UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
___________________________
Form 10-Q
____________________________
(Mark One)
 |
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF | |
| THE SECURITIES EXCHANGE ACT OF 1934 | ||
| For the Quarter ended March 31, 2005 | ||
 |
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF | |
| THE SECURITIES EXCHANGE ACT OF 1934 | ||
| For the transition period from _______ to ________. |
Commission File Number: 000-21240
NEOWARE SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
| Delaware | 23-2705700 | |
| (State or other jurisdiction of incorporation or organization) | (IRS Employer Identification No.) |
400 Feheley Drive
King of Prussia, Pennsylvania 19406
(Address of principal executive offices)
(610) 277-8300
(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 No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes No
As of May 6, 2005, there were 16,089,319 outstanding shares of the Registrant's Common Stock.
NEOWARE SYSTEMS, INC.
INDEX
PART I. FINANCIAL INFORMATION
NEOWARE SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data) (unaudited)
| March 31, | June 30, | |||||||
| ASSETS | 2005 | 2004 | ||||||
| Current assets: | ||||||||
| Cash and cash equivalents | $ | 39,087 | $ | 17,119 | ||||
| Short-term investments | 6,233 | 38,177 | ||||||
| Accounts receivable, net | 13,891 | 10,580 | ||||||
| Inventories | 2,978 | 795 | ||||||
| Prepaid expenses and other | 1,271 | 1,628 | ||||||
| Deferred income taxes | 643 | 643 | ||||||
| Total current assets | 64,103 | 68,942 | ||||||
| Property and equipment, net | 414 | 509 | ||||||
| Goodwill | 27,775 | 17,466 | ||||||
| Intangibles, net | 10,038 | 3,545 | ||||||
| Deferred income taxes | 145 | 145 | ||||||
| $ | 102,475 | $ | 90,607 | |||||
| LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
| Current liabilities: | ||||||||
| Accounts payable | $ | 5,264 | $ | 5,685 | ||||
| Accrued compensation and benefits | 1,624 | 1,534 | ||||||
| Other accrued expenses | 2,857 | 1,071 | ||||||
| Income taxes payable | 2,326 | 854 | ||||||
| Deferred revenue | 989 | 739 | ||||||
| Total current liabilities | 13,060 | 9,883 | ||||||
| Deferred revenue | 310 | 235 | ||||||
| Total liabilities | 13,370 | 10,118 | ||||||
| Stockholders’ equity: | ||||||||
| Preferred stock | — | — | ||||||
| Common stock | 16 | 16 | ||||||
| Additional paid-in capital | 74,571 | 71,718 | ||||||
| Accumulated other comprehensive income | 1,479 | 936 | ||||||
| Treasury stock, 100,000 shares at cost | (100 | ) | (100 | ) | ||||
| Retained earnings | 13,139 | 7,919 | ||||||
| Total stockholders’ equity | 89,105 | 80,489 | ||||||
| $ | 102,475 | $ | 90,607 | |||||
See accompanying notes to consolidated financial statements.
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NEOWARE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data) (unaudited)
| Three Months Ended | Nine Months Ended | |||||||||||
| March 31, | March 31, | |||||||||||
| 2005 | 2004 | 2005 | 2004 | |||||||||
| Net revenues | $ | 19,001 | $ | 15,750 | $ | 55,775 | $ | 46,086 | ||||
| Cost of revenues | 10,748 | 8,326 | 31,686 | 23,059 | ||||||||
| Gross profit | 8,253 | 7,424 | 24,089 | 23,027 | ||||||||
| Sales and marketing | 3,100 | 3,442 | 9,381 | 9,785 | ||||||||
| Research and development | 866 | 712 | 2,299 | 2,120 | ||||||||
| General and administrative | 1,843 | 1,527 | 4,848 | 4,462 | ||||||||
| Operating expenses | 5,809 | 5,681 | 16,528 | 16,367 | ||||||||
| Operating income | 2,444 | 1,743 | 7,561 | 6,660 | ||||||||
| Foreign exchange loss | (7 | ) | — | (243 | ) | — | ||||||
| Interest income, net | 241 | 109 | 594 | 287 | ||||||||
| Income before income taxes | 2,678 | 1,852 | 7,912 | 6,947 | ||||||||
| Income taxes | 913 | 194 | 2,692 | 2,030 | ||||||||
| Net income | $ | 1,765 | $ | 1,658 | $ | 5,220 | $ | 4,917 | ||||
| Earnings per share: | ||||||||||||
| Basic | $ | 0.11 | $ | 0.11 | $ | 0.33 | $ | 0.31 | ||||
| Diluted | $ | 0.11 | $ | 0.10 | $ | 0.32 | $ | 0.31 | ||||
| Weighted average number of common | ||||||||||||
| shares outstanding: | ||||||||||||
| Basic | 16,061 | 15,769 | 15,836 | 15,652 | ||||||||
| Diluted | 16,404 | 16,171 | 16,207 | 15,942 | ||||||||
See accompanying notes to consolidated financial statements.
4
NEOWARE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands, except per share data) (unaudited)
| Nine Months Ended | ||||||
| March 31, | ||||||
| 2005 | 2004 | |||||
| Cash flows from operating activities: | ||||||
| Net income | $ | 5,220 | $ | 4,917 | ||
| Adjustments to reconcile net income to net cash provided by operating | ||||||
| activities: | ||||||
| Depreciation | 199 | 209 | ||||
| Amortization of intangibles | 1,117 | 782 | ||||
| Tax benefit on stock option exercises | 385 | 1,708 | ||||
| Changes in operating assets and liabilities, net of effect from acquisitions: | ||||||
| Accounts receivable | (3,013 | ) | (94 | ) | ||
| Inventories | (1,523 | ) | 24 | |||
| Prepaid expenses and other | 595 | (650 | ) | |||
| Accounts payable | (479 | ) | 1,317 | |||
| Accrued compensation and benefits | 229 | (2 | ) | |||
| Other accrued expenses | 948 | 98 | ||||
| Income taxes payable | 1,485 | 67 | ||||
| Deferred revenue | 292 | 284 | ||||
| Net cash provided by operating activities | 5,455 | 8,660 | ||||
| Cash flows from investing activities: | ||||||
| Purchase of the Visara thin client business | (3,805 | ) | — | |||
| Purchase of the ThinTune thin client business | (10,119 | ) | — | |||
| Purchase of the Mangrove Systems, SAS | (2,829 | ) | — | |||
| Purchase of the TeemTalk software business | — | (9,995 | ) | |||
| Purchases of short-term investments | (20,233 | ) | (50,187 | ) | ||
| Sales of short-term investments | 52,239 | 21,153 | ||||
| Purchase of intangible assets | — | (125 | ) | |||
| Purchases of property and equipment | (90 | ) | (129 | ) | ||
| Net cash provided by (used in) investing activities | 15,163 | (39,283 | ) | |||
| Cash flows from financing activities: | ||||||
| Repayments of capital leases | (5 | ) | (4 | ) | ||
| Proceeds from issuance of common stock, net of expenses | — | 24,609 | ||||
| Expenses for prior issuance of common stock | — | (3 | ) | |||
| Exercise of stock options and warrants | 1,168 | 834 | ||||
| Net cash provided by financing activities | 1,163 | 25,436 | ||||
| Effect of foreign exchange rate changes on cash | 187 | (4 | ) | |||
| Increase (decrease) in cash and cash equivalents | 21,968 | (5,191 | ) | |||
| Cash and cash equivalents, beginning of period | 17,119 | 26,014 | ||||
| Cash and cash equivalents, end of period | $ | 39,087 | $ | 20,823 | ||
| Supplemental disclosures: | ||||||
| Cash paid for income taxes | $ | 60 | $ | 264 | ||
| Issuance of common stock for purchase of Mangrove Systems, SAS | $ | 1,300 | $ | — | ||
See accompanying notes to consolidated financial statements.
5
NEOWARE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 1. Basis of Presentation
The accompanying unaudited consolidated financial statements of Neoware Systems, Inc. and Subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements. These statements, while unaudited, reflect all normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the consolidated financial statements. The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period. Certain information and footnote disclosures included in financial statements have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements. The consolidated financial statements included in this Form 10-Q should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2004, filed with the Securities and Exchange Commission on September 13, 2004.
Note 2. Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R (revised 2004), “Share-Based Payment”, which replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” (SFAS No. 123) and supercedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first annual period beginning after June 15, 2005. The pro forma disclosures previously permitted under SFAS No. 123 no longer will be an alternative to financial statement recognition. The Company is required to adopt SFAS 123R in the first quarter of fiscal 2006. Under SFAS 123R, the Company must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include prospective and retroactive adoption options. Under the retroactive option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R, while the retroactive methods would record compensation expense for all unvested stock options and restricted stock beginning with the first period restated. Management is evaluating the requirements of SFAS 123R and expects that the adoption of SFAS 123R will have a material impact on its financial statements.
In December 2004, the FASB issued FASB Staff Position (FSP) No. FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004.” The American Jobs Creation Act includes a tax deduction of up to 9 percent (when fully phased-in) of the lesser of (a) “qualified production activities income,” as defined in the Act, or (b) taxable income (after the deduction for the utilization of any net operating loss carry forwards). This tax deduction is limited to 50 percent of W-2 wages paid by the taxpayer. Pursuant to FSP No. 109-1, the deduction should be accounted for as a special deduction in accordance with SFAS No. 109 rather than as a tax rate reduction. FSP No. 109-1 is effective upon issuance. The Company is eligible for this deduction beginning in fiscal 2006 and will account for it as a special deduction. The Company has not yet determined the impact that this deduction will have on its effective rate in fiscal 2006.
In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Asset’s” an amendment of APB Opinion No. 29, “Accounting for Nonmonetary Transactions.” SFAS No. 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for nonmonetary asset exchanges beginning in the Company’s first quarter of fiscal 2006.
In December 2004, the FASB issued FASB Staff Position (FSP) No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.” The American Jobs Creation Act (Job Act) introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met.
6
FSP No. 109-2 provides accounting and disclosure guidance for the repatriation provision. FSP No. 109-2 is effective immediately and the Job Act was enacted in October 2004. FSP No. 109-2 allows for time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS No. 109. The Company has not yet completed evaluating the impact of the repatriation provisions. Accordingly, the Company has not adjusted amounts that have been reinvested in foreign jurisdictions under APB No. 23, “Accounting for Income Taxes-Special Areas,” to reflect the repatriation provisions of the Jobs Act.
Note 3. Stock-Based Compensation
The Company applies APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations for stock options and other stock-based awards while disclosing pro forma net income and earnings per share as if the fair value method had been applied in accordance with SFAS No. 123, “Accounting for Stock-based Compensation” and SFAS No. 148 “Accounting for Stock Based Compensation Transition and Disclosure.” Had compensation cost been recognized consistent with SFAS No. 123 and SFAS No. 148, the Company’s consolidated net income and earnings per share would have been as follows (in thousands, except per share data):
| Three Months Ended | Nine Months Ended | |||||||||||
| March 31, | March 31, | |||||||||||
| 2005 | 2004 | 2005 | 2004 | |||||||||
| Net income | ||||||||||||
| As reported | $ | 1,765 | $ | 1,658 | $ | 5,220 | $ | 4,917 | ||||
| Less: | ||||||||||||
| Total stock-based employee | ||||||||||||
| compensation expense determined | ||||||||||||
| under the fair value based method | ||||||||||||
| for all awards, net of tax | (762 | ) | (871 | ) | (2,128 | ) | (2,369 | ) | ||||
| Pro forma | $ | 1,033 | $ | 787 | $ | 3,092 | $ | 2,548 | ||||
| Basic earnings per share: | ||||||||||||
| As reported | $ | 0.11 | $ | 0.11 | $ | 0.33 | $ | 0.31 | ||||
| Pro forma | $ | 0.06 | $ | 0.05 | $ | 0.20 | $ | 0.16 | ||||
| Diluted earnings per share: | ||||||||||||
| As reported | $ | 0.11 | $ | 0.10 | $ | 0.32 | $ | 0.31 | ||||
| Pro forma | $ | 0.06 | $ | 0.05 | $ | 0.19 | $ | 0.16 | ||||
The fair value of the Company’s stock-based awards to employees was estimated at the date of grant using the Black-Scholes option pricing model, assuming an estimated life of five to ten years, no dividends, volatility of 70% -126%, and risk-free interest rates of 2.1% - 6.8%.
In December 2004 the Company’s stockholders approved the 2004 Equity Incentive Plan (“the 2004 Plan”) and the 1995 Stock Option Plan (“1995 Plan”) and the 2002 Non-Qualified Stock Option Plan (the “2002 Plan”) were terminated as to any shares then available for future grant. The 2004 Plan permits the Company to grant equity-based awards to its directors, executives and a broad-based category of employees. The 2004 Plan provides for the issuance of up to 1,500,000 shares of common stock plus all outstanding options which terminate, expire or are canceled under the existing plan on or after December 1, 2004.
Note 4. Business Combination
Qualystem Technology S.A.S.
On April 4, 2005, the Company acquired all of the outstanding stock of Qualystem Technology S.A.S. (“Qualystem”), a privately held provider of software that streams Windows® and application components on-demand from a server to other servers, personal computers, and thin clients, for $3.4 million in cash plus a potential earn-out based upon performance. The acquisition will be accounted for using the purchase method of accounting and the results of operations of Qualystem will be included in the Company’s statements of operations from the date of the acquisition.
7
Thintune Thin Client Business
On March 5, 2005, the Company acquired the Thintune thin client business of eSeSIX Computer GmbH (“eSeSIX Computer”) which included customer lists, intellectual property and technology, and also entered into reseller, supplier and non-competition agreements and on March 4, 2005 acquired all of the outstanding stock of eSeSIX Information-Technologies (“eSeSIX Tech”), eSeSIX Computer’s development and engineering affiliate. eSeSIX Computer together with eSeSIX Tech are collectively referred to as the Thintune thin client business. The purchase consideration was $10.1 million in cash, including transaction costs, plus a potential earn-out based upon performance.
The preliminary allocation of the purchase price that follows was based upon our estimates and assumptions and are subject to change upon the receipt of the independent valuation report (in thousands).
| Cash | $ | 28 | |
| Inventory | 660 | ||
| Services to be provided by eSeSIX Computer | 199 | ||
| Other assets | 194 | ||
| Warranty liability assumed | (448 | ) | |
| Other liabilities | (142 | ) | |
| Intangibles | 4,245 | ||
| Goodwill | 5,411 | ||
| $ | 10,147 | ||
The results of operations of the Thintune business have been included in the Company’s statements of operations from the date of the acquisition. The pro forma results of operations disclosed below give effect to the acquisition of the Thintune business as if the acquisition was consummated on July 1, 2003.
Mangrove Systems S.A.S.
On January 27, 2005, the Company acquired all of the outstanding stock of Mangrove Systems S.A.S. (“Mangrove”), a privately held provider of Linux software solutions, for $2.8 million in cash, including transaction costs, and 153,682 shares of the Company’s common stock valued at $1.3 million, plus a potential earn-out based upon performance. The assets acquired as part of the Mangrove acquisition included customer lists, intellectual property and technology and non-compete agreements.
The preliminary allocation of the purchase price was based upon our estimates and assumptions and is subject to change upon the receipt of the independent valuation report (in thousands)..
| Cash | $ | 74 | |
| Other assets | 199 | ||
| Liabilities | (193 | ) | |
| Intangibles | 1,645 | ||
| Goodwill | 2,478 | ||
| $ | 4,203 | ||
The results of operations of Mangrove have been included in the Company’s statements of operations from the date of the acquisition. The pro forma results of operations disclosed below give effect to the acquisition of Mangrove as if the acquisition was consummated on July 1, 2003.
TeleVideo, Inc.
On January 12, 2005 the Company entered into an Asset Purchase Agreement to acquire the TeleVideo, Inc. (“TeleVideo”) thin client business including all thin client assets, certain contract obligations, a trademark license, product brands, customer lists, customer contracts and non-competition agreements for $5.0 million in cash plus a potential earn-out based upon performance. The boards of both companies have approved the transaction, and the two majority stockholders of TeleVideo owning approximately 62% of its common stock have executed a written consent approving the transaction. Therefore, no further stockholder action will be required to approve the transaction, and TeleVideo will not hold a stockholders meeting in connection with the transaction. TeleVideo will
8
file an information statement with the Securities and Exchange Commission and, subject to clearance by the SEC, will distribute it to its stockholders. The acquisition is expected to close in July 2005. The closing of the TeleVideo acquisition is subject to certain closing conditions including a satisfactory completion of due diligence. The acquisition will be accounted for using the purchase method of accounting and results of operations of TeleVideo will be included in the Company’s statements of operations from the date of the acquisition. The Company also entered into a reseller agreement with TeleVideo as of January 12, 2005 that named Neoware as its exclusive distributor and sales agent and commenced selling the TeleVideo products on that date.
Visara International, Inc.
On September 22, 2004, the Company acquired the thin client business of Visara International, Inc. (“Visara”), for $3.8 million in cash, including transaction costs, plus a potential earn-out based upon performance. The Company acquired substantially all of the assets of the Visara thin client business, including customer lists, intellectual property and technology, and also entered into reseller, supplier and non-competition agreements. The acquisition was accounted for using the purchase method of accounting. The Company has completed the allocation of the purchase price, based on an independent valuation, as follows: $2.1 million to goodwill, $1.0 million to acquired technology and $650,000 to customer relationships.
The results of operations of the Visara thin client business have been included in the Company’s statements of operations from the date of the acquisition. The pro forma results of operations disclosed below give effect to the acquisition of the Visara thin client business as if the acquisition was consummated on July 1, 2003.
Pro Forma Results of Operations
The following unaudited pro forma information presents the results of the Company’s operations as though the Thintune, Mangrove, and Visara acquisition had been completed as of July 1, 2003. The pro forma results have been prepared for comparative purposes only and are not necessarily indicative of the actual results of operations had the acquisition been completed as of July 1, 2003 or the results that may occur in the future (in thousands, except per share data):
| Nine Months Ended | ||||||
| March 31, | ||||||
| 2005 | 2004 | |||||
| Total net revenue | $ | 61,386 | $ | 55,444 | ||
| Net income | 4,770 | 4,167 | ||||
| Basic earnings per share | 0.30 | 0.26 | ||||
| Diluted earnings per share | 0.29 | 0.26 | ||||
Note 5. Goodwill and Intangible Assets
The carrying amount of goodwill was $27.8 million and $17.5 million at March 31, 2005 and June 30, 2004, respectively. The increase in goodwill is due to the acquisitions of the Visara ($2.1 million), Mangrove ($2.5 million), and Thintune businesses ($5.4 million) (See Note 4).
Intangible assets with finite useful lives are amortized over their respective estimated useful lives. The following table provides a summary of the Company’s intangible assets including the impact of exchange rates (in thousands):
| March 31, 2005 | |||||||||||
| Estimated | Gross | Net | |||||||||
| Useful | Carrying | Accumulated | Carrying | ||||||||
| Life | Amount | Amortization | Amount | ||||||||
| Tradenames | Indefinite | $ | 612 | $ | — | $ | 612 | ||||
| Customer relationships | 2-4 years | 4,827 | 626 | 4,201 | |||||||
| Distributor relationships | 5 years | 2,325 | 1,497 | 828 | |||||||
| Acquired technology | 5-10 years | 4,761 | 847 | 3,914 | |||||||
| Non-compete | 6 years | 495 | 12 | 483 | |||||||
| $ | 13,020 | $ | 2,982 | $ | 10,038 | ||||||
9
| June 30, 2004 | |||||||||||
| Estimated | Gross | June 30, 2004 | Net | ||||||||
| Useful | Carrying | Accumulated | Carrying | ||||||||
| Life | Amount | Amortization | Amount | ||||||||
| Tradenames | Indefinite | $ | 259 | $ | — | $ | 259 | ||||
| Customer relationships | 2 years | 546 | 273 | 273 | |||||||
| Distributor relationships | 5 years | 2,325 | 1,149 | 1,176 | |||||||
| Acquired technology | 5-10 years | 2,253 | 416 | 1,837 | |||||||
| $ | 5,383 | $ | 1,838 | $ | 3,545 | ||||||
The amortization expense of intangible assets is set forth below (in thousands):
| Three Months Ended | Nine Months Ended | |||||||||||
| March 31, | March 31, | |||||||||||
| 2005 | 2004 | 2005 | 2004 | |||||||||
| Customer relationships | $ | 178 | $ | 84 | $ | 369 | $ | 239 | ||||
| Distributor relationships | 116 | 108 | 349 | 298 | ||||||||
| Acquired technologies | 165 | 86 | 387 | 245 | ||||||||
| Non-compete | 12 | — | 12 | — | ||||||||
| $ | 471 | $ | 278 | $ | 1,117 | $ | 782 | |||||
Amortization expense for customer relationships and distributor relationships is included in sales and marketing expenses and amortization expense for acquired technologies is included in cost of revenues.
The following table provides estimated future amortization expense related to intangible assets (assuming there is no write down associated with these intangible assets causing an acceleration of expense) (in thousands):
| Future | ||||
| Year Ending June 30, | Amortization | |||
| Remainder of fiscal 2005 | $ | 640 | ||
| 2006 | 2,209 | |||
| 2007 | 1,959 | |||
| 2008 | 1,769 | |||
| 2009 | 1,622 | |||
| 2010 through 2013 | 1,228 | |||
| $ | 9,427 | |||
Note 6. Comprehensive Income
Excluding net income, the Company’s sources of other comprehensive income are unrealized income relating to foreign exchange rate fluctuations. The following summarizes the components of comprehensive income (in thousands):
| Three Months Ended | Nine Months Ended | |||||||||||
| March 31, | March 31, | |||||||||||
| 2005 | 2004 | 2005 | 2004 | |||||||||
| Net income | $ | 1,765 | $ | 1,658 | $ | 5,220 | $ | 4,917 | ||||
| Foreign currency translation | ||||||||||||
| adjustment | (312 | ) | 337 | 543 | 1,014 | |||||||
| Comprehensive income | $ | 1,453 | $ | 1,995 | $ | 5,763 | $ | 5,931 | ||||
Note 7. Revenue Recognition
Net revenues include sales of thin client appliance systems, which include the appliance device and related software, and services. The Company follows AICPA Statement of Position No. 97-2, “Software Revenue Recognition” (“SOP 97-2”) for revenue recognition because the software component of the thin client appliance systems is more than incidental to the thin client appliance systems as a whole. These products and services are sold either separately or as part of a multiple-element arrangement. Revenue is recognized on product sales when persuasive evidence of an arrangement exists, delivery of the product has occurred, the fee is fixed or determinable and collectibility is probable.
10
Revenue related to post-contract support services is generally recognized with the initial product sale when the fee is included with the initial product fee, post-contract services are for one year or less, the estimated cost of providing such services during the arrangement is insignificant, and unspecified updates and enhancements offered during the period historically have been and are expected to continue to be minimal and infrequent. Otherwise, revenue from extended warranty and post-contract support service contracts is recorded as deferred revenue and subsequently recognized over the term of the related support period.
Revenue from consulting and training services is recognized upon performance.
Stock rotation rights and price protection are provided to certain distributors. Stock rotation rights are generally limited to a maximum amount per quarter and require a corresponding order of equal or greater value at the time of the stock rotation. Price protection provides for a rebate in the event the Company reduces the price of products which the distributors have yet to sell to end-users. The Company reserves for these arrangements based on historical experience and the level of inventories in the distribution channel and reduces current period revenue accordingly.
Product warranty costs are accrued at the time the related revenues are recognized.
Note 8. Major Customers and Dependence on Suppliers
The following table sets forth sales to customers comprising 10% or more of the Company’s net revenue and accounts receivable balances:
| Three Months Ended | Nine Month Ended | |||||||
| March 31, | March 31, | |||||||
| 2005 | 2004 | 2005 | 2004 | |||||
| Net revenues | ||||||||
| IBM | 16 | % | 18 | % | 18 | % | 16 | % |
| North American distributor | 11 | % | * | 11 | % | * | ||
| European distributor | * | 14 | % | * | * | |||
| March 31, | ||||||||
| 2005 | 2004 | |||||||
| Accounts receivable | ||||||||
| IBM | 16 | % | 16 | % | ||||
| North American distributor | 11 | % | * | |||||
| European distributor | 12 | % | 18 | % | ||||
(*) Amounts do not exceed 10% for such period
IBM and the Company’s distributors resell the Company’s products to individual resellers and/or end-users. The percentage of revenue derived from IBM, individual distributors, resellers or end-users can vary significantly from quarter to quarter. In addition to the Company’s direct sales to IBM, IBM can purchase the Company’s products through individual distributors and/or resellers. Furthermore, IBM can influence an end-user’s decision to purchase the Company’s products even though the end-user may not purchase the Company’s products through IBM. While it is difficult to quantify the net revenues associated with these purchases, the Company believes that these sales are significant and can vary significantly from quarter to quarter. Subsequent to March 31, 2005, IBM completed the announced sale of its PC Group to Lenovo. The Company’s agreement with IBM continues in effect and we executed a mirror agreement with Lenovo. Accordingly, we do not currently anticipate any change in our IBM related business.
For the three months ended March 31, 2005 and 2004 revenues from Europe, the Middle East and Africa, based on the location of the Company’s primary selling activities with its customers accounted for 42% and 43%, respectively, of net revenues. Sales to the United Kingdom accounted for 17% and 16% of net revenue for the three months ended March 31, 2005 and 2004. For the nine months ended March 31, 2005 and 2004 revenues from Europe, the Middle East and Africa, based on the location of the Company’s primary selling activities with its customers accounted for 36% and 40%, respectively of net revenues. Sales to the United Kingdom accounted for 14% of net revenue for the nine months ended March 31, 2005. No single country accounted for more than 10% of net revenue for the nine months ended March 31, 2004.
11
The Company depends upon a limited number of sole source suppliers for its thin client appliance products and for several of the components in them. One of the Company’s suppliers who provides a substantial portion of the Company’s thin client products informed the Company in late fiscal 2004 that it was experiencing cash liquidity constraints and was evaluating and undertaking financial restructuring actions. In December 2004, the Company agreed to accommodate the supplier by purchasing products for inventory in advance of our contractual obligations and the Company anticipated continuing this practice until such time as the supplier’s cash liquidity situation was resolved. In the March 2005 quarter, this supplier’s liquidity improved and the Company reduced its advance purchase of inventory. Accordingly, inventory levels at March 31, 2005 decreased from the December 31, 2004 levels. However, in the event that this supplier experiences future cash liquidity constraints, the Company could be requested to make advance purchases which would decrease the Company’s cash balance. Additionally, the Company could face an interruption in the supply of a substantial portion of its products. Although the Company has identified alternative suppliers that could produce comparable products, it is likely there would be an interruption of supply during any transition, which would limit the Company’s ability to ship product to fully meet customer demand. If this were to happen, the Company’s revenue would decline and its profitability would be adversely impacted.
The Company also depends on limited sources to supply several other industry standard components and relies on certain foreign suppliers, which also subject the Company to risks associated with foreign operations such as the imposition of unfavorable governmental controls or other trade restrictions, changes in tariffs, political instability and currency fluctuations. A weakening dollar could result in greater costs to the Company for its components.
Note 9. Inventories
Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out method and consists of the following (in thousands):
| March 31 | June 30, | |||||
| 2005 | 2004 | |||||
| Purchased components and subassemblies | $ | 359 | $ | 234 | ||
| Finished goods | 2,619 | 561 | ||||
| $ | 2,978 | $ | 795 | |||
Note 10. Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” Under the asset-and-liability method of SFAS No. 109,