UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2005
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 0-220-20
CASTELLE
(Exact name of Registrant as specified in its charter)
California 77-0164056
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
855 Jarvis Drive, Suite 100, Morgan Hill, California 95037
(Address of principal executive offices, including zip code)
(408) 852-8000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
The number of shares of Common Stock outstanding as of July 25, 2005 was
3,914,060.
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes|_| No |X|
CASTELLE
Table of Contents
PAGE
PART I - FINANCIAL INFORMATION...............................................3
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.....................3
CONDENSED CONSOLIDATED BALANCE SHEETS...........................3
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS...................4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS.................5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS............6
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS...............................13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS..........................................14
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK......27
ITEM 4. CONTROLS AND PROCEDURES.........................................28
PART II - OTHER INFORMATION.................................................29
ITEM 1. LEGAL PROCEEDINGS..............................................29
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS......................29
ITEM 3. DEFAULTS UPON SENIOR SECURITIES................................29
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............29
ITEM 5. OTHER INFORMATION..............................................29
ITEM 6. EXHIBITS.......................................................29
SIGNATURES..................................................................30
AMENDMENT TO SILICON VALLEY BANK LOAN AGREEMENT............................E-1
RULE 13A-14(A)/15D-14(A) CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER......E-4
RULE 13A-14(A)/15D-14(A) CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER......E-5
SECTION 1350 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER..................E-6
SECTION 1350 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER..................E-7
2
PART I - FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
CASTELLE
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
June 30, 2005 December 31, 2004
(unaudited)
------------------ --------------------
Assets:
Current assets:
Cash and cash equivalents $ 6,350 $ 5,599
Accounts receivable, net of allowance for doubtful accounts of
$40 and $30, respectively 723 857
Inventories 1,553 1,785
Prepaid expenses and other current assets 178 130
Deferred taxes 231 231
------------------ --------------------
Total current assets 9,035 8,602
Property and equipment, net 203 203
Other non-current assets 46 50
Deferred taxes, non-current 1,292 1,292
------------------ --------------------
Total assets $ 10,576 $ 10,147
================== ====================
Liabilities and Shareholders' Equity:
Current liabilities:
Long-term debt, current portion $ 15 $ 15
Accounts payable 277 511
Accrued liabilities 1,098 1,073
Deferred revenue 1,334 1,253
------------------ --------------------
Total current liabilities 2,724 2,852
Long term debt, net of current portion 5 14
------------------ --------------------
Total liabilities 2,729 2,866
------------------ --------------------
Shareholders' equity:
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 3,904 and 3,799 shares, 27,783 27,668
respectively
Accumulated deficit: (19,936) (20,387)
------------------ --------------------
Total shareholders' equity 7,847 7,281
------------------ --------------------
Total liabilities and shareholders' equity $ 10,576 $ 10,147
================== ====================
See accompanying notes to condensed consolidated financial statements.
3
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
(in thousands, except per share amounts)
(unaudited)
Three months ended Six months ended
................................ ...............................
June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004
---------------- -------------- --------------- ---------------
Net sales:
Products $ 2,116 $ 2,090 $ 4,009 $ 4,102
Services 730 601 1,431 1,128
---------------- -------------- --------------- ---------------
Total net sales 2,846 2,691 5,440 5,230
Cost of sales:
Products 674 592 1,216 1,231
Services 258 216 528 414
---------------- -------------- --------------- ---------------
Total cost of sales 932 808 1,744 1,645
---------------- -------------- --------------- ---------------
Gross profit 1,914 1,883 3,696 3,585
Operating expenses:
Research and development 418 428 857 842
Sales and marketing 618 675 1,216 1,270
General and administrative 582 508 1,217 973
---------------- -------------- --------------- ---------------
Total operating expenses 1,618 1,611 3,290 3,085
---------------- -------------- --------------- ---------------
Income from operations 296 272 406 500
Interest income, net 35 5 60 8
Other expense, net (15) (10) (15) (14)
---------------- -------------- --------------- ---------------
Income before provision for income taxes 316 267 451 494
Provision for income taxes - 121 - 219
---------------- -------------- --------------- ---------------
Net income $ 316 $ 146 $ 451 $ 275
================ ============== =============== ===============
Net Income per share:
Net income per common share - basic $ 0.08 $ 0.04 $ 0.12 $ 0.08
Net income per common share - diluted $ 0.07 $ 0.03 $ 0.10 $ 0.06
Shares used in per share calculation - basic 3,871 3,573 3,843 3,536
Shares used in per share calculation - diluted 4,460 4,428 4,463 4,439
See accompanying notes to condensed consolidated financial statements.
4
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Six months ended
......................................
June 30, 2005 June 30, 2004
----------------- ------------------
Cash flows from operating activities:
Net income $ 451 $ 275
Adjustment to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 95 103
Provision for doubtful accounts 10 (3)
Provision for excess and obsolete inventory (474) (210)
Allowance for sales returns and stock rotation (55) 16
Loss on disposal of fixed assets - 1
Deferred taxes - 219
Changes in assets and liabilities:
Accounts receivable 179 (115)
Inventories 706 (78)
Prepaid expenses and other current assets (44) (122)
Accounts payable (234) 104
Accrued liabilities 25 (242)
Deferred revenue 81 132
----------------- ------------------
Net cash provided by operating activities 740 80
----------------- ------------------
Cash flows from investing activities:
Acquisition of equipment (95) (15)
----------------- ------------------
Net cash used in investing activities (95) (15)
----------------- ------------------
Cash flows from financing activities:
Repayment of long-term debt (9) (9)
Proceeds from exercise of stock options 115 172
----------------- ------------------
Net cash provided by financing activities 106 163
Net increase in cash and cash equivalents 751 228
Cash and cash equivalents at beginning of period 5,599 4,614
----------------- ------------------
Cash and cash equivalents at end of period $ 6,350 $ 4,842
================= ==================
See accompanying notes to condensed consolidated financial statements.
5
CASTELLE
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation:
The accompanying unaudited condensed consolidated financial statements
include the accounts of Castelle and its wholly-owned subsidiary in the
United Kingdom. These financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of
America. All intercompany balances and transactions have been eliminated.
In our opinion, all adjustments (consisting only of normal recurring
adjustments) considered necessary for a fair presentation of our financial
position, results of operations and cash flows at the dates and for the
periods indicated have been included. Because all of the disclosures
required by accounting principles generally accepted in the United States
of America are not included in the accompanying condensed consolidated
financial statements and related notes, they should be read in conjunction
with the audited consolidated financial statements and related notes
included in the Company's Form 10-K for the year ended December 31, 2004.
The condensed consolidated balance sheet data as of December 31, 2004 was
derived from our audited financial statements and does not include all of
the disclosures required by accounting principles generally accepted in the
United States of America. The results of operations for the periods
presented are not necessarily indicative of results that we expect for any
future period, or for the entire year.
The preparation of financial statements in conformity with generally
accepted accounting principles requires us to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
We believe that our existing cash balances and anticipated cash flows from
operations will be sufficient to meet our anticipated capital requirements
for the next 12 months. If we have a need for additional capital resources,
we may be required to sell additional equity or debt securities, secure
additional lines of credit or obtain other third party financing. The
timing and amount of such capital requirements cannot be determined at this
time and will depend on a number of factors, including demand for our
existing and new products, if any, and changes in technology in the
networking industry. There can be no assurance that such additional
financing will be available on satisfactory terms when needed, if at all.
Failure to raise such additional financing, if needed, may result in us not
being able to achieve our long-term business objectives. To the extent that
additional capital is raised through the sale of additional equity or
convertible debt securities, the issuance of such securities would result
in additional dilution to our shareholders.
In addition, because we are dependent on a small number of distributors for
a significant portion of the sales of our products, the loss of any of our
major distributors or their inability to satisfy their payment obligations
to us could have a significant adverse effect on our business, operating
results and financial condition. In the first six months of 2005 and 2004,
our two largest distributors collectively represented approximately 43% and
48% of our net sales, respectively.
We do not currently have any material long-term supply contracts with any
of our manufacturing subcontractors or component suppliers. We purchase
finished products and components on a purchase order basis. We own all
engineering, sourcing documentation, functional test equipment and tooling
used in the manufacturing of our products and believe that we could shift
product assembly to alternate suppliers if necessary. Certain key
components of our products, including a
6
modem chip set from Conexant,
microprocessors from Motorola, integrated circuits from Intel and Kendin,
are currently available from single sources. Other components of our
products are currently available from only a limited number of sources. In
addition, certain manufacturers have announced the end-of-life of certain
standard off-the-shelf components which are being used by us in the
manufacture of our FaxPress Products. However, we have purchased what we
believe to be at least two years worth of supplies of these end-of-life
components in an effort to guarantee an uninterrupted supply of FaxPress
Products to our customers for the next two years, while we decide whether
to re-engineer our Products with the manufacturers' suggested replacement
parts, or develop new replacement products. 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.
2. 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 and determinable; collection is probable; and returns can be
reasonably estimated. If an acceptance period or other contingency exists,
revenue is recognized upon satisfaction of the contingency, customer
acceptance or expiration of the acceptance period. Shipment generally
occurs and title and risk of loss is transferred when the product is
delivered to a common carrier.
We evaluate product sales through our distribution channels and the related
reserve requirement to establish an estimate for our sales returns reserve
by reviewing detailed point-of-sales and on-hand inventory reports provided
to us by our channel partners. Based on a combination of historical return
experience, the sales activities to end-user customers by our channel
partners and the level of inventories on hand at the channel partners, we
determine our returns reserve at the end of each financial period, and
increases or reduce the reserve balance accordingly.
We provide standard support to our customers for an initial period of sixty
days, which includes advance swap of the defective hardware and software,
bug fixes, software upgrades and technical support. In addition to standard
support, we also offer our customers the option to purchase extended
support at the time of product purchase or anytime thereafter. Extended
support covers hardware and software for a period of one year. We have
established vendor-specific objective evidence with respect to the fair
value of the standard support contracts based on standalone sales and
renewals of our one-year extended support contracts. The fair value of our
sixty day support contracts included with product sales is determined by
pro-rating the related one-year extended support contracts. We recognize
revenue from extended support contracts ratably over the period of the
contract based on
7
contract service dates.
3. Net Income Per Share:
Basic net income per share is computed by dividing net income by the
weighted average number of common shares outstanding for such period.
Diluted net income per share reflects the potential dilution from the
exercise or conversion of other securities into common stock that were
outstanding during the period. Diluted net income per share excludes shares
that are potentially dilutive if their effect is antidilutive. Dilutive
potential shares consist of incremental common shares issuable upon
exercise of stock options.
Basic and diluted net income per share is calculated as follows for the
first two quarters of 2005 and 2004 (Unaudited, in thousands, except per
share amounts):
(in thousands, except per share amounts)
........................................................
(Unaudited)
........................................................
Three months ended Six months ended
........................... ............................
June 30, 2005 June 30, June 30, June 30, 2004
2004 2005
--------------------------- ------------- --------------
Basic:
Weighted average common shares outstanding 3,871 3,573 3,846 3,536
=========================== ============= ==============
Net income $ 316 $ 146 $ 451 $ 275
=========================== ============= ==============
Net income per common share - basic $ 0.08 $ 0.04 $ 0.12 $ 0.08
=========================== ============= ==============
Diluted:
Weighted average common shares outstanding 3,871 3,573 3,846 3,536
Common equivalent shares from stock options 589 855 617 903
--------------------------- ------------- --------------
Shares used in per share calculation - diluted 4,460 4,428 4,463 4,439
=========================== ============= ==============
Net income $ 316 $ 146 $ 451 $ 275
=========================== ============= ==============
Net income per common share - diluted $ 0.07 $ 0.03 $ 0.10 $ 0.06
=========================== ============= ==============
The calculation of diluted shares outstanding for all periods presented
excludes 123,000 shares of common stock issuable upon exercise of
outstanding stock options, as their effect was antidilutive in the period.
4. Stock-Based Compensation
We account for our stock-based compensation plans using the intrinsic value
method prescribed in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees." Compensation cost for stock
options, if any, is measured by the excess of the quoted market price of
our stock at the date of grant over the amount an employee must pay to
acquire the stock. SFAS No. 123, "Accounting for Stock-Based Compensation,"
established accounting and disclosure requirements using a fair-value based
method of accounting for stock-based employee compensation plans.
Had compensation costs been determined consistent with SFAS No. 123, our
net income, net of income taxes, would have been changed to the amounts
indicated below (unaudited, in thousands, except per share data):
8
Three months ended Six months ended
............................. .................................
June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004
-------------- -------------- ---------------------------------
Net Income - as reported $ 316 $ 146 $ 451 $ 275
Fair value of stock-based compensation, net (99) (159) (297) (255)
of taxes
Net income (loss) - pro forma 217 (13) 154 20
Net income per share - basic - as reported $ 0.08 $ 0.04 $ 0.12 $ 0.08
Net income per share - diluted - as reported $ 0.07 $ 0.03 $ 0.10 $ 0.06
Net income (loss) per share - basic - pro
forma $ 0.06 $ 0.00 $ 0.04 $ 0.01
Net income (loss) per share - diluted - pro $ 0.05 $ 0.00 $ 0.03 $ 0.00
forma
We account for stock-based compensation arrangements with non-employees in
accordance with Emerging Issues Task Force ("EITF") Abstract No. 96-18,
Accounting for Equity Instruments That Are Issued to Other Than Employees
for Acquiring, or in Conjunction with Selling, Goods or Services.
Accordingly, unvested options and warrants held by non-employees are
subject to revaluation at each balance sheet date based on the then current
fair market value.
5. Inventories:
Inventories are stated at the lower of standard cost (which approximates
cost on a first-in, first-out basis) or market. Inventory details are as
follows (unaudited, in thousands):
June 30, 2005 December 31, 2004
----------------------- -----------------------
Raw material $ 853 $ 1,202
Work in process 81 118
Finished goods 619 465
-----------------------------------------------
Total inventory $ 1,553 $ 1,785
===============================================
After the announcement by our component suppliers that new components are
available to replace certain of their end-of-life components currently used
in our FaxPress products, we purchased approximately two years worth of
these end-of-life components in an effort to guarantee a smooth supply of
our FaxPress Products to our customers. As of June 30, 2005, we have
approximately $470,000 worth of end-of-life components as compared to
$675,000 at the end of December 31, 2004. We believe that most of these
end-of-life components will be utilized in the following two years,
resulting in insignificant amounts of excessive inventory, or none at all.
Inventories are reduced for excess and obsolete inventories. These
write-downs are based on management's review of inventories on hand on a
quarterly basis, compared to management's assumptions about future demand,
market conditions and anticipated timing of the release of product upgrades
or next generation products. If actual market conditions for future demand
are less favorable than those projected by us or if product upgrades or
next generation products are released earlier than anticipated, additional
inventory write-downs may be required. Obsolete products removed from gross
inventory are physically scrapped.
9
6. Segment Information:
We have determined that we operate in one segment. Revenues by geographic
area are determined by the location of the customer and are summarized as
follows (unaudited, in thousands):
Three months ended Six months ended
......................... ........................
June 30, June 30, June 30, June 30,
2005 2004 2005 2004
------------------------- ------------------------
United States $ 2,170 $ 2,279 $ 4,360 $ 4,390
Europe 119 148 212 332
Pacific Rim 290 153 531 335
Rest of Americas, excluding United States 267 111 337 173
------------------------- ------------------------
Total Revenues $ 2,846 $ 2,691 $ 5,440 $ 5,230
========================= ========================
Customers that individually accounted for greater than 10% of net sales are
as follows (unaudited, in thousands):
....................................................................................................
Quarter Ended Six Months Ended
................................................. ..................................................
June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004
Customer Amount Percentage Amount Percentage Amount Percentage Amount Percentage
-------- ------ ---------- ------ ---------- ------ ---------- ------ ----------
A $ 415 15% $ 562 21% $ 870 16% $ 1,439 28%
B $ 773 27% $ 701 26% $ 1,475 27% $ 1,076 20%
C $ 256 9% * * $ 520 10% * *
* This customer accounted for less than 10% in 2004.
7. Comprehensive Income:
Comprehensive income is the change in equity from transactions and other
events and circumstances other than those resulting from investments by
owners and distributions to owners. There are no significant components of
comprehensive income excluded from net income, therefore, no separate
statement of comprehensive income has been presented.
8. Commitments and Contingencies:
Contingencies
From time to time, we are involved in various legal proceedings in the
ordinary course of business. We are not currently involved in any
litigation, which, in our opinion, would have a material adverse effect on
our business, operating results, cash flows or financial condition;
however, there can be no assurance that any such proceeding will not
escalate or otherwise become material to our business in the future.
Lease Commitments
The following represents combined aggregate maturities for all of our
financing and commitments under operating and capital leases as of June 30,
2005 (unaudited, in thousands):
10
Capital Lease Total
Operating Leases Obligations Commitments
----------------------------------------------------
Six months ending December 31, 2005 $ 103 $ 15 $ 118
Year ending December 31, 2006 207 5 212
Year ending December 31, 2007 207 - 207
Year ending December 31, 2008 207 - 207
Year ending December 31, 2009 86 - 86
----------------------------------------------------
Total Commitments $ 810 $ 20 $ 830
====================================================
We have extended our building lease for a term of five years commencing on
June 1, 2004 and expiring on May 31, 2009, with one conditional three-year
renewal option, which if exercised, would extend the lease to May 31, 2012
commencing with rent at ninety-five percent of fair market value.
We lease certain of our equipment under various operating and capital
leases that expire at various dates through 2006. The lease agreements
frequently include renewal, escalation clauses and purchase provisions, and
require us to pay taxes, insurance and maintenance costs. As of June 30,
2005, we had $20,000 outstanding under a loan and security agreement, which
is subject to an interest rate of 12.8%.
In September, 2004, we entered into a $4.0 million collateralized revolving
line of credit with a bank. This line of credit has been extended through
August of 2006. 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 June 30, 2005, we have not drawn down on the
line of credit and were in compliance with the terms of the agreement.
Product Warranties and Guarantor Arrangements
We offer warranties on certain products and record a liability for the
estimated future costs associated with warranty claims, which is based upon
historical experience and our estimate of the level of future costs.
Warranty costs are reflected in the Statement of Operations as a Cost of
Sales. A reconciliation of the changes in our warranty liability is as
follows (unaudited, in thousands):
(Unaudited)
....................................................
Three months ended Six months ended
......................... ........................
June 30, June 30, June 30, June 30,
2005 2004 2005 2004
------------------------- ------------------------
Balance at beginning of period $ 18 $ 23 $ 13 $ 24
Accruals for warranties issued during the - 1 5 1
period
Actual warranty expense - (2) - (3)
------------------------- ------------------------
Balance at end of period $ 18 $ 22 $ 18 $ 22
========================= ========================
As permitted under California law, and under the provisions of our articles
of incorporation and by-laws, we are obligated to indemnify our officers
and directors for certain events or occurrences while the officer or
director is, or was, serving at our request in such capacity. The term of
the indemnification period is for the officer's or director's lifetime. The
maximum potential amount of future payments the Company could be required
to make under these indemnification agreements is unlimited; however, we
have a director and officer insurance policy that limits our exposure and
11
enables us to recover a portion of any future amounts paid. As a result of
our insurance policy coverage, we believe the estimated fair value of these
indemnification agreements is insignificant.
We enter into standard indemnification agreements with our customers in the
ordinary course of business. Pursuant to these agreements, we indemnify,
hold harmless, and agree to reimburse the indemnified party for losses
suffered or incurred by the indemnified party, generally our business
partners or customers, in connection with any U.S. patent, or any copyright
or other intellectual property infringement claim by any third party with
respect to our products. The term of these indemnification agreements is
generally perpetual following execution of the agreement. The maximum
potential amount of future payments we could be required to make under
these indemnification agreements is unlimited; however, we have never
incurred claims or costs to defend lawsuits or settle claims related to
these indemnification agreements.
9. Recent Accounting Pronouncements:
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment," a
revision of SFAS No. 123, "Accounting for Stock-Based Compensation" and
superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees."
SFAS No. 123R requires the Company to expense grants made under the
Company's stock option program. That cost will be recognized over the
vesting period of the plans. SFAS No. 123R is effective for fiscal years
beginning after June 15, 2005. The Company is evaluating the alternatives
allowed under the standard, which the Company is required to adopt
effective for its first quarter of fiscal 2006.
In December 2004, the FASB issued Staff Position SFAS No. 109-1,
Application of FASB Statement No. 109, Accounting for Income Taxes (FSP No.
109-1) to the Tax Deduction on Qualified Production Activities Provided by
the American Jobs Creation Act of 2004 which was signed into law by the
President of the United States on October 22, 2004. Companies that qualify
for the recent tax law's deduction for domestic production activities must
account for it as a special deduction under SFAS No. 109 and reduce their
tax expense in the period or periods the amounts are deductible, according
to FSP No. 109-1, effective for the Company in its fiscal year 2005. The
FASB's guidance is not expected to have a material impact to the Company's
financial results.
12
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This document contains forward-looking statements that involve risks and
uncertainties. Our operating results may vary significantly from quarter to
quarter due to a variety of factors, including changes in our product and
customer mix, constraints in our manufacturing and assembling operations,
shortages or increases in the prices of raw materials and components, changes in
pricing policy by us or our competitors, a slowdown in the growth of the
networking market, seasonality, timing of expenditures, and economic conditions
in the United States, Europe and Asia. Words such as "believes," "anticipates,"
"expects," "intends" and similar expressions are intended to identify
forward-looking statements, but are not the exclusive means of identifying such
statements. Unless the context otherwise requires, references in this Form 10-Q
to "we," "us," or the "Company" refer to Castelle. Readers are cautioned that
the forward-looking statements reflect management's analysis only as of the date
hereof, and we assume no obligation to update these statements. Actual events or
results may differ materially from the results discussed in the forward-looking
statements. Factors that might cause such a difference include, but are not
limited to the risks and uncertainties discussed herein, as well as other risks
set forth under the caption "Risk Factors" below and in our Annual Report on
Form 10-K for the year ended December 31, 2004.
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and Results of
Operations contains forward-looking statements that are subject to many risks
and uncertainties that could cause actual results to differ significantly from
expectations. For more information on forward-looking statements, refer to the
"Special Note on Forward-Looking Statements" prior to this section. The
following discussion should be read in conjunction with the unaudited Condensed
Consolidated Financial Statements and the Notes thereto included in Item 1 of
this Quarterly Report on Form 10-Q and our Form 10-K for the year ended December
31, 2004.
Critical Accounting Policies
Castelle's financial statements and accompanying notes are prepared in
accordance with accounting principles generally accepted in the United States of
America. Preparing financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets, liabilities, sales
and expenses. These estimates and assumptions are affected by management's
application of accounting policies. Critical accounting policies for us include
revenue recognition; distributor programs and incentives; warranty; credit,
collection and allowances for doubtful accounts; inventories and related
allowance for obsolete and excess inventory; and income taxes, which are
discussed in more detail under the caption "Critical Accounting Policies" in our
2004 Annual Report on Form 10-K.
Consolidated Statements of Operations - As a Percentage of Net Sales
Three months ended Six months ended
................................ ................................
June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004
---------------- -------------- ---------------- --------------
Net sales:
Products 74% 78% 74% 78%
Services 26% 22% 26% 22%
---------------- -------------- ---------------- --------------
Total net sales 100% 100% 100% 100%
Cost of sales:
Products 24% 22% 22% 23%
Services 9% 8% 10% 8%
---------------- -------------- ---------------- --------------
Total cost of sales 33% 30% 32% 31%
Gross profit 67% 70% 68% 69%
Operating expenses:
Research and development 15% 16% 16% 17%
Sales and marketing 22% 25% 22% 24%
General and administrative 20% 19% 23% 18%
---------------- -------------- ---------------- --------------
Total operating expenses 57% 60% 61% 59%
Income from operations 10% 10% 7% 10%
Interest income, net 1% * 1% *
Other expense, net * (1%)
* *
---------------- -------------- ---------------- --------------
Income before provision for income taxes 11% 10% 8% 9%
Provision for income taxes - 5% - 4%
---------------- -------------- ---------------- --------------
Net income 11% 5% 8% 5%
================ ============== ================ ==============
* Less than 1%
14
Results of Operations
Net Sales
Three months ended Six months ended
................................. .................................
June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004
----------------- -------------- --------------- ----------------
Net sales
Products $ 2,116 $ 2,090 $ 4,009 $ 4,102
Services 730 601 1,431 1,128
----------------- -------------- --------------- ----------------
Total Net sales $ 2,846 $ 2,691 $ 5,440 $ 5,230
================= ============== =============== ================
Net sales for the second quarter of 2005 increased 6% to $2.8
million from $2.7 million in the same period in 2004. Net sales for the
first six months of 2005 increased 4% to $5.4 million from $5.2 million for
the same period in 2004.
Product sales of $2.1 million for the second quarter of 2005 were
relatively unchanged as compared to the same period in 2004. Product sales
of $4.0 million for the first six months of 2005 represent a slight
decrease of $93,000 compared to the first six months of 2004, or a 2%
decrease for that period.
Service revenues are comprised primarily of extended warranty and
support programs as well as 60-days of maintenance bundled with initial
product sales. Revenue related to these arrangements is recognized ratably
over the period of the arrangement. Service revenues in the second quarter
of 2005 increased 21% to $730,000 from $601,000 in the same period in 2004.
For the first six months of 2005, service revenues increased 27% to $1.4
million from $1.1 million in the same period in 2004. The increase in
service revenues was primarily due to increased sales of extended warranty
contracts due to an increase in our installed customer base resulting from
the launch of our FaxPress Premier fax server products in the second half
of 2003.
Three months ended Six months ended
......................... ........................
June 30, June 30, June 30, June 30,
2005 2004 2005 2004
------------------------- ------------------------
United States $2,170 $ 2,279 $ 4,360 $ 4,390
Europe 119 148 212 332
Pacific Rim 290 153 531 335
Rest of Americas, excluding United States 267 111 337 173
------------------------- ------------------------
Total Revenues $2,846 $ 2,691 $ 5,440 $ 5,230
========================= ========================
Sales in the United States in the second quarter of 2005 were $2.2
million, as compared to $2.3 million for the same period in 2004,
representing 76% and 85% of total net sales in the second quarter of 2005
and 2004, respectively. The reduction in percentage of net sales in the
second quarter of 2005 is mostly due to increases in sales to distribution
channels outside of the United States. Sales for the first six months of
2005 and 2004 were $4.4 million, which represents 80% and 84% of total net
sales in 2005 and 2004, respectively. The decrease in sales is mostly due
to lower sales for the FaxPress family of products offset partially by
higher service revenues.
15
International sales (excluding sales to the rest of the Americas)
for the second quarter of 2005 were $409,000 as compared to $301,000 in the
second quarter of 2004. This represents 14% and 11% of net sales for 2005
and 2004, respectively. International sales were $743,000 for the first six
months of 2005, as compared to $667,000 for the same period in 2004, which
represents 14% and 13% of total net sales for 2005 and 2004, respectively.
The increase in international sales is due to increased sales of the
FaxPress and FaxPress Premier fax server products to Japan as a result of
the FaxPress Premier fax server launch in Japan in the first quarter of
2005.
Sales to the rest of the Americas (excluding the United States) in
the second quarter of 2005 were $267,000 as compared to $111,000 in the
year-ago quarter, representing 9% of total net sales for 2005 and 4% for
2004, respectively. The increase in sales was mostly due to sales of our
FaxPress Premier products to Latin America. For the six months ended June
30, sales to the Rest of the Americas were $337,000 and $173,000 for 2005
and 2004, respectively. This represents 6% and 3% of net sales for 2005 and
2004, respectively.
Cost of Sales; Gross Profit
Three months ended Six months ended
.................................. ....................................
June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004
----------------- ---------------- ---------------- -----------------
Products:
Revenue $ 2,116 $ 2,090 $ 4,009 $ 4,102
Cost of product sales 674 592 1,216 1,231
----------------- ---------------- ---------------- -----------------
Gross profit 1,442 1,498 2,793 2,871
Gross profit % 68% 72% 70% 70%
Services:
Revenue 730 601 1,431 1,128
Cost of service sales 258 216 528 414
----------------- ---------------- ---------------- -----------------
Gross profit 472 385 903 714
Gross profit % 65% 64% 63% 63%
Total gross profit $1,914 $1,883 $ 3,696 $ 3,585
Gross profit % 67% 70% 68% 69%
Gross profit was $1.9 million for the second quarter of 2005 and
2004, or 67% and 70% of net sales, respectively. Gross profit for the first
six months of 2005 and 2004 was $3.7 million and $3.6 million, or 68% and
69% of net sales, respectively. The increase in gross profit was mainly due
to higher service revenue in the three and six months ended June 30, 2005
as compared to the same periods in 2004.
Research & Development
Research and development expenses for the second quarter of 2005
were $418,000, or 15% of net sales, as compared to $428,000 or 16% of net
sales for the same period in 2004. For the first six months of 2004,
research and development expenses were $857,000, as compared to $842,000 in
the same period of 2004, or 16% of net sales for both periods. Research and
development expenses are not expected to change significantly for fiscal
year 2005.
16
Sales & Marketing
Sales and marketing expenses for the second quarter of 2005 were
$618,000, or 22% of net sales, as compared to $675,000, or 25% of net
sales, for the same period in 2004. Sales and marketing expenses were $1.2
million for the first six months of 2005, and $1.3 million for the same
period of 2004, which represents 22% and 24%, respectively, of net sales
for the period. The decrease for the quarter of $55,000 is due to reduced
use of outside consultants due to a completion of short-term projects, and
the decrease of $53,000 is due to lower advertising costs for the six month
period.
General & Administrative
General and administrative expenses were $582,000 for the second
quarter of 2005 as compared to $508,000 for the same period in 2004. This
represents 20% and 19% of net sales of the second quarter of 2005 and 2004,
respectively. For the first six months of 2004, general and administrative
expenses were $1.2 million, or 23% of net sales, as compared to $973,000,
or 18% of net sales for the first six months of 2004. The increase of
$74,000 for the second quarter and $244,000 for the six month period ended
June 30, 2005, is primarily due to increases in accounting and legal fees
related to the restatement of the Company's historical financial statements
included in the Company's December 31, 2004 Annual Report on Form 10-K and
Castelle's response to a series of comment letters issued by the Division
of Corporate Finance of the Securities and Exchange Commission during the
first quarter of fiscal 2005. These restatements are discussed in detail in
the Company's December 31, 2004 Form 10-K. General and administrative
expenses are also expected to increase in fiscal 2005 as the Company begins
to prepare for Sarbanes-Oxley internal control compliance.
Provision for Income Tax
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 establish a valuation allowance to the extent
that all or some portion of the deferred tax assets will not be recoverable
against future taxable income.
Significant management judgment is required in determining the
provision for income taxes, and in particular, any valuation allowance
recorded against our deferred tax assets. During 2004 and 2003, we recorded
tax benefits of $1,067,000 and $537,000, respectively. This portion of the
valuation allowance was reversed because we determined that it was more
likely than not that certain future tax benefits will be realized as a
result of projected future income. Due to our limited history of generating
taxable income, we recorded a tax provision at an effective rate of
approximately 40% during the first three quarters of fiscal 2004. Based in
large part on our projected future taxable income we did not record income
tax provision in the second quarter of 2005. We will record a tax provision
in future periods when all available non-operating losses and tax credit
carryforwards are fully utilized or the remaining deferred tax assets are
deemed to be unrealizable.
At December 31, 2004, we had net operating loss carryforwards of
approximately $12,955,000 and $2,296,000 available to offset future federal
and California taxable income, respectively. These loss carryforwards will
expire in varying amounts beginning in 2005 through 2021. In addition, at
December 31, 2004, we had federal and California Research and Development
credit and alternative minimum tax credit carryforwards of approximately
$1,152,000 and $728,000,
17
respectively. The federal Research and Development
credits expire in varying amounts beginning in 2007. The California
Research and Development credits carry-forward indefinitely.
Liquidity and Capital Resources
June 30, 2005 December 31, 2004
(unaudited)
(dollars inthousands)
Cash and cash equivalents $ 6,350 $ 5,599
Working capital $ 6,311 $ 5,750
Working capital ratio 3.3 3.0
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 June 30, 2005, we had $6.4 million of
cash and cash equivalents, an increase of $751,000 from December 31, 2004. The
increase in cash and cash equivalents was primarily attributable to cash
provided by operating activities of $740,000 and $115,000 in proceeds from the
exercise of employee stock options, off-set by the purchase of $95,000 of
equipment.
Our operating activities generated cash of $740,000 in the first six
months of 2005 primarily due to our increased net income, reduction of
inventories as our usage of some of the end-of-life parts and other components
purchased last year more than offset purchases during the first quarter, and a
decrease in accounts receivable achieved by greater collection efforts. Net cash
provided by financing activities was $106,000 and $163,000 in the first two
quarters of 2005 and 2004, respectively, primarily from proceeds from issuance
of common stock.
In September, 2004, we entered into a $4.0 million collateralized
revolving line of credit with a bank. This line of credit has been extended
through August of 2006. 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 June
30, 2005, 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 June 30, 2005,
we had $20,000 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 June 30, 2005, future minimum
payments under the lease were $810,000.
The following represents combined aggregate maturities for all our
financing and commitments as of June 30, 2005 (unaudited, in thousands):
18
Payments Due by Period
--------------------------------------------------------------------
Contractual Obligations Total 1 Year 2 - 3 Years 4 - 5 Years More than 5
Years
--------- ------------- -------------- ------------- ---------------
Capital (Finance) Lease Obligations $ 20 $ 15 $ 5 - -
Operating Lease Obligations $ 810 $ 103 $ 414 $ 207 $ 86
--------- ------------- -------------- ------------- ---------------
Total contractual cash obligations $ 830 $ 118 $ 419 $ 207 $ 86
========= ============= ============== ============= ===============
In addition, because we are dependent on a small number of distributors
for a significant portion of the sales of our products, the loss of any of our
major distributors or their inability to satisfy their payment obligations to us
could have a significant adverse effect on our business, operating results and
financial condition.
We believe that, for the periods presented, inflation has not had a
material effect on our operations.
Recent Accounting Pronouncements:
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment,"
a revision of SFAS No. 123, "Accounting for Stock-Based Compensation" and
superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS
No. 123R requires the Company to expense grants made under the Company's stock
option program. That cost will be recognized over the vesting period of the
plans. SFAS No. 123R is effective for fiscal years beginning after June 15,
2005. The Company is evaluating the alternatives allowed under the standard,
which the Company is required to adopt effective in fiscal 2006.
In December 2004, the FASB issued Staff Position SFAS No. 109-1,
Application of FASB Statement No. 109, Accounting for Income Taxes (FSP No.
109-1) to the Tax Deduction on Qualified Production Activities Provided by the
American Jobs Creation Act of 2004 which was signed into law by the President of
the United States on October 22, 2004. Companies that qualify for the recent tax
law's deduction for domestic production activities must account for it as a
special deduction under SFAS No. 109 and reduce their tax expense in the period
or periods the amounts are deductible, according to FSP No. 109-1, effective for
the Company in its fiscal year 2005. The FASB's guidance is not expected to have
a material impact to the Company's financial results.
RISK FACTORS
Shareholders or investors considering the purchase of shares of our
common stock should carefully consider the following risk factors, in addition
to other information in this Quarterly Report on Form 10-Q and in our Annual
Report on Form 10-K for the year ended December 31, 2004. Additional risks and
uncertainties not presently known to us or that we currently deem immaterial
also may impair our business operations
Our revenue and operating results have fluctuated in the past and are likely to
fluctuate significantly in the future, particularly on a quarterly basis.
19
Our operating results may vary significantly from quarter to quarter
due to many factors, some of which are outside our control. For example, the
following conditions could all affect our results:
o changes in our product sales and customer mix;
o constraints in our manufacturing and assembling operations;
o shortages or increases in the prices of raw materials and components;
o changes in pricing policy by us or our competitors;
o a slowdown in the growth of the networking market;
o seasonality;
o timing of expenditures; and
o economic conditions in the United States, Europe and Asia.
Our sales often reflect orders shipped in the same quarter in which
they are received. In addition, significant portions of our expenses are
relatively fixed in nature, and planned expenditures are based primarily on
sales forecasts. Therefore, if we inaccurately forecast demand for our products,
the impact on net income may be magnified by our inability to adjust spending
quickly enough to compensate for the net sales shortfall.
Other factors contributing to fluctuations in our quarterly operating
results include:
o changes in the demand for our products;
o customer order deferrals in anticipation of new versions of our
products;
o the introduction of new products and product enhancements by us or our
competitors;
o the effects of filling the distribution channels following
introductions of new products and product enhancements;
o potential delays in the availability of announced or anticipated
products;
o the mix of product and revenue derived from the sale of extended
warranty contracts;
o the commencement or conclusion of significant development contracts;
o changes in foreign currency exchange rates; and
o the timing of significant marketing and sales promotions.
Based on the foregoing, we believe that quarterly operating results are
likely to vary significantly in the future and that period-to-period comparisons
of our results of operations are not necessarily meaningful and should not be
viewed as indications of future performance.
We have a history of losses and a large accumulated deficit.
We have experienced significant operating losses and, as of June 30,
2005, had an accumulated deficit of $19.9 million. Our development and marketing
of current and new products will continue to require substantial expenditures.
We incurred of losses in 2001 but since the third quarter of 2001, we have been
profitable. There can be no assurance that growth in net sales will be achieved
or profitability sustained in future years.
Recent FASB Exposure Draft on Share-Based Payments may have a significant effect
on our Results of Operations, if adopted.
In December 2004, the Financial Accounting Standards Board (FASB)
issued Statement No. 123 (revised 2004), "Share-Based Payment" (SFAS 123R). SFAS
123R addresses the accounting for transactions in which an enterprise receives
employee services in exchange for (i) equity instruments of the enterprise or
(ii) liabilities that are based on the fair value of the enterprises' equity
instruments or that may be settled by the issuance of such equity instruments.
SFAS 123R supersede APR No. 25 and will require that such transactions be
accounted for using a fair-value based method and that companies recognize an
expense for compensation cost related to share-based payment arrangements,
20
including stock option and employee stock purchase plans. SFAS 123R is effective
for the first annual period after June 15, 2005 and, therefore, we will be
implementing SFAS 123R on January 1, 2006.
As permitted by Statement 123R, we currently account for share-based
payments to employees using APB 25's intrinsic value method and, as such,
generally recognize no compensation cost for employee stock options.
Accordingly, the adoption of SFAS 123R fair value method will have an impact on
our result of operations, although it will not have an impact on our overall
financial or cash position. The impact of SFAS 123R on our operation results
cannot be predicted at this time, because that will depend on levels of
share-based payments granted in the future. Should we adopt the proposed
statement, it may have a significant impact on our consolidated statement of
operations as we will be required to expense the fair value of our stock options
rather than disclosing the impact on our consolidated net income within our
footnotes (See Note 4 of the notes to the condensed consolidated financial
statements).
The proposed standard would require the modified prospective method be
used, which would require that the fair value of new awards granted from the
beginning of the year of adoption plus unvested awards at the date of adoption
be expensed over the vesting term. In addition, the proposed statement
encourages companies to use the "binomial" approach to value stock options, as
opposed to the Black-Scholes option pricing model that is currently being used
for the fair value of our options.
Substantially all of our revenue comes from the sale of fax server products, and
a decline in demand for those products would harm our business, operating
results and financial condition.
We derive substantially all of our product revenue from the sale of fax
and print server products, with fax server products accounting for 100% of total
sales in 2004 and the first six months of 2005. We expect that our current
products will continue to account for most of our sales in the near future. A
decline in demand for our fax server products as a result of competition,
technological change, shortages of components or other factors, or a delay in
the development and market acceptance of new features and products, would have a
material adverse effect on our business, operating results and financial
condition.
We sell our products through a limited number of distributors, and any
deterioration in our relationship with those distributors would harm our
business, operating results and financial condition.
We sell our products primarily through a two-tier domestic and
international distribution network. Our distributors sell our products to VARs,
e-commerce vendors and other resellers. The distribution of personal computers
and networking products has been characterized by rapid change, including
consolidations due to the financial difficulties of distributors and the
emergence of alternative distribution channels. An increasing number of
companies are competing for access to these channels. Our distributors typically
represent other products that are complementary to, or compete with, our
products. Our distributors are not contractually committed to future purchases
of our products and could discontinue carrying our products at any time for any
reason. In addition, because we are dependent on a small number of distributors
for a significant portion of the sales of our products, the loss of any of our
major distributors or their inability to satisfy their payment obligations to us
could have a significant adverse effect on our business, operating results and
financial condition. We have a stock rotation policy with certain of our
distributors that allows them to return marketable inventory against offsetting
orders. If we reduce our prices, we credit certain distributors for the
difference between the purchase price of products remaining in their inventory
and our reduced price for these products. In addition, inventory levels of our
products held by distributors could become excessive due to industry conditions
or the actions of competitors, resulting in product returns and inventory
write-downs.
21
The market for our products is affected by rapidly changing technology and if we
fail to predict and respond to customers' changing needs, our business,
operating results and financial condition may suffer.
The market for our products is affected by rapidly changing networking
technology, evolving industry standards and the Internet and other new
communication technologies. We believe that our future success will depend upon
our ability to enhance our existing products and to identify, develop,
manufacture and introduce new products that:
o conform to or support emerging network telecommunications standards;
o are compatible with a growing array of computer and peripheral devices;
o support popular computer and network operating systems and applications;
o meet a wide range of evolving user needs; and
o achieve market acceptance.
There can be no assurance that we will be successful in these efforts.
We have incurred, and expect to continue to incur, substantial expenses
associated with the introduction and promotion of new products. There can be no
assurance that the expenses incurred will not exceed research and development
cost estimates or that new products will achieve market acceptance and generate
sales sufficient to offset development costs. In order to develop new products
successfully, we are dependent upon timely access to information about new
technological developments and standards. There can be no assurance that we will
have such access or will be able to develop new products successfully and
respond effectively to technological change or new product announcements by
others.
Complex products such as those offered by us may contain undetected or
unresolved hardware defects or software errors when they are first introduced or
as new versions are released. Changes in our or our suppliers' manufacturing
processes or the inadvertent use of defective components could adversely affect
our ability to achieve acceptable manufacturing yields and product reliability.
We have in the past discovered hardware defects and software errors in certain
of our new products and enhancements after their introduction. Replacement of
discontinued components used in our products could lead to further defects and
errors. There can be no assurance that despite testing by us and by third-party
test sites, errors and defects will not be found in future releases of our
products, which would result in adverse product reviews and negatively affect
market acceptance of these products.
The introduction of new or enhanced products requires us to manage the
transition from the older products to the new or enhanced products or versions,
both internally and for customers. We must manage new product introductions so
as to minimize disruption in customer ordering patterns, avoid excessive levels
of older product inventories and ensure that adequate supplies of new products
can be delivered to meet customer demands. We have from time to time experienced
delays in the shipment of new products. There can be no assurance that we will
successfully manage future product transitions.
Our success depends upon the continued contributions of our key management,
marketing, product development and operational personnel.
Our success will depend, to a large extent, upon our ability to retain
and continue to attract highly skilled personnel in management, marketing,
product development and operations. Competition for employees in the computer
and electronics industries is intense, and there can be no assurance that we
will be able to attract and retain enough qualified employees. Volatility or
lack of positive performance in our stock price may also adversely affect our
ability to retain and continue to attract key employees, many of whom have been
granted stock options. Our inability to retain and attract key employees could
22
have a material adverse effect on our product development, business, operating
results and financial condition. We do not carry key person life insurance with
respect to any of our personnel.
The markets for our products are highly competitive and may become more
competitive in the future.
The network enhancement products and computer software markets are
highly competitive, and we believe that competition will intensify in the
future. The competition is characterized by rapid change and improvements in
technology along with constant pressure to reduce the prices of products. We
currently compete principally in the market for network fax servers, network
print servers and fax-on-demand software. Both direct and indirect competition
could adversely affect our business and operating results through pricing
pressure, loss of market share and other factors. In particular, we expect that,
over time, average selling prices for our print server products will continue to
decline, as the market for these products becomes increasingly competitive. Any
material reduction in the average selling prices of our products would adversely
affect gross margins. There can be no assurance we will be able to maintain the
current average selling prices of our products or the related gross margins.
The principal competitive factors affecting the market for our products
include:
o product functionality;
o performance;
o quality;
o reliability;
o ease of use;
o quality of customer training and support;
o name recognition;
o price; and
o compatibility and conformance with industry standards and changing
operating system environments.
Several of our existing and potential competitors have substantially
greater financial, engineering, manufacturing and marketing resources than us.
We also experience competition from a number of other software, hardware and
service companies. In addition to our current competitors, we may face
substantial competition from new entrants into the network enhancement market,
including established and emerging computer, computer peripheral, communications
and software companies. In the fax server market we compete with companies such
as Captaris Inc., Omtool, Ltd. and Esker Software. There can be no assurance
that competitors will not introduce products incorporating technology more
advanced than the technology used by us in our products. In addition, certain
competing methods of communications such as the Internet or electronic mail
could adversely affect the market for fax products. Certain of our existing and
potential competitors in the print server market are manufacturers of printers
and other peripherals, and these competitors may develop closed systems
accessible only through their own proprietary servers. There can be no assurance
that we will be able to compete successfully or that competition will not have a
material adverse effect on our business, operating results and financial
condition.
We depend on sales in foreign markets, and political or economic changes in
these markets could affect our business, operating results and financial
condition.
Sales to customers located outside the United States accounted for
approximately 18%, 19% and 21% of our net sales for the years ended December 31,
2004, 2003 and 2002, respectively. We sell our products in approximately 44
foreign countries through approximately 89 distributors. Our principal Japanese
distributor accounted for approximately 39%, 38% and 27% of our international
sales in 2004, 2003 and 2002, respectively, and 7%, 7% and 6% of our total net
sales in 2004, 2003 and 2002,
23
respectively. We expect that international sales
will continue to represent a significant portion of our product revenues and
that we will be subject to the normal risks of international sales, such as
export laws, currency fluctuations, longer payment cycles, greater difficulties
in accounts receivable collections and the requirement of complying with a wide
variety of foreign laws. There can be no assurance that we will not experience
difficulties resulting from changes in foreign laws relating to the export of
our products in the future. In addition, because we primarily invoice foreign
sales in U.S. dollars, fluctuations in exchange rates could affect demand for
our products by causing prices to be out of line with products priced in the
local currency. Additionally, any such difficulties would have a material
adverse effect on our international sales and a resulting material adverse
effect on our business, operating results and financial condition. We may
experience fluctuations in European sales on a quarterly basis because European
sales may be weaker during the third quarter than the second quarter due to
extended holiday shutdowns in July and August. There can be no assurance that we
will be able to maintain the level of international sales in the future. Any
fluctuations in international sales will significantly affect our operating
results and financial condition.
The introduction of new products may reduce the demand for our existing products
and increase returns of existing products.
From time to time, we may announce new products, product versions,
capabilities or technologies that have the potential to replace or shorten the
life cycles of existing products. The release of a new product or product
version may result in the write-down of products in inventory if this inventory
becomes obsolete. We have in the past experienced increased returns of a
particular product version following the announcement of a planned release of a
new version of that product. There can be no assurance that product returns will
not exceed our allowance for these returns in the future and will not have a
material adverse effect on our business, operating results and financial
condition.
If we fail to obtain components of our products from third-party suppliers and
subcontractors, our business could suffer.
Our products require components procured from third-party suppliers.
Some of these components are available only from a single source or from limited
sources. In addition, we subcontract a substantial portion of our manufacturing
to third parties, and there can be no assurance that these subcontractors will
be able to support our manufacturing requirements. We purchase components on a
purchase order basis, and generally have no long-term contracts for these
components. If we are unable to obtain a sufficient supply of high-quality
components from our current sources, we could experience delays or reductions in
product shipments. From time to time, component manufacturers announce the end
of life of certain of their products and may or may not have replacement
products. If we are unable to secure enough inventories of the end-of-life
components or their replacements, we might not be able to deliver our products
to our customers and could adversely affect our revenue and net income.
Furthermore, a significant increase in the price of one or more of these
components or our inability to lower component or sub-assembly prices in
response to competitive price reductions could adversely affect our gross
margin.
We depend on proprietary technology, and inability to develop and protect this
technology or license it from third parties could adversely affect our business,
operating results and financial condition.
Our success depends to a certain extent upon our technological
expertise and proprietary software technology. We rely upon a combination of
contractual rights and copyright, trademark and trade secret laws to establish
and protect our technologies. Despite the precautions taken by us, it may be
possible for unauthorized third parties to copy our products or to reverse
engineer or obtain and use information that we regard as proprietary. In
addition, the laws of some foreign countries either do not protect our
24
proprietary rights or offer only limited protection. Given the rapid evolution
of technology and uncertainties in intellectual property law in the United
States and internationally, there can be no assurance that our current or future
products will not be subject to third-party claims of infringement. Any
litigation to determine the validity of any third-party claims could result in
significant expense and divert the efforts our technical and management
personnel, whether or not any litigation is determined in favor of us. In the
event of an adverse result in litigation, we could be required to expend
significant resources to develop non-infringing technology or to obtain licenses
to the technology that is the subject of the litigation. There can be no
assurance that we would be successful in this development or that any such
licenses would be available on commercially reasonable terms. We also rely on
technology licensed from third parties. There can be no assurance that these
licenses will continue to be available upon reasonable terms, if at all. Any
impairment or termination of our relationship with third-party licensors could
have a material adverse effect on our business, operating results and financial
condition. There can be no assurance that our precautions will be adequate to
deter misappropriation or infringement of our proprietary technologies.
We have received, and may receive in the future, communications
asserting that our products infringe the proprietary rights of third parties or
seeking indemnification against the alleged infringement. There can be no
assurance that third parties will not assert infringement claims against us with
respect to current or future products or that any assertion may not require us
to enter into royalty arrangements or result in costly litigation. Any claims,
with or without merit, can be time consuming and expensive to defend. There can
be no assurance that any intellectual property litigation will not have a
material adverse effect on our business, operating results and financial
condition.
Our common stock is listed on the Nasdaq SmallCap Market, and we have had
difficulty satisfying the listing criteria to avoid the delisting of our common
stock.
Our common stock has been listed on the Nasdaq SmallCap Market since
April 1999. In order to maintain our listing on the Nasdaq SmallCap Market, we
must maintain total assets, capital and public float at specified levels, and
our common stock generally must maintain a minimum bid price of $1.00 per share.
If we fail to maintain the standards necessary to be quoted on the Nasdaq
SmallCap Market, our common stock could become subject to delisting. There can
be no assurance that we will be able to maintain the $1.00 minimum bid price per
share of our common stock and thus maintain our listing on the Nasdaq SmallCap
Market. We have traded below $1.00 as recently as December 2002.
If our common stock is delisted, trading in our common stock could be
conducted on the OTC Bulletin Board or in the over-the-counter market in what is
commonly referred to as the "pink sheets." If this occurs, a shareholder will
find it more difficult to dispose of our common stock or to obtain accurate
quotations as to the price of our common stock. Lack of any active trading
market would have an adverse effect on a shareholder's ability to liquidate an
investment in our common stock easily and quickly at a reasonable price. It
might also contribute to volatility in the market price of our common stock and
could adversely affect our ability to raise additional equity or debt financing
on acceptable terms or at all. Failure to obtain desired financing on acceptable
terms could adversely affect our business, financial condition and results of
operations.
Our stock price has been volatile, and is likely to continue to be volatile in
the future.
The price of our common stock has fluctuated widely in the past. Sales
of substantial amounts of our common stock, or the perception that sales could
occur, could adversely affect prevailing market prices for our common stock. Our
management believes past fluctuations may have been caused by the factors
identified above, and that these factors may continue to affect the market price
of our common stock. Additionally, stock markets have experienced extreme price
volatility in recent years. This volatility has had a substantial effect on the
market price of the common stock of us and other high
25
technology companies,
often for reasons unrelated to operating performance. We anticipate that prices
for our common stock may continue to be volatile. Future stock price volatility
may result in the initiation of securities litigation against us, which may
divert substantial management and financial resources and have an adverse effect
on our business, operating results and financial condition.
We may require additional capital in the future, and may be unable to obtain
this capital at all or on commercially reasonable terms.
The development and marketing of products requires significant amounts
of capital. If we need additional capital resources, we may be required to sell
additional equity or debt securities, secure additional lines of credit or
obtain other third party financing. The timing and amount of such capital
requirements cannot be determined at this time and will depend on a number of
factors, including demand for our existing and new products and changes in
technology in the networking industry. There can be no assurance that additional
financing will be available on satisfactory terms when needed, if at all.
Failure to raise such additional financing, if needed, may result in our
inability to achieve our long-term business objectives. The issuance of equity
or convertible debt securities to raise additional capital would result in
additional dilution to our shareholders.
Government regulation could increase our costs of doing business and adversely
affect our gross margin.
Certain aspects of the networking industry in which we compete are
regulated both in the United States and in foreign countries. Imposition of
public carrier tariffs, taxation of telecommunications services and the
necessity of incurring substantial costs and expenditure of managerial resources
to obtain regulatory approvals, or the inability to obtain regulatory approvals
within a reasonable period of time, could have a material, adverse effect on our
business, operating results and financial condition. This is particularly true
in foreign countries where telecommunications standards differ from those in the
United States. Our products must comply with a variety of equipment, interface
and installation standards promulgated by communications regulatory authorities
in different countries. Changes in government policies, regulations and
interface standards could require the redesign of products and result in product
shipment delays which could have a material, adverse impact on our business,
operating results and financial condition.
The costs of compliance with recent developments in corporate governance
regulation may affect our business, operating results and financial condition in
ways that presently cannot be predicted.
Beginning with the enactment of the Sarbanes-Oxley Act of 2002, a
significant number of new corporate governance requirements have been adopted or
proposed through legislation and regulation by the Securities and Exchange
Commission and Nasdaq National Stock Market. We may not be successful in
complying with these requirements at all times in the future. Additionally, we
expect these developments to increase our legal compliance and accounting costs,
and to make some activities more difficult, such as stockholder approval of new
stock option plans. We expect these developments to make it more difficult and
more expensive for us to obtain director and officer liability insurance, and we
may be required to accept reduced coverage or incur substantially higher costs
to obtain coverage. These developments could make it more difficult for us to
attract and retain qualified members of our Board of Directors, or qualified
executive officers. We are presently evaluating and monitoring regulatory
developments and cannot estimate the timing or magnitude of additional costs we
may incur as a result, or the effect that these increased costs may have on our
operating results.
26
Recent terrorist activity in the United States and the military action to
counter terrorism could adversely impact our business.
Terrorist acts or acts of war (wherever located around the world) could
significantly impact our revenue, costs and expenses, and financial condition.
The terrorist attacks that took place in the United States on September 11, 2001
have created many economic and political uncertainties, some of which may
materially harm our business, operating results and financial condition. The
long-term effects on our business of the September 11, 2001 attacks and the
ensuing war on terror are unknown. The potential for future terrorist attacks,
the national and international responses to terrorist attacks or perceived
threats to national security, and other actual or potential conflicts, acts of
war or hostility, including the United States' activities in Iraq, have created
many economic and political uncertainties that could adversely affect our
business, operating results and financial condition in ways that cannot
presently be predicted.
Provisions in our charter documents might deter a company from acquiring us,
which could inhibit your ability to receive an acquisition premium for your
shares.
Our Board of Directors has authority to issue shares of preferred stock
and to fix the rights, including voting rights, of these shares without any
further vote or action by the shareholders. The rights of the holders of our
common stock will be subject to, and may be adversely affected by, the rights of
the holders of any preferred stock that may be issued in the future. The
issuance of preferred stock, while providing desirable flexibility in connection
with possible acquisitions and other corporate purposes, could have the effect
of making it more difficult for a third party to acquire a majority of our
outstanding voting stock, thereby delaying, deferring or preventing a change in
control. Furthermore, such preferred stock may have other rights, including
economic rights, senior to the common stock, and as a result, the issuance
thereof could have a material adverse effect on the market.
Voting control by officers, directors and affiliates may delay, defer or prevent
a change of control.
At July 25, 2005, our officers and directors and their affiliates
beneficially owned approximately 24% of the outstanding shares of common stock.
Accordingly, together they had the ability to significantly influence the
election of our directors and other corporate actions requiring shareholder
approval. Such concentration of ownership may have the effect of delaying,
deferring or preventing a change in control.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We had no holdings of derivative financial or commodity instruments at
June 30, 2005. However, we are exposed to financial market risks, including
changes in interest rates and foreign currency exchange rates. While much of our
revenue is transacted in U.S. dollars, some revenues and capital spending are
transacted in Pounds Sterling. These amounts are not currently material to our
financial statements. Therefore, we believe that foreign currency exchange rates
should not materially affect our overall financial position, results of
operations or cash flows. The fair value of our money market accounts or related
income would not be significantly impacted by increases or decreases in interest
rates due mainly to the highly liquid nature of this investment. However, sharp
declines in interest rates could seriously harm interest earnings.
27
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Regulations under the Securities Exchange Act of 1934 require public
companies, including our company, to maintain "disclosure controls and
procedures," which are defined to mean a company's controls and other procedures
that are designed to ensure that information required to be disclosed in the
reports that it files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized, and reported, within the time periods specified
in the Securities and Exchange Commission's rules and forms. Our Chief Executive
Officer and our Chief Financial Officer, based on their evaluation of our
disclosure controls and procedures as of the end of the period covered by this
report, concluded that our disclosure controls and procedures were effective for
this purpose.
Regulations under the Securities Exchange Act of 1934 require public
companies, including our company, to evaluate any change in our "internal
control over financial reporting," which is defined as a process to provide
reasonable assurance regarding the reliability of financial reporting and
preparation of financial statements for external purposes in accordance with
accounting principles generally accepted in the United States. In connection
with their evaluation of our disclosure controls and procedures as of the end of
the period covered by this report, our Chief Executive Officer and Chief
Financial Officer did not identify any change in our internal control over
financial reporting during the three-month period ended June 30, 2005 that
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
In designing and evaluating our disclosure controls and procedures, our
management recognized that any controls and procedures, no matter how well
designed and operated, can provide only reasonable assurance of achieving their
objectives, and our management necessarily applied its judgment in evaluating
the cost-benefit relationship of possible controls and procedures.
28
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We held our Annual Meeting of Shareholders on May 27, 2005. At the
meeting, our shareholders voted on the following two proposals and
cast their votes as follows:
Proposal 1: To elect the following nominees as directors:
Nominee For Withheld
---------------------------- ---------------- -----------------
Donald L. Rich 3,147,434 65,300
Scott C. McDonald 3,197,389 15,345
Peter R. Tierney 3,155,569 57,165
Robert H. Hambrecht 3,149,434 63,300
Robert O. Smith 3,204,523 8,211
Proposal 2: To ratify the appointment of Grant Thornton LLP as our
independent registered public accounting firm for the 2005 fiscal
year:
For Against Abstain
--------------------- --------------------- --------------------
3,193,934 17,200 1,600
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
In accordance with SEC Release No. 33-8212, Exhibits 32.1 and 32.2
are to be treated as "accompanying" this report rather than "filed"
as part of the report.
10.1 Amendment to Silicon Valley Bank Loan Agreement
31.1 Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer
31.2 Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer
32.1 Section 1350 Certification of Principal Executive Officer
32.2 Section 1350 Certification of Principal Financial Officer
29
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
CASTELLE
By: /s/ Scott C. McDonald Date: August 5, 2005
Scott C. McDonald
Chief Executive Officer and President
(Principal Executive Officer)
By: /s/ Paul Cheng Date: August 5, 2005
Paul Cheng
Vice President of Finance and Administration
Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
30
EXHIBIT INDEX
Exhibit Description
Number
--------------------------------------------------------------------------------------------------
10.1 Amendment to Silicon Valley Bank Loan Agreement
31.1 Rule 13a-14(a)/15d-14(a) Certification of Principal Executive
Officer
31.2 Rule 13a-14(a)/15d-14(a) Certification of Principal Financial
Officer
32.1 Section 1350 Certification of Principal Executive Officer
32.2 Section 1350 Certification of Principal Financial Officer
31