UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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 November 08, 2004 was
3,689,831.
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/A
TABLE OF CONTENTS
PAGE
----
PART I - FINANCIAL INFORMATION.......................................................2
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.............................2
CONDENSED CONSOLIDATED BALANCE SHEETS...................................4
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS...........................5
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS.........................6
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS....................7
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS..........................................19
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS..................................................20
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK..............35
ITEM 4. CONTROLS AND PROCEDURES................................................35
PART II - OTHER INFORMATION.........................................................37
ITEM 5. LEGAL PROCEEDINGS......................................................37
ITEM 6. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS............37
ITEM 7. DEFAULTS UPON SENIOR SECURITIES........................................37
ITEM 8. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS....................37
ITEM 9. OTHER INFORMATION......................................................37
ITEM 10. EXHIBITS...............................................................37
SIGNATURES.............................................................38
EXHIBIT 31.1 CERTIFICATION PURSUANT TO SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002............................................E-1
EXHIBIT 31.2 CERTIFICATION PURSUANT TO SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002............................................E-2
EXHIBIT 32.1 CERTIFICATION 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 CERTIFICATION 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
EXPLANATORY NOTE
In a report on Form 8-K filed on March 31, 2005, Castelle ("the Company", or
"we") indicated that it has completed a review of its accounting practices with
respect to the historical classification of cost of service revenues, procedures
for recognizing revenue associated with extended support contracts and
procedures for establishing the accrual for paid-time-off, and determined that
its historical financial statements as of and for the years ended December 31,
2002 and 2003, and the three quarters ended March 31, June 30 and September 30
of 2004 contained certain errors in the application of Generally Accepted
Accounting Principles as described below:
a) Classification of cost of service revenues
The Company has concluded that its historical classification of cost
of service revenues did not conform to Generally Accepted Accounting
Principles. Historically, such costs have been improperly included
as a component of sales and marketing expenses on the Company's
consolidated statements of earnings; however under Generally
Accepted Accounting Principles, such costs are required to be
classified as cost of service revenues. For the three months ended
September 30, 2004 and 2003, the Company has reclassified $207,000
and $193,000, respectively, out of sales and marketing and included
these amounts within cost of service revenues in its statements of
earnings. For the nine months ended September 30, 2004 and 2003, the
Company has reclassified $621,000 and $542,000, respectively, out of
sales and marketing and included these amounts within cost of
service revenues. The reclassification had no impact on reported
sales, net income, earnings per share, or cash flows from operations
for the respective periods. The misclassification, however, did
result in cost of sales being understated, and gross profit and
operating expenses being overstated by equal amounts. The Company
has concluded that the internal control deficiency that led to the
errors in the historical classification of cost of service revenues
is a "material weakness" as defined by the Public Company Accounting
Oversight Board's Auditing Standard No. 2.
Effective January 1, 2005, the Company established a separate cost
center to capture solely the cost of service revenues and such costs
will be classified as a component of cost of sales.
The Company's review of such costs was prompted in part by the
receipt in November 2004 and thereafter of a series of comment
letters issued by the Division of Corporation Finance of the
Securities and Exchange Commission to the Company.
b) Revenue recognition related to extended support contracts
The Company has determined that as a result of an internal control
deficiency, service revenues attributable to extended support
contracts were overstated by $13,000 and $5,000 for the three months
ended September 30, 2004 and 2003, respectively, and $58,000 and
$20,000 for the first nine months of 2004 and 2003, respectively.
These amounts should have been deferred and recognized as service
revenues in subsequent periods. Such errors were the result of
inadequate procedures in place to correctly recognize sales related
to extended support contracts. The revenue overstatements represent
less than 1% of the Company's total sales for the respective
periods. In
2
connection with their audit of the Company's consolidated financial
statements for the year ended December 31, 2004, the Company's
independent registered public accounting firm, Grant Thornton LLP,
concluded that the internal control deficiency that led to the
aforementioned revenue recognition errors is a "material weakness"
as defined by the Public Company Accounting Oversight Board's
Auditing Standard No. 2.
During the first quarter of 2005, the Company enhanced its internal
accounting system to ensure that revenue is recognized over the
actual contract term.
c) Accrual for paid-time-off
The Company has also identified an error that resulted in an
overstatement of its accrual for paid-time-off beginning in 2002 and
continuing through 2004. This error resulted in the overstatement of
expenses by $1,000 and $2,000 in each of the three-month period
which ended September 30, 2004 and 2003. The overstatement of
expenses was $3,000 and $5,000 for the nine months of 2004 and 2003,
respectively. During the first quarter of fiscal 2005, the Company
corrected the internal control deficiency that led to such
over-accrual.
The outcome of the review referred to above necessitated adjustments to
Castelle's previously filed condensed consolidated balance sheets as of
September 30, 2004 and December 31, 2003, and statements of earnings for each of
the three and nine months ended September 30, 2004 and 2003. These adjustments,
together, reduced the reported net income by $12,000 and $3,000 for the three
months ended September 30 of 2004 and 2003, respectively, and $55,000 and
$15,000 for the nine months of 2004 and 2003, respectively. Basic net income per
share did not change for the three months ended September 30, 2004 and 2003
compared to the amounts previously reported. Diluted income per share was
reduced by $0.01 for the three months ended September 30, 2003, but did not
change for the three months ended September 30, 2004, as compared to the amounts
previously reported. As a result of the adjustments referenced to above, the
historical financial statements and related financial information contained in
Castelle's Quarterly Reports on Form 10-Q for the period ended September 30,
2004 should no longer be relied upon and are superceded by the financial
statements and financial information in this Quarterly Report on Form 10-Q/A.
This amended Form 10-Q/A amends Items 1 and 2 of Part I of Castelle's quarterly
report of Form 10-Q filed on November 12, 2004 to reflect these adjustments.
3
CASTELLE
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited and restated)
(in thousands)
September 30, 2004 December 31, 2003
------------------ -----------------
Assets:
Current assets:
Cash and cash equivalents $ 5,032 $ 4,614
Accounts receivable, net of allowance for doubtful accounts
of $37 and $39, respectively 948 873
Inventories 1,532 1,177
Prepaid expenses and other current assets 187 134
Deferred taxes 212 380
---------- ----------
Total current assets 7,911 7,178
Property and equipment, net 243 376
Other non-current assets 103 103
Deferred taxes, non-current -- 146
---------- ----------
Total assets $ 8,257 $ 7,803
========== ==========
Liabilities and Shareholders' Equity:
Current liabilities:
Long-term debt, current portion $ 14 $ 16
Accounts payable 338 314
Accrued liabilities 1,225 1,737
Deferred revenue 1,218 955
---------- ----------
Total current liabilities 2,795 3,022
Long term debt, net of current portion 18 29
---------- ----------
Total liabilities 2,813 3,051
---------- ----------
Shareholders' equity:
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 3,682 and 3,425, respectively 27,545 27,258
Accumulated deficit (22,101) (22,506)
---------- ----------
Total shareholders' equity 5,444 4,752
---------- ----------
Total liabilities and shareholders' equity $ 8,257 $ 7,803
========== ==========
See accompanying notes to unaudited condensed consolidated financial statements.
4
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
(in thousands, except per share amounts)
(unaudited and restated)
Three months ended Nine months ended
----------------------------- -----------------------------
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
------------- ------------- ------------- -------------
Net sales:
Products $ 2,079 $ 2,081 $ 6,181 $ 6,232
Services 606 480 1,734 1,325
-------- -------- -------- --------
Total net sales 2,685 2,561 7,915 7,557
Cost of sales:
Products 674 555 1,905 1,825
Services 207 192 621 540
-------- -------- -------- --------
Total cost of sales 881 747 2,526 2,365
-------- -------- -------- --------
Gross profit 1,804 1,814 5,389 5,192
-------- -------- -------- --------
Operating expenses:
Research and development 470 427 1,312 1,211
Sales and marketing 612 652 1,882 1,796
General and administrative 486 497 1,459 1,463
-------- -------- -------- --------
Total operating expenses 1,568 1,576 4,653 4,470
-------- -------- -------- --------
Income from operations 236 238 736 722
Interest income, net 10 5 18 13
Other expense, net (21) (3) (35) (32)
-------- -------- -------- --------
Income before provision for income taxes 225 240 719 703
Provision for income taxes 95 2 314 6
-------- -------- -------- --------
Net income $ 130 $ 238 $ 405 $ 697
======== ======== ======== ========
Income per share:
Net income per common share - basic $ 0.04 $ 0.07 $ 0.11 $ 0.21
Net income per common share - diluted $ 0.03 $ 0.05 $ 0.09 $ 0.17
Shares used in per share calculation - basic 3,647 3,286 3,573 3,260
Shares used in per share calculation - diluted 4,353 4,344 4,414 4,154
See accompanying notes to unaudited condensed consolidated financial statements.
5
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited and restated)
Nine months ended
------------------------------
September 30, September 30,
2004 2003
------------- -------------
Cash flows from operating activities:
Net income $ 405 $ 697
Adjustments to reconcile net income to net cash provided by
operating activities:
Loss on disposal of fixed assets 2 --
Depreciation and amortization 155 160
Provision for doubtful accounts and sales returns (10) (227)
Provision for excess and obsolete inventory (32) (139)
Deferred taxes 314 --
Changes in assets and liabilities:
Accounts receivable (65) 80
Inventories (323) 132
Prepaid expenses and other current assets (53) (127)
Accounts payable 24 (2)
Accrued liabilities (512) 114
Deferred revenue 263 297
-------- --------
Net cash provided by operating activities 168 985
Cash flows from investing activities:
Purchase of property and equipment (24) (140)
-------- --------
Net cash used in investing activities (24) (140)
Cash flows from financing activities:
Repayment of long-term debt (13) (16)
Repurchase of common stock -- (49)
Proceeds from issuances of common stock, 287 191
-------- --------
Net cash provided by financing activities 274 126
Net increase in cash and cash equivalents 418 971
Cash and cash equivalents at beginning of period 4,614 3,460
-------- --------
Cash and cash equivalents at end of period $ 5,032 $ 4,431
======== ========
Supplemental Information:
Cash paid during the period for:
Interest $ 4 $ 7
======== ========
See accompanying notes to unaudited condensed consolidated financial statements.
6
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 Forms 10-K for the years ended
December 31, 2003 and 2004. 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 nine months of
2004 and 2003, Ingram Micro and Tech Data, our two largest distributors,
collectively represented approximately 44% and 50% 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 components on a purchase order basis. We own all
engineering, sourcing documentation, functional test equipment
7
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 assure 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. We believe that most of these
end-of-life components will be utilized in the following two years,
resulting in insignificant amounts of excessive inventory, or none at all.
We believe that Castelle's liquidity continues to be strong despite these
purchases, as our cash reserves have increased during the periods when the
parts were purchased.
Certain reclassifications have been made to the prior period's financial
statements to conform to the current period presentation. We have restated
the three and nine months ended September 30, 2003 to show separate
presentation of product and service revenue, to conform with the current
period disclosure.
2. Restatement of Issued Financial Statements
The Company has completed a review of its accounting practices with
respect to the historical classification of cost of service revenues,
procedures for recognizing revenue associated with extended support
contracts and procedures for establishing the accrual for paid-time-off,
and determined that its previously filed condensed consolidated balance
sheets as of September 30, 2004 and December 31, 2003, and statements of
earnings for each of the three and nine months ended September 30, 2004
and 2003 contained certain errors in the application of Generally Accepted
Accounting Principles as described below:
a. Classification of cost of service revenues
The Company has concluded that its historical classification of cost
of service revenues did not conform to Generally Accepted Accounting
Principles. Historically, such costs have been improperly included
as a component of sales and marketing expenses on the Company's
consolidated statements of earnings; however under Generally
Accepted Accounting Principles, such costs are required to be
classified as cost of service revenues. For the three months ended
September 30, 2004 and 2003, the Company has reclassified $207,000
and $193,000, respectively, out of sales and marketing and included
these amounts within cost of service revenues in its statements of
earnings. For the nine months ended September 30, 2004 and 2003, the
Company has reclassified $621,000 and 542,000, respectively, out of
sales and marketing and included these amounts within cost of
service revenues. The reclassification had no impact on reported
sales, net income, earnings per share, or cash flows from operations
for the respective periods. The misclassification, however, did
result in cost of sales being understated, and gross profit and
operating expenses being overstated by equal amounts. Effective
January 1, 2005, the Company established a separate cost center to
capture solely the cost of service revenues and such costs will be
classified as a component of cost of sales.
b. Revenue recognition related to extended support contracts
8
The Company has determined that as a result of an internal control
deficiency, service revenues attributable to extended support
contracts were overstated by $13,000 and $5,000 for the three months
ended September 30, 2004 and 2003, respectively, and $58,000 and
$20,000 for the first nine months of 2004 and 2003, respectively.
These amounts should have been deferred and recognized as service
revenues in subsequent periods. Such errors were the result of
inadequate procedures in place to correctly recognize sales related
to extended support contracts. The revenue overstatements represent
less than 1% of the Company's total sales for the respective
periods.
During the first quarter of 2005, the Company enhanced its internal
accounting system to ensure that revenue is recognized over the
actual contract term.
c) Accrual for paid-time-off
The Company has also identified an error that resulted in an
overstatement of its accrual for paid-time-off beginning in 2002 and
continuing through 2004. This error resulted in the overstatement of
expenses by $1,000 and $2,000 in each of the three-month period
which ended September 30, 2004 and 2003. The overstatement of
expenses was $3,000 and $5,000 for the nine months of 2004 and 2003,
respectively. During the first quarter of fiscal 2005, the Company
corrected the internal control deficiency that led to such
over-accrual.
9
The following tables summarize the impact of the adjustments described
above (amounts in thousands, except per share data):
Reconciliation of Condensed Consolidated Statements of Earnings
For the three months ended For the nine months ended
September 30, 2004 September 30, 2004
------------------------------------ ------------------------------------
As As As As
-- -- -- --
reported Adjustments restated reported Adjustments restated
-------- ----------- -------- -------- ----------- --------
Sales:
Products $2,079 -- $2,079 $6,181 -- $6,181
Services 619 (13) 606 1,792 (58) 1,734
------------------------------------ ------------------------------------
Net sales 2,698 (13) 2,685 7,973 (58) 7,915
Cost of sales
Products 674 -- 674 1,905 -- 1,905
Services -- 207 207 -- 621 621
------------------------------------ ------------------------------------
Total cost of sales 621
674 207 881 1,905 2,526
Gross Profit 2,024 (220) 1,804 6,068 (679) 5,389
Operating expenses:
Research and engineering 470 -- 470 1,312 -- 1,312
Sales and marketing 820 (208) 612 2,506 (624) 1,882
General and administrative 486 -- 486 1,459 -- 1,459
------------------------------------ ------------------------------------
Total operating expenses 1,776 (208) 1,568 5,277 (624)
4,653
Operating income 248 (12) 236 791 (55) 736
Other income/(expense), net (11) -- (11) (17) -- (17)
------------------------------------ ------------------------------------
Income before provision for/(benefit
from) income taxes 237 (12) 225 774 (55) 719
Provision for (benefit from) income
taxes 95 -- 95 314 -- 314
------------------------------------ ------------------------------------
Net income $142 ($12) $130 $460 ($55) $405
==================================== ====================================
Net income per common share:
Basic $0.04 -- $0.04 $0.13 ($0.02) $0.11
==================================== ====================================
Diluted $0.03 -- $0.03 $0.10 ($0.01) $0.09
==================================== ====================================
Shares used in per share calculation
Basic 3,647 3,647 3,573 3,573
==================================== ====================================
Diluted 4,353 4,353 4,414 4,414
==================================== ====================================
10
For the three months ended For the nine months ended
September 30, 2003 September 30, 2003
------------------------------------ ------------------------------------
As As As As
-- -- -- --
reported Adjustments restated reported Adjustments restated
-------- ----------- -------- -------- ----------- --------
Sales:
Products $2,081 -- $2,081 $6,232 -- $6,232
Services 485 (5) 480 1,345 (20) 1,325
------------------------------------ ------------------------------------
Net sales 2,566 (5) 2,561 7,577 (20) 7,557
Cost of sales
Products 555 -- 555 1,825 -- 1,825
Services -- 192 192 -- 540 540
------------------------------------ ------------------------------------
Total cost of sales 540
555 192 747 1,825 2,365
Gross Profit 2,011 (197) 1,814 5,752 (560) 5,192
Operating expenses:
Research and engineering 427 -- 427 1,211 -- 1,211
Sales and marketing 846 (194) 652 2,341 (545) 1,796
General and administrative 497 -- 497 1,463 -- 1,463
------------------------------------ ------------------------------------
Total operating expenses 1,770 (194) 1,576 5,015 (545)
4,470
Operating income 241 (3) 238 737 (15) 722
Other income/(expense), net (2) -- 2 (19) -- (19)
------------------------------------ ------------------------------------
Income before provision for/(benefit 243 (3) 240 (15)
from) income taxes 718 703
Provision for (benefit from) income
taxes 2 -- 2 6 -- 6
------------------------------------ ------------------------------------
Net income $241 ($3) $238 $712 ($15) $697
==================================== ====================================
Net income per common share:
Basic $0.07 -- $0.07 $0.22 ($0.01) $0.21
==================================== ====================================
Diluted $0.06 ($0.01) $0.05 $0.17 -- $0.17
==================================== ====================================
Shares used in per share calculation
Basic 3,286 3,286 3,260 3,260
==================================== ====================================
Diluted 4,344 4,344 4,154 4,154
==================================== ====================================
11
Summary of Adjustments to Condensed Consolidated Balance Sheets
As of September 30, 2004 As of December 31, 2003
------------------------------------ ------------------------------------
As As As As
reported Adjustments restated reported Adjustments restated
Current liabilities:
Accrued liabilities $1,250 $25 $1,225 $1,759 $22 $1,737
Deferred revenue 1,114 (104) 1,218 909 (46) 955
Total current liabilities 2,716 (79) 2,795 2,998 (24) 3,022
Total liabilities 2,734 (79) 2,813 3,027 (24) 3,051
Shareholders' equity:
Accumulated deficit (22,022) (79) (22,101) (22,482) (24) (22,506)
Total shareholders' equity 5,523 (79) 5,444 4,776 (24) 4,752
Total liabilities and
shareholders' equity $8,257 -- $8,257 7,803 -- 7,803
3. Revenue Recognition:
We recognize revenue based on the provisions of Staff Accounting Bulletin
No. 104 "Revenue Recognition," AICPA Statement of Position No. 97-2 ("SOP
97-2") "Software Revenue Recognition," as amended by SOP 98-9,
"Modification of SOP 97-2, Software Revenue Recognition, with Respect to
Certain Transactions," and Statement of Financial Accounting Standards
("SFAS") No. 48 "Revenue Recognition When Right of Return Exists."
The Company uses the residual method to recognize revenue when an
agreement includes one or more elements to be delivered at a future date.
If there is an undelivered element under the arrangement, the Company
defers revenue based on vendor-specific objective evidence of the fair
value of the undelivered element, as determined by the price charged when
the element is sold separately. If vendor-specific objective evidence of
fair value does not exist for all undelivered elements, the Company defers
all revenue until sufficient evidence exists or all elements have been
delivered.
Product revenue is recognized when all of the following criteria are met:
persuasive evidence of an arrangement exists; delivery has occurred; the
fee is fixed and determinable; collection is probable; and returns can be
reasonably estimated. If an acceptance period or other contingency exists,
revenue is recognized upon satisfaction of the contingency, customer
acceptance or expiration of the acceptance period. 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.
Pursuant to our agreements with distributors, we also protect our
distributors' exposure related to the impact of price reductions. Future
price adjustments are estimated and accrued at the time of sale as a
12
reduction in revenue.
We generally provide our distributors the opportunity to earn volume
incentive rebates based on sales volume achieved during the fiscal
quarter. These incentive rebates are accrued in the quarter incurred and
recorded as a reduction in revenue.
We also provide co-op and market development funds to our distributors.
These incentives are accrued at the time revenue is recognized and
recorded as a reduction in revenue.
We offer a standard trade-in discount to all of our end-user customers
under which the customer, upon trade-in of any previously purchased
product, is entitled to a discount from our published price list on any
product included in our current product offerings. We require our
customers to physically return the previously purchased products to
qualify for the trade-in discount. We account for the trade-in discount as
a reduction of revenue at the time the product is traded in and a new
product is purchased.
Payment terms to our distributors and customers are generally thirty days,
cash in advance, or by credit card.
We evaluate product sales through our distribution channels and the
related reserve requirement to establish an estimate for our sales returns
reserve by reviewing detailed point-of-sales and on-hand inventory reports
provided to us by our channel partners. Based on a combination of
historical return experience, the sales activities to end-user customers
by our channel partners and the level of inventories on hand at the
channel partners, we determine our returns reserve at the end of each
financial period, and increases or reduce the reserve balance accordingly.
We provide standard support to our customers for an initial period of
sixty days, which includes advance swap of the defective hardware and
software, bug fixes, software upgrades and technical support. In addition
to standard support, we also offer our customers the option to purchase
extended support at the time of product purchase or anytime thereafter.
Extended support covers hardware and software for a period of one year. We
have established vendor-specific objective evidence with respect to the
fair value of the standard support contracts based on standalone sales and
renewals of our one-year extended support contracts. The fair value of our
sixty day support contracts included with product sales is determined by
pro-rating the related one-year extended support contracts. We recognize
revenue from extended support contracts ratably over the period of the
contract based on contract service dates.
We do not sell software, which is incorporated into our hardware,
separately, other than for our customers to purchase an upgrade to their
existing products when we announce a major release of the software.
4. 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 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.
13
Basic and diluted net income per share is calculated as follows for the
third quarter and first nine months of 2004 and 2003 (in thousands, except
per share amounts):
(in thousands, except per share amounts)
------------------------------------------------
(Unaudited and restated)
------------------------------------------------
Three months ended Nine months ended
---------------------- ----------------------
September September September September
30, 2004 30, 2003 30, 2004 30, 2003
--------- --------- --------- ---------
Basic:
Weighted average common shares outstanding 3,647 3,286 3,573 3,260
======== ======== ======== ========
Net income $ 130 $ 238 $ 405 $ 697
======== ======== ======== ========
Net income per common share - basic $ 0.04 $ 0.07 $ 0.11 $ 0.21
======== ======== ======== ========
Diluted:
Weighted average common shares outstanding 3,647 3,286 3,573 3,260
Common equivalent shares from stock options 706 1,058 840 894
-------- -------- -------- --------
Shares used in per share calculation - diluted 4,353 4,344 4,414 4,154
======== ======== ======== ========
Net income $ 130 $ 238 $ 405 $ 697
======== ======== ======== ========
Net income per common share - diluted $ 0.03 $ 0.05 $ 0.09 $ 0.17
======== ======== ======== ========
The calculation of diluted shares outstanding for the three months ended
September 30, 2004 excludes 162,750 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 nine
months ended September 30, 2004 excludes 25,205 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 nine months ended September 30, 2003 excludes 121,000 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 September 30, 2003 does not exclude
any shares of common stock that are antidilutive, as there were none for
the period.
5. 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.
Had compensation costs been determined consistent with SFAS No. 123, our
net income, would have been changed to the amounts indicated below
(unaudited, in thousands, except per share data):
14
Three months ended Nine months ended
---------------------- ----------------------
September September September September
30, 2004 30, 2003 30, 2004 30, 2003
--------- --------- --------- ---------
(Restated)
Net Income - as reported $ 130 $ 238 $ 405 $ 697
Fair value of stock-based compensation, net
of taxes (128) (86) (382) (173)
Net income - pro forma 2 152 23 524
Net income per share - basic - as reported $ 0.04 $ 0.07 $ 0.11 $ 0.21
Net income per share - diluted - as reported $ 0.03 $ 0.05 $ 0.09 $ 0.17
Net income per share - basic - pro forma $ 0.00 $ 0.05 $ 0.01 $ 0.16
Net income per share - diluted - pro forma $ 0.00 $ 0.03 $ 0.01 $ 0.13
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.
6. 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):
September 30, 2004 December 31, 2003
------------------ -----------------
Raw material $ 1,072 $ 610
Work in process 104 --
Finished goods 356 567
-------- --------
Total inventory $ 1,532 $ 1,177
======== ========
After the announcement by our component suppliers that new components are
available to replace certain of their end-of-life components currently
used in our FaxPress products, we have purchased approximately two years
worth of these end-of-life components in an effort to guarantee a smooth
supply of our FaxPress Products to our customers. As of September 30,
2004, we have approximately $600,000 worth of end-of-life components as
compared to $361,000 at the end of December 31, 2004. We believe that most
of these end-of-life components will be utilized in the following two
years, resulting in insignificant amounts of excessive inventory, or none
at all.
Inventories are reduced for excess and obsolete inventories. These
write-downs are based on management's review of inventories on hand on a
quarterly basis, compared to management's assumptions about future demand,
market conditions and anticipated timing of the release of product
upgrades or next generation products. If actual market conditions for
future demand are less favorable than those projected by us or if product
upgrades or next generation products are released earlier than
anticipated, additional inventory write-downs may be required. Obsolete
products removed from gross inventory are physically scrapped.
15
7. 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):
(Unaudited and restated)
---------------------------------------------
Three months ended Nine months ended
--------------------- ---------------------
September September September September
30, 2004 30, 2003 30, 2004 30, 2003
--------- --------- --------- ---------
United States $ 2,182 $ 1,961 $ 6,572 $ 5,954
Europe 186 192 518 520
Pacific Rim 265 297 600 797
Rest of Americas, excluding United States 52 111 225 286
-------- -------- -------- --------
Total Revenues $ 2,685 $ 2,561 $ 7,915 $ 7,557
======== ======== ======== ========
Customers that individually accounted for greater than 10% of net sales
are as follows (unaudited, in thousands):
Quarter Ended Nine Months Ended
---------------------------------------- -----------------------------------------
September 30, 2004 September 30, 2003 September 30, 2004 September 30, 2003
Customer Amount Percentage Amount Percentage Amount Percentage Amount Percentage
-------- ------ ---------- ------ ---------- ------ ---------- ------ ----------
A $ 357 13% $ 496 19% $ 1,796 23% $ 1,608 21%
B $ 592 22% $ 874 34% $ 1,668 21% $ 2,188 29%
8. 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.
9. 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
September 30, 2004 (unaudited, in thousands):
16
Operating Capital Lease Total
Leases Obligations Commitments
---------------------------------------
Three months ending December 31, 2004 $ 52 $ 4 $ 56
Year ending December 31, 2005 207 18 225
Year ending December 31, 2006 207 15 222
Year ending December 31, 2007 207 -- 207
Year ending December 31, 2008 207 -- 207
Year ending December 31, 2009 86 -- 86
-------------------------------------
Total Commitments $ 967 $ 37 $ 1,004
Less amount representing interest -- (5) (5)
-------------------------------------
Present value of lease $ 967 $ 32 $ 999
obligations
=====================================
We have extended our building lease for a term of five years commencing on
June 1, 2004 and expiring on May 31, 2009, with one conditional three-year
renewal option, which if exercised, would extend the lease to May 31, 2012
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
September 30, 2004, we had $32,000 outstanding under a loan and security
agreement, which is subject to an interest rate of 12.8%.
On August 2, 2004, we secured from Silicon Valley Bank a new revolving
line of credit to replace the previous credit facility. The new revolving
line of credit provides for borrowings of up to $4.0 million and has a
one-year term. Borrowings under this line of credit agreement are
collateralized by all of our assets and bear interest at the bank's prime
rate plus 0.50%. Under the new facility we are required to maintain
certain minimum cash and investment balances with the bank and meet
certain other financial covenants. As of September 30, 2004, we have not
drawn down on the line of credit and were in compliance with the terms of
the agreement.
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 Earnings as a Cost of
Sales. If actual warranty costs are different from our estimated costs, or
if the warranty claims were to be significantly higher than our historical
experience, then revisions to the estimated warranty liability may be
required and the warranty expense could change from current levels. A
reconciliation of the changes in our warranty liability during the periods
presented is as follows (in thousands):
(Unaudited)
---------------------------------------------
Three months ended Nine months ended
--------------------- ---------------------
September September September September
30, 2004 30, 2003 30, 2004 30, 2003
--------- --------- --------- ---------
Balance at beginning of period $ 22 $ 31 $ 22 $ 34
Accruals for warranties issued during the period -- 16 2 49
Actual warranty expense (5) (8) (7) (44)
------ ------ ------ ------
Balance at end of period $ 17 $ 39 $ 17 $ 39
====== ====== ====== ======
17
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.
10. 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 $2.3 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 1.6 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
$420,000 as of September 30, 2004.
11. 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 Company was required to adopt
the provisions of FIN 46R in 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.
18
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/A 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
Reports on Form 10-K for the years ended December 31, 2003 and 2004.
19
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/A and our Annual Reports on Form 10-K for the
years ended December 31, 2003 and 2004.
We have completed a review of our accounting practices with respect to the
historical classification of cost of service revenues, procedures for
recognizing revenue associated with extended support contracts and procedures
for establishing the accrual for paid-time-off, and determined that our
historical financial statements contained certain errors in the application of
Generally Accepted Accounting Principles. Consequently, we have restated our
consolidated financial statements as of September 30, 2004 and December 31,
2003, and for the three and nine months ended September 30, 2004 and 2003 in
this Quarterly Report on Form 10-Q/A to correct for these errors. This
Management's Discussion and Analysis of Financial Condition and Results of
Operations reflects the restated amounts. Note 2 to the consolidated financial
statements discloses the impact of the adjustments arising from the accounting
errors described above on the statements of earnings and balance sheets for the
restated quarterly periods.
Critical Accounting Policies
Castle'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 and 2004 Annual Reports on Form 10-K.
20
Consolidated Statements of Operations - As a Percentage of Net Sales
Three months ended Nine months ended
----------------------------- -----------------------------
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
------------- ------------- ------------- -------------
(Restated)
Net sales:
Products 77% 81% 78% 82%
Services 23% 19% 22% 18%
-------- -------- -------- --------
Total net sales 100% 100% 100% 100%
Cost of sales:
Products 25% 22% 24% 24%
Services 8% 7% 8% 7%
-------- -------- -------- --------
Total cost of sales 33% 29% 32% 31%
-------- -------- -------- --------
Gross profit 67% 71% 68% 69%
Operating expenses:
Research and development 17% 17% 17% 16%
Sales and marketing 23% 26% 24% 24%
General and administrative 18% 19% 18% 19%
-------- -------- -------- --------
Total operating expenses 58% 62% 59% 59%
-------- -------- -------- --------
Income from operations 9% 9% 9% 10%
Interest income, net * * * *
Other expense, net * * * (1%)
-------- -------- -------- --------
Income before provision for income taxes 9% 9% 9% 9%
Provision for income taxes 4% * 4% *
-------- -------- -------- --------
Net income 5% 9% 5% 9%
======== ======== ======== ========
* Less than 1%
Results of Operations
Net Sales
(Unaudited and restated)
----------------------------------------------------------
Three months ended Nine months ended
---------------------------- ----------------------------
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
------------- ------------- ------------- -------------
Net sales
Products $ 2,079 $ 2,081 $ 6,181 $ 6,232
Services 606 480 1,734 1,325
-------- -------- -------- --------
Total Net sales $ 2,685 $ 2,561 $ 7,915 $ 7,557
======== ======== ======== ========
21
Three months ended Nine months ended
--------------------- ---------------------
September September September September
30, 2004 30, 2003 30, 2004 30, 2003
--------- --------- --------- ---------
Net Sales
United States $ 2,182 $ 1,961 $ 6,572 $ 5,954
Europe 186 192 518 520
Pacific Rim 265 297 600 797
Rest of Americas, excluding United States 52 111 225 286
-------- -------- -------- --------
Total Net Sales $ 2,685 $ 2,561 $ 7,915 $ 7,557
======== ======== ======== ========
Net sales for the third quarter of 2004 were $2.7 million as compared to
$2.6 million in the same period in 2003. Net sales for the first nine months of
2004 were $7.9 million as compared to $7.6 million for the same period in 2003.
Sales in the three and nine months ended September 30, 2004 included a benefit
of $126,000 from an adjustment of certain accruals related to a sales
development program.
Product sales of $2.1 million and $6.2 million for the three and nine
months ended September 30, 2004, respectively, were relatively unchanged as
compared to the same periods in 2003.
Service revenues are comprised primarily of extended warranty and support
programs as well as 60-days of maintenance bundled with initial product sales.
Revenue related to these arrangements is recognized ratably over the period of
the arrangement. Service revenues in the third quarter of 2004 increased 26% to
$606,000 from $480,000 in the same period in 2003. For the first nine months of
2004, service revenues increased 31% to $1.7 million from $1.3 million in the
same period in 2003. The increase in service revenues was primarily due to
increased sales of extended warranty contracts due to an increase in our
installed customer base as well as the launch of our FaxPress Premier fax server
products in the second half of 2003. We anticipate service revenues to increase
as more FaxPress Premier fax servers are sold.
Domestic sales in the third quarter of 2004 were $2.2 million, as compared
to $2.0 million for the same period in 2003, representing 82% and 77% of total
net sales in the third quarter of 2004 and 2003, respectively. Domestic sales
for the first nine months of 2004 were $6.6 million, as compared to $6.0 million
for the same period of 2003, which represents 84% and 79% of total net sales in
2004 and 2003, respectively. The increase in sales was mostly attributable to
higher service revenues and a benefit of $126,000 from a sales development
program adjustment.
International sales (excluding sales to the rest of the Americas) for the
third quarter of 2004 were $451,000 as compared to $489,000 in the third quarter
of 2003. This represents 17% and 19% of net sales for 2004 and 2003,
respectively. International sales (excluding sales to the rest of the Americas)
were $1.1 million for the first nine months of 2004, as compared to $1.3 million
for the same period in 2003, which represents 14% and 17% of total net sales for
the first nine months of 2004 and 2003, respectively. The decline in sales was
mostly due to lower sales of our fax server products. We anticipate
international sales to increase as the FaxPress Premier fax servers are fully
introduced to the rest of the world.
Sales to the rest of the Americas (excluding the United States) in the
third quarter of 2004 were $52,000 as compared to $111,000 in the year-ago
quarter, representing 2% and 4% of total net sales, respectively. The decrease
in sales was mostly due to lower sales of our fax server products.
22
For the nine months ended September 30, sales to the rest of the Americas were
$225,000 and $286,000 for 2004 and 2003, respectively. This represents 3% and 4%
of net sales respectively.
Cost of Sales; Gross Profit
Three months ended Nine months ended
---------------------------- ----------------------------
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
------------- ------------- ------------- -------------
(Restated)
Cost of sales:
Products $ 674 $ 555 $ 1,905 $ 1,825
Services 207 192 621 540
-------- -------- -------- --------
Total cost of sales 881 747 2,526 2,365
Gross profit $ 1,804 $ 1,814 $ 5,389 $ 5,192
Gross profit % 67% 71% 68% 69%
Gross profits were $1.8 million, in both the third quarters of 2004 and
2003, or 67% and 71% of net sales, respectively. Gross profits for the first
nine months of 2004 and 2003 were $5.4 million and $5.2 million, or 68% and
69%%, of net sales, respectively. Gross profit percentage were lower in the
third quarter of 2004 as compared to the same period in 2003 mainly due to the
unfavorable mix from the sale of our fax server products, which has a lower
gross profit contribution, offset in part by higher gross margin from service
revenue. Gross profits for the three and nine months ended September 30, 2004
included the benefit of $126,000 from the sales development program adjustment.
Gross profit for the nine months ended September 30, 2004 also included a
benefit of $61,000 due to adjustment of an estimated liability based on a
settlement reached in the second quarter of 2004.
Research & Development
Research and development expenses for the third quarter of 2004 were
$470,000, or 17% of net sales, as compared to $427,000 or 17% of net sales for
the same period in 2003. For the first nine months of 2004, research and
development expenses were $1.3 million, or 17% of net sales, as compared to $1.2
million in the same period of 2003, or 16% of net sales. The increase for the
nine-month period of $101,000 was mostly attributable to higher outside
consulting expenses to enhance our current product features. The employment of
consultants is expected to continue until the short-term projects are completed.
Sales & Marketing
Sales and marketing expenses for the third quarter of 2004 were $612,000,
or 23% of net sales, as compared to $652,000, or 26% of net sales, for the same
period in 2003. Sales and marketing expenses were $1.9 million for the first
nine months of 2004, and $1.8 million for the same period of 2003, which
represents 24% of net sales for both periods. The increase for the nine-month
period of $86,000 was primarily due to an increase in compensation expense
related to headcount additions of $199,000 offset in part by lower advertising
and promotional expenses of $114,000. Sales and marketing expenses are
anticipated to remain relatively stable.
23
General & Administrative
General and administrative expenses were $486,000 for the third quarter of
2004, or 18% of net sales, as compared to $497,000, or 19% of net sales for the
third quarter of 2003. General and administrative expenses were $1.5 million for
both the first nine months of 2004 and 2003, or 18% and 19% of net sales,
respectively. General and administrative expenses are anticipated to remain
relatively stable.
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 in
2004, for purposes of financial reporting, we are providing for income taxes at
an effective tax rate of 40%. As a result, $95,000 of income tax expense has
been provided in the third quarter of 2004 as compared to $2,000 in the third
quarter of 2003. For the first nine months of 2004, we have provided $314,000
for income taxes, as compared to $6,000 in 2003. However, for income tax
purposes, we had $12.9 million of NOLs available at the end of December 2003 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. If
we determine that the amount of the deferred tax assets to be realized is
greater or less than the amount we have recorded, adjustments may be required.
Liquidity and Capital Resources
September 30, 2004 December 31, 2003 September 30, 2003
------------------ ----------------- ------------------
(dollars in thousands)
Cash and cash equivalents $ 5,032 $ 4,614 $ 4,431
Working capital $ 5,116 $ 4,156 $ 3,284
Working capital ratio 2.8 2.4 2.1
As of September 30, 2004, we had approximately $5.0 million of cash and
cash equivalents. For the nine months ended September 30, 2004, cash generated
from operating activities was $168,000 as compared to $985,000 in the same
period of last year. This reduction of cash from operating activities of
$817,000 is attributable to a number of factors, including (i) an increase in
inventory of $348,000 due mostly to the purchase of end-of-life components, net
of usage, totaling $239,000 and other components to support production of
FaxPress and FaxPress Premier products of $109,000, (ii) a decrease in total
accrued liabilities of $512,000 due to an adjustment of certain accruals related
to a sales development program of $126,000, a software license settlement of
$50,000, a reduction of unneeded reserve of $61,000 after the software
settlement, and use of co-op and market development funds of $181,000 for
product promotions.
Our investing activities in the first nine months of 2004 for $24,000 and
2003 for $140,000 were for purchases of capital assets to replace obsolete
computer equipment.
We generated $274,000 from financing activities in the first nine months
of 2004 as compared to $126,000 in the same period of 2003 primarily from
proceeds received from issuance of common stock,
24
offset partially by repayment of debt. In the first three months of 2003, we
also used $49,000 to repurchase common stock.
In the fourth quarter of 2002, our Board of Directors authorized us, from
time to time, to repurchase at market prices, up to $2.3 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 1.7 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 have extended our lease for our corporate headquarters in Morgan Hill,
California. The modified lease on the Morgan Hill facility has a term of five
years, commencing on June 1, 2004 and expiring in May 31, 2009, with one
conditional three-year renewal option, which if exercised, would extend the
lease to May 2012 commencing with rent at 95% of fair market value. As of
September 30, 2004, future minimum payments under the lease were $967,000.
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
September 30, 2004, the aggregate value of future minimum payments was $37,000.
The following represents combined aggregate maturities for all our
financing and commitments as of September 30, 2004:
Payments Due by Period
----------------------------------------------------------------
Contractual Obligations Total 1 Year 2 - 3 Years 4 - 5 Years More than 5
Years
----------------------------------------------------------------
Capital (Finance) Lease Obligations $ 37 $ 18 $ 19 -- --
Operating Lease Obligations $ 967 $ 207 $ 415 $ 345 --
-------- -------- -------- -------- --------
Total contractual cash obligations $ 1,004 $ 225 $ 434 $ 345 --
======== ======== ======== ======== ========
As of September 30, 2004, we had a $4.0 million collateralized revolving
line of credit with a bank, which is to expire in August 2005. The revolving
line of credit provides for borrowings of up to $4.0 million. Borrowings under
this line of credit agreement are collateralized by all of our assets and bear
interest at the bank's prime rate plus 0.50%. Under the new facility we are
required to maintain certain minimum cash and investment balances with the bank
and meet certain other financial covenants. As of September 30, 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-
25
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, 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.
26
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/A and in our Annual Reports on
Form 10-K for the years ended December 31, 2003 and 2004. 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 outside consulting
contracts for our product development;
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.
27
We have a history of losses and a large accumulated deficit.
We have experienced significant operating losses and, as of September 30,
2004, had an accumulated deficit of $22.0 million. Our development and marketing
of current and new products will continue to require substantial expenditures.
We incurred $564,000 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 $635,000 in
2002 and $1.6 million in 2003, and $405,000 for the first nine months in 2004.
There can be no assurance that growth in net sales will be achieved or
profitability sustained in future years.
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 nine months 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, 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;
28
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.
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-
29
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
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 and for 17% for the first nine months of 2004. 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 42% for the
first nine months of 2004, and 7%, 6% and 10% of our total net sales in 2003,
2002 and 2001, respectively and 7% for the first nine months of 2004. 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
30
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, 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
31
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 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.
32
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 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.
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).
33
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, 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 October 31, 2004, our officers and directors and their affiliates
beneficially owned approximately 26% 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.
34
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We had no holdings of derivative financial or commodity instruments at
September 30, 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.
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..
At the time of the original filing on November 12, 2004 of the Company's
report on Form 10-Q for the quarter ended September 30, 2004 which this Form
10-Q/A amends, officers of Castelle provided conclusions regarding the
effectiveness of the Company's disclosure controls and procedures that they
believed were then accurate. However, during the fourth quarter of fiscal 2004,
the Company determined that: 1) its historical classification of cost of service
revenues did not conform to Generally Accepted Accounting Principles as such
costs were classified as a component of sales and marketing expenses rather than
cost of sales, due primarily to the fact that our internal financial reporting
system did not track this information separately from certain sales and
marketing expenses; and 2) as a result of an internal control deficiency,
service revenues attributable to extended support contracts were overstated due
to inadequate procedures in place to correctly recognize sales related to
extended support contracts.
Our management evaluated, with the participation of our Chief Executive
Officer and our Chief Financial Officer, the effectiveness of our disclosure
controls and procedures as of the end of the period covered by our 2004 Annual
Report on Form 10-K and as of the periods affected by the restatement referred
to elsewhere in the Form 10-K. As a result of the restatement of the Company's
quarterly financial information included herein, and based on this evaluation,
our Chief Executive Officer and our Chief Financial Officer have concluded that
our disclosure controls and procedures were not effective as of September 30,
2004 to ensure that information we are required to disclose in reports that we
file or submit under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in Securities and
Exchange Commission rules and forms.
35
Effective January 1, 2005, the Company established a cost center to
separately capture the cost of service revenues as a component of cost of sales.
During the first quarter of fiscal 2005, the Company also enhanced its internal
accounting system to ensure that revenue relating to extended support contracts
is recognized over the actual contract term. Our Chief Executive Officer and
Chief Financial Officer believe that our disclosure controls and procedures were
effective as of March 31, 2005.
In designing and evaluating our disclosure controls and procedures, our
management recognized that any controls and procedures, no matter how well
designed and operated, can provide only reasonable assurance of achieving their
objectives, and our management necessarily applied its judgment in evaluating
the cost-benefit relationship of possible controls and procedures.
36
PART II - OTHER INFORMATION
ITEM 5. LEGAL PROCEEDINGS
None.
ITEM 6. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 7. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 8. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 9. OTHER INFORMATION
None.
ITEM 10. EXHIBITS
(a) Exhibits:
Additional Exhibits
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.
37
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 4, 2005
Scott C. McDonald
Chief Executive Officer and President
(Principal Executive Officer)
By: /s/ Paul Cheng Date: May 4, 2005
Paul Cheng
Vice President of Finance and Administration
Chief Financial Officer
(Principal Financial Officer and
Principal Accounting Officer)
38
Exhibit
Number Description
------ --------------------------------------------------------------------
31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 - Chief Executive Officer
31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 - Chief Financial Officer
32.1 Certification Pursuant to 8 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002 - Chief Executive
Officer
32.2 Certification Pursuant to 8 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002 - Chief Financial
Officer
39