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, 2004
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 0-220-20
CASTELLE
(Exact name of Registrant as specified in its charter)
California 77-0164056
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
855 Jarvis Drive, Suite 100, Morgan Hill, California 95037
(Address of principal executive offices, including zip code)
(408) 852-8000
(Registrant's telephone number, including area code)
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, 2004 was $10,086,628.
The number of shares of common stock outstanding at March 14, 2005 was
3,832,796.
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
2004 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, 2005.
Castelle
Table of Contents
PAGE
PART I.........................................................................3
ITEM 1. BUSINESS...........................................................3
ITEM 2. PROPERTIES........................................................12
ITEM 3. LEGAL PROCEEDINGS.................................................12
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS.............13
PART II.......................................................................14
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED
SHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES....14
ITEM 6. SELECTED FINANCIAL DATA...........................................15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS...............................19
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........37
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.......................37
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE..............................................38
ITEM 9A. CONTROLS AND PROCEDURES...........................................38
ITEM 9B. OTHER INFORMATION.................................................39
PART III......................................................................40
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................40
ITEM 11. EXECUTIVE COMPENSATION............................................40
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT....40
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................40
ITEM 14. PRINCIPAL AUDITOR FEES AND SERVICES...............................40
PART IV.......................................................................41
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K...41
SIGNATURES....................................................................44
FINANCIAL STATEMENTS.........................................................F-3
i
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 28 in this document.
EXPLANATORY NOTE
This Annual Report on Form 10-K for the year ended December 31, 2004 includes
restated financial statements as of December 31, 2003 and for each of the two
fiscal years in the period ended December 31, 2003.
In April 2005, the Company completed a review of its accounting practices with
respect to the historical classification of cost of service revenues, procedures
for recognizing revenue associated with extended support contracts and
procedures for establishing the accrual for paid-time-off, and determined that
its historical financial statements as of and for the years ended December 31,
2002 and 2003 contained certain errors in the application of generally accepted
accounting principles as described below:
1. Classification of cost of service revenues
The Company has concluded that its historical classification of cost
of service revenues did not conform to Generally Accepted Accounting
Principles. Historically, such costs have been improperly included
as a component of sales and marketing expenses on the Company's
consolidated statements of earnings; however under generally
accepted accounting principles, such costs are required to be
classified as cost of service revenues. The Company has reclassified
$711,000 and $729,000 in fiscal 2002 and 2003 out of sales and
marketing and included these amounts within cost of service revenues
in its statements of earnings. The reclassification had no impact on
reported sales, net income, earnings per share, or cash flows from
operations for the respective periods. The misclassification,
however, did result in cost of sales being understated, and gross
profit and operating expenses being overstated by equal amounts. The
Company has concluded that the internal control deficiency that led
to the errors in the historical classification of cost of service
revenues is a "material weakness" as defined by the Public Company
Accounting Oversight Board's Auditing Standard No. 2.
Effective January 1, 2005, the Company established a separate cost
center to capture solely the cost of service revenues and such costs
will be classified as a component of cost of sales.
The Company's review of such costs was prompted in part by the
receipt in November 2004 and thereafter of a series of comment
letters issued by the Division of Corporation Finance of the
Securities and Exchange Commission to the Company.
1
2. Revenue recognition related to extended support contracts
The Company has determined that as a result of an internal control
deficiency, service revenues attributable to extended support
contracts were overstated by approximately $39,000 and $34,000 for
fiscal 2002 and fiscal 2003, respectively. These amounts should have
been deferred and recognized as service revenues in subsequent
periods. Such errors were the result of inadequate procedures in
place to correctly recognize sales related to extended support
contracts. The revenue overstatements represent less than 1% of the
Company's total sales for the respective periods. In connection with
their audit of the Company's consolidated financial statements for
the year ended December 31, 2004, the Company's independent
registered public accounting firm, Grant Thornton LLP, concluded
that the internal control deficiency that led to the aforementioned
revenue recognition errors is a "material weakness" as defined by
the Public Company Accounting Oversight Board's Auditing Standard
No. 2.
During the first quarter of 2005, the Company enhanced its internal
accounting system to ensure that revenue is recognized over the
actual contract term.
3. Accrual for paid-time-off
The Company has also identified an error that resulted in an
overstatement of its accrual for paid-time-off beginning in 2002 and
continuing through 2004. This error resulted in the overstatement of
expenses by approximately $15,000 and $7,000 in fiscal 2002 and
2003, respectively. During the first quarter of 2005, the Company
corrected the error that led to such over-accrual. The reported
results as of and for the year ended December 31, 2004 reflect the
appropriate accrual and expense for paid-time-off.
The Company has restated its consolidated financial statements for fiscal 2002
and 2003 in this 2004 Annual Report on Form 10-K to correct for these errors.
The Company has also restated the unaudited quarterly consolidated financial
statements for each of the 2003 and 2004 periods included in Item 8 in this 2004
Annual Report on Form 10-K to correct for the quarterly impact of such errors.
Consequently, the historical financial statements and related financial
information contained in Castelle's Annual Report on Form 10-K for the year
ended December 31, 2003 and each of Castelle's Forms 10-Q for the year ended
December 31, 2004 should no longer be relied upon and are superceded by the
financial statements and financial information in this Annual Report on Form
10-K.
Note 3, Restatement of Previously Issued Financial Statements, to the notes to
the consolidated financial statements discloses the impact of the adjustments
arising from the accounting errors described above on the statements of earnings
and balance sheets for the restated annual periods. In addition, Note 3 to the
consolidated financial statements discloses the effect of the restatement on
opening retained earnings as of January 1, 2002, which adjustment reflects the
impact of the restatement on periods prior to 2002. This adjustment decreased
previously reported accumulated deficit by $27,000 with a corresponding decrease
to deferred revenue relating to extended support contracts. For information on
the impact of the restatement on fiscal 2000 and 2001, reference is made to Item
6, Selected Financial Data, in Part II of this Form 10-K.
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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 our 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 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. 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.
As a result, we experienced annual operating losses during 1997 through 1999.
During the past eight 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. During 2004, we
discontinued our LANpress print server and InfoPress product lines, but will
continue to provide support to our customers during the warranty periods.
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 since then, we have recorded fourteen straight quarters of
profitability.
3
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, as 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 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-
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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.
Server appliances, such as communications/messaging 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.
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 server product family. Our products are installed in many Fortune 1000
firms, small and medium sized businesses worldwide, integrating desktop fax
automation, email, Internet connectivity 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 keep
abreast of, and respond
5
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.
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 Pacific Rim.
During 2004, 2003, and 2002, fax products represented 99%, 97%, and 95%,
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
6
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 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 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 8.X network fax software that adds integration with popular email
packages, and many advanced fax management and integration features. Our
FaxPress Small Business Edition ("SBE") fax server does not include email
integration started with our FaxPress 7.1.1 network fax software. 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, Windows
Product Model Channels Integration Topology 6.x (IPX,IP) 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 4, 8, 12, 16 x Ethernet n/a x
FaxPress Premier Digital T1 8, 24, 48, 72 x Ethernet n/a x
FaxPress Premier ISDN 4, 8, 12 x Ethernet n/a x
FaxPress Premier Digital E1 10, 30, 60, 90 x Ethernet n/a 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
7
our product offerings, to maintain technological competitiveness and meet an
expanding range of customer requirements. We spent $1.7 million, $1.6 million
and $1.4 million in research and product development activities in 2004, 2003
and 2002, 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 2004, we developed and released version 8.0 of our FaxPress software
and version 3.0 of our FaxPress Premier software. The new releases of FaxPress
8.0 and FaxPress Premier 3.0 Network Fax Software offer a new level of email
integration, expanded operating environments and fax automation. It 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
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.
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 2004, Ingram Micro and Tech Data individually accounted for more than
10% of our sales and collectively represented approximately 44% of our net
sales. In 2003 and 2002, the same distributors accounted for approximately 50%
and 51% of our net sales for the respective years. Total sales to customers
located in the Pacific Rim, Europe and rest of Americas comprised approximately
18%, 19%, and 21% of our net sales in 2004, 2003 and 2002, respectively.
8
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.
Most of our products are manufactured by third-party manufacturers that provide
customized, integrated manufacturing services, including procurement,
manufacturing, printed circuit board assembly and final testing. 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 believe that we could shift product assembly to
alternate suppliers if necessary. Certain key components of our products,
including a modem chip set from Conexant, microprocessors from Motorola,
integrated circuits from Intel and Kendin, are currently available from single
sources. Other components of our products are currently available from only a
limited number of sources. In addition, certain manufacturers have announced the
end-of-life of certain standard off-the-shelf components which are being used by
us in the making of our FaxPress Products. However, we have purchased at least
two years worth of supplies of these end-of-life components, and are constantly
replenishing our inventory from secondary markets too, 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 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
9
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.
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 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, 2005, we employed a total of 48 full-time equivalent
personnel, 9 in operations, 13 in sales and marketing, 9 in engineering, 11 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, 2005 are
set forth below:
10
Name Age Position
Scott C. McDonald 51 President, Chief Executive Officer
Eric Chen 52 Senior Vice President, Engineering
and Business Development
Paul Cheng 56 Vice President, Finance and Administration,
Chief Financial Officer and Secretary
Richard Fernandez 45 Vice President, Operations
Edward J. Heinze 59 Vice President, Sales, U.S.
Michael Petrovich 43 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 a director 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.
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 i(n) 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.
11
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. 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 May 31, 2009 with one conditional
three-year option, which if exercised, would extend the lease to May 31, 2012.
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.
12
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
Subsequent to our Annual Meeting of Shareholders held on May 28, 2004,
there were no matters submitted to a vote of securities holders during the
remainder of 2004.
13
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS,
AND ISSUER PURCHASES OF EQUITY SECURITIES
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.
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
2004 HIGH LOW
First Quarter $7.80 $2.95
Second Quarter $5.35 $2.77
Third Quarter $3.39 $2.31
Fourth Quarter $4.29 $2.71
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 April 12, 2005 there were 700 holders of record of our common stock.
On April 12, 2005 the last sale price reported on the Nasdaq SmallCap Market for
our common stock was $3.25 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 have performed no stock
repurchases since then. 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.
14
Equity Compensation Plan Information
The following table sets forth a summary of our equity compensation plans
as of December 31, 2004. Details of the plans are discussed in Note 7 to the
Consolidated Financial Statements.
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 by security holders 7,000 $2.38 -0-
1998 (1988) Equity compensation
plan (As Amended) approved by
security holders 896,391 $0.98 -0-
2002 Equity compensation plan
approved by security holders 389,205 $3.07 460,045
Equity compensation plans not
approved by security holders -0- n/a -0-
-------------------------------------------------------------------------
Total 1,292,596 $1.61 460,045
ITEM 6. SELECTED FINANCIAL DATA
The five-year financial summary in this Item 6 has been revised to reflect
the Company's restatement of previously reported results (see Note 3 to the
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.
15
Years ended December 31,
----------------------------------------------------------------------
2004 2003 2002 2001 2000
------- ------- --------- ------- -------
(Restated) (Restated) (Restated) (Restated)
(in thousands, except per share amounts)
STATEMENT OF EARNINGS DATA:
Net Sales $10,457 $10,180 $ 9,720 $ 9,381(5) $14,832
Gross Profit $ 7,075 $ 6,969 $ 6,180 $ 5,479(6) $ 8,360(6)
Gross Profit as a % of Net Sales 68% 68% 64% 58% 56%
Net income (loss) $ 2,119(1) $ 1,606(2) $ 635 ($564)(4) $ 732
Net income (loss) as a % of Net Sales 20%(1) 16%(2) 7% (6%) 5%
Net income (loss) per share - diluted $ 0.48(1) $ 0.38(2) $ 0.14 ($0.12) $ 0.14
BALANCE SHEET DATA:
Cash and Cash Equivalents $ 5,599 $ 4,614 $ 3,460(3) $ 4,568 $ 3,893
Working Capital $ 5,750 $ 4,156 $ 2,437 $ 3,587 $ 3,969
Total Assets $10,147 $ 7,803 $ 5,635 $ 7,010 $ 8,543
Long-term Liabilities $ 14 $ 29 $ 44 $ 64 $ 63
Shareholders' Equity $ 7,281 $ 4,752 $ 2,926(3) $ 4,229 $ 4,776
(1) In 2004, we recorded a non-cash tax benefit of $1.1 million, or $0.24
per diluted share. This was a result of releasing a portion of our tax valuation
allowance due to our continued profitability and a determination that it is more
likely than not that certain future tax benefits will be realized.
(2) 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 of 2003, 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 was 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.
(3) 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.
(4) Net loss for 2001 includes net charges for restructuring and other
non-recurring items of $239,000.
(5) Net sales in 2001 have been restated to increase service revenues by
$27,000 as compared to previously reported net sales in relation to the extended
support contracts adjustment. Consequently, the net loss for 2001 decreased to
$564,000 as compared to the previously reported net loss of $591,000. There was
no impact on previously reported net loss per share for 2001.
(6) Gross profit and operating expenses for 2001 and 2000 have been
restated to reduce such balances by equal amounts of $813,000 and $1 million,
respectively, as compared to previously reported amounts, as a result of the
reclassification of cost of service revenues from operating expenses to cost of
sales.
Unaudited Quarterly Results of Operations
The following table sets forth certain consolidated quarterly financial data for
the eight quarters ended December 31, 2004. 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
16
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.
The consolidated quarterly financial data presented below reflects the
restatement of the periods through September 30, 2004 to reflect the adjustment
for certain errors noted by the Company during the fourth quarter of fiscal
2004. For a description of the restatement items and the effect on annual
periods for fiscal 2003 and 2002, see Note 3 to the Company's consolidated
financial statements.
Selected Quarterly Data (unaudited)
Year 2004, Quarter Ended
-------------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
---------- ---------- ---------- ----------
(in thousands, except per share data)
(Restated) (Restated) (Restated)
Net sales (1) $2,539 $2,691 $2,685 $2,542
Gross profit (2) 1,702 1,883 1,804 1,686
Operating income (3) 228 272 236 330
Net income(4) 129 146 130 1,714(5)
Net income per share, basic (4) 0.04 0.04 0.04 0.46(5)
Net income per share, diluted (4) 0.03 0.03 0.03 0.39(5)
(1) Net sales in the 2004 quarters ended March 31, June 30 and September
30 have been restated to reduce service revenues by $19,000, $26,000
and $13,000, respectively, as compared to previously reported net
sales in relation to the extended support contract adjustments.
(2) Gross profit and operating expenses for the quarters ended March 31,
June 30 and September 30, 2004 have been restated to reduce such
balances by equal amounts of $198,000, $216,000 and $207,000,
respectively, as compared to previously reported amounts, as a
result of the reclassification of cost of service revenues from
operating expenses to cost of sales.
(3) Operating income for the quarters ended March 31, June 30, and
September 30, 2004 has been increased by an additional $1,000 in
each of the three quarters, as compared to previously reported
amounts to correct the overstatement of the Company's paid-time-off
accrual.
(4) The restatement adjustments referred to above reduced previously
reported net income by $18,000, $25,000 and $12,000 in 2004 for the
quarters ended March 31, June 30 and September 30, respectively.
Both basic and diluted net income per share as restated decreased by
$0.01 for the quarter ended June 30, 2004 as compared to the amounts
previously reported. Basic and diluted net income per share as
restated did not change from the amounts previously reported for the
quarters ended March 31 and September 30.
(5) Includes a non-cash tax benefit of $1.4 million, or $0.37 per basic
share, and $0.31 per diluted share, resulting from the release of a
portion of our tax valuation allowance.
Year 2003, Quarter Ended
--------------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
---------- ---------- ---------- ----------
(in thousands, except per share data)
(Restated) (Restated) (Restated) (Restated)
Net sales (1) $2,495 $2,501 $2,561 $2,623
Gross profit (2) 1,626 1,752 1,814 1,777
Operating income (3) 252 232 238 357
Net income (4) 239 220 238 909(5)
Net income per share, basic (4) 0.07 0.07 0.07 0.27(5)
Net income per share, diluted (4) 0.06 0.05 0.05 0.21(5)
17
(1) Net sales in the 2003 quarters ended March 31, June 30, September 30 and
December 31 have been restated to reflect the reduction of service
revenues by $5,000, $10,000, $5,000 and $14,000, respectively, as compared
to previously reported amounts in relation to the extended support
contract adjustments.
(2) Gross profit and operating expenses for the quarters ended March 31, June
30, September 30 and December 31, 2003 have been restated to reduce such
balances by equal amounts of $172,000, $177,000, $193,000 and $187,000,
respectively, as compared to previously reported amounts, as a result of
the reclassification of cost of service revenues from operating expenses
to cost of sales.
(3) Operating income has been increased by $1,000 in the quarter ended March
31, 2003 and $2,000 in each of the remaining quarters of 2003, as compared
to previously reported amounts, to correct the overstatement of the
Company's paid-time-off accrual.
(4) The restatement adjustments referred to above reduced previously reported
net income by $4,000, $8,000, $3,000 and $12,000 for the quarters ended
March 31, June 30, September 30 and December 31, respectively. Basic net
income per share as restated decreased by $0.01 for the quarter ended
March 31 and did not change for the quarters ended June 30, September 30
or December 31, as compared to the amounts previously reported. Diluted
net income per share as restated decreased by $0.01 for the quarters ended
June 30 and September 30 and did not change for the quarters ended March
31 or December 31, as compared to the amounts previously reported.
(5) 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.
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
(All tabular amounts in thousands except per share amounts and as noted)
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 began to decline 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. Today, our analog fax
servers can provide up to 16 fax channels, the digital servers up to 71 T1 fax
channels, the ISDN servers up to 12 fax channels and the E1 servers up to 90 fax
channels. Our current FaxPress and FaxPress Premier software versions are 8.0
and 3.0, respectively, to support our hardware.
In April 2005, we completed a review of our accounting practices with
respect to the historical classification of cost of service revenues, procedures
for recognizing revenue associated with extended support contracts and
procedures for establishing the accrual for paid-time-off, and determined that
our historical financial statements as of and for the years ended December 31,
2002 and 2003 contained certain errors in the application of generally accepted
accounting principles. Consequently, we have restated our consolidated financial
statements for fiscal 2002 and 2003 in this 2004 Annual Report on Form 10-K to
correct for these errors. This Management's Discussion and Analysis of Financial
Condition and Results of Operations reflects the restated amounts. Note 3 to the
consolidated financial statements discloses the impact of the adjustments
arising from the accounting errors described above on the statements of earnings
and balance sheets for the restated annual periods.
Improved cash management and operating results resulted in positive
operating cash flows in 2002, 2003 and 2004. Cash balances increased to $5.6
million at December 31, 2004 from $4.6 million and $3.5 million at December 31,
2003 and December 31, 2002, respectively.
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 been replenishing, through secondary markets, and keeping 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.
We believe that most of these end-of-life components will be utilized in the
following two years, resulting in insignificant amounts of excessive inventory,
or none at all. We believe that Castelle's liquidity continues to be strong
despite these purchases, as our cash reserves have increased during the periods
when the parts were purchased. 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. These end-of-life products represent $675,000 of the ending
inventory balance.
19
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. 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-7. Note that preparation of this Annual Report on
Form 10-K requires us to make estimates and assumptions that affect the reported
amounts of assets and liabilities, and disclosure of contingent assets and
liabilities at the date of our financial statements, and reported amounts of
revenue and expenses during the reporting period. Estimates about future events
and their effects 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
No. 104 "Revenue Recognition," AICPA Statement of Position No. 97-2 ("SOP 97-2")
"Software Revenue Recognition," as amended by SOP 98-9, "Modification of SOP
97-2, Software Revenue Recognition with Respect to Certain Transactions," and
Statement of Financial Accounting Standards ("SFAS") No. 48 "Revenue Recognition
When Right of Return Exits."
The Company uses the residual method to recognize revenue when an
agreement includes one or more elements to be delivered at a future date. If
there is an undelivered element under the arrangement, the Company defers
revenue based on vendor-specific objective evidence of the fair value of the
undelivered element, as determined by the price charged when the element is sold
separately. If vendor-specific objective evidence of fair value does not exist
for all undelivered elements, the Company defers all revenue until sufficient
evidence exists or all elements have been delivered.
Product revenue is recognized when all of the following criteria are met:
persuasive evidence of an arrangement exists; delivery has occurred; the fee is
fixed or determinable; collection is probable; and returns can be reasonably
estimated. If an acceptance period or other contingency exists, revenue is
recognized upon satisfaction of the contingency, customer acceptance or
expiration of the acceptance period. Shipment generally occurs and title and
risk of loss is transferred when the product is delivered to a common carrier.
We enter into agreements with some of our distributors that permit limited
stock rotation rights. These stock rotation rights allow the distributor to
return products for credit but require the purchase of additional products of
equal value. Customers who purchase products directly from us also have limited
return rights, which expire 30 days from product shipment. Revenues subject to
stock rotation or other return rights are reduced by our estimates of
anticipated exchanges and returns.
Pursuant to our agreements with distributors, we also protect our
distributors' exposure related to the impact of price reductions. Future price
adjustments are estimated and accrued at the time of sale as a reduction in
revenue.
We generally provide our distributors the opportunity to earn volume
incentive rebates based on sales volume achieved during the fiscal quarter.
These incentive rebates are accrued in the quarter incurred and recorded as a
reduction in revenue.
We also provide co-op and market development funds to our distributors.
These incentives are accrued at the time revenue is recognized and recorded as a
reduction in revenue.
20
We offer a standard trade-in discount to all of our end-user customers
under which the customer, upon trade-in of any previously purchased product, is
entitled to a discount from our published price list on any product included in
our current product offerings. We require our customers to physically return the
previously purchased products to qualify for the trade-in discount. We account
for the trade-in discount as a reduction of revenue at the time the product is
traded in and a new product is purchased.
Payment terms to our distributors and customers are generally thirty days,
cash in advance, or by credit card.
We evaluate product sales through our distribution channels and the
related reserve requirement to establish an estimate for our sales returns
reserve by reviewing detailed point-of-sales and on-hand inventory reports
provided to us by our channel partners. Based on a combination of historical
return experience, the sales activities to end-user customers by our channel
partners and the level of inventories on hand at the channel partners, we
determine our returns reserve at the end of each financial period, and increases
or reduce the reserve balance accordingly.
We provide standard support to our customers for an initial period of
sixty days, which includes advance swap of the defective hardware and software,
bug fixes, software upgrades and technical support. In addition to standard
support, we also offer our customers the option to purchase extended support at
the time of product purchase or anytime thereafter. Extended support covers
hardware and software for a period of one year. We have established
vendor-specific objective evidence with respect to the fair value of the
standard support contracts based on standalone sales and renewals of our
one-year extended support contracts. The fair value of our sixty day support
contracts included with product sales is determined by pro-rating the related
one-year extended support contracts. We recognize revenue from extended support
contracts ratably over the period of the contract.
We do not sell software, which is incorporated into our hardware,
separately, other than for our customers to purchase as an upgrade to their
existing products when we announce a major release of the software.
Product Warranty
Hardware is warranted for one year from the date of sale and is repaired
free-of-charge. 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.
Distributor Programs and Incentives
We enter into agreements with some of our distributors that permit limited
stock rotation rights. These stock rotation rights allow the distributor to
return products for credit but require the purchase of additional products of
equal value. We also protect our distributors' exposure related to the impact of
price reductions. We generally provide our distributors the opportunity to earn
volume incentive rebates based upon the amount of sales volume achieved during
the fiscal quarter. We also provide co-op and market development funds to our
distributors.
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. Moreover, if the actual
incentive offerings are different from our estimates, or if the actual incentive
claims are significantly higher than our historical experience, then revisions
to the estimated incentive programs may be required resulting in additional
reductions to revenue.
21
We record estimated reductions to revenues for these distributor programs
and incentive offerings including special pricing agreements, promotions and
other volume-based incentives.
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 60%, 69% and 68% of accounts receivable at December 31, 2004, 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. We record write downs for excess
and obsolete inventory equal to the difference between the cost of inventory and
the estimated fair value based on assumptions about future product life-cycles,
product demand and market conditions. If actual product life cycles, product
demand and market conditions are less favorable than those projected by
management, additional inventory write-downs may be required. At the point of
the loss recognition, a new, lower-cost basis for that inventory is established,
and subsequent changes in facts and circumstances do not result in the
restoration or increase in that newly established cost basis.
In light of the approximately two years worth of end-of-life components we
have purchased to ensure a smooth supply of our FaxPress Products to our
customers, our management periodically reviews the usage, supply and inventory
levels of these parts to determine whether additional purchases or excessive
inventory provisions are necessary. As of December 31, 2004, we have
approximately $675,000 worth of end-of-life components on hand and we believe
that most of these components will be utilized in the following two years,
resulting in insignificant amounts of excessive inventory, or none at all.
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.
22
Results of Operations
Comparison of Years Ended December 31, 2004 and 2003
Net Sales
Year Ended December 31,
-----------------------------------------
2004 2003 2002
--------- --------- ---------
Net Sales: (Restated) (Restated)
Products $ 8,011 $ 8,337 $ 8,617
Services 2,446 1,843 1,103
--------- --------- ---------
Total net sales $ 10,457 $ 10,180 $ 9,720
========= ========= =========
Year Ended December 31,
-----------------------------------------
2004 2003 2002
--------- --------- ---------
Net Sales: (Restated) (Restated)
United States $ 8,574 $ 8,222 $ 7,660
Europe 785 704 826
Pacific Rim 804 883 887
Rest of Americas, excluding United States 294 371 347
--------- --------- ---------
Total net sales $ 10,457 $ 10,180 $ 9,720
========= ========= =========
Net sales increased 3% to $10.5 million in 2004 from $10.2 million
in 2003. The increase of $277,000 was primarily from increased sales
derived from services of $603,000, offset by a reduction in products sales
of $326,000.
Products sales of $8.0 million in 2004, which represents 77% of
total sales, declined by 4% as compared to $8.3 million in 2003, which
represents 82% of total sales. The lower sales in 2004 are due largely to
the Company's decision to divest its legacy products as part of its
overall strategy to transition to its new generation of network fax
servers, FaxPress Premier. We anticipate sales of our FaxPress Premier fax
servers to grow as we continue to expand into Japan, Hong Kong and
Mainland China markets. Product sales in 2004 also included a one-time
pre-tax benefit of $126,000 from an adjustment of certain accruals related
to a sales development program.
Service revenues are comprised of extended warranty and support
programs as well as 60-days of maintenance included with initial product
sales. Revenue related to these arrangements is recognized ratably over
the period of the arrangement. Service revenues in 2004, which represents
23% of total sales, increased 33% to $2.4 million from $1.8 million in
2003, which represents 18% of total sales. The increase in service
revenues was primarily due to increased sales of extended warranty
contracts due to an increase in our installed customer base as well as the
launch of our FaxPress Premier fax server products in the second half of
2003. We anticipate service revenue to increase as more FaxPress Premier
fax servers are sold.
Domestic sales were $8.6 million in 2004 as compared to $8.2 million
in 2003, representing 82% and 81%, respectively, of total net sales. The
increase in sales was mostly attributable to the introduction of the new
FaxPress Premier fax server products, which carry higher selling prices,
an
23
increase in service revenues and a benefit of $126,000 from a sales
development program adjustment.
International sales (excluding sales to the rest of the Americas)
were $1.6 million in 2004 and 2003, representing 15% and 16%,
respectively, of total net sales. 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
$294,000 in 2004, as compared to $371,000 in 2003, representing 3% and 4%
of total net sales in 2004 and 2003, respectively. The decrease in sales
was mostly due to lower sales of our FaxPress fax server products.
In 2004, Ingram Micro, Tech Data and Macnica, our top three
customers accounted for approximately 51% of our net sales. In 2003, the
same three distributors accounted for 57% of net sales.
Cost of Sales; Gross profit
Year Ended December 31
-------------------------------------------
2004 2003 2002
--------- --------- ---------
Cost of sales: (Restated) (Restated)
Products $ 2,556 $ 2,485 $ 2,833
Services 826 726 707
Total cost of sales 3,382 3,211 3,540
Gross profit $ 7,075 $ 6,969 $ 6,180
Gross profit as % of sales 68% 68% 64%
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 from service revenues in
fiscal 2004 increased by $503,000 from fiscal 2003 due mostly to higher
sales while cost of sales increased moderately. The higher gross profit
from service revenues was offset by lower gross profit of $397,000 from
product sales due to product mix. Gross profit in 2004 included the
benefit of $126,000 from the sales development program adjustment.
Periodically we review obsolete and unmarketable products in our
inventory and make appropriate allowances for excess and obsolete
inventory. Products that are determined to be obsolete and unmarketable
are physically scrapped when it is determined that such inventories are no
longer usable or salable. In 2004, we identified $35,000 of unmarketable
products, which were scrapped, as compared to $154,000 worth of
unmarketable products scrapped in 2003.
Research and Development
Year Ended December 31
-------------------------------------------
2004 2003 2002
--------- --------- ---------
(Restated) (Restated)
Research and development expenses $ 1,722 $ 1,590 $ 1,379
Research and development expenses as % of sales 17% 15% 14%
24
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. The higher research
and development expenses in 2004 were mostly due to higher outside
consulting expenses of $154,000 to enhance our current product features
and $71,000 in higher compensation due to increased headcount, offset by a
decrease in materials expense of $61,000. The employment of consultants is
expected to continue until the short-term projects are completed. 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
Year Ended December 31
-------------------------------------------
2004 2003 2002
--------- --------- ---------
(Restated) (Restated)
Sales and marketing expenses $ 2,486 $ 2,398 $ 2,301
Sales and marketing expenses as % of sales 24% 24% 23%
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. The increase in sales and
marketing expenses was largely due to increased compensation expenses of
$216,000 related to headcount additions, offset in part by lower
advertising and promotional expenses of $129,000. Sales and marketing
expenses are anticipated to remain relatively stable.
General and Administrative
Year Ended December 31
-------------------------------------------
2004 2003 2002
--------- --------- ---------
(Restated) (Restated)
General and administrative expenses $ 1,801 $ 1,902 $ 1,943
General and administrative expenses as % of sales 17% 18% 20%
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. The lower expenses
in 2004, as compared to 2003, were mainly attributable to lower
compensation expenses of $88,000 mostly because of lower incentive
payments due to performance goals that were not met. General and
administrative expenses are expected to increase in fiscal 2005 in
relation to Sarbanes-Oxley internal control compliance.
Interest and Other Income (Expenses)
Interest and other income (expense) consists 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 (expense) for 2004 was $14,000 as compared $10,000 in
2003.
Provision for Income Tax
In fiscal 2004 and 2003, we recorded non-cash tax benefits of $1.1
million and $526,000, respectively, as a result of releasing portions of
our tax valuation allowance. Consequently, as of December 31, 2004, we
have recorded a total of $1.5 million of deferred tax assets. We have not
25
reported significant income tax expenses because we have been able to
utilize available Net Operating Loss ("NOL") and tax credit carryforwards
to offset taxable income. Prior to December 31, 2003, the Company's NOLs
were fully offset by a valuation allowance due to uncertainly surrounding
the likelihood of their realization. Due to our continued profitability
over the past 14 quarters and a determination that it is more likely than
not that certain future tax benefits will be realized, a portion of the
Company's deferred tax assets have been recognized during the fourth
quarters of fiscal 2003 and 2004.
Comparison of Years Ended December 31, 2003 and 2002
Net Sales
Net sales increased 5% to $10.2 million in 2003 from $9.7 million in
2002. The increase of $460,000 resulted primarily from increased sales
derived from services of $740,000 offset by a reduction in product sales
of $280,000.
Products sales of $8.3 million in 2003, which represents 82% of
total sales, declined by 3% as compared to $8.6 million in 2002, which
represents 89% of total sales, mostly due to lower sales of our FaxPress
fax servers.
Service revenues in 2003, which represents 18% of total sales,
increased 67% to $1.8 million from $1.1 million in 2002, which represents
11% of total sales. The increase in service revenues was primarily due to
increased sales of extended warranty contracts due to an increase in our
installed customer base.
Domestic sales were $8.2 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 in the fourth quarter of 2003, which
carry higher selling prices, and an increase in service revenues.
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.
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% of
total net sales in both 2003 and 2002.
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 was $7.0 million, or 68% of net sales, in 2003,
compared to $6.2 million, or 64% of net sales, in 2002. Gross profit from
service revenues in fiscal 2003 increased by $721,000 from fiscal 2002 due
mostly to higher sales while cost of sales was relatively flat. Continuous
product cost reductions in 2003 and increased outsourcing of manufacturing
contributed to the improvement in gross profit from product sales in 2003
by $68,000.
In 2003, we identified $154,000 of unmarketable products, which were
scrapped, as compared to $158,000 in 2002.
Research and Development
26
Research and product development expenses were $1.6 million in 2003,
as compared to $1.4 million in 2002, and represent 15% 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.
Sales and Marketing
Sales and marketing expenses were $2.4 million and $2.3 million for
2003 and 2002, respectively, and represent 24% and 23% of net sales for
those 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.
General and Administrative
General and administrative expenses were $1.9 million in both 2003
and 2002, and represent 18% 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(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 and a determination that
it is more likely than not that certain future tax benefits will be
realized, a portion of the deferred tax assets were recognized in the
fourth quarter of fiscal 2003.
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.
LIQUIDITY AND CAPITAL RESOURCES
December 31, 2004 December 31, 2003
----------------- -----------------
(dollars in thousands)
(Restated)
Cash and cash equivalents $ 5,599 $ 4,614
Working capital $ 5,750 $ 4,156
Working capital ratio 3.0 2.4
27
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, 2004, we had $5.6 million
of cash and cash equivalents, an increase of $985,000 from December 31, 2003.
The increase in cash and cash equivalents was primarily attributable to cash
provided by operating activities of $626,000 and $410,000 in proceeds from the
exercise of stock options.
Even though cash and cash equivalents in 2004 improved over 2003, cash
provided by operating activities declined by $492,000 primarily due to a planned
increase in inventory of $608,000, mostly attributable to the purchase, net of
usage, of $675,000 worth of end-of-life parts used in our FaxPress products in
an effort to guarantee a smooth supply to our customers for the next two years,
and the timing of accounts payable. The increase in cash provided by operating
activities in 2003 as compared to 2002 was mainly due to higher earnings.
In 2004, net cash provided by financing activities was $394,000 primarily
from proceeds from issuance of common stock. In the first quarter of 2003, we
repurchased $48,000 of our stock from open market transactions. We acquired
additional property and equipment of $35,000, $164,000 and $34,000 in 2004, 2003
and 2002, respectively. 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 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. We performed no stock repurchases during the rest of 2003
and 2004. However, we may continue to execute our buyback program as we deem
necessary.
In September, 2004, we entered into a $4.0 million collateralized
revolving line of credit with a bank, which is to expire in August 2005. The
revolving line of credit provides for borrowings of up to $4.0 million.
Borrowings under this line of credit agreement are collateralized by all of our
assets and bear interest at the bank's prime rate plus 0.50%. Under the new
facility we are required to maintain certain minimum cash and investment
balances with the bank and meet certain other financial covenants. As of
December 31, 2004, we have not drawn down on the line of credit and were in
compliance with the terms of the agreement.
We lease certain of our equipment under various operating and capital
leases that expire at various dates through 2006. The lease agreements
frequently include renewal, escalation clauses and purchase provisions, and
require us to pay taxes, insurance and maintenance costs. As of December 31,
2004, we had $32,000 outstanding under a loan and security agreement, which is
subject to an interest rate of 12.8%.
We lease our headquarters in Morgan Hill, California. We have extended our
building lease for a term of five years commencing on June 1, 2004 and expiring
on May 31, 2009, with one conditional three-year renewal option, which if
exercised, would extend the lease to May 31, 2012 commencing with rent at
ninety-five percent of fair market value. As of December 31, 2004, future
minimum payments under the lease were $915,000.
The following represents combined aggregate maturities for all our
financing and commitments as of December 31, 2004:
28
Payments Due by Period
--------------------------------------------------------------------
Contractual Obligations Less Than More than 5
Total 1 Year 1 - 3 Years 3 - 5 Years Years
--------------------------------------------------------------------
Capital (Finance) Lease Obligations $ 32 $ 18 $ 14 -- --
Operating Lease Obligations $ 915 $ 207 $ 622 $ 86 --
--------------------------------------------------------------------
Total contractual cash obligations $ 947 $ 225 $ 636 $ 86 --
====================================================================
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
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.
29
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.
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,
2004, had an accumulated deficit of $20 million. Our development and marketing
of current and new products will continue to require substantial expenditures.
We incurred $591,000 of losses as recently as 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.
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