**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

** **

**FORM 10–Q**

 

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**(MarkOne)**

**ý****        Quarterly reportpursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**

** **

**For thequarterly period ended September 30, 2001**

** **

**or**

** **

**o****        Transitionreport pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934**

** **

**For thetransition period from ______ to ______**

** **

**Commission File Number 0-26778**

 

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**APPLIED  MICROSYSTEMS  CORPORATION**

(Exact name of registrant as specified inits charter)

 

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| **Washington**                                                                                                          |   |                                     |
|-------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------|
| (State of  incorporation)                                                                                          |   | **91–1074996**                      |
|                                                                                                                    |   | (I.R.S. Employer  Identification Number) |
|                                                                                                                    |   |                                     |
| **5020  148th Avenue N.E., Redmond, Washington  98052-5172****(425)  882-2000**                                    |
| (Address of principal  executive offices, including zip code; registrant’s telephone number,  including area code) |

 

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                Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor 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 ý         No o

 

                Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date.

 

Commonstock, $.01 par value: 7,127,490 shares outstanding as of November 2, 2001.

 

 

**APPLIED MICROSYSTEMS CORPORATION**

 

**FORM 10-Q**

 

**QUARTER ENDED SEPTEMBER 30, 2001**

 

**INDEX**

 
|         |                                                                                                            |   |
|--------------|-----------------------------------------------------------------------------------------------------------------|--------|
|         |                                                                                                            |   |
| **PART I:**  | **FINANCIAL INFORMATION**                                                                                       |   |
|         |                                                                                                            |   |
| Item 1.      | Financial Statements:                                                                                           |   |
|         |                                                                                                            |   |
|         | Consolidated Balance Sheets  as of September 30, 2001 and December 31, 2000                                     |   |
|         |                                                                                                            |   |
|         | Consolidated  Statements of Operations for the three months and nine months ended   September 30, 2001 and 2000 |   |
|         |                                                                                                            |   |
|         | Consolidated  Statements of Cash Flows for the nine months ended   September 30, 2001 and 2000                  |   |
|         |                                                                                                            |   |
|         | Notes  to Consolidated Financial Statements                                                                     |   |
|         |                                                                                                            |   |
| Item  2.     | Management’s  Discussion and Analysis of Financial Condition and Results of   Operations                   |   |
|         |                                                                                                            |   |
| Item  3.     | Quantitative  and Qualitative Disclosures About Market Risk                                                     |   |
|         |                                                                                                            |   |
| **PART II:** | **OTHER INFORMATION**                                                                                           |   |
|         |                                                                                                            |   |
| Item 6.      | Exhibits and  Reports on Form 8-K                                                                               |   |
|         |                                                                                                            |   |
| Signatures   |                                                                                                            |   |

 

 

**PART I - FINANCIAL INFORMATION**

 

**Item 1.                    FinancialStatements**

 

**APPLIEDMICROSYSTEMS CORPORATION**

 

**CONSOLIDATED BALANCE SHEETS**

 
|                                            |   | **September 30,**  |   | **December 31,** |   |
|-------------------------------------------------|--------|--------------------|--------|------------------|--------|
|                                            |   | **2001**           |   | **2000**         |   |
|                                            |   | **(unaudited)**    |   |             |   |
|                                            |   | **(in thousands)** |   |
|                                            |   |               |   |             |   |
| ASSETS                                          |   |               |   |             |   |
| Current assets:                                 |   |               |   |             |   |
| Cash and cash  equivalents                      |   | $                  | 3,608  |             | $      | 7,956 |   |
| Securities available-for-sale                   |   | 4,105              |   | 2,526            |   |
| Accounts receivable, net                        |   | 3,686              |   | 5,729            |   |
| Inventories                                     |   | 2,180              |   | 2,358            |   |
| Prepaid and other current assets                |   | 423                |   | 314              |   |
| Total current assets                            |   | 14,002             |   | 18,883           |   |
|                                            |   |               |   |             |   |
| Property and equipment, net                     |   | 1,565              |   | 2,109            |   |
| Other assets                                    |   | 392                |   | 461              |   |
| Total assets                                    |   | $                  | 15,959 |             | $      | 21,453 |   |
|                                            |   |               |   |             |   |
| LIABILITIES  AND SHAREHOLDERS' EQUITY           |   |               |   |             |   |
| Current liabilities:                            |   |               |   |             |   |
| Accounts payable                                |   | $                  | 1,453  |             | $      | 2,954 |   |
| Accrued payroll                                 |   | 1,559              |   | 1,993            |   |
| Other accrued expenses                          |   | 1,388              |   | 1,029            |   |
| Deferred revenue                                |   | 3,724              |   | 4,654            |   |
| Total current liabilities                       |   | 8,124              |   | 10,630           |   |
|                                            |   |               |   |             |   |
| Capital lease obligation, less current  portion |   | 186                |   | —           |   |
| Accrued cost of business restructuring          |   | 815                |   | —           |   |
| Total long-term liabilities                     |   | 1,001              |   | —           |   |
|                                            |   |               |   |             |   |
| Shareholders' equity:                           |   |               |   |             |   |
| Preferred stock, par value $0.01                |   | —             |   | —           |   |
| Common stock, par value $0.01                   |   | 26,856             |   | 26,360           |   |
| Accumulated other comprehensive loss            |   | (764               | )      | (879             | )      |
| Accumulated deficit                             |   | (19,258            | )      | (14,658          | )      |
| Total shareholders' equity                      |   | 6,834              |   | 10,823           |   |
| Total liabilities and shareholders'  equity     |   | $                  | 15,959 |             | $      | 21,453 |   |

 

See accompanying notes.

 

##### **APPLIED MICROSYSTEMS CORPORATION**

** **

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(UNAUDITED)**

 
|                                                                                          |   | **Three  Months ended   September 30,**       |       | **Nine  Months ended   September 30,** |       |
|-----------------------------------------------------------------------------------------------|--------|-----------------------------------------------|------------|----------------------------------------|------------|
|                                                                                          |   | **2001**                                      |       | **(Restated)****2000**                 |       | **2001** |   | **(Restated)****2000** |   |
|                                                                                          |   | **(in  thousands, except per-share amounts)** |       |
|                                                                                          |   |                                          | ** ** |                                   | ** ** |   | ** ** |   | ** ** |
|                                                                                          |   |                                          |       |                                   |       |   |   |   |   |
| Net  sales                                                                                    |   | $                                             | 4,605      |                                   | $          | 7,968 |   | $ | 23,559 |   | $ | 23,513 |   |
| Cost  of sales                                                                                |   | 1,181                                         |       | 2,370                                  |       | 6,504 |   | 7,012 |   |
| Gross  profit                                                                                 |   | 3,424                                         |       | 5,598                                  |       | 17,055 |   | 16,501 |   |
|                                                                                          |   |                                          |       |                                   |       |   |   |   |   |
| Operating  expenses:                                                                          |   |                                          |       |                                   |       |   |   |   |   |
| Sales,  general and administrative                                                            |   | 2,971                                         |       | 4,146                                  |       | 10,859 |   | 12,887 |   |
| Research  and development                                                                     |   | 2,182                                         |       | 3,456                                  |       | 8,741 |   | 9,884 |   |
| Business  restructuring                                                                       |   | 2,289                                         |       | —                                 |       | 2,289 |   | — |   |
| Total  operating expenses                                                                     |   | 7,442                                         |       | 7,602                                  |       | 21,889 |   | 22,771 |   |
| Loss  from operations                                                                         |   | (4,018                                        | )          | (2,004                                 | )          | (4,834 | ) | (6,270 | ) |
| Interest  income and other, net                                                               |   | 50                                            |       | 158                                    |       | 234 |   | 518 |   |
| Loss  before cumulative effect of change in accounting principle                              |   | (3,968                                        | )          | (1,846                                 | )          | (4,600 | ) | (5,752 | ) |
| Cumulative  effect of change in accounting principle                                          |   | —                                        |       | —                                 |       | — |   | (1,110 | ) |
| Net  loss                                                                                     |   | $                                             | (3,968     | )                                      | $          | (1,846 | ) | $ | (4,600 | ) | $ | (6,862 | ) |
|                                                                                          |   |                                          |       |                                   |       |   |   |   |   |
| Basic  and diluted loss per share before cumulative effect of change in accounting  principle |   | $                                             | (0.56      | )                                      | $          | (0.27 | ) | $ | (0.65 | ) | $ | (0.83 | ) |
| Cumulative  effect of change in   accounting principle                                        |   | —                                        |       | —                                 |       | — |   | (.16 | ) |
| Basic  and diluted net loss per share                                                         |   | $                                             | (0.56      | )                                      | $          | (0.27 | ) | $ | (0.65 | ) | $ | (0.99 | ) |
| Shares  used in per-share calculation                                                         |   | 7,113                                         |       | 6,938                                  |       | 7,053 |   | 6,902 |   |

 

Seeaccompanying notes.

 

**APPLIEDMICROSYSTEMS CORPORATION**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(UNAUDITED)**

 
|                                                                                                                              |   | **Nine Months Ended September 30,** |     |
|-----------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------|----------|
|                                                                                                                              |   | ** 2001**                      |     | **(Restated)   2000** |   |
|                                                                                                                              |   | **(in thousands)**                  |     |
| *Operating  activities*                                                                                                           |   |                                |     |   |   |
| Net loss                                                                                                                          |   | $                                   | (4,600   | ) | $ | (6,862 | ) |
| Adjustments to reconcile net loss to  net cash used in operating   activities:                                                    |   |                                |     |   |   |
| Depreciation and amortization                                                                                                     |   | 774                                 |     | 773 |   |
| Cumulative effect of change in accounting  principle                                                                              |   | —                              |     | 1,110 |   |
| Loss on write off and/or disposal of  assets                                                                                      |   | 148                                 |     | — |   |
| Net change in operating accounts:                                                                                                 |   |                                |     |   |   |
| Accounts receivable                                                                                                               |   | 1,935                               |     | (2,267 | ) |
| Inventories                                                                                                                       |   | 49                                  |     | (421 | ) |
| Prepaid and other current assets                                                                                                  |   | (104                                | )        | 121 |   |
| Other assets                                                                                                                      |   | 28                                  |     | (4 | ) |
| Accounts payable, accrued expenses, and  accrued business   restructuring                                                         |   | (657                                | )        | 647 |   |
| Deferred revenue                                                                                                                  |   | (963                                | )        | 149 |   |
| Net cash used in operating activities                                                                                             |   | (3,390                              | )        | (6,754 | ) |
|                                                                                                                              |   |                                |     |   |   |
| *Investing activities*                                                                                                            |   |                                |     |   |   |
| Purchases of securities available-for-sale                                                                                        |   | (6,026                              | )        | (5,364 | ) |
| Maturities of securities  available-for-sale                                                                                      |   | 4,447                               |     | 10,631 |   |
| Additions to property and equipment                                                                                               |   | (180                                | )        | (502 | ) |
| Net cash provided by (used in)  investing activities                                                                              |   | (1,759                              | )        | 4,765 |   |
|                                                                                                                              |   |                                |     |   |   |
| *Financing activities*                                                                                                            |   |                                |     |   |   |
| Sale of common stock to employees                                                                                                 |   | 287                                 |     | 142 |   |
| Stock options exercised                                                                                                           |   | 209                                 |     | 400 |   |
| Net cash provided by financing  activities                                                                                        |   | 496                                 |     | 542 |   |
|                                                                                                                              |   |                                |     |   |   |
| Effects of foreign exchange rate  changes on cash                                                                                 |   | 305                                 |     | (143 | ) |
| Net decrease in cash and cash  equivalents                                                                                        |   | (4,348                              | )        | (1,590 | ) |
| Cash and cash equivalents at beginning  of period                                                                                 |   | 7,956                               |     | 5,682 |   |
| Cash and cash equivalents at end of  period                                                                                       |   | $                                   | 3,608    |   | $ | 4,092 |   |
|                                                                                                                              |   |                                |     |   |   |
| *Supplemental  disclosure of non-cash activities:*                                                                                |   |                                | * * |   | * * |
| During  the first quarter of 2001, the Company obtained equipment under a five-year  capital lease obligation of $250,000.   |   |

 

See accompanying notes.

 

 

**APPLIED MICROSYSTEMS CORPORATION**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

 

**1.         Basis ofPresentation**

 

The accompanying unaudited consolidatedfinancial statements have been prepared by Applied Microsystems Corporation(“Applied” or the “Company”) in accordance with generally accepted accountingprinciples for interim financial information and according to the rules andregulations of the Securities and Exchange Commission.  Accordingly, they do not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements. In the opinion of management, alladjustments (which include only normal recurring adjustments) considerednecessary for a fair presentation have been included.  The balance sheet at December 31, 2000 has been derived from theaudited financial statements included in the Company’s Form 10-K for the yearthen ended.  The results of operationsfor the three-month and nine-month periods ended September 30, 2001, are notnecessarily indicative of results to be expected for the entire year endingDecember 31, 2001 or for any other fiscal period.  For further information, refer to the consolidated financialstatements and footnotes thereto included in the Company's Form 10-K for theyear ended December 31, 2000.

 

**2.             Computationof Loss Per Share**

 

                Basicand diluted loss per share is computed using the weighted-average number ofcommon shares outstanding during the period. Common stock equivalent shares are excluded from the computation ofdiluted loss per share because their effect is antidilutive due to theCompany’s net losses.

 

**3.             Comprehensive Loss**

 

                As defined by applicableaccounting and reporting standards, Applied's comprehensiveloss is comprised of net loss and the effects of current-period translationadjustments, which are recorded directly to equity.  During the third quarter of 2001, comprehensive loss amounted to$4.0 million, compared to comprehensive loss of $2.0 million for the thirdquarter of 2000.  For the nine monthsended September 30, 2001, comprehensive loss amounted to $4.5 million, comparedto comprehensive loss of $7.7 million for the nine months ended September 30,2000.

 

**4.             Inventories**

 

Inventoriesconsist of the following:

 
|            |   | **September 30,**  |   | **December 31,** |   |
|-----------------|--------|--------------------|--------|------------------|--------|
|            |   | **2001**           |   | **2000**         |   |
|            |   | **(in thousands)** |   |
|            |   |               |   |             |   |
| Finished goods  |   | $                  | 722    |             | $      | 794 |   |
| Work in process |   | 104                |   | 72               |   |
| Purchased parts |   | 1,354              |   | 1,492            |   |
|            |   | $                  | 2,180  |             | $      | 2,358 |   |

 

**5.             Cumulative Effect of Change inAccounting Principle**

 

                Inthe fourth quarter of 2000, the Company implemented the Securities and ExchangeCommission’s Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition inFinancial Statements.”  SAB 101 providesguidance related to revenue recognition based upon interpretations andpractices followed by the SEC.  As aresult of the Company’s assessment of these new guidelines, Applied changed itsrevenue recognition practices for sales in Japan to reflect revenues upon theearlier of customer inspection and acceptance or, in the absence ofnotification of inspection and acceptance, upon receipt of payment.  Applied adopted SAB 101 under the cumulativecatch-up method of accounting, which is the manner prescribed under applicableaccounting and reporting rules.  Underthese rules, the cumulative effect of a change in accounting principle isrecognized as an additional item on the Company’s statement of operations inthe first quarter of the year in which the change is made.

 

Applied’s adoption of this new standard resultedin a $1.1 million cumulative adjustment increasing the Company’s Q1 2000 netloss.  Revenues and cost of goods soldin each of the 2000 quarters were likewise restated as if the new accountingprinciple had been adopted since January 1, 2000.  Deferred revenue at January 1, 2000 included $1,406,000 relatedto goods that were shipped and previously recognized as revenue but do not meetthe new criteria for revenue recognition. During the nine months ended September 30, 2000, the entire amountdeferred was recognized as revenue.

 

**6.             Business Restructuring Activities**

 

                Inthe third quarter of 2001, in response to economic uncertainty and reducedrevenue streams, Applied implemented a restructuring plan designed to reduceoperating costs.  The restructuring planincluded a reduction of approximately 90 full-time employees worldwide acrossthe Company’s functional organizations, or 39% of the workforce; discontinuanceor reallocation of selected projects and activities not essential to theCompany’s long-term goals; abandonment of excess space at the Company’sheadquarters; as well as other cost reduction and control measures.  As a result of adopting the restructuringplan, Applied recorded a restructuring charge of $2.3 million in the thirdquarter of 2001.

 

 

                 The restructuring charge and related activityare as follows:

 
|                           |   | **Restructuring   Charge** |   | **Amounts Paid   or Charged   Off** |   | **Accrued   Balance at   September 30, 2001** |   |
|--------------------------------|--------|----------------------------|--------|-------------------------------------|--------|-----------------------------------------------|--------|
|                           |   | **(in thousands)**         |   |
|                           |   |                       |   |                                |   |                                          |   |
| Severance and related expenses |   | $                          | 1,000  |                                | $      | 639                                           |   | $ | 361 |   |
| Asset  write-offs              |   | 131                        |   | 131                                 |   | —                                        |   |
| Abandoned facilities           |   | 1,158                      |   | —                              |   | 1,158                                         |   |
|                           |   |                       | $      | 2,289                               |   | $                                             | 770    |   | $ | 1,519 |   |
|                                |        |                            |        |                                     |        |                                               |        |  |  |  |  |

 

Substantially all of theremaining severance and related expenses are expected to be paid during thefourth quarter ending December 31, 2001. Asset write-offs consisted primarily of excess computer equipment andcertain leasehold improvements located in abandoned facilities.  The charge for abandoned facilities relatesto leased facilities that Applied has abandoned in connection with therestructuring; the corresponding accrued liability will be reduced as theCompany pays its lease commitments.  Aportion of the accrued restructuring liabilities, representing leasecommitments which will not be settled in the next 12 months, is classified aslong term on the Company’s balance sheet. The remaining accrued restructuring liabilities are classified ascurrent liabilities as of September 30, 2001, and consist of accounts payableof $66,000, accrued payroll of $240,000, and other accrued expenses of$398,000.

 

**7.             Recent Accounting Pronouncements**

 

In September 1998, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards (“SFAS”) 133,“Accounting for Derivative Instruments and Hedging Activities.”  SFAS 133 requires companies to recordderivatives on the balance sheet as assets or liabilities, measured at fairvalue.  Gains or losses resulting fromchanges in the fair values of those derivatives would be accounted for incurrent earnings unless specific hedge criteria are met.  The key criterion for hedge accounting isthat the hedging relationship must be highly effective in achieving offsettingchanges in fair value or cash flows.  Appliedmust formally document, designate, and assess the effectiveness of transactionsthat receive hedge accounting, if any. SFAS 133 is effective for the Company’s consolidated financialstatements for the year ending December 31, 2001.  No hedging activities were in effect during the first nine monthsof 2001, nor at any time during 2000; therefore, the adoption of this Statementis not expected to have a material effect on the Company’s operations.

 

**8.             Liquidity**

 

                As of September 30, 2001, theCompany had $7.7 million in cash, cash equivalents, and short-term investments,compared to $10.5 million as of December 31, 2000.  As a result of actions taken to reduce operating expenses, theCompany’s expenditure levels were substantially reduced during the thirdquarter of 2001 and are expected to decline further in the fourth quarter of2001.  The Company’s cost-reductionefforts are expected to contribute to a corresponding improvement in theCompany’s ability to conserve its capital resources.  The Company believes that its existing working capital willprovide the Company with sufficient funds to finance its operations for atleast the next 12 months.  However, anysubstantial inability to achieve the current business plan could have amaterial adverse impact on the Company’s financial position, liquidity, orresults of operations and may require the Company to further reduce itsexpenditures or seek other sources of financing.

 

**9.             Reclassifications**

 

Certain prior-period amounts have beenreclassified to conform to the current-period presentation.

 

**Item 2.                    Management's Discussion and Analysis of Financial Condition and Resultsof Operations**

 

**Overview**

 

                AppliedMicrosystems Corporation is a leader and innovator in software developmenttools and technologies.  Applieddevelops, markets and supports a comprehensive suite of software andhardware-enhanced development and test tools for the development of complexembedded microprocessor-based applications. Applied’s products and services help customers bring products to marketfaster by providing innovative tools to develop, debug, and test productsfaster, more reliably, and at a lower cost. For more than 20 years, the Company has targeted its products to meetthe needs of embedded systems markets and has developed significant experienceand expertise in high-end microprocessors, real-time systems, and softwareanalysis technology – three key competencies that position the Company to meetthe needs of software developers.  Theembedded systems market has in recent years expanded from its traditional baseof industrial automation, medical devices, and avionic applications to includemarket segments such as Internet devices, high-speed networking, wirelesstechnologies, game consoles, and set top boxes.

 

On August 1, 2001, theCompany announced that, similar to other companies that sell to thetelecommunications industry, it had experienced project and order delays andcancellations among Applied’s networking customer base during the quarter endedJune 30, 2001.  As a result, the Companyexpected that overall revenues in the second half of 2001 would besignificantly lower than the first half of 2001 due to expected continuedweakness in the networking space as well as reduced revenue expected from gamedevelopment tools after shipping initial orders for Microsoft’s Xbox videogaming system in the first half of 2001. As a result of these business circumstances, Applied took immediatemeasures to lower its operating expenses, thereby incurring a one-time businessrestructuring charge of $2.3 million in the quarter ended September 30, 2001.

 

**Results of Operations**

 
|                       |   | **Three  Months Ended September 30,** |   | **Nine  Months Ended September 30,** |   |
|----------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
| **(dollars in thousands)** |   | **2001**                              |   | **Change**                           |   | **2000** |   | **2001** |   | **Change** |   | **2000** |   |
|                       |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |
| Net sales                  |   | $                                     | 4,605  |                                 | $      | (3,363 | ) | $ | 7,968 |   | $ | 23,559 |   | $ | 46 |   | $ | 23,513 |   |
|                       |   |                                  |   | (42                                  | )%     |   |   |   |   | 0 | % |   |   |
|                            |        |                                       |        |                                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company earns revenue on the sale ofhardware and software products.  TheCompany also earns revenue on the sale of services, including hardware andsoftware support, installation, training, and professional engineeringservices.  As further described under“Cumulative effect of change in accounting principle,” in the fourth quarter of2000 the Company adopted the Securities and Exchange Commission’s Staff AccountingBulletin No. 101 (“SAB 101”), “Revenue Recognition in Financial Statements,”effective retroactive to January 1, 2000.

 

                The42% decrease in net sales in the third quarter was attributable primarily todecreased sales of hardware-enhanced debug, test, and performance solutions,which totaled $2.4 million in the third quarter of 2001, compared to $5.3million in the third quarter of the prior year.  Sales of these “run control” products were $9.0 million in thenine months ended September 30, 2001, compared to $16.8 million in the firstnine months of 2000.   These decreaseswere due primarily to generally soft demand from telecommunications customers,overall lower average selling prices, and slower-than-anticipated unit volumesthrough run-control distribution channels. Subsequent to September 30, 2001, the Company signed new agreements withthird-party sales representatives to further boost its sales efforts throughdistribution channels.  The decreases inrun control product revenues were also attributable to the Company’s focus ondeveloping products and channels for software analysis tools as customers havemoved from hardware development to software development; therefore, the Companyhas invested less in developing and supporting run control products than inprior periods.

 

Game development tools accounted for near zerorevenue in the third quarter of 2001, compared to approximately $800,000 in thethird quarter of 2000, as both Microsoft and Nintendo were focused onsupporting the expected November 2001 launch of their new game consoles, andthese companies placed less emphasis during the third quarter of 2001 onshipping tools to new developers.  Gamedevelopment tools revenue totaled $8.2 million in the first nine months of2001, compared to $2.2 million in the nine months ended September 30,2000.  Year-to-date game developmenttools revenue in 2001 was comprised primarily of shipments of game developmenttools for Microsoft’s Xbox video gaming system during the first six months of2001.  This new revenue source was adirect result of Applied’s development initiatives that began in early 1999 toextend the Company’s technology to meet the needs of game developers.  These initiatives led to agreements withNintendo and Microsoft to develop and manufacture game development tools forNintendo’s GameCube and Microsoft’s Xbox video console systems.  The Company expects that future gamedevelopment tools revenue will depend significantly on the success of these newgame consoles.

 

Applied’s softwareanalysis tools revenue was $2.2 million in the third quarter of 2001, comparedto $1.9 million in the third quarter of 2000; software analysis revenue was$6.4 million in the first nine months of 2001, compared to $4.5 million in thenine months ended September 30, 2000. These increases were due in part to the timing of license orders from athird-party developer of integrated development environments.

 

The Company's net salesalso include product support revenues, which are included within the aforementionedmajor categories of Applied’s products. These support revenues totaled approximately $800,000 in the thirdquarter of 2001, compared to $1.0 million in the third quarter of 2000. Supportrevenues were $2.5 million in the nine months ended September 30, 2001,compared to $3.2 million in the nine-month period ended September 30,2000.  These declines were due primaryto lower run control product sales, for which support contracts are often sold.

 

                Internationalsales were 45% of net sales in the third quarter of 2001, as compared to 33% ofnet sales in the third quarter of 2000. For the nine-month period ended September 30, 2001, international salesaccounted for 27% of net sales, as compared to 38% of net sales for the ninemonths ended September 30, 2000. Applied’s third quarter 2001 and year-to-date international revenueswere lower in Japan and Europe, than in the comparable periods in 2000,primarily due to the previously mentioned slowdown among telecommunicationscustomers.  The higher level of revenuesfrom game development tools sold domestically in the first six months of 2001also contributed to the lower percentage of international revenues in the ninemonths ended September 30, 2001, as compared to the comparable period in theprior year.

Applied’s sales through its foreign subsidiaries aregenerally denominated in local currencies; as a result, fluctuations incurrency exchange rates can have a significant effect on the Company's reportednet sales.  The Company is unable topredict currency exchange rate fluctuations and anticipates that suchfluctuations will continue to affect its net sales to varying degrees in thefuture.

 

|                       |   | **Three  Months Ended   September 30,** |   | **Nine  Months   Ended   September 30,** |   |
|----------------------------|--------|----------------------------------------------|--------|------------------------------------------|--------|
| **(dollars in thousands)** |   | **2001**                                     |   | **2000**                                 |   | **2001** |   | **2000** |   |
|                       |   |                                         |   |                                     |   |   |   |   |   |
| *Cost of Sales*            |   | $                                            | 1,181  |                                     | $      | 2,370 |   | $ | 6,504 |   | $ | 7,012 |   |
| *% of net sales*           |   | 26                                           | %      | 30                                       | %      | 28 | % | 30 | % |
|                       |   |                                         |   |                                     |   |   |   |   |   |
| *Gross profit*             |   | $                                            | 3,424  |                                     | $      | 5,598 |   | $ | 17,055 |   | $ | 16,501 |   |
| *% of net sales*           |   | 74                                           | %      | 70                                       | %      | 72 | % | 70 | % |

 

Applied’s gross profit percentages in the threeand nine months ended September 30, 2001 were higher than in the comparableperiods of 2000 due primarily to product revenue mix, as well as increased 2001throughput in the Company’s manufacturing operations that resulted from initialproduction and shipment of game development tools for Microsoft’s Xbox.  Despite the lack of significant gamedevelopment tools revenue in the third quarter of 2001, the Company continuedto benefit somewhat from the increased manufacturing throughput in the firstsix months of the year because certain products sold during the third quarterof 2001 were manufactured in prior quarters and had lower allocations ofoverhead.  Since the gross profitpercentage for game development tools is generally lower than Applied’shistorical average for other products, the increase in third quarter 2001 grossprofit percentage was also attributable to lower proportional game developmenttools revenue in the quarter.

 

The Company expects itsgross profit percentage to fluctuate based upon its product and service mix,potential changes in material and labor costs, geographic mix, foreign currencyfluctuations, product and patent license royalties, and variances in volume andrelated absorption of overhead costs.

 
|                                          |   | **Three  Months Ended September 30,** |   | **Nine  Months Ended September 30,** |   |
|-----------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
| **(dollars in thousands)**                    |   | **2001**                              |   | **Change**                           |   | **2000** |   | **2001** |   | **Change** |   | **2000** |   |
|                                          |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |
| *Sales, general and  administrative expenses* |   | $                                     | 2,971  |                                 | $      | (1,175 | ) | $ | 4,146 |   | $ | 10,859 |   | $ | (2,028 | ) | $ | 12,887 |   |
|                                          |   |                                  |   | (28                                  | )%     |   |   |   |   | (16 | )% |   |   |
|                                               |        |                                       |        |                                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decreases in sales, general andadministrative expenses in the third quarter and the nine-month period endingSeptember 30, 2001, as compared to the comparable periods in 2000, were due tothe Company’s adoption of its cost-reduction plan in August 2001, as well asoverall lower personnel-related expenditures. Sales of game development tools, which have lower sales-related expensesthan Applied’s other hardware and software products, also contributed to lowerexpense levels in the nine month period ended September 30, 2001.  Since the Company’s cost reduction plan wasimplemented during the quarter, the third quarter 2001 expenses reflect only apartial benefit of the cost reductions. Sales, general and administrative expenses are expected to declinefurther in the fourth quarter of 2001 as a result of the cost reduction planand further cost-reduction actions.

 

When incurred, minorforeign exchange gains and losses are included in sales, general andadministrative expenses. In order to mitigate certain intercompany risksassociated with exchange rate fluctuations, the Company may choose to hedge aportion of its foreign exchange risk. No such hedging activities were in effect during the first nine monthsof 2001, nor in the prior two years. Although the Company may engage in exchange-rate hedging activities withrespect to certain exchange-rate risks, there can be no assurance that it willdo so or that any such activities will successfully protect the Company againstsuch risks.

 
|                                 |   | **Three  Months Ended September 30,** |   | **Nine  Months Ended September 30,** |   |
|--------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
| **(dollars in thousands)**           |   | **2001**                              |   | **Change**                           |   | **2000** |   | **2001** |   | **Change** |   | **2000** |   |
|                                 |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |
| *Research and development  expenses* |   | $                                     | 2,182  |                                 | $      | (1,274 | ) | $ | 3,456 |   | $ | 8,741 |   | $ | (1,143 | ) | $ | 9,884 |   |
|                                 |   |                                  |   | (37                                  | )%     |   |   |   |   | (12 | )% |   |   |
|                                      |        |                                       |        |                                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decreases in research and developmentexpenses in the three and nine-month periods ending September 30, 2001, ascompared to the comparable periods in 2000, were primarily due to the Company’sadoption of its cost-reduction plan in August 2001.  Since the Company’s cost reduction plan was implemented duringthe quarter, the third quarter 2001 expenses reflect only a partial benefit ofthe cost reductions.  Research anddevelopment expenses are expected to decline further in the fourth quarter of2001 as a result of the cost reduction plan and further cost-reduction actions.

 

The Company believesthat its continued investment in focused research and development activities iscritical to Applied’s future success. Despite an overall reduction in resources available for research anddevelopment (as a result of the Company’s cost-control efforts), the Companyintends to continue to invest in product development.   Research and development expenses may fluctuate to the extent thatApplied’s engineering resources are utilized to fulfill the needs of customersunder contractual development arrangements. In such cases, engineering costs are charged to costs of goods sold.

 
|                       |   | **Three  Months Ended September 30,** |   | **Nine  Months Ended September 30,** |   |
|----------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
| **(dollars in thousands)** |   | **2001**                              |   | **Change**                           |   | **2000** |   | **2001** |   | **Change** |   | **2000** |   |
|                       |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |
| *Business   restructuring* |   | $                                     | 2,289  |                                 | $      | 2,289 |   | $ | — |   | $ | 2,289 |   | $ | 2,289 |   | $ | — |   |
|                       |   |                                  |   | 100                                  | %      |   |   |   |   | 100 | % |   |   |
|                            |        |                                       |        |                                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

                Inthe third quarter of 2001, in response to economic uncertainty and reducedrevenue streams, Applied implemented a restructuring plan designed to reduceoperating costs.  The restructuring planincluded a reduction of approximately 90 full-time employees worldwide across theCompany’s functional organizations, or 39% of the workforce; discontinuance orreallocation of selected projects and activities not essential to the Company’slong-term goals; abandonment of excess space at the Company’s headquarters; aswell as other cost reduction and control measures.  As a result of adopting the restructuring plan, Applied recordeda restructuring charge of $2.3 million in the third quarter of 2001.  During the third quarter of 2001, theCompany also implemented a 10% reduction in salaries for executive personneland closed the Company’s facilities for one week to further reduce costs.

 

                OnOctober 22, 2001, the Company announced that it would take further steps toreduce its operating expenses, including reductions in pay for most U.S.personnel that the Company expects will result in a 10% reduction incorresponding base salary expenses.

 
|                               |   | **Three  Months Ended September 30,** |   | **Nine  Months Ended September 30,** |   |
|------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
| **(dollars in thousands)**         |   | **2001**                              |   | **Change**                           |   | **2000** |   | **2001** |   | **Change** |   | **2000** |   |
|                               |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |
| *Interest income and   other, net* |   | $                                     | 50     |                                 | $      | (108 | ) | $ | 158 |   | $ | 234 |   | $ | (284 | ) | $ | 518 |   |
|                               |   |                                  |   | (68                                  | )%     |   |   |   |   | (55 | )% |   |   |
|                                    |        |                                       |        |                                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

                The Company’s interest incomeand other, net, decreased from the prior year’s periods due primarily to adecrease in the Company’s cash available for short-term investments.

 
|                                                       |   | **Three  Months Ended September 30,** |   | **Nine  Months Ended September 30,** |   |
|------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
| **(dollars in thousands)**                                 |   | **2001**                              |   | **Change**                           |   | **2000** |   | **2001** |   | **Change** |   | **2000** |   |
|                                                       |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |
| *Cumulative Effect of   Change in   Accounting  Principle* |   | $                                     | — |                                 | $      | — |   | $ | — |   | $ | — |   | $ | (1,110 | ) | $ | (1,110 | ) |
|                                                       |   |                                  |   |                                 |   |   |   |   |   | (100 | )% |   |   |
|                                                            |        |                                       |        |                                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Applied implemented SAB 101 in the fourthquarter of 2000, effective retroactive to January 1, 2000.  SAB 101 provides guidance related to revenuerecognition policies based on interpretations and practices followed by the SEC.  As a result of the Company’s assessment ofthese new guidelines, Applied changed its revenue recognition practices forsales in Japan to reflect revenues upon the earlier of customer inspection andacceptance or, in the absence of notification of inspection and acceptance,upon receipt of payment.  Appliedadopted SAB 101 under the cumulative catch-up method of accounting, which isthe manner prescribed under applicable accounting and reporting rules.  Under these rules, the cumulative effect ofa change in accounting principle is recognized as an additional item on theCompany’s statement of operations in the first quarter of the year in which thechange is made.  Applied’s adoption ofthis new standard resulted in a $1.1 million cumulative adjustment increasingthe Company’s first quarter 2000 net loss. Revenues and expenses in each of the 2000 quarters were likewiseadjusted as if the new accounting principle had been adopted since January 1,2000.

 

**IncomeTaxes**

 

                Applicableaccounting standards require that the Company calculate an estimated annualeffective tax rate and apply such tax rate to the pre-tax operating results ofinterim periods.  Deferred income taxesreflect the net tax effects of temporary differences between the tax basis ofassets and liabilities and the corresponding financial statement amounts.  Due to the uncertainty of the Company’sability to utilize its net deferred tax assets, including its net operatinglosses and research and development credits, a valuation allowance has beenestablished for financial reporting purposes equal to the amount of the netdeferred tax assets.  Accordingly, noincome tax provision or benefit is recorded for the three and nine-monthperiods ended September 30, 2001 and 2000.

 

**Liquidityand Capital Resources**

 

                As of September 30, 2001, theCompany had $7.7 million in cash, cash equivalents, and short-term investments,compared to $10.5 million as of December 31, 2000.  As a result of actions taken to reduce operating expenses duringthe third quarter of 2001, the Company’s expenditure levels have beensubstantially reduced and are expected to decline further in the fourth quarterof 2001.  The Company’s cost-reductionefforts are expected to reduce quarterly operating losses, with a correspondingimprovement of the Company’s ability to conserve its capital resources.

 

TheCompany requires capital primarily for the financing of inventories andaccounts receivable, sales and marketing efforts, product developmentactivities, capital equipment purchases, and to fund operating losses.   Applied used cash of $3.4 million foroperating activities in the first nine months of 2001, compared to using $6.8million for operating activities in the first nine months of the prioryear.  The Company purchased $180,000 inproperty and equipment in the first nine months of 2001, compared to purchasing$502,000 in the first nine months of 2000.

 

TheCompany believes that its existing working capital will provide the Companywith sufficient funds to finance its operations for at least the next 12months, even if revenue levels were to remain at third-quarter 2001levels.  The Company's future capitalrequirements will depend on a number of factors, including the duration ofweakness in certain customer sectors and in international sales, management’sability to lead the Company to breakeven or better during continued slow marketconditions, costs associated with sales and marketing programs, productdevelopment efforts, and the use of funds for strategic purposes.  To the extent additional funds are required,the Company may sell additional equity, debt or convertible securities, orobtain credit facilities; however, there can be no assurance that the Companywill be able to obtain such funds or on terms that are acceptable.

 

**CertainFactors That May Affect Future Results of Operations**

 

                This report containsforward-looking statements reflecting management’s current forecast of certainaspects of the Company’s future.  Suchstatements are based on current information, which management has assessed butwhich by its nature is dynamic and subject to rapid and even abruptchanges.  Forward-looking statementsinclude statements regarding the Company’s cost-reduction plan, intent topursue new market and product opportunities, and estimates of future operatingtrends.

 

                TheCompany’s actual results could differ materially from those stated or impliedby such forward-looking statements due to risks and uncertainties associatedwith the Company’s business which include, but are not limited to, theCompany’s recent operating losses, potential adverse consequences arising fromcorporate restructuring, dependence on industries characterized by rapidlychanging technology, manufacturing and product ship schedules, customer designstarts utilizing environments served by Applied, relationships withsemiconductor manufacturers, Applied’s focus on a few key markets,relationships with a few key game console developers, competition, dependenceon key personnel, intellectual property rights and the potential forcorresponding litigation, the potential for product liability, uncertaintiessurrounding international operations, potential fluctuations in quarterlyoperating results, and potential continued volatility of stock price.  The forward-looking statements should beconsidered in the context of these and other risk factors disclosed in theCompany’s most recent filings with the Securities and Exchange Commission andthe Company’s 2000 Annual Report on Form 10-K.

 

 

**Item 3.                    Quantitative and QualitativeDisclosures About Market Risk**

 

                Applieddevelops products in the United States and sells primarily in North America,Asia and Europe.  As a result, financialresults could be affected by factors such as changes in foreign currencyexchange rates or weak economic conditions in foreign markets.  Since the Company’s products are generallyinitially priced in U.S. Dollars and translated to local currency amounts, astrengthening of the dollar could make the Company’s products less competitivein foreign markets.

 

                TheCompany is exposed to market risk related to changes in interest rates, whichcould adversely affect the value of the Company's short-term investments.  Applied maintains a short-term investmentportfolio consisting of interest bearing securities with an average maturity ofless than one year.  These securitiesare classified as “available-for-sale” securities.  These interest-bearing securities are subject to interest raterisk and will fall in value if market interest rates increase.  If market interest rates were to increaseimmediately and uniformly to 110% of their levels at September 30, 2001, thefair value of the portfolio would decline by an immaterial amount.  The Company does not expect its operatingresults or cash flows to be affected to any significant degree by a suddenchange in market interest rates.

 

**PART II - OTHER INFORMATION**

 
| **Item 6.**                                                                                       |   | **Exhibits and Reports on Form  8-K**                     |
|---------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------|
|                                                                                              |   |                                                      |
|                                                                                              | (A)    | The following exhibits  are filed as part of this report. |
|                                                                                              |   |                                                      |
|                                                                                              |   | None                                                      |
|                                                                                              |   |                                                      |
|                                                                                              | (B)    | Report on Form 8-K                                        |
|                                                                                              |   |                                                      |
| The registrant did not  file any reports on Form 8-K during the quarter ended September 30, 2001. |

 

 

 

 

**SIGNATURES**

 

                Pursuant to the requirements ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 

**                                                                                               ****APPLIEDMICROSYSTEMS CORPORATION**

                                                                                                (Registrant)

 
| Date:  | November  13, 2001 |   | By:    | /s/  Robert C. Bateman |                                           |
|--------|--------------------|--------|--------|-----------------------------|------------------------------------------------|
|   |               |   |   |                        | Robert  C. Bateman                             |
|   |               |   |   |                        | *Vice President, Chief  Financial Officer,*    |
|   |               |   |   |                        | *Secretary and Treasurer*                      |
|   |               |   |   |                        | *(Principal  Financial and Accounting Officer* |
|   |               |   |   |                        | * and Duly Authorized Signing Officer)*   |
|        |                    |        |        |                             |                                                |  |