARE Basic EPS is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS is computed giving effect to all dilutive potential common shares that were outstanding during the period. Dilutive potential common shares consist of incremental shares issuable upon exercise of stock options. 5 A reconciliation of the numerator and denominator of basic and diluted EPS is provided as follows (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS):

Options to purchase 1.8 million and 1.5 million shares of common stock were outstanding at June 30, 1999, and June 30, 2000, respectively, but were not included in the calculation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares during the three months ended June 30, 1999 and 2000, respectively. 4. New accounting pronouncements In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities," that requires companies to record derivative financial instruments on their balance sheets as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative instrument and whether it qualifies for hedge accounting. The key criterion for hedge accounting is that the hedging relationship must be highly effective in achieving offsetting changes in fair value or cash flows. In June 1999, the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of the Effective Date of FASB Statement No. 133," that amends SFAS No. 133 to be effective for all fiscal quarters of fiscal years beginning after June 15, 2000. In June 2000, the Financial Accounting Standards Board issued SFAS No. 138, "Accounting for Derivative Instruments and Hedging Activities--An Amendment of FASB No. 133." SFAS 138 amends the accounting and reporting standards for certain derivatives and hedging activities such as net settlement contracts, foreign currency translations and intercompany derivatives. To date, the Company has not engaged in derivatives or hedging activities. In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101 ("SAB 101") "Revenue Recognition in Financial Statements," which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. SAB 101 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosures related to revenue recognition policies. The Company must adopt SAB 101 in the first quarter of fiscal 2001. Management believes that the impact of SAB 101 will not have a material effect on the financial position or results of operations of the Company. However, the interpretation of SAB 101 is still under discusison by the Securities and Exchange Commission and may be revised. Such revisions could have a material effect on the financial position or results of operations of the Company. In March 2000, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 44 ("FIN 44") "Accounting for Certain Transactions involving Stock Compensation," an interpretation of APB Opinion No. 25. FIN 44 clarifies the application of Opinion 25 for (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a noncompensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. FIN 44 is effective July 1, 2000, but certain conclusions cover specific events that occur after either December 15, 1998, or January 12, 2000. Management does not expect that the adoption of the remaining provisions will have a material effect on the consolidated financial statements. 5. CONTINGENCIES In January 1999, two class action complaints were filed in the United States District Court for the Northern District of California against the Company, certain of its officers and directors, and certain underwriters. The complaints allege that defendants made false and misleading statements about the Company's business condition and prospects during a class period of January 7, 1997 to October 13, 1998 and assert claims for violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The complaints in both actions seek damages of unspecified amounts. On December 20, 1999, Electronics for Imaging ("EFI") filed a complaint in the United States District Court for the Northern District of California against the Company. The complaint alleges that the defendant's products infringe upon three EFI patents. The suit is aimed at enforcing patents in the areas of color management, color calibrations and continuous printing technologies. The Company believes that it has meritorious defenses and it intends to defend them vigorously. However, litigation is subject to inherent uncertainties and, thus, there can be no assurance that these complaints will be resolved favorably to the Company or that they will not have a material adverse affect on the Company's financial condition and results of operations. No provision for any liability that may result upon adjudication has been made in the accompanying financial statements. The Company and its subsidiaries are also parties to various other legal actions and administrative proceedings. The Company believes that the disposition of these matters will not have a material effect on the financial position of the Company. 6 ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THIS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND OTHER PARTS OF THIS FORM 10Q CONTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. ALL FORWARD-LOOKING STATEMENTS INCLUDED IN THIS DOCUMENT ARE BASED ON INFORMATION AVAILABLE TO THE COMPANY ON THE DATE HEREOF, AND THE COMPANY ASSUMES NO OBLIGATION TO UPDATE ANY SUCH FORWARD-LOOKING STATEMENTS. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING THOSE SET FORTH IN "FACTORS AFFECTING FUTURE RESULTS". RESULTS OF OPERATIONS The Company has achieved operating profitability each year since fiscal 1994, before purchase accounting adjustments. The Company's profitability and growth are contingent on a number of factors, many of which are outside of its control. These factors include the overall rate of growth in the color server market, the impact of varying economic conditions in different regions in which the Company sells its product, and customer purchasing patterns. Due to these and other factors (including a relatively high base from which to grow), the Company's historical profitability may be difficult to attain or exceed in the future. In addition, the Company's overall expense level has increased and is expected to continue to increase as the Company continues to build corporate infrastructure and expand its operations. Accordingly, the Company believes that period-to-period comparisons of its financial results should not be relied upon as an indication of future performance. The Company establishes its expenditure levels for operating expenses based on projected sales levels and margins, and expenses are relatively fixed in the short term. Moreover, the Company expects to continue to expand its sales and marketing, technical and customer support, research and product development and administrative activities. Accordingly, if sales are below expectations in any given quarter, the adverse impact of the shortfall in revenues on operating results may be increased by the Company's inability to adjust spending in the short term to compensate for the shortfall. The following table sets forth consolidated statement of operations data as a percentage of net revenue for the periods indicated:

NET REVENUE. The Company's net revenue increased 32% to $22.4 million in the three months ended June 30, 2000 from $16.9 million in the three months ended June 30, 1999. Net revenue increased 39% to $46.2 million in the six months ended June 30, 2000 from $33.2 million in the six months ended June 30, 1999. This increase was primarily attributable to an increasing demand for Xerox's DC12 print engine to which the Company's products connect. This resulted in increased demand for the Company's products, including its G Series product, and the Company's first controller device incorporated into the structure of the copier ("integrated controller") product. Any decrease in market acceptance for the Xerox DC12 print engine, or any other products to which the Company's products connect, would adversely affect the Company. The Company sells a range of products, and the revenue for any period will be determined by the product mix sold in that period. The Company currently sells a substantial portion of its products to two customers, Xerox and to a significantly lesser extent, Fuji Xerox Company Ltd. ("Fuji Xerox") on an OEM basis and, historically, fluctuations in net revenue are in part due to the purchasing patterns of these customers. There can be no assurance that either of the Company's two major customers, Xerox or, to a significantly lesser extent, Fuji Xerox will not change their mix of product or purchasing patterns in a manner which 7 materially adversely impacts net revenue. During the first half of 2000, the company introduced its T200 line of products. The T200 series products are currently compatible with certain print engines manufactured by Canon Corporation ("Canon"). There can be no assurance that the company will be successful in selling these Canon compatible products, or any other non-Xerox compatible product it develops in the future. All sales to Fuji Xerox, and a portion of the Company's sales to Xerox, are international sales. In addition, given Xerox's international customer base, the Company believes that a portion of Splash products purchased by Xerox in the U.S. are resold outside the United States. The Company expects that direct and indirect international sales will continue to represent a substantial portion of its net revenue for the foreseeable future. While the Company's international sales are generally denominated in U.S. dollars, fluctuations in currency exchange rates could cause, and, in the case of Japan, have caused, the Company's products to become relatively more expensive to end users in a that country, leading to pressure to reduce the U.S. dollar denominated price to the Company's OEM customers and to lost sales. Such pressure has in the past and could again in the future result in a reduction in net revenue and profitability. GROSS MARGIN. Gross margins were 55% and 46% in the three months ended June 30, 1999 and 2000, respectively. Gross margins were 55% and 46% for the six months ended June 30, 1999 and 2000, respectively. The significant decline in gross margins was primarily due to a sales shift toward certain lower margin integrated controllers, partially offset by economies of scale derived from higher sales volumes, and cost reductions achieved through product designs. In 1999, the Company introduced its first integrated controller product. This product has substantially lower margins than the Company's other products. The Company expects that gross margins will fluctuate from period to period and may decrease in future periods. Gross margin is affected by a number of factors, including product mix, product pricing and manufacturing and component costs. The average selling price ("ASP") of the Company's products has decreased in the past primarily as a result of competitive market pressures, the introduction of lower priced products and, in certain cases, in response to new product introductions by the Company's customers. The Company expects this trend to continue in the future. Any decline in average selling prices of a particular product which is not offset by a reduction in production costs or by sales of other products with higher gross margins would decrease the Company's overall gross margin and adversely affect the Company's operating results. RESEARCH AND DEVELOPMENT. Research and development expenses increased 9% to $4.1 million in the three months ended June 30, 2000 from $3.7 million in the three months ended June 30, 1999. Research and development expenses increased 13% to 8.0 million in the six months ended June 30, 2000 from 7.0 million in the six months ended June 30, 1999. As a percentage of net revenue, research and development decreased to 18% in the three months ended June 30, 2000 from 22% in the three months ended June 30, 1999. As a percentage of net revenue, research and development decreased to 17% in the six months ended June 30, 2000 from 21% in the six months ended June 30, 1999. The increase in research and development spending in absolute dollars is attributable to costs associated with expanding the Company's product line. Historically, the Company had invested in research and development to develop products which were primarily compatible with print engines distributed and manufactured by Xerox and Fuji Xerox. The Company intends to increase its research and development efforts to develop products for print engines from suppliers other than Xerox and Fuji Xerox. For example, the T200 line of products, which the company recently introduced, is compatible with print engines manufactured by Canon. All research and development costs to date have been expensed as incurred. In view of current projects under development and planned, research and development expenses may increase in future periods. SALES, GENERAL AND ADMINISTRATIVE. Sales, general and administrative expenses increased 26% to $4.8 million in the three months ended June 30, 2000 from $3.8 million in the three months ended June 30, 1999. As a percentage of net revenue, sales, general and administrative expenses decreased to 22% in the three months ended June 30, 2000 from 23% in the three months ended June 30, 1999. As a percentage of net revenue, sales, general and administrative expenses decreased to 22% in the six months ended June 30, 2000 from 24% in the six months ended June 30, 1999. The increase in these expenditures in absolute dollars was primarily related to expansion of the Company's sales support and marketing staff and associated costs (primarily to increase the Company's level of support for its customers sales organization), the implementation of promotional programs designed to improve name and product recognition in the end-user community and the Company's increased participation in industry trade shows. In addition, the Company incurred significant expenses related to the introduction of its new T200 line of product, as well as costs associated with developing its new distribution channel for the T200 line. During the March 31, 2000 quarter, the Company announced IKON Office Products as a distribution partner for the T200 product line. In addition, the increases in these expenditures were due to increased salary and related costs from increased headcount related to the Company's efforts to enhance its corporate infrastructure and to support expansion of its operations. The Company believes that its sales, general and administrative expenses will increase in the foreseeable future as it continues to implement additional management and operational systems, and expand its administrative staff. Sales, general, and administrative expenses are also expected to increase in future periods as the Company increases its sales support and marketing staff and associated costs to expand its presence in sales channels other than Xerox and Fuji Xerox. There is no assurance that the Company will be able to maintain or increase its presence in its existing customers or to successfully penetrate any additional sales channels. PROVISION FOR INCOME TAXES. The Company accounts for income taxes in accordance with the Financial Accounting Standards Board's Statement of Financial Accounting Standard No.109 "Accounting for Income Taxes". The Company's effective tax rate was 22% and 20% for the six months ended June 30, 1999 and 2000, respectively. The effective tax rate differs from the statutory rate primarily due to the benefits derived from the Splash Foreign Sales Corporation and research and development credits. 8 LIQUIDITY AND CAPITAL RESOURCES The Company's cash balances and marketable securities are sufficient to satisfy its current liquidity requirements. The Company had $75.4 million of cash, cash equivalents and marketable securities and had no borrowings outstanding under its $10 million bank line of credit as of June 30, 2000. Borrowings under the line of credit bear interest at the prime rate or libor plus 1.25% to 2%, and are available based on a percentage of eligible accounts receivable. For the six months ended June 30, 2000, the Company generated $12.9 million in cash from operating activities, primarily due to a decrease in accounts receivable and other assets and an increase in deferred revenue, partially offset by an increase in inventories and a decrease in trade accounts payable, and other accrued liabilities. For the six months ended June 30, 1999, the Company generated $9.8 million in cash from operating activities primarily from net income, a decrease in accounts receivable and inventories, and an increase in trade accounts payable, partially offset by an increase in other assets and a decrease in other liabilities. In the six months ended June 30, 1999, investing activities provided $1.3 million primarily related to the redemption of marketable securities. In the six months ended June 30, 2000, investing activities provided $0.5 million, primarily from the redemption of marketable securities. Financing activities for the six months ended June 30, 1999 and 2000 were immaterial. The Company has no material financing commitments other than its obligations under operating leases. The Company believes that cash flows from operations and existing cash balances will be sufficient to satisfy the Company's cash requirements for at least the next twelve months. FACTORS AFFECTING FUTURE RESULTS FLUCTUATIONS IN OPERATING RESULTS; SEASONAL PURCHASING PATTERNS. The Company's operating results have fluctuated and will likely continue to fluctuate in the future on a quarterly and annual basis as a results of a number of factors, many of which are outside the Company's control. These fluctuations are in part due to the purchasing patterns of the Company's two large customers, Xerox and, to a significantly lesser extent, Fuji Xerox. In the past, inventory balancing activities by the Company's customers have resulted, and may continue to result, in variations in the timing of purchases by such customers. There can be no assurance that the Company will receive sufficient inventory information from its OEM customers or that the Company will be able to prevent significant inventory issues in the future. In 1999, the Company suffered a substantial decrease in sales to its customer, Fuji Xerox. This materially adversely affected the Company's business and operating results for 1999. The Company's customers may also vary their purchasing and inventory patterns in conjunction with their or their competitor's introduction of new products, their actual or potential delays in new product introductions, or their cancellations of planned new products or existing products. Also, announcements by the Company or its competitors of new products and technologies could cause customers to defer purchases of the Company's existing products. In the event that anticipated orders fail to materialize, or delivery schedules are deferred or canceled as a result of the above factors or other unanticipated factors, it would materially and adversely affect the Company's business, operating results and financial condition. Results in any period could also be affected, and in 1999, were materially adversely affected by changes in market demand, competitive market conditions, sales promotion activities by the Company, its OEM customers or its competitors market acceptance of new or existing products, sales of color copiers with which the Company's products are compatible, the cost and availability of components, expansion of and the mix of the Company's customer base and sales channels, the amount of any third-party funding of development expenses, the mix of products sold, the Company's ability to effectively expand its sales and marketing organization, the Company's ability to attract and retain key technical and managerial employees, and general economic conditions. As a result, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indicative of future performance. Due to all of the foregoing factors, the Company's operating results in one or more future periods may be subject to significant fluctuations of public market analysts and investors, the price of the Company's common stock would be materially and adversely affected. The Company's gross margin is affected by a number of factors, including product mix, product pricing, and manufacturing, component and royalty costs. The average selling price of the Company's products has decreased substantially in the past and may continue to do so, primarily as a result of competitive market pressures, the introduction of lower priced products and, in certain cases, in response to new product introductions by the Company's customers. The Company expects this trend to continue. During the second half of 1999, the Company delivered its first integrated product. The integrated 9 products and its Intel-based M series products have gross margins that are significantly lower than those of the PCI and DC series. In September 1999, the Company also launched its G610 and G710 server products. These products replaced the Company's PCI and DC Series products, respectively. The average selling price ("ASPs") of these newly introduced products are lower than those of the PCI and DC Series products they replaced. The G610 is only compatible with Xerox's newly introduced DC12 color laser copier. If the Xerox DC12 color laser copier has low levels of market acceptance, the Company's operating results would be adversely affected. The Company expects a lower gross margin on its G Series products. In the event of significant price competition in the market for color copier servers or competitive systems, the Company could be at a significant disadvantage compared to its competitors, many of which have substantially greater resources or lower product costs than the Company and therefore could more readily withstand an extended period of downward pricing pressure. Any decline in ASPs of a particular product, such as was experienced in 1999, which is not offset by a reduction in production costs or by sales of other products with higher gross margins would decrease the Company's overall gross margin and adversely affect the Company's operating results. The Company establishes its expenditure levels for product development and other operating expenses based on projected sales levels and margins, and expenses are relatively fixed in the short term. Accordingly, if sales are below expectations, as they were in 1999, the adverse impact of the shortfall on the Company's operating results may be increased by the Company's inability to adjust spending in the short term to compensate for the shortfall. COLOR SERVER MARKET. The color server market has, in the past, grown more slowly than anticipated. The markets for digital color copiers and connected color servers are intense. Because current and future competitors are likely to continue to introduce competing solutions, it is difficult to predict the rate at which these markets will grow, if at all. If the market continues to grow slowly, or not grow at all, the Company's business, operating results and financial condition will be adversely affected. The Company intends to continue to spend resources educating potential customers about color servers. However, there can be no assurance that such expenditures will enable the Company's products to achieve any additional degree of market acceptance. Moreover, the Company has historically focused on certain segments of the market (the prepress and graphic arts segments) and has had only limited penetration to date into the broader office segment or other market segments. There can be no assurance that the Company will be able to maintain or increase its presence in its existing market segments or to successfully penetrate such additional market segments. DEPENDENCE ON XEROX AND FUJI XEROX. The Company's products operate primarily with certain color laser copiers offered by Xerox and, to a substantially lesser extent, Fuji Xerox, and the Company currently sells its products primarily to Xerox and Fuji Xerox, which resell the Company's products on an OEM basis to their color copier end users. As a result of this dependence, sales of the Company's products have been and will continue to be influenced heavily by the market acceptance of the Xerox and Fuji Xerox color copiers with which the Company's products operate and the sales efforts of Xerox and Fuji Xerox with respect to Splash products. Xerox and Fuji Xerox face substantial competition from other manufacturers of color copiers, including Canon, which the Company believes has a significant share of the worldwide market for color copiers. If sales of the color copiers of Xerox and Fuji Xerox, with which Splash's products are compatible, decrease, the Company's business, operating results and financial condition would be, as they have been in the past, materially and adversely affected. During 1999, sales of Splash compatible copiers were significantly lower than in prior periods. In particular, sales to Fuji Xerox of products for resale in Japan were negligible in 1999. This reduction in sales has, and any continued reduction from historical levels could, materially and adversely affect the Company's business, operating results and financial condition. Similarly, if Xerox or Fuji Xerox were to introduce color copiers that are not compatible with the Company's products, or if Xerox or Fuji Xerox were to introduce color copiers that already contain a significant portion of the functionality of the Company's products so as to render the Company's products unnecessary, the Company's business, operating results and financial condition would be materially and adversely affected. In addition, Fuji Xerox color copiers are produced in a single location in Japan and any disruption of production at this facility could materially and adversely affect the Company's business, operating results and financial condition. As a result of its reliance on Xerox and Fuji Xerox, the Company currently has a relatively small sales and marketing organization and has limited experience with direct sales efforts. Any change in the sales and marketing efforts of Xerox or Fuji Xerox with respect to Splash's products, including any reduction in the size or effectiveness of the Xerox or Fuji Xerox sales and marketing forces, or changes in incentives for Xerox or Fuji Xerox salespersons to sell Splash products or color servers produced by competitors of Splash, could have, as it has in the past, a material adverse effect on the Company's business, operating results and financial condition. During 1999, Fuji Xerox changed the means by which it sold products in Japan, requiring that its OEM suppliers have a sales support and marketing organization in Japan. The Company had a limited sales support and marketing presence in Japan and only recently began the process of adding personnel in Japan. Xerox currently sells a substantial number of color servers made by companies other than Splash, including those of the Company's principal competitor, Electronics For Imaging ("EFI"). The Company is also a supplier of color servers to Fuji Xerox. However, Fuji Xerox has increased the number of color servers sold to end users that were manufactured by companies other than Splash, including EFI. In addition, the Company is required to permit testing by Xerox and Fuji Xerox of the beta release of the Company's products (including components contained therein) and cannot begin shipping any version to Xerox or Fuji Xerox until such version and components meet their respective quality standards. Any delay in meeting such respective standards would have a detrimental effect to the Company. Xerox and Fuji Xerox promote the use of color servers 10 manufactured by competitors of the Company to the detriment of sales of the Company's products. Either Xerox or Fuji Xerox may choose to manufacture color servers themselves, may choose to manufacture only color copiers that are not compatible with Splash products, or may reduce, delay or cease purchases and sales of Splash color servers. Although the Company has a contract with Xerox, the Company does not have a contract with Fuji Xerox with respect to its products and is currently operating on a purchase order basis with Fuji Xerox. There can be no assurance as to the level of orders from Xerox under its contract or that the Company will continue to receive orders from Xerox or Fuji Xerox. Any decrease in the level of sales to Xerox or continued decrease in the level of sales to Fuji Xerox would have a material adverse effect on the Company's business, operating results and financial condition. INVENTORY RISKS. Xerox and Fuji Xerox may from time to time carry excess inventory of Splash color servers, inaccurately project future demand for Splash products or fail to optimally manage their ordering of Splash products, any of which could result in a significant decrease in orders from such customers in subsequent periods. There can be no assurance that the Company will receive sufficient information from Xerox, Fuji Xerox or other customers over time or that the Company will in any event be able to prevent the recurrence of similar problems in the future. As a result, Splash's customers, among other things, may be required to discount excess inventory, may experience difficulty in selling excess inventory, may experience reduced sales of new products or may become dissatisfied with their relationship with Splash. The Company's customer, in an effort to reduce its inventory levels, orders product with increasingly shorter lead times. If the Company cannot deliver product within these shortened lead times it would have a materially adverse affect on the Company's results. Although customers have no commercial right of return with respect to the Company's products, there can be no assurance that the Company will not elect to make accommodations to significant customers. Reduced sales of Splash products by Xerox or Fuji Xerox or any financial or other accommodation made to Xerox or Fuji Xerox could have a material adverse effect on the business, operating results and financial condition of Splash. DEPENDENCE ON ADOBE SYSTEMS INCORPORATED. The majority of the Company's products depend on the PostScript page description language software developed by Adobe Systems Incorporated ("Adobe") and licensed by the Company from Adobe on a non-exclusive basis. Any delay in the release of future versions of PostScript by Adobe or in the upgrade of the Company's products to be compatible with current or future versions of PostScript, or any material defects in any versions of PostScript software (including defects identified in connection with upgrades of the Company's products), could have a material adverse effect on the Company's business, operating results and financial condition. The Company has, and may continue to experience, delays in the release of its products due to Adobe product delays. The Company is required to pay a royalty for each copy of PostScript that is incorporated in Splash products, which royalty constitutes a substantial portion of the total manufactured cost of the Company's products. In addition, the Company is required to permit testing by Adobe of the beta release version of the Company's products, and the Company cannot begin shipping any version until such version meets Adobe's quality standards. The license agreement between the Company and Adobe expires in March 2003, subject to renewal upon mutual consent. There can be no assurance that Adobe will continue to enjoy its leadership position in the market, renew the current license at the end of its term or license future versions of PostScript to Splash on terms favorable to Splash or at all. If the license agreement between Adobe and the Company is terminated for any reason or the Company's relationship with Adobe is impaired, the Company could be required to change to an alternative page description language which would require the expenditure of significant resources and time and could significantly limit the marketability of the Company's products. Any increase in royalties payable to Adobe also could have a material adverse effect on the Company's operating results. In addition, the Adobe PostScript software is incorporated in the products of certain of the Company's competitors. The Company's business could be materially and adversely affected if Adobe were to make available to the Company's competitors future versions of Adobe PostScript software that include enhancements to the Adobe PostScript software that were originally developed or implemented by Splash. DEPENDENCE ON COMPONENT AVAILABILITY, COST, AND CERTAIN SUPPLIERS. The majority of the Company's current products require the use of an Apple as a computer platform. In the past, Apple has experienced significant financial difficulties and losses in market acceptance, and its products have particularly low levels of market acceptance in the office color printing market into which the Company is seeking to expand. In addition, Apple has experienced significant changes in management. If Apple were to discontinue production of models with which Splash products operate or were unable to provide or otherwise cease to provide an acceptable level of end user customer support, the Company's business, operating results and financial condition would be materially and adversely affected. The Company has experienced sourcing difficulties related to Apple's delay in the release of new models. The Company ships products which may contain discontinued components. The Company has experienced sourcing difficulties in procuring discontinued components in the past. There can be no assurance that the Company will not experience similar difficulties in the future. Any extended delay between the discontinuation of an existing model and the release of an enhanced model by Apple could have a material adverse effect on the Company's business, financial condition and results of operations. Any efforts of the Company to migrate its products to different computer platforms will require a substantial expenditure of resources and time, and there can be no assurance that any such products can be successfully developed or introduced in a timely fashion and at competitive cost or otherwise achieve widespread market acceptance. Certain components necessary for the manufacture of the Company's products are obtained from a sole supplier or a limited group of suppliers. These include motherboards and processors, from Intel and Motorola, certain ASICs and other 11 semiconductor components. The Company does not maintain any long-term agreements with any of its suppliers of components. Because the purchase of certain key components involves long lead times, in the event of unanticipated increases in demand for the Company's products, the Company could be unable to manufacture certain products in a quantity sufficient to meet end user demand. The Company has experienced difficulties related to Apple's delay in the release of new systems and the discontinuation of computers used in Splash's current products. There can be no assurance that the Company will not experience similar difficulties in the future. The Company also purchases memory modules from several suppliers. A change in memory suppliers could require time to effect and could impact production. This risk would be exacerbated in times of memory supply shortages. For instance, during the second half of 1999, the memory market was extremely volatile. Any inability to obtain adequate deliveries of any of the components or any other circumstance that would require the Company to seek alternative sources of supply could affect the Company's ability to ship its products on a timely basis, which could damage relationships with current and prospective customers and could therefore have a material adverse effect on the Company's business, financial condition and operating results. Moreover, there can be no assurance that alternative sources of supply would be available on reasonably acceptable terms, on a timely basis, or at all. The Company has from time to time, including several instances in 1999, experienced shortages in deliveries of certain ASICs sourced exclusively from Toshiba Corporation, which have impacted production. In order to attempt to mitigate the risk of such shortages in the future, the Company has substantially increased its inventory of components for which the Company is dependent upon sole or limited source suppliers. As a result, the Company is subject to an increasingly substantial risk of inventory obsolescence, which could materially and adversely affect its operating results and financial condition. The Company purchases components comprising a portion of the total cost of its color servers. The balance of the inventory required to manufacture the Company's products is purchased by Logistix and SCI. The Company currently sources most of its Apple Macintosh computers that serve as the platforms for its G Series color servers from Apple. The Company is currently operating on a purchase order basis with Apple. The market prices and availability of certain components, particularly memory, other semiconductor components, Apple Macintosh computers and Intel designed components, which collectively represent a substantial portion of the total manufactured cost of the Company's products, have fluctuated significantly in the past. Significant fluctuations in the future could have a material adverse effect on the Company's operating results and financial condition. During late 1999, the Company experienced a significant increase in the price of memory. This resulted in, and may continue to result in, a reduction in gross margins. DEPENDENCE ON SINGLE PRODUCT LINE. Substantially all of Splash's current shipments consist, and are expected to continue to consist, of the Company's color server products. Because of this product concentration, a significant decline in demand for or pricing of these products would have a material adverse effect on the Company's business, operating results and financial condition, whether as a result of a decline in sales of complementary Xerox and Fuji Xerox copiers; a decline in the market for Apple Macintosh computers; increased sales by Xerox or Fuji Xerox of color servers offered by competitors of the Company or developed internally by Xerox or Fuji Xerox; new product introductions by competitors; price competition; or technological change. Any decline in the market for this product line or any failure to timely produce new and enhanced products would have a material adverse effect on the Company's business, financial condition and results of operations. RAPID TECHNOLOGICAL CHANGE; DEPENDENCE ON NEW PRODUCT INTRODUCTIONS. The graphics and color reproduction, color processing and personal computing markets are characterized by rapid changes in customer requirements, frequent introductions of new and enhanced products, and continuing and rapid technological advancement. To compete successfully, the Company must continue to design, develop, manufacture and sell new products that provide increasingly higher levels of performance and reliability, take advantage of technological advancements and changes and respond to new customer requirements. In 1998, the Company's main competitor added enhancements to its product that competed with the Company's DC Series products. These enhancements had an adverse effect on the market acceptance of the Company's DC Series products and its successor, the G710 product. The Company's success in designing, developing, manufacturing and selling new products will depend on a variety of factors, including the identification of market demand for new products, product selection, timely implementation of product design and development, product performance, cost-effectiveness of current products and products under development, effective manufacturing processes and the success of promotional efforts. In 1999, the Company began significant volume shipments of products based on Intel designed components as well as its new generation of Apple based product. The Company recently introduced its T200 product line which is compatible with Canon print engines. There can be no assurance that these products or, for that matter, any of the Company's future products will achieve widespread market acceptance. In addition, the Company has, in the past, experienced delays in the development of new products and the enhancement of existing products, and such delays may occur in the future. If the Company is unable, due to resource constraints or technological or other reasons, to develop and introduce new products or versions in a timely manner, if such new products or releases do not achieve timely and widespread market acceptance, or if the Company's customers reduce, delay or cease the introduction of new models of color copies which use the Company's products, it would have a material adverse effect on the Company's business, operating results and financial condition. COMPETITION. The markets for the Company's products are characterized by intense competition and rapid change. The 12 Company competes directly with other independent manufacturers of color servers and with copier manufacturers, and indirectly with printer manufacturers and others. The Company has a number of direct competitors for color server products, the most significant of which is EFI. Splash also faces competition from copier manufacturers that offer internally developed color server products, such as a non-PostScript color server offered by Fuji Xerox, or that incorporate color server features into their copiers. In addition, the Company faces competition from desktop color laser printers that offer increasing speed and color server capability. As component prices decrease and the processing power and other functionality of copiers, printers and computers increases, it becomes more likely that copier, printer and computer manufacturers will continue to add color server functionality to their systems, which could reduce the market for the Company's existing line of products. The Company also competes indirectly with manufacturers of electronic color prepress systems, which offer similar functionality for the short-run and commercial printing market as is provided by the Company's products. In addition, the Company competes indirectly with providers of color separation, color editing and page layout software. While such software typically is complementary to the Company's systems, this software can also be competitive with the Company's systems and may become increasingly competitive to the extent that the providers of such software extend the functionality of their products in future releases. Many of the Company's current and potential direct and indirect competitors have longer operating histories, are substantially larger, and have substantially greater financial, technical, manufacturing, marketing and other resources than Splash. A number of these current and potential competitors also have substantially greater name recognition and a significantly larger installed base of products than the Company, which could provide leverage to such companies in their competition with Splash. The Company expects competition to increase to the extent the color server market grows, and such increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could materially adversely affect the Company's business, operating results and financial condition. As a result of their greater resources, many of such competitors are in a better position than Splash to withstand significant price competition or downturns in the economy. There can be no assurance that Splash will be able to continue to compete effectively, and any failure to do so would have a material adverse effect upon the Company's business, operating results and financial condition. RISKS ASSOCIATED WITH ACQUISITIONS. The Company frequently evaluates potential acquisitions of complementary businesses, products and technologies. As part of the Company's expansion plans, the Company has acquired and may continue to acquire companies that have an installed base of products not yet offered by the Company, have strategic distribution channels or customer relationships, or otherwise present opportunities which management believes may enhance the Company's competitive position. The success of any acquisition could depend not only upon the ability of the Company to acquire such businesses, products and technologies on a cost-effective basis, but also upon the ability of the Company to integrate the acquired operations or technologies effectively into its organization, to retain and motivate key personnel of the acquired businesses, and to retain the significant customers of the acquired businesses. Any acquisition, depending upon its size, could result in the use of a significant portion of the Company's cash, or if such acquisition is made utilizing the Company's securities, could result in significant dilution to the Company's stockholders. Moreover, such transactions involve the diversion of substantial management resources and evaluation of such opportunities requires substantial diversion of engineering and technological resources. In addition, such transactions could result in large one time write-offs or the creation of goodwill or other intangible assets that would result in amortization expenses. To date, the Company has completed two acquisitions: Quintar Company and ColorAge in May and October of 1997, respectively. There can be no assurance that acquired technology can be successfully developed on a timely basis or at all, or that products based on acquired technology will receive widespread market acceptance. Moreover, there can be no assurance that the Company can successfully integrate acquired technology. The failure to successfully evaluate, negotiate and effect acquisition transactions could have a material adverse effect on the Company's business, operating results and financial condition. MANAGEMENT OF EXPANDING OPERATIONS. The growth in the Company's business has placed, and any further expansion would continue to place, a significant strain on the Company's limited personnel, management and other resources. The Company's ability to manage any future expansion effectively will require it to attract, train, motivate and manage new employees successfully, to integrate new management and employees into its overall operations and to continue to improve its operational, financial and management systems. Moreover, the Company expects to continue to increase the size of its domestic and international sales support staff and the scope of its sales and marketing activities, and to hire additional research and development personnel. The Company's failure to manage any expansion effectively, including any failure to integrate new management and employees or failure to continue to implement and improve financial, operational and management controls, systems and procedures, could have a material adverse effect on the Company's business, operating results and financial condition. DEPENDENCE ON THIRD PARTY MANUFACTURERS. The Company generally outsources the manufacture of its products to third party subcontract manufacturers including SCI Systems, Logistix, Arrow Electronics, and Flash Electronics. Flash Electronics and SCI purchase the components used in Splash boards from their component suppliers and perform double-sided active surface mount assembly, in-circuit test, functional test and system test of the printed circuit boards used in the Company's products, on a turnkey basis. 13 SCI also performs in-warranty and out-of-warranty repair of failed boards for the Company's products. The Company directly purchases Apple Macintosh computers, Intel designed components, Motorola motherboards, monitors and memory, and furnishes these components, as well as the SCI-assembled boards, to Logistix and SCI for final assembly. Logistix and SCI directly purchase a portion of the components used in Splash color servers and do all final assembly and system configuration. While the Company's subcontract manufacturers conduct quality control and testing procedures specified by the Company, the Company has from time to time experienced manufacturing quality problems. There can be no assurance that quality problems will not occur again in the future or that any such problem would not have a material adverse effect on the Company's business, operating results and financial condition. If SCI, Logistix, or other third party manufacturing facilities utilized by the Company become unavailable to the Company, or if the manufacturing operations at these facilities are slowed, interrupted or terminated, the Company's business, operating results and financial condition could be adversely affected. Although the Company believes that there is a variety of companies available with the capability to provide the Company with such services, there can be no assurance that the Company would be able to enter into alternative third party manufacturing arrangements on terms satisfactory to the Company, in a timely fashion, or at all. DEPENDENCE ON PROPRIETARY TECHNOLOGY; RELIANCE ON THIRD PARTY LICENSES. The Company relies, in part, on trademark, copyright and trade secret law to protect its intellectual property in the United States and abroad. The Company seeks to protect its software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection, and there can be no assurances that the steps taken by the Company will prevent misappropriation of its technology. The Splash software included as a part of the Company's products is sold pursuant to "shrink wrap" licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. The Company owns several patents. There can be no assurance that any patent, trademark or copyright owned by the Company, or any patent, trademark or copyright obtained by the Company in the future, will not be invalidated, circumvented or challenged, that the rights granted thereunder will provide competitive advantages to the Company or that any of the Company's pending or future patent applications will be issued with the scope of the claims sought by the Company, if at all. In addition, the laws of some foreign countries do not protect the Company's proprietary rights as fully as do the laws of the United States. Thus, effective intellectual property protection may be unavailable or limited in certain foreign countries. There can be no assurance that the Company's means of protecting its proprietary rights in the United States or abroad will be adequate or that others will not independently develop technologies that are similar or superior to the Company's technology, duplicate the Company's technology or design around any patent of the Company. Moreover, litigation may be necessary in the future to enforce the Company's intellectual property rights, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of management time and resources and could have a material adverse effect on the Company's business, operating results and financial condition. There have been substantial amounts of litigation in the computer and related industries regarding intellectual property rights, and there can be no assurance that third parties will not claim infringement by the Company of their intellectual property rights. The addition of Splash as a defendant in any claims that the Company is infringing on proprietary rights of others, with or without merit, could be time-consuming to defend, result in costly litigation, divert management's attention and resources, and cause product shipment delays. If the Company were found to be infringing on the intellectual property rights of any third party, the Company could be subject to liabilities for such infringement, which liabilities could be material, and could be required to seek licenses from other companies or to refrain from using, manufacturing or selling certain products or using certain processes. Although holders of patents and other intellectual property rights often offer licenses to their patent or other intellectual property rights, no assurance can be given that licenses would be offered or that the terms of any offered license would be acceptable to the Company. In December 1999, EFI filed suit against Splash for patent infringement. Any need to redesign the products or enter into any royalty or licensing agreement as the result of any alleged infringement could have a material adverse effect on the Company's business, operating results and financial condition. The Company relies upon certain software licensed from third parties. There can be no assurance that the software licensed by the Company will continue to provide competitive features and functionality or that licenses for software currently utilized by the Company or other software which the Company may seek to license in the future will be available to the Company on commercially reasonable terms. The loss of, or inability to maintain, existing licenses could result in shipment delays or reductions until equivalent software or suitable alternative products could be developed, identified, licensed and integrated, and the inability to license key new software that may be developed, on commercially reasonable terms, would have a material adverse effect on the Company's competitive position. Any such event would materially adversely affect the Company's business, operating results and financial condition. RISK OF PRODUCT DEFECTS. The Company's products consist of hardware and software developed by Splash and others. Products such as those of the Company may contain undetected errors when first introduced or when new versions are released, and the Company has in the past discovered software and hardware errors in certain of its new products after their introduction. There can be no assurance that errors would not be found in new versions of Splash products after commencement of commercial shipments, or that any such errors would not result in a loss of or delay in market acceptance 14 and have a material adverse effect upon the Company's business, operating results and financial condition. In addition, errors in the Company's products (including errors in licensed third party software) detected prior to new product release could result in delay in the introduction of new products and incurring of additional expense, which also could have a material adverse effect upon the Company's business, operating results and financial condition. INTERNATIONAL SALES. All sales to Fuji Xerox and some Xerox affiliated entities are international sales. Although a majority of sales to Xerox are accounted for as U.S. sales, Xerox has a significant international customer base, and the Company believes that a portion of Splash products purchased by Xerox are resold outside the United States. The Company expects that direct and indirect international sales will continue to represent a substantial portion of its net revenue for the foreseeable future. While the Company's international sales are generally denominated in U.S. dollars, fluctuations in currency exchange rates could cause the Company's products to become relatively more expensive to end users in a particular country, leading to pressure to reduce the U.S. dollar denominated price to the Company's OEM customers, which could in turn result in a reduction in net revenue and profitability. In addition, to the extent that an increased portion the Company's sales are denominated in foreign currencies, the Company could be exposed to currency exchange risks. Other risks inherent in international sales include unexpected changes in regulatory requirements, tariffs and other trade barriers and uncertainties relative to regional circumstances. These risks, and in particular risks related to the economic circumstances in Japan, could have a material adverse affect on the Company's business, operating results and financial condition. In addition, the Company's business, operating results and financial condition would be materially adversely affected if foreign markets do not continue to develop. DEPENDENCE ON KEY PERSONNEL. Because of the nature of the Company's business, the Company is highly dependent on the continued service of, and on its ability to attract and retain, qualified technical, marketing, sales and managerial personnel, including senior members of management. The competition for such personnel is intense, and the loss of any of such persons, as well as the failure to recruit additional key technical and sales personnel in a timely manner, would have a material adverse effect on the Company's business and operating results. There can be no assurance that the Company will be able to continue to attract and retain the qualified personnel necessary for the development of its business. The Company currently does not have employment contracts with any of its employees and does not maintain key person life insurance policies on any of its employees. The Company is highly dependent on the services of its Executive Officers. The loss of service of any of these executive officers could have a material adverse effect on the Company's business. 15 PART II ITEM 1. LEGAL PROCEEDINGS In January 1999, two class action complaints were filed in the United States District Court for the Northern District of California against the Company, certain of its officers and directors, and certain underwriters. The complaints allege that defendants made false and misleading statements about the Company's business condition and prospects during a class period of January 7, 1997 - October 13, 1998, and assert claims for violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The complaints in both actions seek damages of an unspecified amount. There has been no discovery to date and no trial is scheduled in these actions. On December 20, 1999, Electronics For Imaging ("EFI") filed a complaint in the United States District Court for the Northern District of California against the Company. The complaint alleges that the defendant's products infringe upon three EFI patents. The suit is aimed at enforcing patents in the areas of color management, color calibrations, and continuous printing technologies. On January 10, 2000, the Company filed a counter complaint in the United States District Court for the Northern California District of California against EFI. The complaint alleges EFI infringed upon a Company patent. The EFI litigation is in the initial stages of discovery. No trial date has been set. The Company believes it has meritorious defenses in all these actions and intends to defend them vigorously. Failure by the Company to obtain a favorable resolution of the claims set forth in these actions could have a material adverse affect on the Company's business, results of operations and financial condition. Currently, the amount of such material effect cannot be reasonably estimated. ITEM 2. CHANGES IN SECURITIES NONE ITEM 3. DEFAULT UPON SENIOR SECURITIES NONE ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Company's Annual Meeting of Shareholders held on May 24, 2000, Mark Hill and Peter Y. Chung were elected to serve as Class I directors of the Company with 12,242,902 and 12,242,502 votes for and 22,774 and 23,174 votes withheld, respectively. Mssrs. Hill and Chung will serve for a three-year term expiring upon the Annual Meeting of Stockholders in 2003. ITEM 5. OTHER INFORMATION NONE ITEM 6. EXHIBITS 27.1 FINANCIAL DATA SCHEDULE REPORTS ON FOR 8-K NONE 16 SIGNATURE Pursuant to the requirements of the Securities Act of 1934, this report has been signed and thereunto duly authorized, in the City of Sunnyvale, State of California, on August 14, 2000. SPLASH TECHNOLOGY HOLDINGS, INC By: /s/ Kevin MACGILLIVRAY ------------------------------------- Kevin Macgillivray President and Chief Executive Officer 17

SPLASH TECHNOLOGY HOLDINGS INC 10-Q