UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 0-220-20
CASTELLE
(Exact name of Registrant as specified in its charter)
California 77-0164056
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
855 Jarvis Drive, Suite 100, Morgan Hill, California 95037
(Address of principal executive offices, including zip code)
(408) 852-8000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No __
The number of shares of Common Stock outstanding as of April 30, 2004 was
3,561,391.
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes __ No |X|
CASTELLE
FORM 10-Q
TABLE OF CONTENTS
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets 2
Condensed Consolidated Statements of Operations 3
Condensed Consolidated Statements of Cash Flows 4
Notes to Condensed Consolidated Financial Statements 5
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS 12
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 13
Item 3Quantitative and Qualitative Disclosures About Market Risk 25
Item 4Controls and Procedures 25
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 26
Item 2. Changes in Securities and Use of Proceeds 26
Item 3. Defaults Upon Senior Securities 26
Item 4. Submission of Matters to a Vote of Security Holders 26
Item 5. Other Information 26
Item 6. Exhibits and Reports on Form 8-K 26
Signatures 28
Exhibit 31.1 - Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002 E-1
Exhibit 31.2 - Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002 E-2
Exhibit 32.1 - Certificate pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002 E-3
Exhibit 32.2 - Certificate pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002 E-4
1
PART I - FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
CASTELLE
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands)
March 31, 2004 December 31, 2003
---------------------- --------------------
Assets:
Current assets:
Cash and cash equivalents $ 4,368 $ 4,614
Accounts receivable, net of allowance for doubtful accounts
of $37 and $39, respectively 1,252 873
Inventories 1,217 1,177
Prepaid expenses and other current assets 243 134
Deferred taxes 282 380
---------------------- --------------------
Total current assets 7,362 7,178
Property and equipment, net 329 376
Other non-current assets 103 103
Deferred taxes, non-current 146 146
---------------------- --------------------
Total assets $ 7,940 $ 7,803
====================== ====================
Liabilities and Shareholders' Equity:
Current liabilities:
Long-term debt, current portion $ 14 $ 16
Accounts payable 286 314
Accrued liabilities 1,612 1,759
Deferred revenue 957 909
---------------------- --------------------
Total current liabilities 2,869 2,998
Long term debt, net of current portion 25 29
---------------------- --------------------
Total liabilities 2,894 3,027
---------------------- --------------------
Shareholders' equity:
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 3,551 and 3,425, respectively 27,381 27,258
Accumulated deficit: (22,335) (22,482)
---------------------- --------------------
Total shareholders' equity 5,046 4,776
---------------------- --------------------
Total liabilities and shareholders' equity $ 7,940 $ 7,803
====================== ====================
See accompanying notes to consolidated financial statements.
2
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)
Three months ended
......................................
March 31, 2004 March 31, 2003
----------------- ------------------
Net sales $ 2,558 $ 2,500
Cost of sales 639 697
----------------- ------------------
Gross profit 1,919 1,803
----------------- ------------------
Operating expenses:
Research and development 414 355
Sales and marketing 794 735
General and administrative 465 457
----------------- ------------------
Total operating expenses 1,673 1,547
----------------- ------------------
Income from operations: 246 256
Interest income, net 3 4
Other expense, net (4) (15)
----------------- ------------------
Income before provision for income taxes 245 245
Provision for income taxes 98 2
----------------- ------------------
Net income $ 147 $ 243
================= ==================
Earnings per share:
Net income per common share - basic $ 0.04 $ 0.08
Net income per common share - diluted $ 0.03 $ 0.06
Shares used in per share calculation - basic 3,499 3,200
Shares used in per share calculation - diluted 4,450 3,828
See accompanying notes to consolidated financial statements.
3
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Three months ended
......................................
March 31, 2004 March 31, 2003
----------------- ------------------
Cash flows from operating activities:
Net income $ 147 $ 243
Adjustment to reconcile net income to net cash provided
by/(used in) operating activities:
Depreciation and amortization 52 57
Provision for doubtful accounts and sales returns (15) (143)
Provision for excess and obsolete inventory (143) (5)
Loss on disposal of fixed assets 1 -
Changes in assets and liabilities:
Accounts receivable (364) (73)
Inventories 103 152
Deferred taxes 98 -
Prepaid expenses and other current assets (109) (113)
Accounts payable (28) (77)
Accrued liabilities (147) (86)
Deferred revenue 48 64
----------------- ------------------
Net cash provided by/(used in) operating activities (357) 19
----------------- ------------------
Cash flows from investing activities:
Acquisition of equipment (6) (90)
----------------- ------------------
Net cash used in investing activities (6) (90)
----------------- ------------------
Cash flows from financing activities:
Repayment of long-term debt (6) (5)
Proceeds from exercise of options 123 21
Repurchase of common stock - (49)
----------------- ------------------
Net cash provided by/(used in) financing activities 117 (33)
Net decrease in cash and cash equivalents (246) (104)
Cash and cash equivalents at beginning of period 4,614 3,460
----------------- ------------------
Cash and cash equivalents at end of period $ 4,368 $ 3,356
================= ==================
See accompanying notes to consolidated financial statements.
4
CASTELLE
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation:
The accompanying unaudited condensed consolidated financial statements
include the accounts of Castelle and its wholly-owned subsidiary in the
United Kingdom. These financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of
America. All intercompany balances and transactions have been eliminated.
In our opinion, all adjustments (consisting only of normal recurring
adjustments) considered necessary for a fair presentation of our financial
position, results of operations and cash flows at the dates and for the
periods indicated have been included. Because all of the disclosures
required by accounting principles generally accepted in the United States
of America are not included in the accompanying condensed consolidated
financial statements and related notes, they should be read in conjunction
with the audited consolidated financial statements and related notes
included in the Company's Form 10-K for the year ended December 31, 2003.
The condensed balance sheet data as of December 31, 2003 was derived from
our audited financial statements and does not include all of the
disclosures required by accounting principles generally accepted in the
United States of America. The results of operations for the periods
presented are not necessarily indicative of results that we expect for any
future period, or for the entire year.
The preparation of financial statements in conformity with generally
accepted accounting principles requires us to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
We believe that our existing cash balances and anticipated cash flows from
operations will be sufficient to meet our anticipated capital requirements
for the next 12 months. If we have a need for additional capital resources,
we may be required to sell additional equity or debt securities, secure
additional lines of credit or obtain other third party financing. The
timing and amount of such capital requirements cannot be determined at this
time and will depend on a number of factors, including demand for our
existing and new products, if any, and changes in technology in the
networking industry. There can be no assurance that such additional
financing will be available on satisfactory terms when needed, if at all.
Failure to raise such additional financing, if needed, may result in us not
being able to achieve our long-term business objectives. To the extent that
additional capital is raised through the sale of additional equity or
convertible debt securities, the issuance of such securities would result
in additional dilution to our shareholders.
In addition, because we are dependent on a small number of distributors for
a significant portion of the sales of our products, the loss of any of our
major distributors or their inability to satisfy their payment obligations
to us could have a significant adverse effect on our business, operating
results and financial condition. In the first three months of 2004 and
2003, Ingram Micro and Tech Data, our two largest distributors,
collectively represented approximately 49% and 51% of our net sales,
respectively.
We do not currently have any material long-term supply contracts with any
of our manufacturing subcontractors or component suppliers. We purchase
finished products and
5
components on a purchase order basis. We own all
engineering, sourcing documentation, functional test equipment and tooling
used in manufacturing our products and believe that we could shift product
assembly to alternate suppliers if necessary. Certain key components of our
products, including a modem chip set from Conexant, microprocessors from
Motorola, integrated circuits from Intel and Kendin, are currently
available from single sources. Other components of our products are
currently available from only a limited number of sources. In addition,
certain manufacturers have announced the end-of-life of certain standard
off-the-shelf components which are being used by us in the manufacture of
our FaxPress Products. However, we have purchased what we believe to be at
least two years worth of supplies of these end-of-life components in an
effort to guarantee an uninterrupted supply of FaxPress Products to our
customers for the next two years, while we decide whether to re-engineer
our Products with the manufacturers' suggested replacement parts, or
develop new replacement products.
2. Revenue Recognition:
We recognize revenue based on the provisions of Staff Accounting Bulletin
No. 104 "Revenue Recognition" and Statement of Financial Accounting
Standards ("SFAS") No. 48 "Revenue Recognition When Right of Return
Exists."
Product revenue is recognized upon shipment if a signed contract or
purchase order exists, the fee is fixed or determinable, collection of the
resulting receivable is probable and product returns are reasonably
estimable. Shipment generally occurs and title and risk of loss is
transferred when the product is delivered to a common carrier.
We enter into agreements with some of our distributors that permit limited
stock rotation rights. These stock rotation rights allow the distributor to
return products for credit but require the purchase of additional products
of equal value. Customers who purchase products directly from us also have
limited return rights, which expire 30 days from product shipment. Revenues
subject to stock rotation or other return rights are reduced by our
estimates of anticipated exchanges and returns. We establish our returns
allowance for distributors and direct customers based on historic return
rates.
Pursuant to our agreements with distributors, we also protect our
distributors' exposure related to the impact of price reductions. Price
adjustments are recorded at the time price reductions are communicated to
our distributors.
Revenue for transactions that include multiple elements such as hardware
and post-contract customer support is allocated to each element based on
its relative fair value and recognized for each element when the revenue
recognition criteria have been met for such element. Fair value is
generally determined based on the price charged when the element is sold
separately.
We recognize revenue from support or maintenance contracts, including
extended warranty and support programs, ratably over the period of the
contract.
We recognize royalty income on the sale of LANpress products by a Japanese
distributor. Royalties are recognized when the products are sold by the
distributor to its end customer.
3. Net Income Per Share:
Basic net income per share is computed by dividing net income by the
weighted average number of common shares outstanding for such period.
Diluted net income per share reflects
6
the potential dilution from the exercise or conversion of other securities
into common stock that were outstanding during the period. Diluted net
income per share excludes shares that are potentially dilutive if their
effect is antidilutive. Dilutive potential shares consist of incremental
common shares issuable upon
exercise of stock options.
Basic and diluted net income per share is calculated as follows for the
first quarters of 2004 and 2003 (in thousands, except per share amounts):
Three Months Ended
March 31, 2004 March 31, 2003
----------------------------------------
Basic:
Weighted average common shares outstanding 3,499 3,200
========================================
Net income $ 147 $ 243
========================================
Net income per common share - basic $ 0.04 $ 0.08
========================================
Diluted:
Weighted average common shares outstanding 3,499 3,200
Common equivalent shares from stock options 951 628
----------------------------------------
Shares used in per share calculation - diluted 4,450 3,828
========================================
Net income $ 147 $ 243
========================================
Net income per common share - diluted $ 0.03 $ 0.06
========================================
The calculation of diluted shares outstanding for the three months ended
March 31, 2004 excludes 10,000 shares of common stock issuable upon
exercise of outstanding stock options, as their effect was antidilutive in
the period. The calculation of diluted shares outstanding for the three
months ended March 31, 2003 excludes 1,558,000 shares of common stock
issuable upon exercise of outstanding stock options as their effect was
antidilutive in the period.
4. Stock-Based Compensation
We account for our stock-based compensation plans using the intrinsic value
method prescribed in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees." Compensation cost for stock
options, if any, is measured by the excess of the quoted market price of
our stock at the date of grant over the amount an employee must pay to
acquire the stock. SFAS No. 123, "Accounting for Stock-Based Compensation,"
established accounting and disclosure requirements using a fair-value based
method of accounting for stock-based employee compensation plans.
7
Had compensation costs been determined consistent with SFAS No. 123, our
net income, net of income taxes, would have been changed to the amounts
indicated below (unaudited, in thousands, except per share data):
Three Months Ended
March 31, 2004 March 31, 2003
Net income - as reported $ 147 $ 243
Fair value of stock-based compensation (96) (42)
------------------ -------------------
Net income - pro forma $ 51 $ 201
================== ===================
Net income per share - basic - as reported $ 0.04 $ 0.08
Net income per share - diluted - as reported $ 0.03 $ 0.06
Net income per share - basic - pro forma $ 0.01 $ 0.06
Net income per share - diluted - pro forma $ 0.01 $ 0.05
We account for stock-based compensation arrangements with non-employees in
accordance with Emerging Issues Task Force ("EITF") Abstract No. 96-18,
Accounting for Equity Instruments That Are Issued to Other Than Employees
for Acquiring, or in Conjunction with Selling, Goods or Services.
Accordingly, unvested options and warrants held by non-employees are
subject to revaluation at each balance sheet date based on the then current
fair market value.
5. Inventories:
Inventories are stated at the lower of standard cost (which approximates
cost on a first-in, first-out basis) or market and net of provisions for
excess and obsolete inventory. Inventory details are as follows (unaudited,
in thousands):
March 31, 2004 December 31, 2003
----------------------- -----------------------
Raw material $ 634 $ 610
Work in process 9 -
Finished goods 574 567
-----------------------------------------------
Total inventory $ 1,217 $ 1,177
===============================================
6. Segment Information:
We have determined that we operate in one segment. Revenues by geographic
area are determined by the location of the customer and are summarized as
follows (unaudited, in thousands):
Three Months Ended
------------------------------------------
March 31, 2004 March 31, 2003
--------------------- --------------------
United States $ 2,169 $ 1,977
Europe 128 175
Pacific Rim 198 242
Rest of Americas, excluding United States 63 106
------------------------- -----------------
Total Revenue $ 2,558 $ 2,500
========================= =================
8
Customers that individually accounted for greater than 10% of net sales are
as follows (unaudited, in thousands):
March 31, 2004 March 31, 2003
Customer Amount Percentage Amount Percentage
--------------------------------- ---------------- ----------------- ---------------- ---------------
A $ 877 34% $ 664 27%
B $ 375 15% $ 605 24%
7. Comprehensive Income:
Comprehensive income is the change in equity from transactions and other
events and circumstances other than those resulting from investments by
owners and distributions to owners. There are no significant components of
comprehensive income excluded from net income, therefore, no separate
statement of comprehensive income has been presented.
8. Commitments and Contingencies:
Contingencies
From time to time, we are involved in various legal proceedings in the
ordinary course of business. We are not currently involved in any
litigation, which, in our opinion, would have a material adverse effect on
our business, operating results, cash flows or financial condition;
however, there can be no assurance that any such proceeding will not
escalate or otherwise become material to our business in the future.
Lease Commitments
The following represents combined aggregate maturities for all of our
financing and commitments under operating and capital leases as of March
31, 2004 (unaudited, in thousands):
Capital Lease Total
Operating Leases Obligations Commitments
----------------------------------------------------
Nine months ending December 31, 2004 $ 202 $ 13 $ 215
Year ending December 31, 2005 263 18 281
Year ending December 31, 2006 - 15 15
----------------------------------------------------
Total Commitments $ 465 $ 46 $ 511
====================================================
The lease on our headquarters facility has a term of 5 years, expiring in
December 2005 with one conditional three-year renewal option, which if
exercised would extend the lease to December 2008 commencing with rent at
ninety-five percent of fair market value.
We lease certain of our equipment under various operating and capital
leases that expire at various dates through 2006. The lease agreements
frequently include renewal, escalation clauses and purchase provisions, and
require us to pay taxes, insurance and maintenance costs. As of March 31,
2004, we had $39,000 outstanding under loan and security agreements which
are subject to interest rates of 12.5% to 12.8%.
We have a $3.0 million collateralized revolving line of credit with a bank,
which expires in March 2005, pursuant to which we may borrow 100% against
pledges of cash at the bank's prime rate. Borrowings under this line of
credit agreement are collateralized by all of our assets. As of March 31,
2004, we have not drawn down on the line of credit and were in compliance
with the terms of the agreement.
9
Product Warranties and Guarantor Arrangements
We offer warranties on certain products and record a liability for the
estimated future costs associated with warranty claims, which is based upon
historical experience and our estimate of the level of future costs.
Warranty costs are reflected in the Statement of Operations as a Cost of
Sales. A reconciliation of the changes in our warranty liability during the
three months ended March 31, 2004, is as follows (in thousands):
Warranty accrual as of December 31, 2003 $ 24
Accruals for warranties issued during the quarter -
Settlements made in kind during the quarter (1)
----------------
Warranty accrual as of March 31, 2004 $ 23
================
As permitted under California law, and under the provisions of our articles
of incorporation and by-laws, we are obligated to indemnify our officers
and directors for certain events or occurrences while the officer or
director is, or was, serving at our request in such capacity. The term of
the indemnification period is for the officer's or director's lifetime. The
maximum potential amount of future payments the Company could be required
to make under these indemnification agreements is unlimited; however, we
have a director and officer insurance policy that limits our exposure and
enables us to recover a portion of any future amounts paid. As a result of
our insurance policy coverage, we believe the estimated fair value of these
indemnification agreements is minimal.
We enter into standard indemnification agreements with our customers in the
ordinary course of business. Pursuant to these agreements, we indemnify,
hold harmless, and agree to reimburse the indemnified party for losses
suffered or incurred by the indemnified party, generally our business
partners or customers, in connection with any U.S. patent, or any copyright
or other intellectual property infringement claim by any third party with
respect to our products. The term of these indemnification agreements is
generally perpetual following execution of the agreement. The maximum
potential amount of future payments we could be required to make under
these indemnification agreements is unlimited; however, we have never
incurred claims or costs to defend lawsuits or settle claims related to
these indemnification agreements.
9. Stock Buyback:
In the fourth quarter of 2002, our Board of Directors authorized us, from
time to time, to repurchase at market prices, up to $2.25 million of our
common stock for cash in open market, negotiated or block transactions. The
timing of such transactions will depend on market conditions, other
corporate strategies and will be at the discretion of our management. No
time limit was set for the completion of this program. At the time of the
approval by the Board of Directors, we had approximately 4.8 million shares
of common stock outstanding. During the fourth quarter of 2002, we
repurchased from open market and negotiated transactions a total of
approximately 1.62 million shares for approximately $1.8 million, at an
average per share price of $1.10. During the first quarter of 2003, we
repurchased from open market transactions a total of 46,500 shares for
$49,000, at an average per share price of $1.04. We have not repurchased
any shares since the first quarter of 2003, but intend to continue to
execute our buyback program as we determine necessary. The approximate
dollar value of shares that may yet be repurchased under the plan was
$419,640 as of March 31, 2004.
10
10. Recent Accounting Pronouncements:
In December 2003, the Financial Accounting Standards Board ("FASB") issued
a revised FASB interpretation No. 46, "Consolidation for Variable Interest
Entities, an interpretation of ARB No. 51" ("FIN 46R"). The FASB published
the revision to clarify and amend some of the original provisions of FIN
46, which was issued in January 2003, and to exempt certain entities from
its requirements. A Variable Interest Entity ("VIE") refers to an entity
subject to consolidation according to the provisions of the Interpretation.
FIN 46R applies to entities whose equity investment at risk is insufficient
to finance that entity's activities without receiving additional
subordinated financial support provided by any parties, including equity
holders, or where the equity investors (if any) do not have a controlling
financial interest. FIN 46R provides that if an entity is the primary
beneficiary of a VIE, the assets, liabilities, and results of operations of
the VIE should be consolidated in the entity's financial statements. In
addition, FIN 46R requires that both the primary beneficiary and all other
enterprises with a significant variable interest in a VIE provide
additional disclosures. The provisions of FIN 46R are effective for the
Company's fiscal 2004 first quarter. The adoption of FIN 46R did not have a
material impact on the Company's financial position or results of
operations.
11
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This document contains forward-looking statements that involve risks and
uncertainties. Our operating results may vary significantly from quarter to
quarter due to a variety of factors, including changes in our product and
customer mix, constraints in our manufacturing and assembling operations,
shortages or increases in the prices of raw materials and components, changes in
pricing policy by us or our competitors, a slowdown in the growth of the
networking market, seasonality, timing of expenditures, and economic conditions
in the United States, Europe and Asia. Words such as "believes," "anticipates,"
"expects," "intends" and similar expressions are intended to identify
forward-looking statements, but are not the exclusive means of identifying such
statements. Unless the context otherwise requires, references in this Form 10-Q
to "we," "us," or the "Company" refer to Castelle. Readers are cautioned that
the forward-looking statements reflect management's analysis only as of the date
hereof, and we assume no obligation to update these statements. Actual events or
results may differ materially from the results discussed in the forward-looking
statements. Factors that might cause such a difference include, but are not
limited to the risks and uncertainties discussed herein, as well as other risks
set forth under the caption "Risk Factors" below and in our Annual Report on
Form 10-K for the year ended December 31, 2003.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and Results of
Operations contains forward-looking statements that are subject to many risks
and uncertainties that could cause actual results to differ significantly from
expectations. For more information on forward-looking statements, refer to the
"Special Note on Forward-Looking Statements" prior to this section. The
following discussion should be read in conjunction with the unaudited Condensed
Consolidated Financial Statements and the Notes thereto included in Item 1 of
this Quarterly Report on Form 10-Q and our Form 10-K for the year ended December
31, 2003.
Critical Accounting Policies
Castelle's financial statements and accompanying notes are prepared in
accordance with generally accepted accounting principles in the United States of
America. Preparing financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets, liabilities, sales
and expenses. These estimates and assumptions are affected by management's
application of accounting policies. Critical accounting policies for us include
revenue recognition; distributor programs and incentives; warranty; credit,
collection and allowances for doubtful accounts; inventories and related
allowance for obsolete and excess inventory; and income taxes, which are
discussed in more detail under the caption "Critical Accounting Policies" in our
2003 Annual Report on Form 10-K.
Consolidated Statements of Operations - As a Percentage of Net Sales
THREE MONTHS ENDED
......................................
March 31, 2004 March 31, 2003
------------------ ------------------
Net sales 100% 100%
Cost of sales 25% 28%
------------------ ------------------
Gross profit 75% 72%
------------------ ------------------
Operating expenses:
Research and development 16% 14%
Sales and marketing 31% 30%
General and administrative 18% 18%
------------------ ------------------
Total operating expense 65% 62%
Income from operations 10% 10%
Interest income, net * *
Other income/(expense), net * *
------------------ ------------------
Income before provision for income taxes 10% 10%
Provision for income taxes 4% *
------------------ ------------------
Net income 6% 10%
================== ==================
* Less than 1%
13
Results of Operations
Net Sales
Net sales increased 2.3% in the first quarter of 2004 from $2.5
million in the same period in 2003. The slight increase was primarily from
sales of our enterprise level FaxPress Premier fax server products to
domestic customers.
Domestic sales in the first quarter of 2004 were $2.2 million, as
compared to $2.0 million for the same period in 2003, representing 85% and
79%, respectively, of total net sales. The increase in sales was mostly
attributable to sales of the new FaxPress Premier fax server products.
International sales (excluding sales to the rest of the Americas)
were $326,000, or 13% of total net sales, and $417,000, or 17% of total net
sales, for the first quarter of 2004 and 2003, respectively. The decline in
sales was mostly due to lower sales of our fax server products.
Sales to the rest of the Americas in the first quarter of 2003,
excluding the United States, were $63,000 as compared to $106,000 in the
year-ago quarter, representing 2% and 4% of total net sales, respectively.
The decline in sales was mostly due to lower sales of our fax server
products.
Cost of Sales; Gross Profit
Gross profit was $1.9 million or 75% of net sales for the first
quarter of 2004, as compared to $1.8 million or 72% of net sales for the
same period in 2003. Continuous product cost reductions and outsourcing of
manufacturing contributed to the improvement in gross profit in the first
quarter of 2004.
Research & Development
Research and product development expenses were $414,000, or 16% of
net sales for the first quarter of 2004, as compared to $355,000, or 14% of
net sales for the same period in 2003. The increase of $59,000 is due to
higher compensation expenses relating to headcount additions.
Sales & Marketing
Sales and marketing expenses were $794,000, or 31% of net sales
for the first quarter of 2004, as compared to $735,000, or 29% of net sales
in 2003. The increase of $59,000 is primarily due to an increase in
compensation expenses of $93,000 due to increased headcount and higher
consulting expenses of $30,000, offset in part by lower advertising and
promotional expenses of $62,000.
General & Administrative
General and administrative expenses were $465,000 in the first
quarter of 2004, as compared to $457,000 in the first quarter of 2003.
General and administrative expenses represented 18% of net sales in both
the 2004 and 2003 periods.
14
Provision for Income Tax
Prior to the fourth quarter of 2003, we had not reported
significant income tax expenses because we had utilized available net
operating loss (NOL) and tax credit carry-forwards. These NOLs were fully
reserved by a valuation allowance due to uncertainty surrounding the
likelihood of their realization. Due to our continued profitability and a
determination that it is more likely than not that certain future tax
benefits will be realized, a portion of the deferred tax assets were
recognized in the fourth quarter of 2003. Beginning with the first quarter
of 2004, for purposes of financial reporting, we are providing for income
taxes at an effective tax rate of 40%. As a result, $98,000 of income tax
expense had been provided in the first quarter of 2004 as compared to
$2,000 in the first quarter of 2003. However, for income tax purposes, we
had $12.9 million of NOLs available to offset future taxable income, and we
do not expect to utilize significant amounts of cash for income tax
payments until these NOLs have been utilized.
Liquidity and Capital Resources
As of March 31, 2004 we had approximately $4.4 million of cash and cash
equivalents, a decrease of $246,000 from December 31, 2003. The decrease in cash
and cash equivalents is mostly attributable to an increase in accounts
receivable of $379,000 due to slower collections from customers, offset in part
by $123,000 in proceeds from exercise of stock options.
In the fourth quarter of 2002, our Board of Directors authorized us,
from time to time, to repurchase at market prices, up to $2.25 million shares of
our common stock for cash in open market, negotiated or block transactions. The
timing of these transactions has depended and will depend on market conditions,
other corporate strategies and has been and will be at the discretion of our
management. No time limit was set for the completion of this program. Since the
beginning of this program, we have repurchased from open market and negotiated
transactions a total of 1.67 million shares for $1.8 million, at an average per
share price of $1.10. We have not repurchased any shares since the first quarter
of 2003, but intend to continue to execute our buyback program as we deem
appropriate.
We lease our corporate headquarters in Morgan Hill, California. The
lease on the Morgan Hill facility has a term of five years, expiring in December
2005, with one conditional three-year renewal option, which if exercised would
extend the lease to December 2008 commencing with rent at 95% of fair market
value. As of March 31, 2004, future minimum payments under the lease were
$465,000.
In December 2000, as a source of capital asset financing, we entered
into a loan and security agreement with a finance company for an amount of
$75,000. This loan bears interest at 12.8% and is repayable by December 2006. As
of March 31, 2004, the aggregate value of future minimum payments was $46,000.
In April 2001, as a source of capital asset financing, we entered into
a loan and security agreement with a finance company for an amount of $25,000.
This loan bears interest at 12.5% and is repayable by April 2004. As of March
31, 2004, there was an inconsequential amount remaining.
The following represents combined aggregate maturities for all our
financing and commitments as of March 31, 2004:
15
Payments Due by Period
--------- ------------- -------------- ------------- ---------------
Contractual Obligations Total 1 Year 2 - 3 Years 4 - 5 Years More than 5
Years
--------- ------------- -------------- ------------- ---------------
Capital (Finance) Lease Obligations $ 46 $ 13 $ 33 - -
Operating Lease Obligations $ 465 $ 202 $ 263 - -
--------- ------------- -------------- ------------- ---------------
Total contractual cash obligations $ 511 $ 215 $ 296 - -
========= ============= ============== ============= ===============
We have a $3.0 million collateralized revolving line of credit with a
bank, which expires in March 2005, pursuant to which we may borrow 100% against
pledges of cash at the bank's prime rate. Borrowings under this line of credit
agreement are collateralized by all of our assets. As of March 31, 2004, we have
not drawn down on the line of credit and were in compliance with the terms of
the agreement.
We believe that our existing cash balances and anticipated cash flows
from operations will be sufficient to meet our anticipated capital requirements
for the next 12 months. If we have a need for additional capital resources, we
may be required to sell additional equity or debt securities, secure additional
lines of credit or obtain other third party financing. The timing and amount of
such capital requirements cannot be determined at this time and will depend on a
number of factors, including demand for our existing and new products, if any,
and changes in technology in the networking industry. There can be no assurance
that such additional financing will be available on satisfactory terms when
needed, if at all. Failure to raise such additional financing, if needed, may
result in our inability to achieve our long-term business objectives. To the
extent that additional capital is raised through the sale of additional equity
or convertible debt securities, the issuance of such securities would result in
additional dilution to our shareholders.
In addition, because we are dependent on a small number of distributors
for a significant portion of the sales of our products, the loss of any of our
major distributors or their inability to satisfy their payment obligations to us
could have a significant adverse effect on our business, operating results and
financial condition.
We believe that, for the periods presented, inflation has not had a
material effect on our operations.
Recent Accounting Pronouncements:
In December 2003, the FASB issued a revised FASB interpretation No. 46,
"Consolidation for Variable Interest Entities, an interpretation of ARB No. 51"
("FIN 46R"). The FASB published the revision to clarify and amend some of the
original provisions of FIN 46, which was issued in January 2003, and to exempt
certain entities from its requirements. A Variable Interest Entity ("VIE")
refers to an entity subject to consolidation according to the provisions of the
Interpretation. FIN 46R applies to entities whose equity investment at risk is
insufficient to finance that entity's activities without receiving additional
subordinated financial support provided by any parties, including equity
holders, or where the equity investors (if any) do not have a controlling
financial interest. FIN 46R provides that if an entity is the primary
beneficiary of a VIE, the assets,
16
liabilities, and results of operations of the
VIE should be consolidated in the entity's financial statements. In addition,
FIN 46R requires that both the primary beneficiary and all other enterprises
with a significant variable interest in a VIE provide additional disclosures.
The provisions of FIN 46R are effective for our fiscal 2004 first quarter. The
adoption of FIN 46R did not have a material impact on our financial position or
results of operations.
RISK FACTORS
Shareholders or investors considering the purchase of shares of our
common stock should carefully consider the following risk factors, in addition
to other information in this Quarterly Report on Form 10-Q and in our Annual
Report on Form 10-K for the year ended December 31, 2003. Additional risks and
uncertainties not presently known to us or that we currently deem immaterial
also may impair our business operations
Our revenue and operating results have fluctuated in the past and are likely to
fluctuate significantly in the future, particularly on a quarterly basis.
Our operating results may vary significantly from quarter to quarter
due to many factors, some of which are outside our control. For example, the
following conditions could all affect our results:
o changes in our product sales and customer mix;
o constraints in our manufacturing and assembling operations;
o shortages or increases in the prices of raw materials and components;
o changes in pricing policy by us or our competitors;
o a slowdown in the growth of the networking market;
o seasonality;
o timing of expenditures; and
o economic conditions in the United States, Europe and Asia.
Our sales often reflect orders shipped in the same quarter in which
they are received. In addition, significant portions of our expenses are
relatively fixed in nature, and planned expenditures are based primarily on
sales forecasts. Therefore, if we inaccurately forecast demand for our products,
the impact on net income may be magnified by our inability to adjust spending
quickly enough to compensate for the net sales shortfall.
Other factors contributing to fluctuations in our quarterly operating
results include:
o changes in the demand for our products;
o customer order deferrals in anticipation of new versions of our products;
o the introduction of new products and product enhancements by us or our
competitors;
o the effects of filling the distribution channels following introductions
of new products and product enhancements;
o potential delays in the availability of announced or anticipated products;
o the mix of product and revenue derived from the sale of extended warranty
contracts;
o the commencement or conclusion of significant development contracts;
o changes in foreign currency exchange rates; and
o the timing of significant marketing and sales promotions.
Based on the foregoing, we believe that quarterly operating results are
likely to vary significantly in the future and that period-to-period comparisons
of our results of operations are not necessarily meaningful and should not be
viewed as indications of future performance.
17
We have a history of losses and a large accumulated deficit.
We have experienced significant operating losses and, as of March 31,
2004, had an accumulated deficit of $22.3 million. Our development and marketing
of current and new products will continue to require substantial expenditures.
We incurred $591,000 of losses in 2001 attributable to a slowdown in demand for
our products due in part to industry-wide adverse economic factors. We have been
profitable since the third quarter of 2001, with total net income of $659,000 in
2002 and $1.6 million in 2003, and $147,000 for the first three months in 2004.
There can be no assurance that growth in net sales will be achieved or
profitability sustained in future years.
Recent FASB Exposure Draft on Share-Based Payments may have a significant effect
on our Results of Operations, if adopted.
During March 2004, the FASB issued a proposed Statement, "Share-Based
Payment, and amendment of FASB Statements No. 123 and 95". The proposed
Statement addresses the accounting for share-based payment transactions in which
a company receives employee services in exchange for equity instruments of the
company that are based on the fair values of the company's equity instruments or
that may be settled by the issuance of such equity instruments. The proposed
statement eliminates the treatment for share-based transactions using APB
Opinion No. 25, "Accounting for Stock Issued to Employees," and generally would
require that such transactions be accounted for using a fair-value-based method
and recognized as expenses in our statement of income. The proposed standard
would require the modified prospective method be used, which would require that
the fair value of new awards granted from the beginning of the year of adoption
plus unvested awards at the date of adoption be expensed over the vesting term.
In addition, the proposed statement encourages companies to use the "binomial"
approach to value stock options, as opposed to the Black-Scholes option pricing
model that is currently being used for the fair value of our options.
The effective date the proposed standard is recommending is for fiscal
years beginning after December 15, 2004. Should the proposed statement be
finalized, it will have a significant impact on our consolidated statement of
operations as we will be required to expense the fair value of our stock options
rather than disclosing the impact on our consolidated net income within our
footnotes (See Note 4 of the notes to the condensed consolidated financial
statements).
Substantially all of our revenue comes from the sale of fax server products, and
a decline in demand for those products would harm our business, operating
results and financial condition.
We derive substantially all of our revenue from the sale of fax and
print server products, with fax server products accounting for 97% of total
sales in 2003 and almost all sales in the first quarter of 2004. We expect that
our current products will continue to account for most of our sales in the near
future. A decline in demand for our fax server products as a result of
competition, technological change, shortages of components or other factors, or
a delay in the development and market acceptance of new features and products,
would have a material adverse effect on our business, operating results and
financial condition.
We sell our products through a limited number of distributors, and any
deterioration in our relationship with those distributors would harm our
business, operating results and financial condition.
We sell our products primarily through a two-tier domestic and
international distribution network. Our distributors sell our products to VARs,
e-commerce vendors and other resellers. The distribution of personal computers
and networking products has been characterized by rapid change,
18
including consolidations due to the financial difficulties of distributors and
the emergence of alternative distribution channels. An increasing number of
companies are competing for access to these channels. Our distributors typically
represent other products that are complementary to, or compete with, our
products. Our distributors are not contractually committed to future purchases
of our products and could discontinue carrying our products at any time for any
reason. In addition, because we are dependent on a small number of distributors
for a significant portion of the sales of our products, the loss of any of our
major distributors or their inability to satisfy their payment obligations to us
could have a significant adverse effect on our business, operating results and
financial condition. We have a stock rotation policy with certain of our
distributors that allows them to return marketable inventory against offsetting
orders. If we reduce our prices, we credit certain distributors for the
difference between the purchase price of products remaining in their inventory
and our reduced price for these products. In addition, inventory levels of our
products held by distributors could become excessive due to industry conditions
or the actions of competitors, resulting in product returns and inventory
write-downs.
The market for our products is affected by rapidly changing technology and if we
fail to predict and respond to customers' changing needs, our business,
operating results and financial condition may suffer.
The market for our products is affected by rapidly changing networking
technology, evolving industry standards and the Internet and other new
communication technologies. We believe that our future success will depend upon
our ability to enhance our existing products and to identify, develop,
manufacture and introduce new products that:
o conform to or support emerging network telecommunications standards;
o are compatible with a growing array of computer and peripheral devices;
o support popular computer and network operating systems and applications;
o meet a wide range of evolving user needs; and
o achieve market acceptance.
There can be no assurance that we will be successful in these efforts.
We have incurred, and expect to continue to incur, substantial expenses
associated with the introduction and promotion of new products. There can be no
assurance that the expenses incurred will not exceed research and development
cost estimates or that new products will achieve market acceptance and generate
sales sufficient to offset development costs. In order to develop new products
successfully, we are dependent upon timely access to information about new
technological developments and standards. There can be no assurance that we will
have such access or will be able to develop new products successfully and
respond effectively to technological change or new product announcements by
others.
Complex products such as those offered by us may contain undetected or
unresolved hardware defects or software errors when they are first introduced or
as new versions are released. Changes in our or our suppliers' manufacturing
processes or the inadvertent use of defective components could adversely affect
our ability to achieve acceptable manufacturing yields and product reliability.
We have in the past discovered hardware defects and software errors in certain
of our new products and enhancements after their introduction. Replacement of
discontinued components used in our products could lead to further defects and
errors. There can be no assurance that despite testing by us and by third-party
test sites, errors and defects will not be found in future releases of our
products, which would result in adverse product reviews and negatively affect
market acceptance of these products.
19
The introduction of new or enhanced products requires us to manage the
transition from the older products to the new or enhanced products or versions,
both internally and for customers. We must manage new product introductions so
as to minimize disruption in customer ordering patterns, avoid excessive levels
of older product inventories and ensure that adequate supplies of new products
can be delivered to meet customer demands. We have from time to time experienced
delays in the shipment of new products. There can be no assurance that we will
successfully manage future product transitions.
Our success depends upon the continued contributions of our key management,
marketing, product development and operational personnel.
Our success will depend, to a large extent, upon our ability to retain
and continue to attract highly skilled personnel in management, marketing,
product development and operations. Competition for employees in the computer
and electronics industries is intense, and there can be no assurance that we
will be able to attract and retain enough qualified employees. Volatility or
lack of positive performance in our stock price may also adversely affect our
ability to retain and continue to attract key employees, many of whom have been
granted stock options. Our inability to retain and attract key employees could
have a material adverse effect on our product development, business, operating
results and financial condition. We do not carry key person life insurance with
respect to any of our personnel.
The markets for our products are highly competitive and may become more
competitive in the future.
The network enhancement products and computer software markets are
highly competitive, and we believe that competition will intensify in the
future. The competition is characterized by rapid change and improvements in
technology along with constant pressure to reduce the prices of products. We
currently compete principally in the market for network fax servers, network
print servers and fax-on-demand software. Both direct and indirect competition
could adversely affect our business and operating results through pricing
pressure, loss of market share and other factors. In particular, we expect that,
over time, average selling prices for our print server products will continue to
decline, as the market for these products becomes increasingly competitive. Any
material reduction in the average selling prices of our products would adversely
affect gross margins. There can be no assurance we will be able to maintain the
current average selling prices of our products or the related gross margins.
The principal competitive factors affecting the market for our products
include:
o product functionality;
o performance;
o quality;
o reliability;
o ease of use;
o quality of customer training and support;
o name recognition;
o price; and
o compatibility and conformance with industry standards and changing operating
system environments.
Several of our existing and potential competitors have substantially
greater financial, engineering, manufacturing and marketing resources than us.
We also experience competition from a number of other software, hardware and
service companies. In addition to our current competitors, we may face
20
substantial competition from new entrants into the network enhancement market,
including established and emerging computer, computer peripheral, communications
and software companies. In the fax server market we compete with companies such
as Captaris Inc., Omtool, Ltd. and Esker Software. There can be no assurance
that competitors will not introduce products incorporating technology more
advanced than the technology used by us in our products. In addition, certain
competing methods of communications such as the Internet or electronic mail
could adversely affect the market for fax products. Certain of our existing and
potential competitors in the print server market are manufacturers of printers
and other peripherals, and these competitors may develop closed systems
accessible only through their own proprietary servers. There can be no assurance
that we will be able to compete successfully or that competition will not have a
material adverse effect on our business, operating results and financial
condition.
We depend on sales in foreign markets, and political or economic changes in
these markets could affect our business, operating results and financial
condition.
Sales to customers located outside the United States accounted for
approximately 19%, 21% and 25% of our net sales in 2003, 2002 and 2001,
respectively. We sell our products in approximately 44 foreign countries through
approximately 89 distributors. Our principal Japanese distributor accounted for
approximately 38%, 27% and 40% of our international sales in 2003, 2002 and
2001, respectively, and 7%, 6% and 10% of our total net sales in 2003, 2002 and
2001, respectively. We expect that international sales will continue to
represent a significant portion of our product revenues and that we will be
subject to the normal risks of international sales, such as export laws,
currency fluctuations, longer payment cycles, greater difficulties in accounts
receivable collections and the requirement of complying with a wide variety of
foreign laws. There can be no assurance that we will not experience difficulties
resulting from changes in foreign laws relating to the export of our products in
the future. In addition, because we primarily invoice foreign sales in U.S.
dollars, fluctuations in exchange rates could affect demand for our products by
causing prices to be out of line with products priced in the local currency.
Additionally, any such difficulties would have a material adverse effect on our
international sales and a resulting material adverse effect on our business,
operating results and financial condition. We may experience fluctuations in
European sales on a quarterly basis because European sales may be weaker during
the third quarter than the second quarter due to extended holiday shutdowns in
July and August. There can be no assurance that we will be able to maintain the
level of international sales in the future. Any fluctuations in international
sales will significantly affect our operating results and financial condition.
The introduction of new products may reduce the demand for our existing products
and increase returns of existing products.
From time to time, we may announce new products, product versions,
capabilities or technologies that have the potential to replace or shorten the
life cycles of existing products. The release of a new product or product
version may result in the write-down of products in inventory if this inventory
becomes obsolete. We have in the past experienced increased returns of a
particular product version following the announcement of a planned release of a
new version of that product. There can be no assurance that product returns will
not exceed our allowance for these returns in the future and will not have a
material adverse effect on our business, operating results and financial
condition.
If we fail to obtain components of our products from third-party suppliers and
subcontractors, our business could suffer.
Our products require components procured from third-party suppliers.
Some of these components are available only from a single source or from limited
sources. In addition,
21
we subcontract a substantial portion of our manufacturing to third parties, and
there can be no assurance that these subcontractors will be able to support our
manufacturing requirements. We purchase components on a purchase order basis,
and generally have no long-term contracts for these components. If we are unable
to obtain a sufficient supply of high-quality components from our current
sources, we could experience delays or reductions in product shipments. From
time to time, component manufacturers announce the end of life of certain of
their products and may or may not have replacement products. If we are unable to
secure enough inventories of the end-of-life components or their replacements,
we might not be able to deliver our products to our customers and could
adversely affect our revenue and net income. Furthermore, a significant increase
in the price of one or more of these components or our inability to lower
component or sub-assembly prices in response to competitive price reductions
could adversely affect our gross margin.
We depend on proprietary technology, and inability to develop and protect this
technology or license it from third parties could adversely affect our business,
operating results and financial condition.
Our success depends to a certain extent upon our technological
expertise and proprietary software technology. We rely upon a combination of
contractual rights and copyright, trademark and trade secret laws to establish
and protect our technologies. Despite the precautions taken by us, it may be
possible for unauthorized third parties to copy our products or to reverse
engineer or obtain and use information that we regard as proprietary. In
addition, the laws of some foreign countries either do not protect our
proprietary rights or offer only limited protection. Given the rapid evolution
of technology and uncertainties in intellectual property law in the United
States and internationally, there can be no assurance that our current or future
products will not be subject to third-party claims of infringement. Any
litigation to determine the validity of any third-party claims could result in
significant expense and divert the efforts our technical and management
personnel, whether or not any litigation is determined in favor of us. In the
event of an adverse result in litigation, we could be required to expend
significant resources to develop non-infringing technology or to obtain licenses
to the technology that is the subject of the litigation. There can be no
assurance that we would be successful in this development or that any such
licenses would be available on commercially reasonable terms. We also rely on
technology licensed from third parties. There can be no assurance that these
licenses will continue to be available upon reasonable terms, if at all. Any
impairment or termination of our relationship with third-party licensors could
have a material adverse effect on our business, operating results and financial
condition. There can be no assurance that our precautions will be adequate to
deter misappropriation or infringement of our proprietary technologies.
We have received, and may receive in the future, communications
asserting that our products infringe the proprietary rights of third parties or
seeking indemnification against the alleged infringement. There can be no
assurance that third parties will not assert infringement claims against us with
respect to current or future products or that any assertion may not require us
to enter into royalty arrangements or result in costly litigation. Any claims,
with or without merit, can be time consuming and expensive to defend. There can
be no assurance that any intellectual property litigation will not have a
material adverse effect on our business, operating results and financial
condition.
Our common stock is listed on the Nasdaq SmallCap Market, and we have had
difficulty satisfying the listing criteria to avoid the delisting of our common
stock.
Our common stock has been listed on the Nasdaq SmallCap Market since
April 1999. In order to maintain our listing on the Nasdaq SmallCap Market, we
must maintain total assets, capital
22
and public float at specified levels, and our common stock generally must
maintain a minimum bid price of $1.00 per share. If we fail to maintain the
standards necessary to be quoted on the Nasdaq SmallCap Market, our common stock
could become subject to delisting. There can be no assurance that we will be
able to maintain the $1.00 minimum bid price per share of our common stock and
thus maintain our listing on the Nasdaq SmallCap Market. We have traded below
$1.00 as recently as December 2002.
If our common stock is delisted, trading in our common stock could be
conducted on the OTC Bulletin Board or in the over-the-counter market in what is
commonly referred to as the "pink sheets." If this occurs, a shareholder will
find it more difficult to dispose of our common stock or to obtain accurate
quotations as to the price of our common stock. Lack of any active trading
market would have an adverse effect on a shareholder's ability to liquidate an
investment in our common stock easily and quickly at a reasonable price. It
might also contribute to volatility in the market price of our common stock and
could adversely affect our ability to raise additional equity or debt financing
on acceptable terms or at all. Failure to obtain desired financing on acceptable
terms could adversely affect our business, financial condition and results of
operations.
Our stock price has been volatile, and is likely to continue to be volatile in
the future.
The price of our common stock has fluctuated widely in the past. Sales
of substantial amounts of our common stock, or the perception that sales could
occur, could adversely affect prevailing market prices for our common stock. Our
management believes past fluctuations may have been caused by the factors
identified above, and that these factors may continue to affect the market price
of our common stock. Additionally, stock markets have experienced extreme price
volatility in recent years. This volatility has had a substantial effect on the
market price of the common stock of us and other high technology companies,
often for reasons unrelated to operating performance. We anticipate that prices
for our common stock may continue to be volatile. Future stock price volatility
may result in the initiation of securities litigation against us, which may
divert substantial management and financial resources and have an adverse effect
on our business, operating results and financial condition.
We may require additional capital in the future, and may be unable to obtain
this capital at all or on commercially reasonable terms.
The development and marketing of products requires significant amounts
of capital. If we need additional capital resources, we may be required to sell
additional equity or debt securities, secure additional lines of credit or
obtain other third party financing. The timing and amount of such capital
requirements cannot be determined at this time and will depend on a number of
factors, including demand for our existing and new products and changes in
technology in the networking industry. There can be no assurance that additional
financing will be available on satisfactory terms when needed, if at all.
Failure to raise such additional financing, if needed, may result in our
inability to achieve our long-term business objectives. The issuance of equity
or convertible debt securities to raise additional capital would result in
additional dilution to our shareholders.
Government regulation could increase our costs of doing business and adversely
affect our gross margin.
Certain aspects of the networking industry in which we compete are
regulated both in the United States and in foreign countries. Imposition of
public carrier tariffs, taxation of telecommunications services and the
necessity of incurring substantial costs and expenditure of managerial resources
to obtain regulatory approvals, or the inability to obtain regulatory approvals
within a reasonable period of time, could have a material, adverse effect on our
business, operating
23
results and financial condition. This is particularly true in foreign countries
where telecommunications standards differ from those in the United States. Our
products must comply with a variety of equipment, interface and installation
standards promulgated by communications regulatory authorities in different
countries. Changes in government policies, regulations and interface standards
could require the redesign of products and result in product shipment delays
which could have a material, adverse impact on our business, operating results
and financial condition.
The costs of compliance with recent developments in corporate governance
regulation may affect our business, operating results and financial condition in
ways that presently cannot be predicted.
Beginning with the enactment of the Sarbanes-Oxley Act of 2002, a
significant number of new corporate governance requirements have been adopted or
proposed through legislation and regulation by the Securities and Exchange
Commission and Nasdaq National Stock Market. We may not be successful in
complying with these requirements at all times in the future. Additionally, we
expect these developments to increase our legal compliance and accounting costs,
and to make some activities more difficult, such as stockholder approval of new
stock option plans. We expect these developments to make it more difficult and
more expensive for us to obtain director and officer liability insurance, and we
may be required to accept reduced coverage or incur substantially higher costs
to obtain coverage. These developments could make it more difficult for us to
attract and retain qualified members of our Board of Directors, or qualified
executive officers. We are presently evaluating and monitoring regulatory
developments and cannot estimate the timing or magnitude of additional costs we
may incur as a result, or the effect that these increased costs may have on our
operating results.
Recent terrorist activity in the United States and the military action to
counter terrorism could adversely impact our business.
Terrorist acts or acts of war (wherever located around the world) could
significantly impact our revenue, costs and expenses, and financial condition.
The terrorist attacks that took place in the United States on September 11, 2001
have created many economic and political uncertainties, some of which may
materially harm our business, operating results and financial condition. The
long-term effects on our business of the September 11, 2001 attacks and the
ensuing war on terror are unknown. The potential for future terrorist attacks,
the national and international responses to terrorist attacks or perceived
threats to national security, and other actual or potential conflicts, acts of
war or hostility, including the United States' activities in Iraq, have created
many economic and political uncertainties that could adversely affect our
business, operating results and financial condition in ways that cannot
presently be predicted.
Provisions in our charter documents might deter a company from acquiring us,
which could inhibit your ability to receive an acquisition premium for your
shares.
Our Board of Directors has authority to issue shares of preferred stock
and to fix the rights, including voting rights, of these shares without any
further vote or action by the shareholders. The rights of the holders of our
common stock will be subject to, and may be adversely affected by, the rights of
the holders of any preferred stock that may be issued in the future. The
issuance of preferred stock, while providing desirable flexibility in connection
with possible acquisitions and other corporate purposes, could have the effect
of making it more difficult for a third party to acquire a majority of our
outstanding voting stock, thereby delaying, deferring or preventing a change in
control. Furthermore, such preferred stock may have other rights, including
economic rights,
24
senior to the common stock, and as a result, the issuance thereof could have a
material adverse effect on the market.
Voting control by officers, directors and affiliates may delay, defer or prevent
a change of control.
At April 30, 2004, our officers and directors and their affiliates
beneficially owned approximately 25% of the outstanding shares of common stock.
Accordingly, together they had the ability to significantly influence the
election of our directors and other corporate actions requiring shareholder
approval. Such concentration of ownership may have the effect of delaying,
deferring or preventing a change in control.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We had no holdings of derivative financial or commodity instruments at
March 31, 2004. However, we are exposed to financial market risks, including
changes in interest rates and foreign currency exchange rates. While much of our
revenue is transacted in U.S. dollars, some revenues and capital spending are
transacted in Pounds Sterling. These amounts are not currently material to our
financial statements. Therefore, we believe that foreign currency exchange rates
should not materially affect our overall financial position, results of
operations or cash flows. The fair value of our money market accounts or related
income would not be significantly impacted by increases or decreases in interest
rates due mainly to the highly liquid nature of this investment. However, sharp
declines in interest rates could seriously harm interest earnings.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Regulations under the Securities Exchange Act of 1934 require public
companies, including our company, to maintain "disclosure controls and
procedures," which are defined to mean a company's controls and other procedures
that are designed to ensure that information required to be disclosed in the
reports that it files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized, and reported, within the time periods specified
in the Securities and Exchange Commission's rules and forms. Our Chief Executive
Officer and our Chief Financial Officer, based on their evaluation of our
disclosure controls and procedures as of the end of the period covered by this
report, concluded that our disclosure controls and procedures were effective for
this purpose.
Regulations under the Securities Exchange Act of 1934 require public
companies, including our company, to evaluate any change in our "internal
control over financial reporting," which is defined as a process to provide
reasonable assurance regarding the reliability of financial reporting and
preparation of financial statements for external purposes in accordance with
accounting principles generally accepted in the United States. In connection
with their evaluation of our disclosure controls and procedures as of the end of
the period covered by this report, our Chief Executive Officer and Chief
Financial Officer did not identify any change in our internal control over
financial reporting during the three-month period ended March 31, 2004 that
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
25
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Additional Exhibit
In accordance with SEC Release No. 33-8212, Exhibits 32.1 and
32.2 are to be treated as "accompanying" this report rather
than "filed" as part of the report.
31.1 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002, executed by Scott C. McDonald, Chief
Executive Officer and President of Castelle
31.2 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002, executed by Paul Cheng, Chief Financial
Officer of Castelle
32.1 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002, executed by Scott C. McDonald, Chief
Executive Officer and President of Castelle
32.2 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002, executed by Paul Cheng, Chief Financial
Officer of Castelle
26
(b) Reports on Form 8-K
Castelle filed a Form 8-K on February 13, 2004. Furnished
under Item 7, "Financial Statements and Exhibits", Castelle
filed a press release regarding its financial results for the
year ended December 31, 2003.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
CASTELLE
By: /s/ Scott C. McDonald Date: May 11, 2004
Scott C. McDonald
Chief Executive Officer and President
(Principal Executive Officer)
By: /s/ Paul Cheng Date: May 11, 2004
Paul Cheng
Vice President of Finance and Administration
Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
28