Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the year ended December 31, 2003
|_| 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)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock,
No Par Value
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 __
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in any amendment to this Form 10-K or in
definitive proxy or information statements incorporated by reference in Part III
of the From 10-K. ___
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes No |X|
--- -----
The approximate aggregate market value of the common stock held by
non-affiliates of the Registrant, based upon the last sale price of the common
stock reported on the Nasdaq SmallCap Market on June 30, 2003 was $9,218,804.
The number of shares of common stock outstanding at March 11, 2004 was
3,542,736.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III of this Form 10-K will be incorporated by
reference from certain portions of Castelle's proxy statement relating to its
2003 Annual Meeting of Shareholders to be filed with the SEC or will be provided
in an amendment to this Form 10-K to be filed with the SEC no later than April
30, 2004.
FORM 10-K
TABLE OF CONTENTS
CASTELLE
FORM 10-K
TABLE OF CONTENTS
PAGE
PART I........................................................................1
ITEM 1. BUSINESS.................................................1
ITEM 2. PROPERTIES..............................................12
ITEM 3. LEGAL PROCEEDINGS.......................................12
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS...12
PART II .....................................................................13
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED
SHAREHOLDER MATTERS.....................................13
ITEM 6. SELECTED FINANCIAL DATA.................................14
ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATION......................16
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK....................................................32
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.............32
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE.....................32
ITEM 9A. CONTROLS AND PROCEDURES.................................32
PART III.....................................................................33
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT......33
ITEM 11. EXECUTIVE COMPENSATION..................................33
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT..............................................33
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS..........33
ITEM 14. PRINCIPAL AUDITOR FEES AND SERVICES.....................33
PART IV......................................................................34
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
FORM 8-K................................................34
SIGNATURES...................................................................36
FINANCIAL STATEMENTS........................................................F-2
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements, within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, that are based on our current expectations
about our company and our industry. All of our forward-looking statements
involve risks and uncertainties. Our actual results could differ significantly
from our expectations and from the results expressed in or implied by these
forward-looking statements. Factors that might cause such a difference include,
but are not limited to, those discussed elsewhere in this Annual Report on Form
10-K. We urge you to consider these cautionary statements carefully in
evaluating our forward-looking statements. Except as required by law, we
undertake no obligation to publicly update any forward-looking statements to
reflect subsequent events and circumstances. Important factors that may cause
results to differ from expectations include those discussed in Risk Factors
beginning on page 24 in this document.
PART I
ITEM 1. BUSINESS
The following summary should be read in conjunction with, and is
qualified in its entirety by, the more detailed information and Consolidated
Financial Statements and Notes thereto appearing elsewhere in this Annual Report
on Form 10-K.
OVERVIEW
Castelle was incorporated in California in 1987, and its principal
offices are located at 855 Jarvis Drive, Suite 100, Morgan Hill, California
95037. Unless the context otherwise requires, references in this Form 10-K to
"we," "us," or the "Company" refer to Castelle. Our telephone number is (408)
852-8000. Castelle(R), LANpress(R) and JetPress(R) are registered trademarks of
the Company. FaxPressTM, FaxPress PremierTM and InfoPressTM are trademarks of
the Company. This Annual Report on Form 10-K includes trademarks and trade names
of other companies. Our common stock is listed on the Nasdaq SmallCap Market
under the symbol CSTL. We maintain a Website with the address www.castelle.com.
We are not including the information contained on its website as a part of, or
incorporating it by reference into, this Annual Report on Form 10-K. We make
available free of charge through our website our Annual Reports on Form 10-K and
Quarterly Reports on Form 10-Q as soon as reasonably practicable after we
electronically file such material with, or furnish such material to, the
Securities and Exchange Commission. In addition, we intend to disclose on our
website any amendments to, or waivers from, our code of business conduct and
ethics, that are required to be publicly disclosed pursuant to rules of the
Securities and Exchange Commission and the Nasdaq Stock Market.
We develop, manufacture, market and support office automation systems
that allow organizations to implement faxing and printing over local area
networks and the Internet. A market leader in fax solutions for small to medium
sized workgroups, our FaxPress fax servers provide a simple way to integrate fax
with email, desktop and back-end applications. We also provides LANpress print
servers, which enable users to locate printers anywhere on the network, and the
InfoPress information-on-demand software suite. Our products are designed to be
easy to use and maintain, and provide an economical way for companies to share
resources over their networks.
Our products have historically centered on fax and print servers and
related technologies. Beginning in 1997, our revenues declined as competition
increased, primarily with the print server products in the Asia Pacific region,
while at the same time the Internet and other networking technologies advanced.
1
As a result, we experienced annual operating losses during 1997 through 1999.
During the past five years, management has redirected our efforts to focus on
server appliances and on development efforts to integrate existing and future
products with the Internet and emerging networking technologies. Through the
introduction of enhanced fax automation products that generate higher gross
profits, restructuring and cost reductions, we were able to report operating
profits in the fourth quarter of 1999 and in each of the four quarters of 2000.
In 2000, we recorded a profit of $732,000 with sales at $14.8 million. We
incurred a loss of $591,000 in 2001 with sales of $9.4 million, resulting from a
decrease in demand for our products due in part to the slowness of the economy.
Our sales and profitability rebounded beginning in the third quarter of 2001,
and we recorded a profit of $659,000 in 2002 with sales at $9.8 million and a
profit of $1.6 million in 2003 with sales at $10.2 million. The pre-tax profit
for 2003 of $1.1 million is the highest since 1996.
Industry Background
In the mid-1980s, organizations began to interconnect personal
computers into local area networks (known as "LANs") in order to allow
workgroups to share files, peripherals such as printers, and other specialized
applications. As LANs have proliferated throughout organizations and
client/server architectures have gained acceptance, they have become
increasingly complex and the applications operating on computer networks have
become more critical to the success of the business enterprise. The further
proliferation of the Internet and Intranets and popularity of electronic
communications expanded the role of LANs as a means to provide common access to
the Internet, email and other office automation applications. Installation,
maintenance and administration of LAN equipment required a staff of highly
skilled professionals. The costs associated with LANs and related equipment,
server-class hardware, specialized software, network integration and support
services are significant and typically affordable only by larger organizations.
Many businesses were not able to afford office automation applications beyond
basic email, such as integrating fax technology into the network. This has
created the opportunity for specialized networking equipment that would perform
a single application very well, known in the industry as a "server appliance."
It is similar to using a toaster instead of an oven, it does a specific job
better and it costs less. A server appliance is an integrated hardware and
software product designed to reduce the complexity and cost for a specific
server-based application. Internet routers, email servers, remote access
servers, communication servers, fax servers and print servers are examples of
server appliances used by businesses today.
We are a pioneer in server appliances, establishing a benchmark for
"plug-and-play" and ease of use with our fax and print server product families.
Fax Office Automation Products: Fax machines have become a basic method
of doing business worldwide. Fax is ubiquitous in business; many homes even have
fax machines. While computers have automated many business applications, faxing
remains as a basic method of business communication. We believe fax is here to
stay, just as the computer, in its quest for the paperless society, has not
replaced paper. Fax servers integrate legacy fax business methods into the
network to improve office productivity. Fax servers also provide the opportunity
for new business applications to be developed to take advantage of the inherent
strength and prevalence of fax machines. Virtually every business in the world
has a fax machine that can be used to receive information. Sending purchase
orders, invoices, order confirmations, etc. directly to a fax machine, as
compared to using the mail, is a growing segment of the fax server market.
The increasing popularity of email and the Internet has provided a
boost to all types of electronic communications as many users and organizations
become more comfortable and accustomed to their use. To further simplify and
improve inter- and intra-organizational communications, corporate Management
Information Services departments are looking for ways to integrate different
types of messaging into a
2
unified messaging environment. Fax remains one of the key business communication
tools and is one of the essential components of the corporate messaging
environment. In corporate communication infrastructures, fax is being integrated
into email. To facilitate this capability companies install email-integrated fax
server systems.
Fax servers allow users to send and receive faxes as easily as emails,
using the same email application for both types of messages. A fax server can
sort incoming faxes directly and deliver them electronically and confidentially
to the electronic mailboxes of the intended recipients. A fax server can also be
used as an independent network shared system in environments that require high
volume incoming and outgoing faxes. Users are able to send and receive faxes
directly from their computers or workstations, eliminating the need to print a
document, take it to a stand-alone fax machine and wait for its transmission.
Fax servers can help reduce fax transmission costs by sending non-urgent faxes
at "off-peak" telephone rates and by utilizing fax over the Internet technology.
Many fax servers are implemented using complex software that requires
the installation of a Windows or UNIX network operating system, a server-class
computer, and specialized expensive fax modems. Our fax servers, FaxPress and
FaxPress Premier, are self-contained units with all the necessary hardware and
software to integrate fax into network, desktop, email and back-end
applications. As server appliances, they are designed to be easy to use and
maintain and we believe that they are more economical than other solutions.
Automated delivery of information is another popular application of fax
technology. Fax-on-demand is the ability to use a touch-tone phone and a fax
machine to request and receive copies of documents on demand. Although there are
a wide variety of applications installed, the two most common applications are
customer support and literature fulfillment applications. The largest industry
using fax-on-demand is the high-technology sector, with applications also
installed in travel, government, newspapers, manufacturing and non-profit
organizations. Essentially, any company with information to disseminate publicly
is a potential information-on-demand customer. Castelle's InfoPress product line
provides a comprehensive solution for automated information delivery via fax and
email.
Print Servers: The sharing of printers, which is a basic benefit of a
LAN, has traditionally been provided by connecting a printer either to a network
file server or to a dedicated personal computer on the network. However, direct
connection to the file server has several disadvantages, including the risk of
the file server being overburdened by the processing required to print large or
graphically complex files, lower print transfer speeds and location
inflexibility. Similarly, printer connection to a dedicated personal computer,
while providing better location flexibility, is more costly and offers
substantially lower print file transfer speed than a dedicated print server can
provide. A print server directly connects one or more printers to a LAN,
providing a cost-effective, high-speed solution to the demand for shared print
resources. In addition, print servers improve network performance by relieving
the burden on the file server. Print servers enable users to access essential
information about the status of the printer and their print files and to select
their desired printer configuration.
Server appliances, such as communications/messaging servers and print
servers, have emerged and gained market acceptance due to their ability to
significantly reduce complexity and cost associated with the installation and
maintenance of networking systems. These appliances also make the complex
functionality of Internet and Intranet communications available and affordable
to smaller businesses. As professionals in enterprises and small organizations
alike continue to recognize the benefits of server appliances, such as remote
access, scanning, faxing, electronic mail and related functions, we believe that
the demand for such network systems will increase.
3
Our Strategy
Our objective is to be a leading worldwide supplier of network server
appliances. We established a benchmark for "plug-and-play" and ease of use with
our fax and print server product families. Our products are installed in many
Fortune 1000 firms, small and medium sized businesses worldwide, integrating
desktop fax automation, email, Internet connectivity, print and other shared
services.
Focus on Server Appliances: We focus exclusively on providing
innovative, reliable, easy-to-use network products. Since our inception, we have
focused on developing networking products that tightly integrate proprietary
hardware systems with standard computing platforms. As a result, we believe we
have developed a high level of expertise in networking, software development,
hardware design and telephony technology. We plan to capitalize on these
attributes by continuing to focus on providing network enhancement products that
enable users to communicate more effectively.
Focus on Application Solutions and Communications: We focus on
developing application solutions for inter and intra-company communications. We
believe that our focus on application servers rather than on infrastructure
systems enables us to offer products that bring higher value services to
customers and provide a higher margin to us.
Expand Product Line: We are leveraging our expertise in server
appliances to offer new easy-to-use, cost-effective solutions. We continue to
expand our fax server products and apply our proven technology to other areas.
Focus on E-commerce and Other High Volume Distribution Channels: We
have established a two-tier domestic and international distribution network of
leading national and regional network product distributors and resellers
including Ingram Micro and Tech Data. Our products are well suited for sale by
e-commerce vendors and we have been successful working with leading resellers
such as CDW and Insight. We are focused on maintaining and strengthening our
current distribution network in North America, Europe and Pacific Rim.
Leverage Strategic Relationships: We augment our product offerings by
establishing relationships with companies able to provide products in areas
outside of our core technical competencies or in instances where internal
development of such products is not cost-effective. We also establish
relationships with numerous leaders in hardware and software technology to
enable it to keep abreast of, and respond quickly to, technological changes that
may affect the network enhancement market.
Products
We develop and market a range of server appliances that enhance network
productivity, performance and functionality. Our current products are grouped
into two areas: fax servers and print servers.
Fax Server Products: We offer the FaxPress family of network fax
servers. We position FaxPress and FaxPress Premier as the easiest way to add
faxing to a company's network and integrate fax with email. FaxPress and
FaxPress Premier allow network users to send, receive, route, print, store, edit
and retrieve fax transmissions from their own personal computers on a network.
FaxPress and FaxPress Premier can be integrated into an email system creating a
unified fax/email environment. FaxPress and FaxPress Premier enable users to
transmit documents directly to a fax device as easily as if they were printing
to a laser printer or sending an email message. The product also provides
network administration features such as, monitoring, logging or configuring
FaxPress and FaxPress Premier users. Our fax server products are designed to
comply with current regulatory standards in the United States, Europe and the
4
Pacific Rim. During 2003, 2002, and 2001, fax products represented 97%, 95%, and
91%, respectively, of total net sales.
Key features of FaxPress and FaxPress Premier products (configured with
its current software versions) include:
o Easy Installation and maintenance: FaxPress and FaxPress
Premier are network fax servers that include all the necessary
hardware and software. The hardware system is a box with an
integrated 10/100 Base-T Ethernet interface and one to
seventy-two fax channels. FaxPress and FaxPress Premier
include all required server and client software.
o Support for popular network operating environments: FaxPress
and FaxPress Premier operate in any local area network based
on Microsoft Windows 98, ME, 2000 and 2003; Windows NT/XP, and
NT Terminal Server; Novell NetWare; or Linux servers.
o Ability to create a unified fax/email messaging environment:
FaxPress and FaxPress Premier have the ability to integrate
fax into a corporate email system, allowing users to send and
receive faxes in the same manner as emails. FaxPress and
FaxPress Premier support Microsoft Exchange/Outlook, Lotus
Notes, Novell GroupWise, Netscape and other SMTP compatible
email systems. Our unique Outlook Direct interface offloads
fax processing from the Microsoft Exchange Server while
maintaining tight integration with the Outlook client.
o Integration with many popular accounting and Customer
Relationship Management applications: FaxPress and FaxPress
Premier are available with the Reform-for-FaxPress software
package from FabSoft that allows users to send faxes from many
popular accounting, financial and payroll systems including
Oracle, SAP, PeopleSoft, Great Plains, ACCPAC and Macola.
Reform can support any application that supports form
printing.
o Ability to send faxes from many applications: Faxing from
within any Windows, Windows 95/98 and Windows NT/2000/XP
application such as Microsoft Office and Lotus Smart Suite.
o Electronic delivery of faxes to desktops: FaxPress and
FaxPress Premier support several methods to deliver incoming
faxes direct to the email or fax inbox of the intended
recipient. Such methods include Direct Inward Dialing, Dual
Tone Multifrequency, T.30 sub-addressing, and line routing.
o Internet faxing capabilities reduce transmission costs:
FaxPress and FaxPress Premier enable users to connect several
units via the Internet or the Intranet to form a private
Fax-over-IP network that can significantly reduce the cost of
fax transmissions.
o Integration into custom applications: We provide a software
development kit that allows programmers to integrate fax
functions into their current applications or to create new
customized applications that use the FaxPress or FaxPress
Premier servers.
o Software Options: We offer a range of value-added software
options that increase the functionality of our FaxPress and
FaxPress Premier systems and enable the FaxPress and FaxPress
Premier to address specialized applications as mentioned
above. Software
5
upgrades and options are available to the installed base of
FaxPress and FaxPress Premier units at prices starting at $495.
We offer a family of FaxPress and FaxPress Premier fax server systems
ranging from entry-level products targeted for small businesses with fewer than
50 users to high-end fax solutions capable of supporting enterprise-wide
installations. The suggested U.S. list prices for FaxPress and FaxPress Premier
fax servers range from $1,495 to $48,995. Server pricing is based on hardware
model, with no per-user costs. The FaxPress 2500, 5000 and 7000 families come
with the FaxPress 7.X network fax software that adds integration with popular
email packages, and many advanced fax management and integration features.
FaxPress 7.1.1 Email Integration is not included on FaxPress Small Business
Edition ("SBE"). The FaxPress Premier family comes with the FaxPress Premier 3.X
network fax software. The following table summarizes our FaxPress and FaxPress
Premier system products:
---------------------------------------
| Network Environment |
-----------------------------------------------------------------------------------------------------------------
NetWare
Number of Email Network 3.x, 4.x, 5.x,
Product Model Channels Integration Topology 6.x (IPX,IP) Windows NT/2000/XP/2003
-----------------------------------------------------------------------------------------------------------------
FaxPress SBE 1 Not available Ethernet x x
FaxPress 2500 2 x Ethernet x x
FaxPress 5000 2, 4 or 8 x Ethernet x x
FaxPress 7000 8 x Ethernet x x
FaxPress 7500 8 x Ethernet x x
FaxPress Premier Analog 8, 12, 16 x Ethernet n/a x
FaxPress Premier Digital T1 24, 48, 72 x Ethernet n/a x
FaxPress Premier ISDN 4, 8, 12 x Ethernet n/a x
-----------------------------------------------------------------------------------------------------------------
Information-on-demand systems: InfoPress software enables the access of
information via any touch-tone phone and a fax machine and allows the
dissemination of information via "broadcasting" to a select database of fax
numbers. InfoPress allows companies to use one source of documents in a Castelle
document library and to automatically publish the documents using either the
fax-on-demand and/or email-on-demand methods.
Our InfoPress is a software product designed to operate on Microsoft
Windows NT/2000/XP platforms. The system utilizes voice and fax processing
hardware, as well as telephone system interface (analog or T1) hardware with as
few as two and as many as 288 ports that are actually deployed at a customer
site.
o Fax-on-Demand: Fax-on-demand allows a user to request and
receive information on demand by dialing a telephone number.
The user interacts with a series of voice prompts to select
specific documents, by simply using the telephone keypad, and
requesting delivery of these documents to a fax number.
o Email-on-Demand: Email-on-demand allows a user to request and
receive information on demand by using email. Auto-reply email
exists today, but is limited to receiving one document,
usually in text format. The main benefit of email-on-demand is
6
the ability to share the document library with fax-on-demand.
o Web Integration: InfoPress supports Web HTML documents in the
document library. The documents are automatically rendered
into a fax document when required.
Print Servers: Printer sharing continues to be one of the important
benefits of computer networking. Print servers are the most efficient and
economical way to share printers on a network. While demand for print servers in
various sizes of businesses continues to grow, the market is very competitive.
We have been involved in the print server business for more than thirteen years.
After continuous improvements to the cost and feature set, our LANpress has
become a well-received print server product line. Our latest print server models
incorporate a RISC microprocessor, Fast Ethernet, Windows, Internet Printing and
many other attractive features. The suggested U.S. list price for LANpress print
servers ranges from $165 to $280. During 2003, 2002 and 2001, print server
products represented 3%, 5% and 9%, respectively, of total net sales.
The following table summarizes our line of LANpress external print
servers:
-------------------------------------------------
| Network Environment |
- ----------------------------------------------------------------------------------------------------------------------
NetWare
Ethernet 3.x, Windows Flash Internet
Network 4.x, 95/ 98/ Apple Upgrade Printing
Product Configuration Interface 5.x, 6.x UNIX TCP/IP NT/2000/2003/XP Ethertalk Capability Protocol
- ----------------------------------------------------------------------------------------------------------------------
LANpress 2000 1P Direct 10/100 x x x x x x
LANpress 3P/100 10/100 x x x x x N/a
LANpress 2000 USB 10/100 x x x x x x
- ----------------------------------------------------------------------------------------------------------------------
Research and Product Development
We have invested substantially in research and product development
since inception. We believe our future performance will depend in large part on
our ability to enhance our current products, to expand our product offerings, to
maintain technological competitiveness and meet an expanding range of customer
requirements. We spent $1.6 million, $1.4 million and $1.8 million in research
and product development activities in 2003, 2002 and 2001, respectively.
We continue to invest in enhancing our server appliance product lines
by developing new versions of client and server software and server hardware.
The product feature set is driven by the increasing complexity of user needs.
The changing corporate communications/messaging environment and increasing
demand for easy-to-use networking systems define these needs. The development
efforts are focused on enhancing functionality of existing products and
developing other systems to expand our product offerings. Our development
efforts are focusing on high value applications, while relying on our partners
to provide basic functionality for some of our product lines.
In 2003, we developed and released version 7.1.1 of our FaxPress
software and version 3.0 of our FaxPress Premier software. The new releases of
FaxPress 7.1.1 and FaxPress Premier 3.0 Network Fax Software offer a new level
of email integration, expanded operating environments and fax automation. It
7
includes a new gateway for IBM Lotus Notes email integration, improved
integration with Microsoft Exchange, enhanced Windows XP and Citrix MetaFrame XP
support, improved Novell client support, production faxing and fax automation
made easy.
The current FaxPress and FaxPress Premier fax server product lines are
continuously being enhanced to offer greater integration into corporate
networking environments.
Sales, Marketing and Distribution
We sell our products through multiple channels, determined by the
product, market and customer need. We have an established two-tier domestic and
international distribution network of leading national and regional network
product distributors and resellers. Software enhancements and options that
complement the FaxPress products are primarily marketed directly by us to
registered end users. The direct sales group works closely with distributors and
value-added resellers ("VARs") in qualifying sales opportunities for the fax and
print server products. We also sell some products through the on-line store on
our Web site. Demand for our products is created through a variety of marketing
programs. These programs are targeted toward end-users to stimulate demand for
the products and toward distributors, resellers, VARs and e-commerce vendors to
promote the product in the sales channel. These programs include targeted and
active participation in industry networking and communication trade shows, as
well as advertising in associated publications. We increase awareness of our
products by Internet marketing via targeted e-advertising, publishing and
sponsoring email newsletters, enhancing our Web presence, print advertising,
conducting direct mail campaigns, offering seminars, trade shows and
conferences, and other forms of public relations efforts. Our Web site has been
updated and designed to assist customers in obtaining information about our
products and contacting our sales personnel, and offers selected products and
services through our on-line store.
Our products are well suited for sale by e-commerce vendors, and we
have experienced success working with leading resellers such as CDW and Insight.
In 2003, Ingram Micro and Tech Data individually accounted for more
than 10% of our sales and collectively represented approximately 50% of our net
sales. In 2002 and 2001, the same distributors accounted for approximately 48%
and 46% of our net sales, respectively. Total sales to customers located in the
Pacific Rim, Europe and rest of Americas comprised approximately 19%, 21% and
25% of our net sales in 2003, 2002 and 2001, respectively.
Customer Service and Support
We provide customers with support services, which are available to
assist customers with installation, use and operation issues in an effort to
ensure smooth and reliable operation of our products. Our network engineers,
located at corporate headquarters, provide technical support via telephone, fax
and email during normal Company business days from 6:00 a.m. to 5:00 p.m.
(Pacific Time). As part of our global partner program, VARs have access to
"priority technical support" via a special toll-free number that provides
immediate access to our network engineers. Support is provided under warranty
terms as well as through extended warranty agreements sold directly to the
customer by us. We also provide other customer support through our Web site. We
have an automated call management distribution system that provides improved
levels of support to help resolve customer issues.
Manufacturing
Our current in-house manufacturing operations consist primarily of
material planning, assembly, final testing, quality control and service repair.
Certain of our products are manufactured by third-party
8
manufacturers that provide customized, integrated manufacturing services,
including procurement, manufacturing, printed circuit board assembly and final
testing. We also rely on SerComm to manufacture certain of our print server
products. These arrangements enable us to shift certain costs to such providers,
thereby allowing us to focus resources on our product development efforts. The
failure of such manufacturers, to meet their contractual commitments to us could
cause delays in product shipments, thereby potentially adversely affecting our
business, operating results and financial condition.
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 and tooling used
in manufacturing our products and believes that it 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 making of our FaxPress Products. However, we have purchased at least
two years worth of supplies of these end-of-life components in an effort to
guarantee an uninterrupted supply of FaxPress Products to our customers for the
next two years, while we decide whether to re-engineer our Products with the
manufacturers' suggested replacement parts, or develop new replacement products.
Competition
The network enhancement products and computer software markets are
highly competitive, and we believe that such competition will intensify in the
future. The competition is characterized by rapid change and improvements in
technology along with constant pressure to reduce the prices of products. We
currently compete principally in the market for network fax servers, network
print servers and fax-on-demand software.
The principal competitive factors affecting the market for our products
include product functionality, performance, quality, reliability, ease of use,
quality of customer training and support, name recognition, price, and
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. 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.
Proprietary Rights
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. Additionally, we generally enter into
confidentiality agreements with those employees, distributors, customers and
suppliers who have access to sensitive information and limits access to and
distribution of our software documentation and other proprietary information.
Because of the rapid pace of technological change in the LAN product industry,
we believe
9
that patent protection for our products is less significant to our success than
the knowledge, ability and experience of our employees, the frequent
introduction and market acceptance of new products and product enhancements, and
the timeliness and quality of our support services. We may not be able to obtain
the necessary intellectual property rights and other parties may contest our
intellectual property rights.
Government Regulation
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, particularly in foreign countries could have a
material, adverse effect on our business, operating results and financial
condition. Additionally, our products must comply with a variety of equipment,
interface and installation standards promulgated by communications regulatory
authorities in different countries.
Employees
As of March 1, 2004, we employed a total of 43 full-time equivalent
personnel, 10 in operations, 11 in sales and marketing, 8 in engineering, 8 in
customer service and 6 in finance and administration. We have not experienced a
work stoppage, no employees are represented by a labor organization and we
consider our employee relations to be good.
Executive Officers
The names and ages of our executive officers as of February 28, 2004
are set forth below:
Name Age Position
Scott C. McDonald 50 President, Chief Executive Officer
Eric Chen 51 Senior Vice President, Engineering and
Business Development
Paul Cheng 55 Vice President, Finance and Adminis-
tration, Chief Financial Officer and
Secretary
Richard Fernandez 44 Vice President, Operations
Edward J. Heinze 58 Vice President, Sales, U.S.
Michael Petrovich 42 Vice President, Sales, International
Scott C. McDonald
Mr. McDonald has served as our President and Chief Executive Officer
since April 2002. Mr. McDonald has served as director of since April 1999.
From May 2001 to the first quarter of 2002, Mr. McDonald served on the
board of directors for Octant Technologies and Digital Power Corporation
and provided consulting services. Mr. McDonald served as the Chief
Financial and Administrative Officer at Conxion Corporation, a network and
Internet services company, from December 1999 to April 2001. From 1997 to
1999, Mr. McDonald served on the board of directors for CIDCO, Inc, Octant
Technologies Inc. and Digital Power Corporation; in addition to providing
consulting services to CIDCO, Inc. Mr. McDonald currently serves on the
board of directors of privately held Octant Technologies, Inc. Mr. McDonald
holds a BS in Accounting from the University of Akron and an MBA from
Golden Gate University.
10
Eric Chen
Mr. Chen has served as our Senior Vice President, Engineering and
Business Development since May 2002. From May 2000 to May 2002, Mr. Chen
served as our Vice President, Engineering. Upon joining us in 1989, Mr.
Chen initially worked on software development projects including developing
the first FaxPress e-mail gateways, porting FaxPress to non-Novell
platforms, and the first menu-driven installation and configuration
programs for both FaxPress and LANpress. Most recently, Mr. Chen served as
the Director of Print Server Product Marketing and Business Unit and has
managed the engineering development and manufacturing business
relationships with our partners. Before joining our company, Mr. Chen was
with 3COM, a network solutions provider. Mr. Chen has a BS in Engineering
from Taiwan and an MS in Computer Science from the University of
Massachusetts.
Paul Cheng
Mr. Cheng has served as our Vice President, Finance and Administration
since April 2000. In March 2001, Mr. Cheng was appointed as Chief Financial
Officer and Secretary. Mr. Cheng brings more than 20 years of financial
experience from a career that was launched in Hong Kong where he was the
Plant Controller of Fairchild Semiconductor Hong Kong Ltd. Before joining
our company, he served as the Vice President of Finance and Administration
at Eclipse International, Inc., a systems development company, from April
1997 to March 2000. In addition, he has held various executive positions
including Vice President of Finance at Quintus Corporation, a developer of
customer relations management software from 1993 to 1995 and Corporate
Controller at Power Integration, Inc., a semiconductor manufacturer from
1995 to 1997. Mr. Cheng is a member of the Chartered Certified Accountants
and holds a BS in Accounting from Hong Kong.
Richard Fernandez
Mr. Fernandez has served as our Vice President of Operations since
December 2002. From June 2002 to December 2002, Mr. Fernandez served as our
Director of Operations. Mr. Fernandez has more than 22 years of
manufacturing and materials planning experience prior to joining the
Company. Prior to joining our company, Mr. Fernandez managed the
acquisition of servers and storage devices for Conxion Corporation from
June 2000 to May 2002. Prior to joining Conxion, Mr. Fernandez was Director
of Operations with CIDCO, Inc. since March 1994. In addition, Mr. Fernandez
has held various management positions with Computer Products Inc., MAD
Intelligent Systems and Sperry Univac.
Edward J. Heinze
Mr. Heinze has served as our Vice President, Sales, U.S. since January
2000. From 1994 to January 2000, Mr. Heinze served in several capacities
including Product Manager of the Fax Product Line, and Regional Sales
Manager. Before joining our company, Mr. Heinze served in several
capacities at Visual/White Pine Software, a software developer, including
Vice President of Sales. Prior to his tenure at White Pine, he was Chief
Operations Officer for XMARK, a computer systems manufacturer, and Vice
President of Sales and Marketing at EIT, Millicom, Olympia, and Ontel. He
holds a BS degree from Waynesburg College.
Michael Petrovich
Mr. Petrovich has served as our Vice President, Sales, International
since October 2000 and has been with us since 1992. Mr. Petrovich
concentrates on developing the sales channels for all sales outside of the
Americas, including Asia, the Asia Pacific and Europe. Prior to joining us,
Mr. Petrovich was the marketing communications manager for Novell's
National Reseller Organization, a software company.
11
In this role Mr.Petrovich focused on business strategies and development of
Novell's direct reseller sales channel. Before joining Novell, Mr.
Petrovich held sales and marketing positions at Excelan, a LAN manufacturer
and International Microcircuits Incorporated, a semiconductor company. Mr.
Petrovich holds a BA in Behavioral Sciences from San Jose State University.
ITEM 2. PROPERTIES
Our headquarters, including our executive offices and corporate
administration, development, manufacturing, marketing, sales and technical
services/support facilities, are located in Morgan Hill, California in
approximately 16,600 square-feet of leased office space. We occupy this facility
under a lease, the term of which expires in December 2005 with one conditional
three-year option, which if exercised, would extend the lease to December 2008.
We also rent office space for sales and customer support in Illinois. We believe
our existing facilities will be adequate to meet our requirements for the
foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
From time to time and in the ordinary course of business, we are
involved in various legal proceedings and third party assertions of patent or
trademark infringement claims against us in the form of letters and other forms
of communication. 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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
Subsequent to our Annual Meeting of Shareholders held on May 29, 2003,
there were no matters submitted to a vote of securities holders in the remainder
of 2003.
12
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
Our common stock (Nasdaq symbol "CSTL") began trading on the Nasdaq
National Market on December 20, 1995 and was transferred to the Nasdaq SmallCap
Market as of April 1999. The following table shows the closing high and low sale
prices per share of our common stock as reported on the Nasdaq SmallCap Market.
Such quotations do not include retail markups, markdowns or commissions.
2002 HIGH LOW
First Quarter $1.01 $0.64
Second Quarter $0.80 $0.57
Third Quarter $0.85 $0.50
Fourth Quarter $1.15 $0.47
2003 HIGH LOW
First Quarter $2.91 $1.03
Second Quarter $3.86 $1.95
Third Quarter $4.90 $3.01
Fourth Quarter $3.50 $2.61
The market price of our common stock has been volatile. See "Risk
Factors - Our stock price has been volatile, and is likely to continue to be
volatile in the future."
As of March 3, 2004 there were 1,081 holders of record of our common
stock. On March 3, 2004 the last sale price reported on the Nasdaq SmallCap
Market for our common stock was $5.46 per share.
Stock Buyback
In the fourth quarter of 2002, our Board of Directors authorized us,
from time to time, to repurchase at market prices, up to $2.25 million of our
common stock for cash in open market, negotiated or block transactions. The
timing of these transactions will depend on market conditions, other corporate
strategies and will be at the discretion of 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
and as of the end of the third quarter 2002, cash and cash equivalents were
approximately $4.8 million. During the fourth quarter of 2002, we repurchased
from open market and negotiated transactions a total of 1.62 million shares for
$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 $48,000, at an average per share price of $1.04. We performed no stock
repurchases during the rest of 2003. However, we may continue to execute our
buyback program as we deem necessary.
Dividend Policy
We have not paid cash dividends on our common stock. The Board of
Directors currently intends to retain any and all earnings for use in our
business and we do not anticipate paying cash dividends in the foreseeable
future.
Equity Compensation Plan Information
The following table sets forth a summary of our equity compensation
plans as of December 31, 2003. Details of the plans are discussed in Note 6 to
the Consolidated Financial Statements.
13
Number of securities to Weighted average
be issued upon exercise exercise price of Number of
of outstanding options, outstanding options, securities remaining
warrants and rights warrants and rights for future
issuance
1988 Equity compensation plan approved 7,000 $2.38 -0-
by security holders
1998 (1988) Equity compensation plan
(As Amended) approved by security 1,279,706 $1.01 -0-
holders
2002 Equity compensation plan approved 303,500 $2.94 546,500
by security holders
Equity compensation plans not approved -0- n/a -0-
by security holders
--------------------------- -------------------------- ---------------------
Total 1,590,206 $1.38 546,500
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial information has been derived from the
audited Consolidated Financial Statements. The information set forth below is
not necessarily indicative of results of future operations, and should be read
in conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements and related
Notes thereto included elsewhere in this Annual Report on Form 10-K.
Years ended December 31,
...................................................................
2003 2002 2001 2000 1999
-------------- ------------- -------------- ------------ ------------
(in thousands, except per share amounts)
INCOME STATEMENT DATA:
Net Sales $10,214 $9,759 $9,354 $14,832 $16,116
Gross Profit $7,729 $6,923 $6,265 $9,380 $ 8,404
Gross Profit as a % of Net Sales 76% 71% 67% 63% 52%
Net income/(loss) $1,633(1) $659 ($591)(3) $732 ($3,555)(3)
Net income/(loss) as a % of Net Sales 16%(1) 7% (6%) 5% (22%)
Net income/(loss) per share - diluted $0.39(1) $0.14 ($0.12) $0.14 ($0.78)
BALANCE SHEET DATA:
Cash and Cash Equivalents $4,614 $3,460(2) $4,568 $3,893 $4,714
Working Capital $4,180 $2,434 $3,560 $3,969 $3,555
Total Assets $7,803 $5,635 $7,010 $8,543 $8,502
Long-term Liabilities $29 $44 $64 $63 --
Shareholders' Equity $4,776 $2,923(2) $4,202 $4,776 $4,020
(1) In the fourth quarter of 2003, we recorded a non-cash tax benefit
of $526,000, or $0.12 per diluted share, resulting from the release of a portion
of our tax valuation allowance. Prior to the fourth quarter, we had not reported
significant income tax expenses because we had utilized available Net Operating
Loss ("NOL") and tax credit carryforwards. These NOLs were fully reserved by a
valuation allowance due to uncertainly surrounding the likelihood of their
realization. Due to our continued profitability over the past ten quarters 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.
14
(2) In 2002, cash and cash equivalents and shareholders' equity reflect
the use of $2 million of cash for the repurchase of 1.62 million shares of our
common stock and the associated expenses.
(3) Net loss for 2001 and 1999 includes net charges for restructuring
and other non-recurring items of $239,000 and $400,000, respectively.
Quarterly Results of Operations
The following table sets forth certain consolidated quarterly financial
data for the eight quarters ended December 31, 2003. This information is
unaudited, but in our opinion, has been prepared on the same basis as the
audited consolidated financial statements appearing elsewhere in this report,
and all necessary adjustments, consisting only of normal recurring adjustments,
have been included in the amounts stated below to present fairly the unaudited
interim results. The results of operations for any quarter are not necessarily
indicative of the results of operations for any future period.
Selected Quarterly Data (unaudited)
Year 2003, Quarter Ended
---------------------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
---------------------------------------------------------
(in thousands, except per share data)
Net sales $2,500 $2,511 $2,566 $2,637
Gross profit 1,803 1,938 2,011 1,977
Operating income 256 240 241 369
Net income 243 228 241 921(1)
Net income per share, basic 0.08 0.07 0.07 0.27(1)
Net income per share, diluted 0.06 0.06 0.06 0.21(1)
(1) Includes a non-cash tax benefit of $526,000, or $0.16 per basic share, and
$0.12 per diluted share, resulting from the release of a portion of our tax
valuation allowance.
Year 2002, Quarter Ended
--------------------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
----------------------------- --------------------------
(in thousands, except per share data)
Net sales $2,368 $2,261 $2,543 $2,587
Gross profit 1,591 1,592 1,808 1,932
Operating income 11 53 222 335
Net income 32 62 228 337
Net income per share, basic 0.01 0.01 0.05 0.09
Net income per share, diluted 0.01 0.01 0.05 0.08
15
ITEM 7. 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" at the
front of this Annual Report on Form 10-K.
Our products have historically centered on fax and print servers and
related technologies. Starting in 1997, our revenues have declined as
competition increased, primarily with the print server products in the Asia
Pacific Region, while at the same time the Internet and other networking
technologies advanced. As a result, we experienced annual operating losses
beginning in 1997 through 1999. We redirected our efforts to focus on server
appliances and on development efforts to integrate existing and future products
with the Internet and emerging networking technologies. We introduced our new
products, the FaxPress 5000 in February 1999, FaxPress 2500 in November 1999,
FaxPress SBE in February 2000 and the FaxPress 7500 in September 2000. In
September 2003, we launched our newest enterprise level fax servers, the
FaxPress Premier Analog and FaxPress Premier Digital, which can provide up to 16
analog fax channels and 71 T1 fax channels, respectively. In support of our
hardware, we introduced a major release of our FaxPress software, FaxPress 7.0,
in November 2002 and FaxPress Premier 3.0, in September 2003. Through mainly the
release of these enhanced products in the fax messaging family and continuous
efforts in product cost reductions, our gross profit margins improved from 52%
in 1999 to 76% in 2003.
Additionally, improved cash management and operating results resulted
in positive operating cash flows in 2001, 2002 and 2003. Cash balances increased
to $4.6 million at December 31, 2003 from $3.5 million at December 31, 2002.
From time to time, component manufacturers announce the end of life of
certain of their products and at the same time introduce replacement components
which are usually more efficient or cost effective. We have been informed by
several of 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. We believe this will give us ample time to decide whether to
re-engineer our Products with the manufacturers' suggested replacement parts, or
develop new replacement products. Even though we believe we have secured enough
components for the next two years, there is no assurance that we will be able to
secure additional components in the future, or be able to redesign new products
in a timely manner.
Critical Accounting Policies
We have identified the policies below as critical to our business
operations and to the understanding of our results of operations. We have
defined a critical accounting policy as one that is both important to the
portrayal of our financial condition and results of operations and requires our
management to make difficult, subjective or complex judgments. The impact of
risks associated with these policies on our business operations is discussed in
Management's Discussion and Analysis of Financial Condition and Results of
Operations. For a detailed discussion on the application of these and other
accounting policies, see Note 2 in the Notes to the Consolidated Financial
Statements of this Annual Report on Form 10-K, beginning on page F-6. Note that
preparation of this Annual Report on Form 10-K requires us to make estimates and
assumptions that affect the reported amount of assets and liabilities, and
disclosure of contingent assets and liabilities at the date of our financial
statements, and reported amounts of revenue and expenses during the reporting
period. Estimates about future events and their effects
16
cannot be made with certainty. We based our estimates on historical experience
and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments. These
estimates may change as new events occur, as more experience is acquired, as
additional information is obtained and as our operating environment changes.
Revenue recognition
We recognize revenue based on the provisions of Staff Accounting
Bulletin ("SAB") No. 104 "Revenue Recognition" and Statement of Financial
Accounting Standards ("SFAS") No. 48 "Revenue Recognition When Right of Return
Exists."
Product revenue is recognized upon shipment if a signed contract or
purchase order exists, the fee is fixed or determinable, collection of the
resulting receivable is probable and product returns are reasonably estimable.
Shipment generally occurs and title is transferred when product is delivered to
a common carrier.
We enter into agreements with some of our distributors which 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. End-user customers who purchase our products directly from us also
have limited return rights, which expire 30 days from product shipment. Revenues
subject to stock rotation or other return rights are reduced by our estimates of
anticipated exchanges and returns. We establish our reserve for sales returns
for distributors and direct end-user customers based on historic return rates.
If the historical data used by the Company to calculate these estimates does not
properly reflect future returns, these estimates could be revised.
Pursuant to our agreements with distributors, we also protect our
distributors' exposure related to the impact of price reductions. Price
adjustments are recorded at the time price reductions are communicated to our
distributors.
Revenue for transactions that include multiple elements such as
hardware and post-contract customer support is allocated to each element based
on its relative fair value and recognized for each element when the revenue
recognition criteria have been met for such element. Fair value is generally
determined based on the price charged when the element is sold separately.
We recognize revenue from the sale of extended warranty contracts
ratably over the period of the contracts.
We recognize royalty income on the sale of LANpress products by a
Japanese distributor. Royalties are not recognized as revenue until the products
are sold by the distributor.
Distributor Programs and Incentives
We record estimated reductions to revenues for distributor programs and
incentive offerings including special pricing agreements, trade-in credits,
promotions and other volume-based incentives. If market conditions were to
change, we may take actions to increase distributor incentive offerings possibly
resulting in an incremental reduction of revenues at the time the incentive is
offered.
17
Warranty
Provisions for estimated warranty costs are recorded at the time
products are shipped as a charge to cost of sales. While we engage in extensive
product quality programs and processes, our warranty obligation is affected by
product failure rates, material usage and service delivery costs incurred in
correcting a product failure. Should product failure rates, material usage or
service delivery cost differ from our estimates, revision to the estimated
warranty liability would be required, which could affect the amount of gross
profit reported.
Credit, collection and allowance for doubtful accounts
We perform ongoing customer credit evaluations based on a number of
factors, including past transaction history with the customer and the
credit-worthiness of the customer. When credit criteria are not met, we require
cash-on-delivery or payment by credit card before products are shipped. On a
quarterly basis, we specifically analyze accounts receivable, historical bad
debts, customer concentration, and changes in our customer payment terms when
evaluating the adequacy of the allowance for doubtful accounts. Such losses have
generally been within our expectations. If the financial condition of our
customers were to deteriorate, resulting in an impairment of their ability to
make payments, additional allowances may be required. Three customers accounted
for 69% and 68% of accounts receivable at December 31, 2003 and 2002,
respectively.
Inventories and related write-downs for excess and obsolete inventory
Inventories are stated at the lower of standard cost (which
approximates cost on a first-in, first-out basis) or market. 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.
Income taxes
We account for income taxes in accordance with the liability method.
Under the liability method, deferred assets and liabilities are recognized based
upon anticipated future tax consequences attributable to differences between
financial statement carrying amounts of assets and liabilities and their
respective tax bases. The provision for income taxes is comprised of the current
tax liability and the change in deferred tax assets and liabilities. We assess
the likelihood that our deferred tax assets will be recovered from future
taxable income and to the extent we believe that recovery is not likely, we must
establish a valuation allowance against these tax assets. Significant management
judgment is required in determining the provision for income taxes and any
valuation allowance recorded against our deferred tax assets. The establishment
or reversal of any valuation allowance is based in large part on projected
future taxable income.
Results of Operations
Comparison of Years Ended December 31, 2003 and 2002
Net Sales
Net sales increased 5% to $10.2 million in 2003 from $9.8
million in 2002. The increase of $455,000 resulted primarily from sales
of our enterprise level FaxPress Premier fax server products, which
were launched in September 2003.
18
Domestic sales were $8.3 million in 2003 as compared to $7.7
million in 2002, representing 81% and 79%, respectively, of total net
sales. The increase in sales was mostly attributable to the
introduction of the new FaxPress Premier fax server products.
International sales (excluding sales to the rest of the
Americas) were $1.6 million in 2003 as compared to $1.7 million in
2002, representing 16% and 18%, respectively, of total net sales.
International sales were lower largely due to lower sales of our
FaxPress server products to Europe. Most of our international sales are
denominated in U.S. dollars and thus could be adversely affected by
changes in demand resulting from fluctuations in currency exchange
rates.
Sales to the rest of the Americas, excluding the United
States, were $371,000 in 2003, as compared to $347,000 in 2002,
representing 4% and 3% of total net sales in both 2003 and 2002,
respectively.
In 2003, Ingram Micro, Tech Data and Macnica, our top three
customers accounted for approximately 57% of our net sales. In 2002,
the same three distributors accounted for 56% of net sales.
Cost of Sales; Gross profit
Gross profit is equal to net sales less cost of sales. Cost of
sales includes cost of materials, including components, manuals,
diskettes, packaging materials and shipping. Cost of sales also
includes compensation costs and overhead related to our manufacturing
operations, inventory obsolescence and warranty expenses. Gross profit
was $7.7 million, or 76% of net sales, in 2003, compared to $6.9
million, or 71% of net sales, in 2002. Sales growth, continuous product
cost reductions in 2003, increased outsourcing of manufacturing and
higher sales of our fax server products, which have better gross profit
relative to our print server products contributed to the improvement in
gross profit in 2003.
Research and Development
Research and development expenses represent costs associated
with the development of new products and consist primarily of
employee-related expenses, material costs and allocated facility costs.
Research and product development expenses were $1.6 million in 2003,
compared to $1.4 million in 2002, and represented 16% and 14% of net
sales for those periods, respectively. The higher research and
development expenses in 2003 were mostly due to additional material
costs of $106,000 used in the development of our FaxPress Premier
server products that were launched in September 2003, and higher
compensation expense of $82,000 due to increased headcount. Research
and development spending has supported both existing products and the
development of new server appliances. We remain committed to the
development of highly competitive new products and services through the
efficient utilization of our engineering resources.
Sales and Marketing
Sales and marketing expenses consist primarily of
employee-related expenses, commissions to sales representatives,
product promotion expenses, and allocated facilities expenses,
including expenses associated with our regional sales and support
offices. Sales and marketing expenses were $3.1 million and $3.0
million for 2003 and 2002, respectively, and represented 31% of net
sales for both periods. The slight increase in sales and marketing
expenses was largely due to increased promotional and travel related
expenses of $235,000 and higher compensation expenses of $76,000 due to
increased headcount, offset in part by lower consulting expenses of
$173,000.
19
General and Administrative
General and administrative expenses consist primarily of
employee-related expenses for administration, finance, human resources
and general management, as well as consulting, outside services, legal
and accounting expenses, and allocated facilities expenses. General and
administrative expenses were $1.9 million in both 2003 and 2002, and
represented 19% and 20% of net sales for those periods. The slightly
lower expenses in 2003 as compared to 2002 were mainly attributable to
lower consulting expenses of $180,000 and legal and accounting fees of
$166,000, offset partially by higher compensation expenses of $151,000
and investor relation expenses of $86,000. General and administrative
expenses in 2002 included legal expenses of $128,000 and outside
consulting expenses of $209,000, which were chiefly attributable to our
stock repurchase and Nasdaq listing issues.
Interest and other income
Interest and other income consist primarily of interest income
earned from our invested cash balances, interest expense on capital
leases, bank service fees, and miscellaneous income and expenses.
Interest and other expenses for 2003 were $10,000 as compared to income
of $44,000 in 2002. The decrease in interest and other income was
chiefly due to a $29,000 reduction in interest income due to lower
interest rates and decreased miscellaneous income of $26,000.
Provision for Income Tax
In the fourth quarter of 2003, we recorded a non-cash tax
benefit of $526,000, resulting from the release of a portion of our tax
valuation allowance. Prior to the fourth quarter, we had not reported
significant income tax expenses because we had utilized available Net
Operating Loss ("NOL") and tax credit carryforwards. These NOLs were
fully reserved by a valuation allowance due to uncertainly surrounding
the likelihood of their realization. Due to our continued profitability
over the past ten quarters 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.
In 2002, our provision for income taxes was $6,000,
representing state income taxes. The tax provision for federal income
taxes was offset by utilization of our net operating loss
carryforwards.
Comparison of Years Ended December 31, 2002 and 2001
Net Sales
Net sales increased 4% to $9.8 million in 2002 from $9.4
million in 2001. The increase of $405,000 in net sales resulted
primarily from an increase in sales of our FaxPress fax server products
to the domestic channels of $763,000, offset partially by a decrease in
our print server product sales to international markets of $358,000.
Domestic sales were $7.7 million in 2002 as compared to $7.0
million in 2001, representing 79% and 75%, respectively, of total net
sales. The increase was mostly attributable to higher sales of our
FaxPress fax server products.
International sales (excluding sales to the rest of the
Americas) were $1.7 million in 2002 as compared to $2.0 million in
2001, representing 18% and 21%, respectively, of total net sales. Lower
international sales were largely due to reduced demand for our print
server products in the
20
Asia Pacific region. Most of our international
sales are denominated in U.S. dollars and thus could be adversely
affected by changes in demand resulting from fluctuations in currency
exchange rates.
Sales to the rest of the Americas, excluding the United
States, were $347,000 in 2002, as compared to $321,000 in 2001,
representing 3% and 4% of total net sales in 2002 and 2001,
respectively.
In 2002, Ingram Micro, Tech Data and Macnica, our top three
customers accounted for approximately 56% of our net sales. In 2001,
the same three distributors accounted for 55% of net sales.
Cost of Sales; Gross profit
Gross profit was $6.9 million, or 71% of net sales, in 2002,
compared to $6.3 million, or 67% of net sales, in 2001. Efficiencies
realized from the restructuring in 2001, continuous product cost
reductions in 2002, increased outsourcing of manufacturing and an
increase in the mix of sales of our fax server products, which have
higher gross profit relative to our print server products, contributed
to the improvement in gross profit in 2002.
Research and Development
Research and product development expenses were $1.4 million in
2002, compared to $1.8 million in 2001, and represented 14% and 19% of
net sales for those periods, respectively. The lower research and
development expenses in 2002 were mostly due to lower support costs of
$213,000 and reduced use of outside consulting, resulting in a savings
of $244,000.
Sales and Marketing
Sales and marketing expenses were $3.0 million and $3.6
million for 2002 and 2001, respectively, and represented 31% and 38% of
net sales for those periods. The reduction in sales and marketing
expenses was largely due to a reduction in personnel related costs of
$395,000, which was partly realized from the restructuring actions in
2001 and lower product promotional expenses of $291,000, offset in part
by higher support costs of $55,000.
General and Administrative
General and administrative expenses were $1.9 million and $1.3
million for 2002 and 2001, respectively, or 20% and 14% of net sales
for those periods. The increase in expenses in 2002 was mostly due to
higher legal expenses of $128,000 and outside consulting expenses of
$209,000, which were chiefly attributable to our stock repurchase and
Nasdaq listing issues. Increased accounting fees of $81,000,
compensation to our board of directors of $49,000, investor relations
expenses of $72,000 and the absence of benefit obtained from the
collection of bad debts previously written-off in 2001 of $115,000 also
contributed to the higher general and administrative expenses in 2002.
Restructuring Expenses
In April 2001, we terminated 17 regular, temporary and
contractor positions, which constituted approximately 25% of our
workforce. This action resulted in a restructuring charge of $239,000
in 2001. In the second quarter of 2002, a non-recurring benefit of
$40,000 arising from the reversal of previously recorded restructuring
charges was included in our results of operations, following the
completion of our 2001 restructuring program for less than previously
anticipated. The following table sets forth an analysis of the
components of the reserve balance carried-forward from fiscal 2001 (in
thousands of dollars):
21
Asset Write
Employee Costs Facilities Down Other Total
--------------------------------------------------------------------
Balance as of December 31, 2001 $36 $28 $ - $ 25 $ 89
Cash payments (36) - - (13) (49)
Reversal of excess accrual - (28) - (12) (40)
--------------------------------------------------------------------
Balance as of 12/31/2002 $ - $ - $ - $ - $ -
Interest and other income
Interest and other income consist primarily of interest income
earned from our invested cash balances, interest expense on capital
leases, bank service fees, and miscellaneous income and expenses.
Interest and other income was $44,000 and $111,000 in 2002 and 2001,
respectively. The decrease in other income in 2002 when compared to
2001 primarily reflected lower interest income of $52,000 due to the
decline in interest rates during 2002 and miscellaneous income of
$64,000, offset in part by lower bank fees of $51,000.
Provision for Income Tax
In fiscal 2002, our provision for income taxes was $6,000,
representing state income taxes. The tax provision for federal income
taxes was offset by utilization of our net operating loss
carryforwards.
In fiscal 2001, we incurred a loss and there were no
substantial federal or state income taxes recognized.
Liquidity and Capital Resources
Since our initial public offering of common stock in December 1995, our
principal source of funding has been cash from our operations, with some funding
from capital equipment lease lines. As of December 31, 2003, we had $4.6 million
of cash and cash equivalents, an increase of $1.2 million from December 31,
2002. The increase in cash and cash equivalents was primarily attributable to
the increase in income before tax of $1.1 million and $268,000 in proceeds from
the exercise of stock options, offset in part by $164,000 of investment in new
computers and other production equipment.
On March 12, 2002, we received a notice from the Nasdaq Stock Market
that our common stock had failed to maintain the minimum bid price of $1.00 per
share required for continued listing on the Nasdaq SmallCap Market. On November
18, 2002, we were granted a temporary exception to Nasdaq's minimum bid price
requirement, subject to us meeting certain conditions during the term of the
exception. On December 30, 2002, our common stock bid price closed at $1.00 per
share and since then the bid price has closed above $1.00. On January 16, 2003,
we received a letter from the Nasdaq stating that we have demonstrated full
compliance with the Nasdaq Qualifications Exception issued to us on November 18,
2002.
In the fourth quarter of 2002, our Board of Directors authorized us,
from time to time, to repurchase at market prices, up to $2.25 million shares of
our common stock for cash in open market, negotiated or block transactions. The
timing of such 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. As of
December 31, 2003, we have repurchased from open market and negotiated
transactions a total of 1.67 million shares for $1.8 million, at an average per
share price of $1.10.
22
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 is subject to interest of 12.8% and is repayable by December
2006. As of December 31, 2003, the future minimum payments are $50,000.
In April 2001, as a source of capital asset financing, we entered into
a loan and security agreement with a finance company for an amount of $25,000.
This loan is subject to interest of 12.5% and is repayable by April 2004. As of
December 31, 2003, the future minimum payments are $2,000.We have entered into a
noncancelable operating lease that expires in 2005 and other capital leases that
expire at various stages in 2006, and are responsible for certain maintenance
costs, taxes and insurance under the leases. We lease our headquarters in Morgan
Hill, California.. The lease has a term of 5 years, expiring in December 2005
with one conditional three-year option, which if exercised would extend the
lease to December 2008 commencing with rent at ninety-five percent of fair
market value.
The following represents combined aggregate maturities for all our
financing and commitments as of December 31, 2003:
Payments Due by Period
---------- ------------- --------------- ------------- ---------------
Contractual Obligations Total Less Than 1 1 - 3 Years 3 - 5 Years More than 5
Year Years
---------- ------------- --------------- ------------- ---------------
Capital (Finance) Lease Obligations $ 53 $ 20 $ 33 - -
Operating Lease Obligations $ 532 $ 269 $ 263 - -
---------- ------------- --------------- ------------- ---------------
Total contractual cash obligations $ 585 $ 289 $ 296 - -
========== ============= =============== ============= ===============
In addition to the commitments shown above, we have a $3.0 million
secured revolving line of credit with a bank, which expires in March 2005,
pursuant to which we may borrow 100% against pledges of cash at the bank's prime
rate (4% at December 31, 2003). Borrowings under this line of credit agreement
are collateralized by all of our assets. Under the agreement, we must comply
with certain financial and other covenants. As of December 31, 2003, we have not
drawn down on the line of credit, were in compliance with these covenants and
have no borrowings outstanding under the line of credit.
Net cash provided by operations in 2003 was $1.1 million as compared to
$882,000 in 2002. The increase was largely a result of sales increases, and
better gross profit arising from improved operational efficiencies and cost
reductions.
Net cash used in financing activities of $2.0 million in 2002 was
largely for the repurchase of our stock and the professional fees associated
with such repurchase. In the first quarter of 2003, we repurchased $48,000 of
our stock from open market transactions. We acquired additional property and
equipment of $164,000, $34,000 and $105,000 in 2003, 2002 and 2001,
respectively.
We believe that our existing cash balances, anticipated cash flows from
operations and available lines of credit will be sufficient to meet our
anticipated capital requirements for the next 12 months. If we have a need for
additional capital resources, we may be required to sell additional equity or
debt securities, secure additional lines of credit or obtain other third party
financing. The timing and amount of such capital requirements cannot be
determined at this time and will depend on a number of factors, including demand
for our existing and new products, if any, and changes in technology in the
networking industry. There can be no assurance that such additional financing
will be available on satisfactory terms when needed, if at all. Failure to raise
such additional financing, if needed, may result in our inability to achieve our
long-term business objectives. To the extent that additional capital is raised
23
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 of our dependency 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.
RISK FACTORS
Shareholders or investors considering the purchase of shares of the our
common stock should carefully consider the following risk factors, in addition
to other information in this Annual Report on Form 10-K. 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 and acceptance 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 service revenue,
O the commencement or conclusion of significant development contracts;
O changes in foreign currency exchange rates; and
O the timing of significant marketing and sales promotions.
Based on the foregoing, we believe that quarterly operating results are
likely to vary significantly in the future and that period-to-period comparisons
of our results of operations are not necessarily meaningful and should not be
viewed as indications of future performance.
24
We have a history of losses and may not be able to sustain profitability.
We have experienced significant operating losses and, as of December
31, 2003, had an accumulated deficit of $22 million. Our development and
marketing of current and new products will continue to require substantial
expenditures. We incurred $591,000 of losses in 2001 due to a slowdown in demand
for our products due in part to industry-wide adverse economic conditions. We
were able to recover and have been profitable since the third quarter of 2001,
with total net income of $659,000 and $1.6 million in 2002 and 2003,
respectively. There can be no assurance that growth in net sales will be
achieved or profitability sustained in future years.
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.
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.
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. 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
25
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 emergence of 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 which
O conform to or support emerging network telecommunications standards;
O are compatible with a growing array of computer and peripheral devices;
O support popular computer and network operating systems and applications;
O meet a wide range of evolving user needs; and
O achieve market acceptance.
There can be no assurance that we will be successful in these efforts.
We have incurred, and expect to continue to incur, substantial expenses
associated with the introduction and promotion of new products. There can be no
assurance that the expenses incurred will not exceed research and development
cost estimates or that new products will achieve market acceptance and generate
sales sufficient to offset development costs. In order to develop new products
successfully, we are dependent upon timely access to information about new
technological developments and standards. There can be no assurance that we will
have such access or will be able to develop new products successfully and
respond effectively to technological change or new product announcements by
others.
Complex products such as those offered by us may contain undetected or
unresolved hardware defects or software errors when they are first introduced or
as new versions are released. Changes in our or our suppliers' manufacturing
processes or the inadvertent use of defective components could adversely affect
our ability to achieve acceptable manufacturing yields and product reliability.
We have in the past discovered hardware defects and software errors in certain
of our new products and enhancements after their introduction. Replacement of
discontinued components used in our products could lead to further defects and
errors. There can be no assurance that despite testing by us and by third-party
test sites, errors and defects will not be found in future releases of our
products, which would result in adverse product reviews and negatively affect
market acceptance of these products.
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.
26
Our success depends upon the continued contributions of our key management,
marketing, product development and operational personnel.
Our success will depend, to a large extent, upon our ability to retain
and continue to attract highly skilled personnel in management, marketing,
product development and operations. Competition for employees in the computer
and electronics industries is intense, and there can be no assurance that we
will be able to attract and retain enough qualified employees. Volatility or
lack of positive performance in our stock price may also adversely affect our
ability to retain and continue to attract key employees, many of whom have been
granted stock options. Our inability to retain and attract key employees could
have a material adverse effect on our product development, business, operating
results and financial condition. We do not carry key person life insurance with
respect to any of our personnel.
The markets for our products are highly competitive and may become more
competitive in the future.
The network enhancement products and computer software markets are
highly competitive, and we believe that competition will intensify in the
future. The competition is characterized by rapid change and improvements in
technology along with constant pressure to reduce the prices of products. We
currently compete principally in the market for network fax servers, network
print servers and fax-on-demand software. Both direct and indirect competition
could adversely affect our business and operating results through pricing
pressure, loss of market share and other factors. In particular, we expect that,
over time, average selling prices for our print server products will continue to
decline, as the market for these products becomes increasingly competitive. Any
material reduction in the average selling prices of our products would adversely
affect gross margins. There can be no assurance we will be able to maintain the
current average selling prices of our products or the related gross margins.
The principal competitive factors affecting the market for our products
include:
o product functionality;
o performance;
o quality;
o reliability;
o ease of use;
o quality of customer training and support;
o name recognition;
o price; and
o compatibility and conformance with industry standards and changing
operating system environments.
Several of our existing and potential competitors have substantially
greater financial, engineering, manufacturing and marketing resources than us.
We also experience competition from a number of other software, hardware and
service companies. In addition to our current competitors, we may face
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.
27
We depend on sales in foreign markets, and political or economic changes in
these markets could affect our business, operating results and financial
condition.
Sales to customers located outside the United States accounted for
approximately 19%, 21% and 25% of our net sales in 2003, 2002 and 2001,
respectively. We sell our products in approximately 40 foreign countries through
approximately 50 international distributors. Our principal Japanese distributor
accounted for approximately 38%, 27% and 40% of our international sales in 2003,
2002 and 2001, respectively, and 7%, 6% and 10% of our total net sales in 2003,
2002 and 2001, respectively. We expect that international sales will continue to
represent a significant portion of our product revenues and that we will be
subject to the normal risks of international sales, such as export laws,
currency fluctuations, longer payment cycles, greater difficulties in accounts
receivable collections and the requirement of complying with a wide variety of
foreign laws. There can be no assurance that we will not experience difficulties
resulting from changes in foreign laws relating to the export of our products in
the future. In addition, because we primarily invoice foreign sales in U.S.
dollars, fluctuations in exchange rates could affect demand for our products by
causing prices to be out of line with products priced in the local currency.
Additionally, any such difficulties would have a material adverse effect on our
international sales and a resulting material adverse effect on our business,
operating results and financial condition. We may experience fluctuations in
European sales on a quarterly basis because European sales may be weaker during
the third quarter than the second quarter due to extended holiday shutdowns in
July and August. There can be no assurance that we will be able to maintain the
level of international sales in the future. Any fluctuations in international
sales will significantly affect our operating results and financial condition.
The introduction of new products may reduce the demand for our existing products
and increase returns of existing products.
From time to time, we may announce new products, product versions,
capabilities or technologies that have the potential to replace or shorten the
life cycles of existing products. The release of a new product or product
version may result in the write-down of products in inventory if this inventory
becomes obsolete. We have in the past experienced increased returns of a
particular product version following the announcement of a planned release of a
new version of that product. There can be no assurance that product returns will
not exceed our allowance for these returns in the future and will not have a
material adverse effect on our business, operating results and financial
condition.
If we fail to obtain components of our products from third-party suppliers and
subcontractors, our business could suffer.
Our products require components procured from third-party suppliers.
Some of these components are available only from a single source or from limited
sources. In addition, 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.
28
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.
We depend on proprietary technology, and inability to develop and protect this
technology or license it from third parties could adversely affect our business,
operating results and financial condition.
Our success depends to a certain extent upon our technological
expertise and proprietary software technology. We rely upon a combination of
contractual rights and copyright, trademark and trade secret laws to establish
and protect our technologies. Despite the precautions taken by us, it may be
possible for unauthorized third parties to copy our products or to reverse
engineer or obtain and use information that we regard as proprietary. In
addition, the laws of some foreign countries either do not protect our
proprietary rights or offer only limited protection. Given the rapid evolution
of technology and uncertainties in intellectual property law in the United
States and internationally, there can be no assurance that our current or future
products will not be subject to third-party claims of infringement. Any
litigation to determine the validity of any third-party claims could result in
significant expense and divert the efforts our technical and management
personnel, whether or not any litigation is determined in favor of us. In the
event of an adverse result in litigation, we could be required to expend
significant resources to develop non-infringing technology or to obtain licenses
to the technology that is the subject of the litigation. There can be no
assurance that we would be successful in this development or that any such
licenses would be available on commercially reasonable terms. We also rely on
technology licensed from third parties. There can be no assurance that these
licenses will continue to be available upon reasonable terms, if at all. Any
impairment or termination of our relationship with third-party licensors could
have a material adverse effect on our business, operating results and financial
condition. There can be no assurance that our precautions will be adequate to
deter misappropriation or infringement of our proprietary technologies.
We have received, and may receive in the future, communications
asserting that our products infringe the proprietary rights of third parties or
seeking indemnification against the alleged infringement. There can be no
assurance that third parties will not assert infringement claims against us with
respect to current or future products or that any assertion may not require us
to enter into royalty arrangements or result in costly litigation. Any claims,
with or without merit, can be time consuming and expensive to defend. There can
be no assurance that any intellectual property litigation will not have a
material adverse effect on our business, operating results and financial
condition.
Our 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
29
volatility has had a substantial effect on the market price of the common stock
of us and other high technology companies, often for reasons unrelated to
operating performance. We anticipate that prices for our common stock may
continue to be volatile. Future stock price volatility may result in the
initiation of securities litigation against us, which may divert substantial
management and financial resources and have an adverse effect on our business,
operating results and financial condition.
We may require additional capital in the future, and may be unable to obtain
this capital at all or on commercially reasonable terms.
The development and marketing of products requires significant amounts
of capital. If we need additional capital resources, we may be required to sell
additional equity or debt securities, secure additional lines of credit or
obtain other third party financing. The timing and amou