FAUXCOM INC.
In the information technology industry, change is the name of the game. As a result, success is dependent on a company's ability to anticipate change and its flexibility to manage it. Over the years, change has been both a friend and a foe to FauxCom. In 1987, the Company was a leading manufacturer of dedicated word processing systems; by 1989, it had gone completely out of the business. In 1986, FauxCom acquired a personal computer manufacturer and enjoyed several years of growth in a highmargin business; by 1992, the industry had shifted to a highvolume, lowmargin business where annual unit sales had to increase substantially in order to maintain operating profits at prioryear levels. In 1989, the Company entered the emerging system design and installation business; by 1993, competition had increased to where differentiation now is based primarily on price.
By any measure, 1993 was a successful year for FauxCom. Revenue grew to $2.5 billion, a 55 percent increase over 1992, while core earnings increased to $122 million from $59 million. Core earnings per share totaled $2.38 in 1993 compared with $1.19 in 1992. Cash flows from operating activities, both core and noncore, totaled $155 million. These results reflect the Company's ability to both anticipate and manage change. The PC Segment maintained its reputation for innovation and quality through the introduction of several lowpriced products that gained immediate market acceptance as well as its decision to recall quickly and discontinue a highend product line when reliability concerns surfaced.
Distribution channels were expanded with the successful launch of a direct marketing program as well as increased sales efforts in markets outside of the United States. Cost controls and productivity improvements allowed the Company to increase unit sales by over 80 percent while the average number of employees decreased. The Integration Segment continued to develop, with growth coming from both internal efforts as well as from the acquisition of the Chicagobased InfoSource Consulting Group. In the accompanying report, we have summarized our view of the information technology industry, what changes lie ahead as well as our plans to deal with those changes. February 15, 1994
(in millions except share 1993 1992 1991 1990 1989
data)
FauxCom, Inc. and
Subsidiaries
Revenue 2,484 1,605 1,288 1,231 941
Core earnings 122 59 57 90 74
Net income (loss) 96 74 52 89 (139)
Long-term debt 146 168 113 41 ;
Stockholders' equity 862 753 677 629 768
Current ratio 2.32 2.72 2.86 2.67 3.61
Ratio of debt to total 0.14 0.18 0.17 0.09 0.00
capitalization
Ratio of revenue to 1.91 1.47 1.38 1.61 1.44
average assets
Cash flows provided by 125 174 98 138 72
core operating activities
Capital expenditures 124 148 125 96 200
Weighted average shares 51,200 49,700 48,300 47,100 46,200
outstanding (thousands)
Per share data
Core earnings 2.38 1.19 1.18 1.91 1.60
Net income (loss) 1.88 1.49 1.07 1.89 (3.01)
Cash flows from core 2.44 3.50 2.03 2.93 1.56
operating activities
1 Non-core expense in 1989 includes a $212 million after-tax charge relating to the Company's word processing segment, which was classified as a discontinued operation.
(in millions except 1993 1992 1991 1990 1989 share data) PC Segment Data Revenue 2,277 1,441 1,181 1,169 890 Core earnings 118 60 63 95 79 Gross margin (%) 28.1 33.9 41.2 44.0 44.2 Working capital 393 331 269 218 187 Property, plant, and 373 355 320 277 251 equipment Cash flows provided by 122 167 103 139 68 core operating activities PC units sold 1,085 588 347 308 238 (thousands) Server units sold 27 15 8 4 1 (thousands) Average number of 3,439 3,741 4,725 4,910 4,480 employees Revenue per employee 662 385 250 238 199 (thousands)
(in millions) 1993 1992 1991 1990 1989 Integration Segment Data Revenue 207 164 107 62 51 Core earnings 13 7 2 2 2 Gross margin (%) 25.6 23.2 22.4 27.4 27.4 Working capital 44 32 27 12 10 Cash flows provided by 18 11 (1) 5 4 core operating activities Number of design and 3,060 2,667 2,046 1,359 1,438 installation contracts Number of system 7,714 5,538 3,016 1,551 943 maintenance contracts Average number of 1,518 1,400 1,170 760 735 employees Revenue per employee 136 117 91 82 69 (thousands) Design and installation 24 31 19 11 7 contract backlog
CONSOLIDATED FINANCIAL STATEMENTS
For the years ended December 31, 1993 and 1992 (in millions) 1993 1992 Assets Current assets Cash and equivalents 44 46 Accounts receivable, net 427 285 Inventories, net 361 244 Deferred tax assets 19 16 Other core current assets 18 15 Non-core current assets ; 53 869 659 Property, plant, and 396 381 equipment Other long-term assets 137 135 Non-core assets 10 9 Total assets 1,412 1,184 Liabilities Current liabilities Accounts payable and 363 238 accrued expenses Income tax payable 9 2 Current portion of 3 2 long-term debt 375 242 Long-term debt 143 166 Deferred tax liabilities 32 23 Total liabilities 550 431 Stockholders' Equity Common stock, $1 par value; shares authorized 80 million; shares issued and outstanding 48,520,000 and 49 47 47,100,000, respectively Additional paid-in capital 419 401 Retained earnings 411 315 Cumulative comprehensive (17) (10) income excluded from net income Total stockholders' equity 862 753 Total liabilities and 1,412 1,184 stockholders' equity
The accompanying notes to consolidated financial statements are an integral part of these statements.
For the years ended
December 31, 1993, and
1992
(in millions except per 1993 1992
share data)
Revenue 2,484 $ 1,605
Cost of revenue 1,792 1,079
Gross margin 692 526
Operating expenses
Selling and marketing 193 156
Depreciation and 130 133
amortization
Research and development 88 75
General and administrative 77 64
Pre-tax core earnings 488 428
204 98
Income taxes related to 39
core earnings
Core earnings 122 59
Non-core items and (45) 25
interest expense
Income tax expense (19) 10
(benefit) related to
non-core items and
interest expense
(26) 15
Net income 96 $ 74
Per share
Core earnings 2.38 $ 1.19
Net income 1.88 1.49
Weighted average shares 51,200 49,700
outstanding (thousands)
The accompanying notes to consolidated financial statements are an integral part of these statements.
For the years ended December 31, 1993 and 1992 (in millions) 1993 1992 Cash flows from operating activities Core Core earnings 122 59 Depreciation and amortization 130 133 Deferred tax provision (3) (2) (Increase) decrease in accounts (141) (54) receivable, net (Increase) decrease in inventories, (110) (18) net (Increase) decrease in other current (2) 5 assets Increase (decrease) in accounts 122 54 payable and accrued expenses Increase (decrease) in income tax 7 (3) payable Cash flows provided by core 125 174 activities Non-core Non-core items and interest expense (26) 15 Deferred tax provision 9 3 Realized gain on sale of land held (6) ; for investment, net of income taxes (Increase) decrease in accounts 53 (53) receivable from U.S. Department of Justice Cash flows provided by (used in) 30 (35) non-core activities Cash flows from investing activities Purchases of property, plant, and (124) (148) equipment Investment in joint venture ; (15) Loan to supplier (15) ; Acquisition of subsidiaries (8) (10) Proceeds from sale of land held for 7 ; investment, net of income taxes Cash flows used in investing (140) (173) activities Cash flows from financing activities Proceeds from long-term debt 147 173 borrowings Repayments of long-term debt (170) (143) Proceeds from exercise of stock 6 6 options Cash flows provided by (used in) (17) 36 financing activities Net increase (decrease) in cash (2) 2 Cash and equivalents at beginning of 46 44 year Cash and equivalents at end of year 44 46 Cash flows from core activities per 2.44 3.50 share
The accompanying notes to consolidated financial statements are an integral part of these statements.
Cumulative
Paid-in Retained comprehensive
Shares Common capital earnings income
(in millions) stock excluded
from net
income
Balances at 46 46 387 241 3 677
December 31,
1991
Net income ; ; ; 74 ; 74
Tax benefit ; ; 8 ; ; 8
realized from
stock purchase
plans
Currency ; ; ; ; (13) (13)
translation
adjustment, net
of income taxes
Exercise of 1 1 6 ; ; 7
stock options
Balances at 47 47 401 315 (10) 753
December 31,
1992
Net income ; ; ; ; 96
Tax benefit ; ; 14 ; 14
realized from
stock purchase
plans
Currency ; ; ; ; (8) (8)
translation
adjustment, net
of income taxes
Changes in
unrealized
appreciation of
land held for
investment, net ; ; ; ; 1
of income taxes
Exercise of 2 2 4 6
stock options
Balances at 49 49 419 411 (17) 862
December 31,
1993
The accompanying notes to consolidated financial statements are an integral part of these statements.
Note 1. Significant Accounting Policies The following paragraphs summarize the significant accounting policies used in the preparation of the consolidated financial statements that the Company has selected from acceptable alternative accounting principles.
Marketable securities with original maturities of three months or less are carried at cost plus accrued interest, which approximates market value.
Inventories are stated at the lower of cost or market, cost being determined on a firstin, firstout basis.
Depreciation and amortization of property, plant, equipment, and intangibles are computed by applying the straightline method over the following estimated useful lives.
Asset Category Estimated Useful
Lives.
Buildings 10 years
Machinery and 5 years
equipment
Furniture and 5 years
fixtures
Goodwill 5 years
Intangible assets Life of asset
The financial statements distinguish between core and noncore assets, liabilities, revenues, expenses, and cash flows. Core items are used in or result from continuing, recurring, and usual operating activities. In contrast, items in the noncore category are used in or result from nonrecurring, unusual, and infrequent transactions or events and discontinued operations. Noncore earnings and cash flows also include the effects of interest income and expense. Noncore assets and liabilities are recorded at fair value with changes in unrealized appreciation or depreciation charged or credited directly to stockholders' equity. Land held for investment is the Company's only noncore asset. The accompanying balance sheet includes no noncore liabilities.
The Company recognizes revenue at the time products are shipped or services are provided. Provision is made currently for estimated product returns that may occur under programs the Company has with certain thirdparty resellers as well as for the estimated cost of product warranties.
The Company's foreign subsidiaries use the local currency as the functional currency for financial reporting purposes. Accordingly, local currency financial statements are translated into dollars at current rates of exchange with gains or losses resulting from translation included in the determination of comprehensive income. Cumulative translation adjustments are reflected in a separate component of stockholders' equity. The Company periodically enters into forward and option contracts as one means of hedging its exposure to changes in foreign currency exchange rates. Gains and losses on these contracts are deferred and recognized as offsets to the foreign exchange gains and losses resulting from the designated transactions.
The Company recognizes contingent losses that are both probable and estimable. In this context, the Company defines probability as events that are more likely than not to occur.
Note 2. Acquisitions The Company acquired InfoSource, Inc. in January 1993 for $8 million and WestNet, Inc. in January 1992 for $10 million. These transactions were accounted for as purchase business combinations and, as a result, the amount by which the respective purchase prices exceeded the fair value of identifiable assets acquired and liabilities assumed was recorded as goodwill. Goodwill resulting from these acquisitions totaled $4.8 million and $5.3 million, respectively. Pro forma information reflecting the InfoSource acquisition as of January 1, 1992, has not been provided as the impact of that acquisition on 1992 pro forma core earnings is not significant.
Note 3. Inventories:
Inventories consisted of the following at December 31.
(in millions) 1993 1992
Purchased $ 214 $ 137
components and
materials
Workinprocess 72 47
Finished goods 90 75
376 259
Less: valuation (15) (15)
allowance
$ 361 $244
Note 4. Property, Plant, and Equipment Property, plant, and equipment consisted of the following at December 31.
(in millions) 1993 1992
Land $ 10 $ 10
Buildings 345 254
Equipment 350 332
Furniture and 73 55
fixtures
778 651
Less: (382) (270)
Accumulated
depreciation
$ 396 $ 381
Note 5. Other LongTerm Assets Other longterm assets consisted of the following at December 31.
(in millions) 1993 1992 Investment in $80 $ 80 Predicta Goodwill and 42 53 other intangibles Loan to supplier 15 ; Prepaid pension ; 2 cost $ 137 $ 135
In 1989, the Company joined with nine of its primary component suppliers to form Predicta, a research and development partnership whose primary objective is to develop advanced PC technology. Under terms of the partnership agreement, each participant was required to fund its share of the permanent capital needed to develop an R&D facility in North Carolina. The Company's share of such capital contributions totaled $80 million and is recorded as its investment in Predicta. The Company also is required to fund its pro rata share of Predicta's annual operating costs. The Company's share of these costs, which totaled $40 million in 1993 and $25 million in 1992, is classified within core earnings as R&D expense. Selected financial data for Predicta as of and for the years ended December 31 are as follows.
(in millions) 1993 1992 Research contract $ 400 $ 250 revenue Core earnings 3 (4) (loss) Net income (loss) 3 (4) Working capital 210 193 Total assets 580 607 Partner capital 800 800
In December 1993, the Company loaned $15 million to its primary disk drive supplier to finance the expansion of the supplier's primary manufacturing facility to support the Company's increasing requirements for disk drives. The loan, which bears interest at prime plus 1 percent and is secured by the related facility expansion, is due in full in December 1998. Based on the supplier's financial condition and the fact that the interest rate varies with market conditions, the Company believes the fair value of the loan approximates its carrying value.
Note 6. LongTerm Debt The Company maintains a line of credit with a group of banks that permits borrowings of up to $250 million. The line of credit expires in June 1995 at which time amounts outstanding become due and payable. Interest is payable at either the agent bank's prime rate or the shortterm Eurodollar interbank offered rate (6 percent and 7.5 percent at December 31, 1993, and 1992, respectively).
The agreement provides for a commitment fee at an annual rate of onequarter of 1 percent on the unused portion of the bank's commitment and a facility fee of onequarter of 1 percent on the entire commitment. Borrowings outstanding under this agreement totaled $139 million and $160 million at December 31, 1993, and 1992, respectively. The line of credit agreement requires the Company to maintain compliance with certain financial covenants. The Company's compliance with these covenants at December 31 is summarized below.
The Company leases equipment under the terms of noncancelable lease agreements, which generally do not exceed five years. The present value of future minimum lease payments, which totaled $7 million and $8 million in 1993 and 1992, respectively, is recorded as longterm debt in the accompanying consolidated balance sheet. As of December 31, 1993, these leases, which are secured by the related equipment, require future minimum payments of $4 million in 1994, $4 million in 1995, and $2 million in 1996. The fair value of borrowings outstanding under the line of credit as well as the Company's lease obligations approximate the related carrying values.
Note 7. Income Taxes Geographic sources of pretax core earnings for the years ended December 31 consisted of the following.
(in millions) 1993 1992 United States $ 155 $ 68 Foreign 49 30 $ 204 $ 98
Income tax expense for the years ended December 31 consisted of the following.
(in millions) 1993 1992 Currently payable Federal $27 $ 23 State and local 11 12 Foreign 19 13 57 48 Deferred Federal 7 (1) State and local 4 (1) 11 (2) $ 68 $ 46
A reconciliation of the United States statutory tax rate to the Company's effective tax rate on pretax core earnings for the years ended December 31 is as follows.
1993 1992
Statutory tax 35.0% 34.0%
rate
Taxes 6.0 6.0
attributable to
foreign state,
and local taxes
Research and (3.0) (2.0)
development
credits
Other, net 2.0 2.0
Effective tax 40.0% 40.0%
rate
Deferred income tax assets (liabilities) consisted of the following at December 31.
(in millions) 1993 1992
Liability for 6 4
product
warranties
Allowance for 6 4
doubtful accounts
Inventory 6 6
valuation
allowance
Other 1 2
19 16
Valuation ; ;
allowance
19 16
Depreciation (26) (18)
Other (6) (5)
(32) (23)
(13) (7)
Income tax payments totaled $50 million in 1993 and $47 million in 1992. Note 8. NonCore Items and Interest Expense Noncore items and interest expense consisted of the following for the years ended December 31.
(in millions) 1993 1992
Discontinuation of (43) ;
product line
U.S. Department of ; 38
Justice sale
Interest expense (12) (14)
Realized gain on land 9 ;
held for investment
Interest income 2 2
Interest component of (1) (1)
pension expense
(45) 25
In December 1992, the Company introduced a highend PC product for sophisticated engineering applications. Product reliability concerns surfaced shortly after introduction because of the failure of certain key component parts; as a result, the Company elected to recall the product in February 1993. After a thorough evaluation, the Company determined that the reliability concerns could not be overcome in a costeffective manner and, in March 1993, decided to discontinue the product. In connection with this decision, the Company recorded a pretax charge of $43 million to write off the product inventory and to provide for other related costs.
The Company classified this charge as a noncore item in 1993 as this was the first time in the Company's history that a product was discontinued as a result of product reliability concerns. During the fourth quarter of 1992, the Company negotiated the sale of approximately 115,000 PCs to the U.S. Department of Justice. This sale, which generated approximately $153 million of revenue and $38 million of gross profit, was classified as a noncore item due to the infrequent nature of a transaction this size. In 1989, the Company identified approximately 100 acres of land adjacent to its domestic manufacturing facility as a nonoperating asset held for investment or sale. At December 31, 1992, the carrying amount of the land approximated $9 million while the related unrealized appreciation totaled $7 million on a pretax basis. In March 1993, the U.S. Department of Transportation announced that a new regional airport would be developed within five miles of the property.
This announcement had a positive impact on land values in the area, including the value of the Company's land. The Company obtained an independent appraisal of the land in June 1993, which indicated a value of $20 million, assuming that the property could be sold for the development of light industrial property. Based on the results of this appraisal, the land was written up to its appraisal value. In late 1993, the Company sold 50 acres of the property for $10 million, realizing a pretax gain of $9 million, which is included as a noncore item. The following table summarizes 1993 activity relating to the Company's land held for investment or sale.
Historical Unrealized Carrying (in millions) Cost Appreciation Amount Balance, December 31, 2 7 9 1992 Increase in value resulting from airport ; 11 11 announcement Sale of 50 acres (1) (9) (10) Balance, December 31, 1 9 10 1993
Unrealized appreciation, which approximated $5 million on an aftertax basis at December 31, 1993, is included in cumulative comprehensive income excluded from net income in the accompanying consolidated balance sheet. Interest payments totaled $11 million in 1993 and $12 million in 1992.
Note 9. Employee Stock Option Plan At December 31, 1993, there were 15 million shares of the Company's common stock reserved for issuance under an employee stock option plan that had been approved by the stockholders in 1984. Options are granted at the fair market value of the Company's common stock on the date of grant; as a result, no compensation expense has been recorded. Options granted under the plan vest after five years and must be exercised within ten years. At December 31, 1993, 230,000 options were exercisable at an average price of $3 per share. Option activity for the years ended December 31, 1992, and 1993 is as follows.
Weighted
Option Exercise Average
Shares Price Range Exercise
(in Per Share Price
thousands)
Outstanding, December 7,330 328 7.45
31, 1991
1992 activity
Grants 1,500 1820 19.00
Exercises (1,550) 317 4.23
Cancellations (110) 328 12.05
Outstanding, December 7,170 328 10.65
31, 1992
1993 activity
Grants 1,500 2832 30.00
Exercises (1,420) 328 3.79
Cancellations (20) 328 3.00
Outstanding, December 7,230 332 16.04
31, 1993
Option shares outstanding under the plan at December 31, 1993, were held by 225 individuals. If all such shares were exercised as of that date, the number of common shares outstanding would increase by approximately 13%.
Note 10. Employee Benefits The Company sponsors a definedbenefit pension plan that covers substantially all of its U.S. employees. Benefits are based on years of service or the employee's compensation during the last five years of employment. Participants become fully vested on attaining five years of service. The Company's policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. The Company also provides substantially all of its employees who retire with ten or more years of service with health insurance benefits. Benefits under this plan are based on years of service and in some cases require employee contributions. Benefits under this plan generally are paid as covered expenses are incurred. Actuarial assumptions used in the determination of pension and retiree health costs and the related benefit obligations were as follows.
1993 1992
Plan cost for the year
Discount rate 8.5% 9.0%
Compensation increases .5 6.0
Return on assets 9.5 9.5
Health care cost trend (a) 12.0 12.5
Benefit obligations at
yearend
Discount rate 7.25 9.0
Compensation increases 4.25 6.0
Health care cost trend (a) 9.5 12.0
(a) Gradually declining to
6.6% after 2005.
Employer costs and funding for the pension and retiree health plans are as follows.
(in millions) 1993 1992 Plan cost Pension plan 6 5 Retiree health plan 3 2 Plan funding Pension plan 6 5 Retiree health plan 1 1
The following table compares the market value of assets with the present value of the related benefit obligations.
(in millions) 1993 1992 Pension plan Market value of assets 48 44 Projected benefit 46 46 obligation Retiree health plan Market value of assets ; ; Accumulated benefit 25 22 obligation
The actual return on pension plan assets was 12 percent in 1993 and 11.5 percent in 1992. In February 1992, the Company instituted a definedcontribution retirement plan that complies with section 401(k) of the U.S. Internal Revenue Code. All U.S. employees who have completed one year of service are eligible to participate in the plan. The plan provides for Company matching contributions of 25 percent of employees' voluntary contributions up to 10 percent of their income. Company matching contributions approximated $2 million and $1.5 million in 1993 and 1992, respectively, while employee contributions totaled $8 million and $6 million, respectively.
Note 11. Measurement Uncertainties ; Litigation
Product liability ; As of December 31, 1993, the Company had been named in a total of 28 lawsuits by individuals who claimed the keyboards on several of the Company's PC products caused them to suffer repetitive stressrelated injuries. Aggregate damages claimed in these suits approximate $20 million. These suits are all in the relatively early stages and trial dates have not been set. The Company previously had been involved in three lawsuits of a similar nature.
The first went to trial in 1990, with the jury finding in favor of the plaintiff and awarding damages of $200,000. The Company appealed this decision; however, the appellate court affirmed the trial court's ruling. The two remaining cases went to trial in 1992 with verdicts reached in favor of the Company. The Company believes its keyboards are not responsible for the alleged injuries and intends to defend itself vigorously in these matters. Although its experience in this type of suit has been favorable to date, should the pending cases go to trial, it is reasonably possible that decisions will be reached that are adverse to the Company.
Patent infringement ; In October 1993, Mortan Electronics, Inc. (MEI) filed a patent infringement suit against the Company in U.S. district court seeking unspecified damages and an injunction prohibiting the Company from selling PCs that allegedly infringe on certain of MEI's patents. The Company denies MEI's allegations and is vigorously defending itself in this matter. The Company has been successful in previous patent infringement matters; however, the related defense costs have been substantial. In 1993, the Company accrued $2.5 million in costs, primarily legal fees, which it estimates will be incurred in defense of this matter.
Environmental ; In September 1992, the Company received notification from the U.S. Environmental Protection Agency (EPA) that it may be a potentially responsible party (PRP) at the Middlesex Township Landfill Superfund Site as a result of its waste disposal practices from 1985 to 1987. The Company used an independent waste disposal company to dispose of certain manufacturing solvents during this period. The Company's records indicate that its involvement in the site is insignificant. The Company provided the EPA with the information requested in its notification in January 1993. Additionally, the Company has joined with other PRPs to fund costs relating to a preliminary investigation of the site.
The Company's share of such costs to date has been insignificant. Based on information currently available as well as the opinion of counsel, the ultimate resolution of legal matters affecting the Company is not expected to affect its financial position materially. Litigation and defense costs, however, could have a significant impact on core earnings in one or more future years.
Note 12. Measurement Uncertainties ; Valuation Allowances
Allowance for doubtful accounts ; The Company records a valuation allowance for accounts receivable that ultimately may not be collected. The Company regularly evaluates the allowance based on historical loss experience, specific problem accounts, and general economic conditions in its geographic markets, and adjustments are charged or credited to income. Although the Company believes the allowance is adequate to provide for losses that are inherent in the yearend accounts receivable balance, there is a possibility that actual losses will differ from the amount estimated. An analysis of activity in the allowance for doubtful accounts during 1993 along with other data relating to accounts receivable is as follows.
PC Integration
(in millions) Segment Segment
Total
Allowance for doubtful
accounts
Beginning of year 8.0 1.5 9.5
Provision for doubtful 9.1 2.1 11.2
accounts
Chargeoffs of bad debts (3.9) (1.2) (5.1)
End of year 13.2 2.4 15.6
Accounts receivable
(before
allowance)
Beginning of year 256 39 295
End of year 388 54 443
Days sales outstanding
Beginning of year 62 82 65
End of year 60 92 64
On a consolidated basis, the provision for doubtful accounts increased by 51 percent to $11.2 million in 1993 from $7.4 million in 1992 because of increased sales activity and the resulting growth in the yearend accounts receivable balance. Chargeoffs during 1993 totaled $5.1 million compared with $3.2 million in 1992, with the increase primarily resulting from the bankruptcy in early 1993 of one of the PC Segment's regional distributors.
Days sales outstanding for the PC Segment improved during the year in spite of increased sales as accounts less than 60 days represented 95 percent of the receivable balance at the end of the year compared with 89 percent at the beginning of the year. The increase in days sales outstanding for the Integration Segment is attributable primarily to competitive pressures that have required the Segment to offer extended payment terms on design and installation contracts. Accounts less than 60 days for the Integration Segment represented 71 percent of the receivable balance at the end of the year compared with 77 percent at the beginning of the year.
Inventory valuation allowance ; With the rapid rate of technological change in the computer industry, the risk of excess or obsolete inventory is relatively high. Additionally, substantial decreases in unit selling prices increase the risk that product costs may exceed such prices. The Company closely monitors the market to anticipate product introductions that could have an adverse impact on sales of its existing product line. Also, perunit margins are analyzed to determine if product costs exceed the related net realizable values. The Company maintains a valuation allowance to ensure that the inventories of its PC Segment are stated at the lower of cost or market.
On a regular basis, agings of inventories by product type, both on hand and at key points within the Company's distribution channels, are prepared and compared with expected customer demand. If sales for certain products are not expected to materialize or if the Company has knowledge of impending product introductions or reductions in unit selling prices, the aggregate exposure is determined and, if appropriate, the valuation allowance is increased with a charge to income. Although the Company believe its inventories are stated at the lower of cost or market, it is possible that presently unforeseen events could impair the Company's ability to recover fully the net inventory carrying amount. An analysis of activity in the inventory valuation allowance during 1993 along with other data relating to inventories is as follows.
(in millions) Inventory valuation allowance Beginning of year $ 15.0 Provision to reduce 8.5 inventory carrying values Amounts charged against (8.5) the allowance End of year $ 15.0 Inventory (before allowance) Beginning of year $ 259 End of year $ 376 Days of supply on hand Beginning of year 82 End of year 73
Amounts charged against the allowance, which increased by $4 million to $8.5 million in 1993, related to products in the lower end of the PC product line, which were replaced by products released during the fourth quarter featuring a more powerful microprocessor. The decrease in days of supply on hand is attributable to increased sales as well as programs designed to reduce average inventory levels. Inventories pertaining to the Company's Integration Segment are insignificant.
Note 13. Measurement Uncertainties ; Liability for Product Warranties In 1991, the Company began providing its PC customers with a threeyear unconditional warranty for parts and service. The Company accrues the cost of future warranty repairs at the time of sale using the ratio of warranty repair expense to revenue for the preceding 24 months. On a quarterly basis, warranty claim frequency and severity are analyzed to determine if adjustments to the liability for product warranties are required.
Although the Company believes the liability for product warranties at December 31, 1993, is adequate to provide for the cost of future warranty services pertaining to 19911993 sales, there is a possibility the frequency and severity of such claims will differ from amounts assumed and the cost of such services will be more or less than the amount currently provided. The liability for product warranties approximated $15 million and $9 million at December 31, 1993, and 1992, respectively, while warranty expense approximated $10 million in 1993 and $7 million in 1992. The following table provides information on actual and expected warranty claims for 19911993 sales.
(in 1991 1992 1993
millions)
Estimated 10,650 17,950 24,464
warranty
claims
Warranty
claims
processed
1991 533 ; ;
1992 2,662 898 ;
1993 4,793 4,488 1,223
7,988 5,386 1,223
Estimated
warranty
claims
to be
processed
after
December 2,662 12,564 23,241
31, 1993
The weighted average cost per warranty claim assumed on sales in 19911993 was $382 while the actual average cost of warranty claims processed was $228 in 1993 and $597 in 1992. The unusually high cost per claim in 1992 was attributable to the failure of certain components in one of the Company's server products, which has been rectified.
Note 14. Measurement Uncertainties ; Concentration of Credit Risk Concentration of credit risk with regard to shortterm investments is not considered to be significant due to the Company's cash management policies. These policies restrict investments to lowrisk, highly liquid securities (that is, commercial paper, money market instruments, etc.), outline issuer credit requirements, and limit the amount that may be invested in any one issuer. The Company's accounts receivable are spread among a large number of customers that operate in many different industries and geographic regions. Accordingly, concentration of credit risk is not significant. In 1992, the U.S. Department of Justice accounted for 15 percent of the yearend accounts receivable balance.
This amount was collected in February 1993. At December 31, 1993, and 1992, the Company had entered into forward exchange contracts with several large financial institutions to sell $13 million and $11 million of foreign currencies, respectively. Those contracts, which are valued in U.S. dollars based on yearend spot rates, had maturity dates ranging from three to six months. In the unlikely event that the financial institutions fail to honor one or more of the contracts involved in these transactions, losses would be limited to the difference in exchange rates between the time the contract was entered into and the time it was closed out. At December 31, 1993, the Company's aggregate exposure under these contracts was not significant.
Note 15. Segment Financial Data The Company's operations are conducted primarily through its two industry segments, PC and Integration, while certain business functions such as treasury, income taxes, and legal affairs are conducted at the corporate level. The following schedules present disaggregated income and cash flow information for the PC Segment and the Integration Segment. Intersegment transactions are insignificant.
PC Integrative
Segment Segment (in millions) 1993 1992 1993 1992
Revenue
Computer sales 2,277 1,441 ; ;
Design and installation ; ; 153 128
services
System maintenance ; ; 54 36
services
2,277 1,441 207 164
Cost of revenue
Purchased components, 1,477 848 24 18
materials
Compensation and 84 67 119 100
benefits
Other 77 38 11 8
1,638 953 154 126
Gross margin 639 488 53 38
Selling and marketing
Compensation and 93 109 6 5
benefits
Advertising 81 33 2 1
Other 8 4 2 3
182 146 10 9
Depreciation and 117 120 11 11
amortization
Research and 88 75 ; ;
development
General and
administrative
Compensation and 31 27 6 5
benefits
Other 25 20 3 2
56 47 9 7
Pretax core earnings 196 100 23 11
Income taxes related to (78) (40) (10) (4)
core earnings
Core earnings 118 60 13 7
Noncore items and (45) 38 ;
interest expense
Cash flows provided by
(used in)
operating activities
Core 122 167 18 11
Noncore 26 (30) ; ;
A reconciliation of the segment data to the consolidated financial statements is as follows (intersegment transactions are insignificant).
(in millions)
Pretax core earnings
(loss)
PC Segment 196 100
Integration Segment 23 11
Corporate (15) (13)
204 98
Income tax expense 82 39
Core earnings 122 59
Noncore items and
interest expense
PC Segment (45) 38
Corporate ; (13)
(45) 25
Income tax expense (19) 10
(benefit)
(26) 15
Net income 96 74
The PC Segment manufactures PCs and network servers at plants in Boston, Massachusetts, and Dublin, Ireland, for sale primarily in the United States and Western Europe. The following table summarizes revenue and gross margin data by manufacturing plant and by country for the years ended December 31, 1993, and 1992.
1993 1992
(in million % %
$'s)
By Plant
Revenue
Boston 1,593 70.0 981 68.1
Dublin 684 30.0 460 31.9
2,277 100.0 1,441 100.0
Gross
margin
Boston 444 69.5 330 67.6
Dublin 195 30.5 158 32.4
639 100.0 488 100.0
By Country
Revenue
United 1,020 44.8 617 42.8
States
United 301 13.2 201 13.9
Kingdom
Canada 254 11.2 158 11.0
France 243 10.7 184 12.8
Germany 197 8.6 128 8.9
All other 262 11.5 153 10.6
2,277 100.0 1,441 100.0
Gross
margin
United 284 27.8 209 33.9
States
United 86 28.6 69 34.3
Kingdom
Canada 71 28.0 53 33.6
France 69 28.4 63 34.2
Germany 56 28.4 43 33.6
All other 73 27.9 51 33.3
639 488
The Company believes the opportunities and risks of its Integration Segment do not vary on the basis of geographic locations.
Note 16. Leases The Company leases office space under agreements that expire over the next seven years. Minimum payments for operating leases having initial or remaining noncancelable terms in excess of one year are as follows.
(in millions) 1994 $ 7 1995 6 1996 6 1997 5 1998 4 Remainder 7 $ 35
Total net expense for all operating leases amounted to approximately $8 million and $7 million for 1993 and 1992, respectively. Management's Analysis of Financial and NonFinancial Data PC SEGMENT The information summarized below relates to the PC Segment and is the basis for management's analysis, which follows.
1993 1992
(dollars in % %
millions)
Revenue 2,277 100.0 1,441 100.0
Cost of revenue 1,638 71.9 953 66.1
Gross margin 639 28.1 488 33.9
Selling and 182 8.0 146 10.1
marketing
Depreciation and 117 5.1 120 8.3
amortization
Research and 5.2
development
General and 56 2.5 47 3.4
administrative
Pretax core earnings 196 8.6 100 6.9
Income taxes 78 3.4 40 2.8
Core earnings 118 5.2% 60 4.1%
Revenue PC Segment revenue increased by $836 million or 58 percent over 1992 revenue of $1,441 million. The following table summarizes the reasons for that increase.
(in millions) PCs Servers Total 1992 Revenue 1,323 118 1,441 Revenue changes attributable to Increase in units 1,125 95 1,220 sold Decrease in average (374) (10) (384) unit prices 1993 Revenue 2,074 203 2,277
The composition of the Segment's product line has shifted significantly from 1990 when it focused on the highpriced end of the market. Intense price competition forced the Segment to develop lowpriced products to remain competitive. The Segment's introduction of lowpriced PCs occurred in late 1991. Although fierce price cutting has continued, as demonstrated by the 28 percent drop in unit prices in 1992 and an additional 15 percent drop experienced in 1993, the Segment competes effectively in the lowpriced portion of the market, as evidenced by the 85 percent increase in PC units sold in 1993.
Lowpriced products accounted for approximately 30 percent of 1993 unit sales and are expected to be 35 to 40 percent of total unit sales in 1994. The Segment introduced its network server products in late 1989, and sales have increased to approximately 9 percent of total revenue. Average unit prices decreased slightly in 1993 ; a significant change from the 34 percent drop experienced in 1992. Although pricing pressure is expected to continue, it should be less significant than noted in prior years as a number of manufacturers have dropped this product because of the significant R&D requirements. Server unit sales increased by 80 percent over 1992 primarily as a result of the Segment's introduction of its FNet server line in the fourth quarter of 1992.
FNet unit sales accounted for 55 percent of total server unit sales in 1993. During the fourth quarter of 1992, the Segment sold approximately 115,000 PCs to the Justice Department. As described in Note 8 to the consolidated financial statements, this transaction was treated as a noncore item and, therefore, its impact is not included in the foregoing statistics. Gross Margin The Segment's gross margin increased by $151 million or 31 percent over 1992 levels; however, gross margin as a percentage of revenue declined. Substantially higher unit volumes could not offset the lower perunit contributions caused by continuing price reductions as well as the shift in the sales mix to a higher percentage of lower priced, lower margin products. These factors are illustrated in the following table.
(in millions)
1992 Gross 488
Margin
Contribution
from additional
units sold in
1993
PCs 262
Servers 31
293
Decreased
contribution
caused by price
reductions
and shift in
product mix
PCs (134)
Servers (8)
(142)
1993 Gross 639
Margin
Gross margin per employee increased by $56,000 or 43 percent to $186,000 in 1993 from $130,000 in 1992. This increase is attributable to customer demand for the Segment's lower priced products as well as manufacturing process improvements made in mid1992, which allowed the Segment to attain higher production levels without a substantial increase in manufacturing employees. Unit sales per employee doubled to 323 units in 1993 from 161 units in 1992.
Cost of Revenue Cost of revenue increased by $685 million or 72 percent over 1992 levels. Purchased components and materials continue to be the most significant portion of cost of revenue, accounting for 90.2 percent of such costs in 1993 and 89 percent in 1992. The average perunit cost of purchased components and materials decreased by 7.2 percent as a result of the shifting product sales mix as well as discounts resulting from significantly higher volumes of components purchased.
Employee compensation and related expenses increased by $17 million or 25 percent over 1992 as a result of a slight increase in manufacturing employees, normal wage increases, and higher health care and worker's compensation costs. Employee costs as a percentage of revenue decreased from 1992 levels as a result of productivity improvements from the manufacturing process realignments previously described.
Other costs of revenue consist of several items that generally vary with production and sales levels. Increases in these costs as a percentage of revenue are attributable primarily to the impact of inflation.
Operating Expenses Selling and marketing expenses increased by $36 million or 25 percent over 1992. This increase resulted from increased advertising expenses and from approximately $23 million in costs associated with the direct marketing program implemented during the first half of the year. Those increases were partially offset by a $16 million decrease in employees' compensation due to staffing cuts resulting from the shift in the Segment's distribution strategy toward direct marketing programs.
R&D costs increased by $13 million or 17 percent over 1992. This increase is due primarily to a $15 million increase in the Segment's pro rata share of costs incurred by Predicta, the R&D partnership in which the Segment is a 10 percent participant. (The Segment funded $40 million of such costs in 1993 compared with $25 million in 1992.) This increase was offset by a $3 million decrease in employee compensation resulting from a 14 percent drop in the number of individuals devoted to internal efforts given, the higher level of R&D performed through Predicta. General and administrative expenses increased by $9 million or 19 percent over 1992. This increase resulted from a $5 million increase in employee compensation caused by an 8 percent increase in employees required to support significantly increased sales volumes and normal salary increases. Other costs increased by $4 million primarily due to increased data processing charges
. Changes in Financial Position The Segment invested $120 million and $140 million in property, plant, and equipment in 1993 and 1992, respectively. Expenditures in 1993 related primarily to manufacturing equipment and were split evenly between domestic and Irish manufacturing facilities. Approximately 85 percent of 1992 additions related to the initial expansion of the Irish manufacturing facility, which was required to meet increasing customer demand in European markets. The Segment anticipates that property and equipment additions will approximate $125 million in 1994.
The Segment's accounts payable balance increased from $137 million at December 31, 1992, to $229 million at yearend 1993; an increase of 67 percent, which corresponds to the 74 percent increase in purchased components and materials in 1993. The Segment's policy is to pay its suppliers within the terms of the related purchase agreements, which generally range from 15 to 45 days. The Segment also attempts to take advantage of all meaningful purchase discounts. Approximately 92 percent of the Segment's accounts payable balance was current at December 31, 1993, and 1992, respectively, with the remaining balance attributable to disputed billings that generally are resolved within sixty days.
An average net working capital investment of $.16 was required for each dollar of revenue in 1993 compared with $.19 in 1992. This decrease was attributable to sales volumes increasing at a greater rate than the net working capital investment required to support such increase.
INTEGRATION SEGMENT The information summarized below relates to the Integration Segment and is the basis for management's analysis, which follows.
1993 1992
(dollars in millions) % %
Revenue 207 100.0 164 100.0
Cost of revenue 154 74.4 126 76.8
Gross margin 53 25.6 38 23.2
General and 9 4.4 7 4.3
administrative
Selling and marketing 10 4.8 9 5.5
Depreciation and 11 5.3 11 6.7
amortization
Pretax core earnings 23 11.1 11 6.7
Income taxes 10 4.8 4 2.4
Core earnings 13 6.3% 7 4.3%
Revenue Integration Segment revenue increased by $43 million or 26 percent over 1992 revenue of $164 million. The following table summarizes the reasons for that increase.
(in millions) DI SM Total
1992 Revenue 128 36 164
Revenue increases from
InfoSource acquisition 12 ; 12
Increase in contracts 9 15 24
Increase in average
contract value 4 3 7
1993 Revenue 153 54 207
The January acquisition of the fouroffice InfoSource consulting group accounted for 53 percent of the increase in Design and Installation (DI) contracts. The increase in the average value of DI contracts is due primarily to the increasing complexities brought about by rapid changes in network technology. The increase in System Maintenance (SM) contracts is due to the Segment's ability to generate such contracts from DI clients as well as to retain existing SM clients at the time of annual renewal.
The InfoSource acquisition did not significantly affect SM revenues as such services were not offered by those offices until late in the year. The increase in average revenue per SM contract is due to price increases that went into effect in early 1993 to compensate for the increasing level of services provided. In 1993, the Segment obtained 2,853 DI contracts through competitive proposal compared with 12,480 proposals submitted, for a success rate of approximately 23 percent. This success rate represents a 15 percent improvement on the 1992 rate of 20 percent. The Segment provided services to 7,714 clients in 1993 pursuant to annual system maintenance contracts.
Of this amount, 2,125 contracts were obtained from currentyear DI clients (69 percent of 1993 DI contracts compared with 78 percent in 1992) while 5,156 contracts resulted from renewals of prioryear contracts (93 percent of prioryear contracts were renewed in 1993 compared with 94 percent in 1992). The ratio of contracts generated from currentyear DI clients declined because InfoSource did not offer system maintenance services prior to its acquisition in January 1993. These services were introduced by these offices in late 1993, and the Segment believes its target level of 75 percent will be obtained in 1994.
Backlog represents the contractual amount of revenue to be earned in the following year under DI contracts in process or in place at yearend. Backlog decreased from $31 million or 24 percent of 1992 DI revenue at December 31, 1992, to $24 million or 15 percent of 1993 DI revenue at December 31, 1993.
The $7 million decline in backlog is due primarily to the timing and size of contracts in process at yearend. The Segment does not anticipate a reduction in DI business in 1994 as evidenced by the significant increase in proposal requests received in the first two months of 1994. If the Segment's success rate on these proposals is consistent with the rate experienced in 1993, backlog at the end of the first quarter will be restored to normal levels.
Gross Margin Integration Segment gross margin as a percentage of revenue increased to 25.6 percent in 1993 from 23.2 percent in 1992. The following table summarizes the reasons for that increase.
(in millions) 1992 Gross 38 Margin Increased 19 contribution from existing field office employees Contribution from additional field office employees added 8 during the year Decrease (6) due to higher supplies and material usage Other (6) 1993 Gross 53 Margin
The increase in gross margin is due to the factors relating to the increase in revenue previously discussed and improved workforce productivity. An important measure of productivity is field office employee utilization or the ratio of hours worked on client projects to the total number of hours available for such projects.
That ratio increased to 77 percent in 1993 from 72 percent in 1992 due to the increase in system maintenance contracts, which provide a steady flow of client service opportunities, as well as concerted efforts to balance the size of the work force with client projects. Average gross margin per field office employee, which increased to $38,500 in 1993 from $30,000 in 1992, did not vary significantly by geographic location in either 1993 or 1992. Although markets currently served are expected to become more crowded, the Segment believes it will be able to maintain its margins at current levels in 1994.
Cost of Revenue Cost of revenue increased by $28 million or 22 percent over 1992 levels; however, such costs actually decreased as a percentage of revenue. As in any service business, the most significant portion of the Segment's costs relate to its work force. The composition of the work force shifted slightly from consultants to technicians as a result of the shift in revenue from design and installation to system maintenance. Administrative support staff remained unchanged because of the centralization of certain functions and productivity improvements. Average employee compensation and related expenses per employee increased due to normal rate increases and higher health care costs offset by the change in the composition of the work force. Average employee training costs increased by 18 percent to $6,500 due to the constantly changing environment.
The market for qualified consultants and technicians is extremely competitive, a situation that is expected to continue. In 1990, the Segment experienced employee turnover at an annual rate of 34 percent. In late 1991, the Segment introduced several innovative programs to retain valued employees and to identify individuals with longterm career prospects. These programs have been successful as annual turnover rates have declined to 31 percent, 27 percent, and 22 percent in 1991, 1992, and 1993, respectively. The Segment's target annual turnover rate is 18 percent.
Supplies and materials represent a variety of direct costs incurred in the performance of design, installation, and system maintenance services. Such costs increased at a rate that was slightly higher than the rate of revenue increase as a result of the increasing complexity of network systems. Occupancy costs remained unchanged between years as a result of cost controls instituted at the office level.
Operating Expenses General and administrative expenses consist primarily of employee compensation and related expenses with such costs approximating $6 million and $5 million in 1993 and 1992, respectively. The increase in these costs is attributable to normal salary increases, incentive compensation awards, and higher employee relocation costs. Sales and marketing expenses increased by 11 percent due to business expansion programs. Changes in Financial Position InfoSource, Inc., the Chicagobased consulting group, was acquired in January 1993 for $8 million or approximately three times its estimated 1993 pretax core earnings. InfoSource has offices in Chicago, Detroit, Milwaukee, and Minneapolis and through this acquisition, the Segment was able to establish an immediate presence in cities where several of its existing clients have operations. In exchange for the purchase price, the Segment obtained $1.6 million in net current assets and $2.5 million in property and equipment and assumed lease liabilities of $.9 million. Goodwill resulting from the acquisition totaled $4.8 million.
In January 1992, the Segment acquired WestNet, Inc., an eightoffice practice based in Los Angeles, for $10 million or two and a half times its estimated 1992 pretax core earnings. WestNet has offices in Los Angeles (two), San Diego, San Jose, San Francisco, Sacramento, Portland, and Seattle and provided the Segment with entry to markets in the Western United States. In exchange for the purchase price, the Segment obtained $7.6 million of property and equipment and assumed $2.9 million of liabilities, including $.2 million of net current liabilities.
Goodwill resulting from the acquisition totaled $5.3 million. The Segment invested $4.1 million and $5.4 million in property and equipment in 1993 and 1992, respectively, excluding amounts obtained in the InfoSource and WestNet acquisitions described above. Additions consist primarily of computer equipment used in providing ID and SM services as well as equipment used in internal training programs. The Segment anticipates that property and equipment additions will approximate $7 million in 1994. An average net working capital investment of $.185 was required for each dollar of revenue in 1993 compared with $.18 in 1992. This increase resulted primarily from the increase in the average number of days sales outstanding. The Segment expects its working capital investment per dollar of revenue in 1994 will remain consistent with 1993 levels.
CORPORATE The Company ended 1993 with $44 million in cash and equivalents, approximately the same amount with which it began the year. Cash generated from operating activities totaled $152 million or 18.8 percent of average stockholders' equity compared with $139 million or 19.4 percent in 1992. Currentyear operating cash flows enabled the Company to invest $124 million in property and equipment; lend $15 million to a major PC Segment supplier to facilitate the strategic expansion of the supplier's manufacturing facility; acquire the InfoSource consulting firm for $8 million and repay $23 million of outstanding borrowings. The Company's current ratio was 2.31 at yearend compared with 2.72 at the end of 1992. This decline resulted from the impact of higher accounts payable at yearend 1993 resulting from higher sales volumes coupled with the unusually large amount due from the Justice Department at yearend 1992.
Longterm debt, including the current portion, totaled $146 million at December 31, 1993, and consisted of $139 million in borrowings against the Company's revolving line of credit as well as $7 million in capitalized lease obligations. The Company's debt to capitalization ratio improved from 18.2 percent at December 31, 1992, to 14.5 percent at yearend 1993. This improvement is due to strong operating results in 1993 and the reduction in outstanding borrowings. At December 31, 1993, the Company had over $100 million in borrowing capacity under its revolving line of credit. The Company believes it has adequate resources to meet its cash requirements through 1994.
ForwardLooking Information PC SEGMENT Opportunities and Risks Including Those Resulting from Key Trends The major opportunities and risks facing the Segment result from four key trends that are affecting the PC business. The following identifies and discusses those trends and the resulting opportunities and risks.
Trend 1 ; Growth in unit sales. We expect continued growth in worldwide demand for PCs ; roughly at a rate of about 12 percent in each of the next three years. We also expect that our share of that market will increase, from about 2.8 percent in 1993 to about 3.5 percent in 1996. Thus, we expect to sell about 1.9 million machines in 1996, up about 76 percent from the 1.1 million machines we sold in 1993. Several factors could drive the growth in demand for PCs above our estimates:
(1) falling prices open new markets of individuals and smaller businesses that otherwise would not purchase PCs,
(2) emerging countries have just begun purchasing Pcs,
(3) advances in power and features enable new uses for PCs and make them ever more effective substitutes for mainframe systems, and
(4) the number of PCs eligible for replacement is growing rapidly. We are particularly uncertain about our share of the worldwide market because it is a complex function of
(1) our prices relative to those of our competitors,
(2) the market's perception of the performance, reliability, and service related to our products relative to those of our competitors, and
(3) whether we are first to market with highperforming products. In 1993, we captured market share from lowprice competitors and maintained our market share of highend PCs produced by leading PC makers. We expect those trends to continue in 1994. There are several opportunities that result from the growth in unit sales trend. First, higher unit sales, even at somewhat lower margins, means higher total margin dollars and core earnings.
Second, higher unit volume means less pressure on prices than would otherwise occur.
Third, higher unit volume encourages distribution channels to handle our product. We see little risk that the growth in PC units sold will slow in 1994. There is a greater risk that we will lose market share to competitors if, for example, we encounter serious quality problems that damage our reputation for quality and reliability, fail to introduce or are late in introducing highperformance products, or overprice our products.
Trend 2 ; Rapid innovation that improves the performance, features, and uses of the PC. We expect that dramatic improvements in performance and features that have characterized the PC industry will continue or accelerate in 1994. The following types of improvements are expected within the next few years.
Faster and more powerful PCs. Increases in the speed and power of PCs will (1) motivate current users of old PCs to upgrade to newer machines to save time and to run new applications, (2) make the PC a more effective substitute for centralized processing, (3) allow the use of new operating and applications software, and (4) enable PCs to be used for new purposes.
Improved features on PCs. A number of improvements are anticipated, such as larger, sharper color screens; smaller, lighter machines; machines that consume less power and have longer battery life; more flexible PCs that allow upgrades in microprocessors and additions to memory; PCs that communicate faster and more easily with other machines; and PCs that are physically easier to use.
Advances in software. Dramatic advances in both operating and application software will make machines even more easy to use, speed the functions that PCs currently perform, open the way for entirely new functions, and improve the ability of PCs to communicate with other machines.
Technology that enables new uses for PCs. PCs will be at the heart of the expected merger of the computer, telecommunications, and entertainment industries. New uses will include electronic memo pads and mail, news and entertainment services, and interactive video for shopping and meetings. Rapid innovation offers two opportunities for the Segment. First, the trend will continue to fuel the growth in the unit demand for PCs. With the right combination of price and functions, that growth could become explosive.
Second, rapid innovation is consistent with the Segment's strategy to be first to market with innovative and technologically superior PC products. However, rapid innovation also poses a significant risk for the Segment. Changes in technology could squeeze the Segment's ability to add value to the PC product. That risk results from two sources.
First, competitors could develop proprietary technology that the Segment would be precluded from incorporating into its products. In the current environment, PC makers generally have equal access to leadingedge technology. However, several ventures involving competitors, vendors, and software companies seek to develop proprietary PC systems. If those ventures are successful, the superior features may not be able to be incorporated in the Segment's products. We are unable to predict the success of those ventures and others that are sure to follow.
Second, component vendors could erode the Segment's ability to add value to the PC product by developing components that perform more functions. For example, vendors that build microprocessors could develop a microprocessor that performs some of the functions performed by the circuit boards now designed and built by the Segment. In the extreme case, an advanced microprocessor could eliminate the need for the Segment's circuit board. Thus, less of the PC would be produced by the Segment and more would be embodied in the components purchased from suppliers. In prior years, many component builders were new companies that needed the Segment's help in developing their components to assure the successful application and distribution of those products.
However, many established component builders now see fewer advantages to a close association with the Segment. They prefer to make their leadingedge components available to all PC makers at once to obtain the largest volume for their products. That policy undermines the Segment's ability to be first to market with leading products. The rapid innovation trend also could result in the entry of new and powerful competitors into the PC industry. Potential new uses for PCs already are attracting large and powerful companies in the telecommunication and entertainment industry. Many of those companies, and the ventures created to exploit new technology, are many times larger than the Segment and have considerable skills and resources.
We are unable to predict the longterm impact of rapid innovation on the PC industry and Segment. Within the next three years, however, we expect that the current industry structure will remain largely intact. We expect that technology will continue to fuel strong growth in unit sales. We also expect that we will have access to leading technology and will quickly incorporate that technology into our products when available. We expect that the value we add will remain about the same percentage of sales as is currently the case. Finally, we do not expect major new competitors to have a major impact on the industry within the next three years.
Trend 3 ; Falling prices. Average prices for our PCs declined 28 percent in 1992 and an additional 15 percent in 1993. Over the next three years, we expect that our average prices will decline at a more moderate rate of about 2 percent to 5 percent per year. That decline will result from the continuing shift in the mix of our products toward lowerpriced products directed to the consumer retail market.
Prices could fall faster than the moderate pace that we expect. To maintain unit sales, lowprice competitors are motivated to lower prices even more. Our ability to charge premium prices over those of lowprice competitors is a function of our reputation with customers. If customers are unwilling to pay the current premium, we will lower prices to maintain our market share. Falling prices offer both an opportunity and risk for the Segment. Falling prices help fuel the growth in unit volume because lower prices result in sales of PCs to individuals and businesses that otherwise would not buy PCs. However, falling prices may reduce the gross margin that we can earn from the sale of our products, particularly if prices fall faster than we can increase our productivity.
Trend 4 ; Better productivity. The Segment measures its overall productivity in terms of machines produced per employee. The Segment produced about 330 machines per employee in 1993, up from about 160 machines in 1992. The Segment expects that productivity will increase over the next three years so we can expand our business while maintaining our work force at about 3,300 employees. However, our primary competitors also are showing dramatic improvements in productivity. At a minimum, we must keep pace with increases in our competitors' productivity. Otherwise, prices will fall faster than productivity improves, thereby negatively affecting operating results.
Management believes the Segment will be successful if it can execute its business strategies effectively. The following discussion is structured in terms of the Segment's activities and plans for implementing its strategies. The discussion of each strategy concludes with a description of how that strategy correlates with the opportunities and risks identified in the preceding section.
First to market with innovative and technologically superior PC products. The key to the Segment's success is to incorporate emerging technologies into its products in a timely manner. The Segment works closely with its suppliers to identify emerging technologies with requisite market appeal. It also devotes substantial resources to develop proprietary technologies through internal R&D as well as through participation with Predicta. The Segment must translate these efforts into highquality, reliable products quickly to maximize advantage.
During 1993, the average length of time from when a product was determined to be commercially feasible to when it became available for sale approximated twelve months; a threemonth improvement from 1992. The Segment has established task forces both internally and with Predicta to reduce the average length of product development time to nine months in 1994. The timely introduction of highquality, innovative products will strengthen the Segment's reputation as a market leader and enable it to maximize operating results. Failure to do so will relegate the Segment to the lowvalueadded commodity portion of the market.
Widest distribution. The Segment seeks to maximize the distribution of its products through traditional channels such as dealers, valueadded resellers, and retail outlets. In 1993, the Segment embarked on a direct marketing program whereby users will be able to order products directly from the Segment using an 800 number. This program is being supported by direct mail and television advertising campaigns, which currently are being developed.
Over 50 percent of the Segment's 1993 sales were centered in North America while Western Europe accounted for 33 percent. The Segment will continue its aggressive marketing plans in those areas and also is focusing on emerging markets in Japan, South America, and Asia, which are not yet crowded and have potential for high unit volumes. As product price declines are expected to continue, it is essential for the Segment to increase its unit volumes. Direct marketing programs in its traditional markets as well as successful entry into emerging markets should provide the additional volumes necessary for continued profitable operations.
Service and support. In 1991, the Segment introduced its user support telephone service in the United States which enables users to contact the Segment via an 800 number to have questions answered in a timely manner. The program was expanded to twentyfour hours in 1992. A similar program is currently being instituted in the Segment's major European markets.
In 1991, the Segment also began offering a threeyear unconditional warranty for parts and service. The Segment closely monitors warranty claim activity, including the performance of its authorized representatives, to ensure that service is provided quickly and to identify problems with specific products. The Segment's service and support programs have proven to be costeffective ways to add value to its products. They also provide valuable information in terms of market research and help the Segment maintain its reputation for highquality, innovative products.
Image marketing. The Segment reinforces its reputation through a variety of advertising programs. Prior to 1993, the Segment's advertising efforts focused on print media and were directed primarily toward product introductions. In 1993, print ads were introduced that were not product specific but, rather, focused on the broad themes of quality products and services. In late 1993, a primetime television advertising campaign was directed at the home market with a focus on support services including the twentyfourhour user support line. Followon advertisements currently are being developed. The Segment intends to increase its television advertising campaigns in 1994.
Productivity improvement. In 1992, the Segment established process improvement groups consisting of individuals from each of its functional areas. Improvements developed by these groups were largely responsible for the dramatic increase in productivity experienced in 1993. In 1994, a new incentive compensation program was introduced that rewards employees for developing suggestions for process improvements. Additionally, productivity improvements are becoming a larger component of management's individual incentive compensation goals.
Another factor affecting productivity is the Segment's manufacturing process, which, except for the circuit board production line, is relatively unsophisticated. This lack of sophistication increases labor costs but enables the Segment to adjust its manufacturing lines quickly to accommodate new products or to meet changes in market demand for existing products. The Segment's emphasis on productivity improvements will enable it to meet the anticipated growth in unit sales and help maximize its gross margins.
The Segment's actual 1993 business performance differed from the forwardlooking information disclosed in our 1992 report in the following areas.
PC unit volume and market share. Last year's report stated that we estimated 20 percent growth in PC unit volume and growth in market share from 1.7 percent to 1.9 percent in 1993. Instead, unit volume increased 85 percent and market share increased to 2.8 percent in 1993. We underestimated unit growth for two reasons, both having to do with the 15 percent decline in average unit prices. First, we underestimated the impact that the price decline would have on opening additional markets for PCs with businesses and retail consumers who otherwise would not purchase PCs. Second, we also underestimated the impact of our pricing strategy in taking market share from competitors that offer only lowpriced products.
Employee productivity. Our plans at the beginning of 1993 for improving employee productivity were made in the context of estimates for 20 percent growth in unit volume for 1993. The additional volumes experienced in 1993 were a challenge; however, manufacturing process improvements helped us expand capacity without increasing headcount.
The major opportunities and risks facing the Segment result from four key trends affecting the industry. The following identifies and discusses those trends and the resulting opportunities and risks.
Trend 1 ; Demand for services. Through the end of 1993, the Segment viewed itself as providing two types of services ; integration services and systems maintenance. We now view integration services to design and install clientserver networks as separable from consulting services to improve clients' business performance. Furthermore, trends in the demand for consulting, integration, and maintenance services differ. Each is separately discussed below.
The potential for continued growth in the demand for consulting services is substantial. There are two key factors giving rise to that demand. One is that PC technology already vastly exceeds organizations' ability to use it effectively, and the pace of innovations in PC technology shows no sign of abating. The other factor is the opportunity to use PC technology to improve business processes and thereby reduce inefficiency and redundancy and improve customer service. The market for the design and installation of clientserver networks, on the other hand, obviously is finite.
Eventually, all that need them will have them. Also, improvements in technology might significantly reduce the complexities relating to network installation. The market for systems maintenance currently is growing as more and more organizations install clientserver networks. The market will reach a plateau and then continue in a more or less steady state when most of the organizations that need clientserver networks have them. Opportunities resulting from trends in the demand for the Segment's services include the following:
Risks include the following:
Trend 2 ; Intensity of competition. At present, there is considerable competition among the providers of consulting, integration, and systems maintenance services to mediumsized companies, and in the future the intensity of competition is likely to increase. In addition, very large companies as well as some of the smaller regional businesses may attempt to encroach on our mediumsized company market. The risks of increased competition include the following possibilities:
Trend 3 ; Supply of people. There has been a longstanding shortage of people with the requisite skills. Furthermore, college enrollment in the information systems field is down nationwide. Those two factors coupled with the increased demand for qualified people indicate that the shortage may become more severe. Risks to the Segment include the somewhat lessthanlikely possibilities that:
Trend 4 ; Pace of merger activity. The pace at which large providers of consulting services are acquiring small, regional providers of consulting services is increasing, thereby shrinking the supply of attractive merger candidates. To date, this has not created a problem because the Segment finds that its size, reputation, and technical resources provide a competitive advantage when bidding to acquire a small, regional company. Nevertheless, the shrinking supply of attractive merger candidates will at some point reduce our opportunity to use mergers to expand our client base, diversify into new geographic areas, and acquire more qualified professionals. We do not expect that to occur during the next three years.
Management believes the Segment will be successful if it is able to execute its business strategies effectively. The following discussion is structured in terms of our activities and plans for implementing our strategies. The discussion of each strategy concludes with a description of how that strategy correlates with the opportunities and risks identified in the section above.
Improve clients' business performance. The surest way for the Segment to be successful is by providing services that help our clients to prosper. The only credible judge of the value of our services is our clients. After a client has gained experience with a new system we installed, we contact the client to determine their perception of the value of the services provided. Also, we closely monitor the amount of new business we receive from clients because that is an excellent indicator of their satisfaction with earlier services. Our peoples' performances are evaluated and their salaries and bonuses are determined based on clients' reports on the value of services received and on the amount of new business generated from those clients.
Successful implementation of our strategy to improve clients' business performance will help us maximize opportunities resulting from increases in the demand for consulting services and minimize risks resulting from increased competition.
More services to existing clients. New work for existing clients helps to strengthen our relationships with them as well as to increase revenues and profits. Special activities to implement that strategy include the following:
Recruit, develop, and retain the best people. The Segment's excellent reputation, size, and technical resources including training programs help our efforts to recruit the best people. We make maximum use of those selling points. Following are our other activities:
Although, the scarcity of qualified people is a risk for the industry, the Segment is confident it will be successful in recruiting, developing, and retaining highly qualified individuals.
Mergers. We use mergers to enter new geographic markets, expand our client base, and acquire talented professionals. Special activities to identify attractive merger candidates include the following:
Although the pace of merger activity is increasing, the Segment is confident the supply of attractive merger candidates will continue for the next several years. In fact, current merger negotiations with several attractive candidates are expected to result in at least one acquisition during each of the next three years.
The Segment's actual 1993 business performance was generally in line with the forwardlooking information disclosed in our 1992 report. Three areas deserving special comment are discussed below.
Consulting services. Design and installation services and system maintenance services are the two broad types of activities discussed for the Segment in our reports for the current and prior years. When we design and install clientserver networks, we also provide consulting services on how to use them better. Until recently, however, we seldom provided consulting services unrelated to clientserver network installation, and we saw no need to accumulate revenues and costs separately for each type of service.
Toward the end of 1993 we decided to pursue, for the first time, contracts involving only consulting services. We expect that, eventually, consulting will become our primary service, and design and installation will become an ever smaller percentage of our business. Because of the increasing role of consulting services, we instituted the necessary types of time reporting and accounting procedures at the beginning of 1994 so revenues and costs can be reported separately for design and installation services and for consulting services.
Merger activity. Last year's report discussed the possibility of a major acquisition that would have added offices in several cities where we do not now have a presence, increased annual revenue by more than 25 percent, and added a worldclass expert to our staff in an industry for which we want to increase our business. In April, however, the Segment and the merger candidate both agreed to cease negotiations, and we have no plans to merge with that company.
Utilization of employees. Last year's report discussed our goal to increase field office employee utilization to 80 percent from 72 percent in 1992. That goal was ambitious and we believe that we made excellent progress toward achieving it by increasing utilization to 77 percent in 1993. That improvement increased our gross margin by $19 million in 1993. Our gross margin would have increased by another $7 million if utilization had been 80 percent in 1993. We believe employee utilization will be at approximately 80 percent in 1994.
Exposure to changes in foreign currency exchange rates is managed at Corporate. Forward exchange contracts are used to hedge portions of the consolidated Company's net monetary position in certain currencies. Forward exchange contracts also are used sometimes to hedge commitments for capital expenditures. We believe there is no costeffective way to hedge against our biggest potential risk from changes in exchange rates. That risk stems from the PC Segment and the fact that most of its costs (including those of the plant in Ireland) are incurred in U.S. dollars and more than half of its revenues are received in foreign currencies, primarily those of Canada, the United Kingdom, France, and Germany.
The risk resulting from U.S. dollar costs and foreign currency revenues to recover them is that the U.S. dollar will strengthen against the foreign currency. Absent an increase in the foreign currency sales prices of our products, either profits are reduced or our U.S. dollar costs are not recovered ; that is, we suffer a loss on the sales of the product. Given the downward trend in worldwide prices for PC products (other than high inflation countries), our ability to raise foreign currency sales prices is limited. In 1993, the Segment had approximately $1.2 billion of sales to foreign countries, primarily Canada, the United Kingdom, France, and Germany. If the dollar were to strengthen against most or all of those foreign currencies all at the same time, the effect could be significant.
The Company's affairs are overseen by a tenmember Board of Directors, which is elected by the shareholders at the annual meeting. Daytoday operations are the responsibility of a fiveperson senior management team, which is elected annually by the board. Three members of senior management also serve as directors. Brief biographical sketches of the directors and members of the senior management team follow.
Dan Collins, age 58, is a retired U.S. Navy admiral who has served as a director of the Company since 1988. He also serves as a director of Mardi Gras Cruise Lines and Tanque Verde Mutual Fund Group, Inc.
Russell Ford, age 45, is chief operating officer of Boston Bancorp, the largest independent bank holding company in New England, where he has held various positions since 1975. He has served as a director of the Company since 1991 and also serves as a director of Saugatuck Gas and Electric Company and Oak Creek Communications.
Tom White, age 46, is president and chief executive officer of Tubac Partners, Inc., a venture capital company based in Tucson, Arizona. Before 1987, Mr. White served as a financial consultant to companies in the computer industry. He has served as a director of the Company since 1989 and also serves as a director of Amos Kempfert, an international real estate developer.
Julianne Folger, age 45, is the dean of the College of Engineering at the University of New Mexico. She has served as a director of the Company since 1990 and also serves as a trustee of the Santa Fe Opera.
Robert Hoffman, age 55, is a partner in the San Francisco law firm of Parker, Barton and Mussman, where he specializes in intellectual property. He has served as a director of the Company since 1986 and also serves as director of Caskin Oil Company and Biotech Applications, Inc.
Trent Weaver, age 60, is an international business consultant based in Washington, D.C. From 1980 to 1992, Mr. Weaver served in the U.S. House of Representatives. He was appointed as a director of the Company in February 1993, filling the vacancy created by the death of David Hughes, who had served as a director since 1988.
Cal Cronin, age 40, is president, chief executive officer and a director of Micro Dynamics, Inc., a major component manufacturer that is one of the Company's primary suppliers of disk drives. He has served as a director of the Company since 1991.
Dale Ellis, age 50, president, chief executive officer and chairman of the board. He currently serves as a director of Micro Dynamics, Inc., one of the Company's primary suppliers of disk drives.
Tony Mason, age 46, senior vicepresidentpersonal computers and member of the Board of Directors. He joined the Company as an engineer in 1989 and was responsible for the development and construction of the Company's Irish manufacturing facility.
Fred Snowden, age 45, joined the Company in 1989 as senior vicepresident integration services. He previously served as managing director of Network Solutions, Inc., the 400person integration consulting business acquired by the Company in 1989. He was appointed to the Board of Directors in 1991. He also serves as a director of Great Lakes Trading Company, a commodity brokerage firm.
Eleanor Peters, age 47, senior vicepresident research. She currently serves as a director of Predicta, the research and development partnership in which the Company is a participant.
Joseph Dulin, age 43, elected chief financial officer and appointed to the board in 1992 upon the retirement of Robert McBride. He served as the Compan