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 March 31, 2002
|_| 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 __
The number of shares of Common Stock outstanding as of May 7, 2002 was
4,744,795.
CASTELLE
FORM 10-Q
TABLE OF CONTENTS
PAGE
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS 2
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements:
Consolidated Balance Sheets 3
Consolidated Statements of Income 4
Consolidated Statements of Cash Flows 5
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 11
Item 3 Quantitative and Qualitative Disclosures About Market Risk 14
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 15
Item 2. Changes in Securities and Use of Proceeds 15
Item 3. Defaults Upon Senior Securities 15
Item 4. Submission of Matters to a Vote of Security Holders 15
Item 5. Other Information 15
Item 6. Exhibits and Reports on Form 8-K 23
Signatures 24
Exhibit 10.1 - Employment Agreement Between the Company
and Scott C. McDonald E-1
Exhibit 10.2 - Executive Severance and Transition Benefits Agreement
between the Company and Scott C. McDonald E-5
Exhibit 99.1 - Press Release dated May 1, 2002 E-15
Reports on Form 8-K - Retirement of Donald L. Rich and Appointment
of Scott C. McDonald as CEO dated April 22, 2002
1
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This document contains forward-looking statements that involve risks and
uncertainties. The Company's operating results may vary significantly from
quarter to quarter due to a variety of factors, including changes in the
Company's product and customer mix, constraints in the Company's manufacturing
and assembling operations, shortages or increases in the prices of raw materials
and components, changes in pricing policy by the Company or its 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 the Company assumes 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 the Company's Annual Report on Form 10-K and
Form 10-K/A for the fiscal year ended December 31, 2001.
2
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
CASTELLE
CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands)
March 31, 2002 December 31, 2001
---------------------- --------------------
Assets:
Current assets:
Cash and cash equivalents $ 4,462 $ 4,568
Accounts receivable, net of allowance for doubtful accounts
of $224 in 2002 and $206 in 2001 758 680
Inventories, net 774 926
Prepaid expense and other current assets 116 130
---------------------- --------------------
Total current assets 6,110 6,304
Property, plant & equipment, net 546 598
Other non-current assets 108 108
---------------------- --------------------
Total assets $ 6,764 $ 7,010
====================== ====================
Liabilities & Shareholders' Equity:
Current liabilities:
Long-term debt, current portion $ 18 $ 18
Accounts payable 138 280
Accrued liabilities 2,314 2,446
---------------------- --------------------
Total current liabilities 2,470 2,744
Long term debt, net of current portion 60 64
---------------------- --------------------
Total liabilities 2,530 2,808
---------------------- --------------------
Shareholders' equity:
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 4,745 28,976 28,977
Deferred compensation - (1)
Accumulated deficit (24,742) (24,774)
---------------------- --------------------
Total shareholders' equity 4,234 4,202
---------------------- --------------------
Total liabilities & shareholders' equity $ 6,764 $ 7,010
====================== ====================
See accompanying notes to consolidated financial statements.
3
CASTELLE
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)
Three months ended
......................................
March 31, 2002 March 30, 2001
----------------- ------------------
Net sales $ 2,368 $ 2,293
Cost of sales 777 698
----------------- ------------------
Gross profit 1,591 1,595
----------------- ------------------
Operating expenses:
Research and development 413 385
Sales and marketing 763 1,070
General and administrative 404 444
Restructuring charges - 180
----------------- ------------------
Total operating expenses 1,580 2,079
----------------- ------------------
Income/(loss) from operations 11 (484)
Interest income, net 10 33
Other income, net 11 43
----------------- ------------------
Income/(loss) before provision for income taxes 32 (408)
Provision for income taxes - -
----------------- ------------------
Net income/(loss) $ 32 $ (408)
================= ==================
Earnings per share:
Net income/(loss) per common share - basic $ 0.01 $ (0.09)
Shares used in per share calculation - basic 4,745 4,741
Net income/(loss) per common share - diluted $ 0.01 $ (0.09)
Shares used in per share calculation - diluted 4,774 4,741
See accompanying notes to consolidated financial statements..
4
CASTELLE
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Three months ended
......................................
March 31, 2002 March 30, 2001
----------------- ------------------
Cash flows from operating activities:
Net income (loss) $ 32 $ (408)
Adjustment to reconcile net income (loss) to net cash
provided by/(used in) operating activities:
Depreciation and amortization 54 64
Provision for doubtful accounts and sales returns 111 134
Provision for excess and obsolete inventory ( 50) 72
Compensation expense related to grant of stock options - 4
Loss on disposal of fixed assets 1 -
Changes in assets and liabilities:
Accounts receivable (189) 652
Inventories 202 (222)
Prepaid expenses and other current assets 14 (20)
Accounts payable (142) (491)
Accrued liabilities (132) (176)
Decrease in other assets - 2
----------------- ------------------
Net cash used in operating activities (99) (389)
----------------- ------------------
Cash flows from investing activities:
Return of restricted cash - 125
Acquisition of property, plant and equipment (3) (56)
----------------- ------------------
Net cash provided by/(used in) investing activities (3) 69
----------------- ------------------
Cash flows from financing activities:
Repayment of long-term debt (4) (2)
----------------- ------------------
Net cash used in financing activities (4) (2)
----------------- ------------------
Net decrease in cash and cash equivalents (106) (322)
Cash and cash equivalents at beginning of period 4,568 3,893
----------------- ------------------
Cash and cash equivalents at end of period $ 4,462 $ 3,571
================= ==================
See accompanying notes to consolidated financial statements.
5
CASTELLE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation and Significant Accounting Policies:
----------------------------------------------------------
The accompanying unaudited consolidated financial statements include the
accounts of Castelle and its wholly-owned subsidiaries in the United
Kingdom and the Netherlands, and 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 the
opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation of the Company's
financial position, results of operations and cash flows at the dates and
for the periods indicated have been included. The results of operations for
the interim period presented are not necessarily indicative of the results
for the year ending December 31, 2001. Because all of the disclosures
required by accounting principles generally accepted in the United States
of America are not included in the accompanying 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 and Form 10-K/A for the fiscal year-ended December 31,
2001. The year ended condensed balance sheet data 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 income statements for the periods presented are not
necessarily indicative of results that we expect for any future period, nor
for the entire year. Prior year amounts have been reclassified to conform
with current presentation.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management 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.
The Company believes that its existing cash balances, anticipated cash
flows from operations and available lines of credit will be sufficient to
meet its anticipated capital requirements for the next 12 months. However,
a decline in future orders and revenues might require us to seek additional
capital to meet our working capital needs during or beyond the next twelve
months if we are unable to reduce expenses to the degree necessary to avoid
incurring losses. 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 the
Company's 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.
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 the Company is dependent on a small number of
distributors for a significant portion of the sales of its products, the
loss of any of the Company's major distributors or their inability to
satisfy their payment obligations to the Company could have a significant
adverse effect on the Company's business, operating results and financial
condition.
6
Revenue Recognition
Castelle recognizes revenue based on the provisions of Staff Accounting
Bulletin ("SAB") No. 101 "Revenue Recognition in Financial Statements" and
Statement of Financial Accounting Standards ("SFAS") No. 48 "Revenue
Recognition When Right of Return Exists".
Product revenue is recognized upon shipment if a signed contract exists,
the fee is fixed and determinable, collection of the resulting receivables
is probable and product returns are reasonably estimable. Shipment
generally occurs when product is delivered to a common carrier.
The Company enters into agreements with certain of its distributors which
permit limited stock rotation rights. These stock rotation rights allow the
distributor to return products for credit but require the purchase of
additional products of equal value. Customers who purchase the Company's
products directly from Castelle also have limited return rights, which
expire thirty days from the date of product shipment. Revenues subject to
stock rotation rights are reduced by management's estimates of anticipated
exchanges. Castelle establishes its returns allowance policy for
distributors based on historic return rates from these distributors.
Pursuant to the Company's distributor agreements, the Company also protects
its distributors' exposure related to the impact of price reductions. Price
adjustments are recorded at the time products are shipped. Castelle
estimates the impact of price reductions based on historical data from
these distributors.
The Company recognizes revenue from the sale of extended warranty contracts
ratably over the period of the contracts.
Castelle recognizes royalty on the sale of LANpress products by a Japanese
distributor. Royalty is not recognized as revenue until the products are
sold by the distributor.
Provisions for estimated warranty costs are recorded at the time products
are shipped.
2. Accounting Changes
Effective January 1, 2002, Castelle has redefined its fiscal quarter and
year end for financial reporting purposes to conform with calendar month
ends, i.e., ending on March 31, June 30, September 30 and December 31.
Previously, Castelle set its fiscal quarter as ending on the Friday of the
thirteenth week into the quarter. Castelle believes that the financial
numbers presented below have no significant impact for comparative purposes
due to this change.
Effective January 1, 2002, Castelle implemented Emerging Issues Task Force
No. 01-09, Accounting for Consideration Given by a Vendor to a Customer
(Including a Reseller of the Vendor's Products) ("EITF 01-09"), which
requires that consideration paid by a vendor to a reseller should be
classified on the vendor's income statement as a reduction of sales unless
an identifiable benefit can be matched to the consideration, the benefit
can be valued and the consideration does not exceed such value. Since
Castelle was unable to clearly separate the benefits received from certain
marketing development funds it paid to its resellers, these costs have been
reclassified as a reduction of sales, and financial statements for prior
periods presented for comparative purposes has been reclassified to comply
with the new accounting standard. The effect of the implementation of this
new accounting standard was a reduction of sales of $88,000 and $56,000 in
the first fiscal quarters of 2002 and 2001, respectively, with an
equivalent reduction in operating expenses. The new accounting standard has
7
no impact on the Company's operating margin, net income or earnings per
share. The table below reflects the impact of this new accounting standard
on fiscal 2001 revenues.
2001 SALES - RESTATED FOR EITF 01-09
(in thousands, unaudited)
QUARTER ENDED
Mar 30 Jun 29 Sep 28 Dec 31 TOTAL YEAR
------------- ------------ ------------ ------------ ----------------
Sales:
Original $2,349 $2,370 $2,559 $2,342 $9,620
Restated $2,293 $2,313 $2,500 $2,248 $9,354
Difference ($56) ($57) ($59) ($94) ($266)
3. Net Income/(Loss) Per Share:
Basic net income/(loss) per share is computed by dividing net income/(loss)
available to common shareholders by the weighted average number of common
shares outstanding for that 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 loss
per share excludes shares that are potentially dilutive as their effect is
anti-dilutive. Shares that are potentially dilutive consist of incremental
common shares issuable upon exercise of stock options and warrants.
Basic and diluted earnings per share are calculated as follows for first
quarters of fiscal 2002 and 2001:
(in thousands,
except per share amounts)
(unaudited)
.........................................
March 31, 2002 March 30, 2001
----------------------------------------
Basic:
Weighted average common shares outstanding 4,745 4,741
=========================================
Net income/(loss) $ 32 $ (408)
=========================================
Net income/(loss) per common share - basic $ 0.01 $ (0.09)
=========================================
Diluted:
Weighted average common shares outstanding 4,745 4,741
Common equivalent shares from stock options 29 -
-----------------------------------------
Shares used in per share calculation - diluted 4,774 4,741
=========================================
Net income/(loss) $ 32 $ (408)
=========================================
Net income/(loss) per common share - diluted $ 0.01 $ (0.09)
=========================================
The calculation of diluted shares outstanding excludes 1,235,000 and
1,314,000 shares of common stock issuable upon exercise of outstanding
stock options at March 31, 2002 and March 30, 2001, respectively, as their
effect was antidilutive in the periods.
4. Inventories:
------------
Inventories are stated at the lower of standard cost (which approximates
cost on a first-in, first-out basis) or market and net of reserves for
excess and obsolete inventory. Inventory details are as follows:
8
(in thousands)
(unaudited)
...............................................
March 31, 2002 December 31, 2001
----------------------- -----------------------
Raw material $ 220 $ 295
Work in process 171 182
Finished goods 832 978
Inventory Reserve (449) (529)
-----------------------------------------------
Total Inventory, net $ 774 $ 926
===============================================
5. Segmental Disclosure:
The Company has determined that it operates in one segment. Revenues by
geographic area are determined by the location of the end user and are
summarized as follows (in thousands):
(in thousands)
(unaudited)
..........................................
March 31, 2002 March 30, 2001
------------------------------------------
North America $ 1,978 $ 1,842
Europe 232 319
Pacific Rim 158 132
-------------------------------------------
Total Revenue $ 2,368 $ 2,293
===========================================
6. Comprehensive Income:
Under SFAS No. 130, "Reporting Comprehensive Income" disclosure of
comprehensive income and its components is required in financial
statements. 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.
7. New accounting pronouncements:
In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141, "Business Combinations." SFAS 141 requires the purchase method of
accounting for business combinations initiated after June 30, 2001 and
eliminates the pooling-of-interests method. The adoption of SFAS 141 has
not had a significant impact on the Company's financial statements.
In July 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets," which is effective for fiscal years beginning after March 15,
2001. SFAS 142 requires, among other things, the discontinuance of goodwill
amortization. In addition, the standard includes provisions upon adoption
for the reclassification of certain existing recognized intangibles as
goodwill, reassessment of the useful lives of existing recognized
intangibles, reclassification of certain intangibles out of previously
reported goodwill and the testing for impairment of existing goodwill and
other intangibles. The adoption of SFAS 142 has not had a significant
impact on the Company's financial statements.
9
In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS 144 supercedes SFAS 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of." SFAS 144 applies to all long-lived assets
(including discontinued operations) and consequently amends Accounting
Principles Board Opinion No. 30. SFAS 144 develops one accounting model for
long-lived assets that are to be disposed of by sale. SFAS 144 requires
that long-lived assets that are to be disposed of by sale be measured at
the lower of book value or fair value less cost to sell. Additionally, SFAS
144 expands the scope of discontinued operations to include all components
of an entity with operations that (1) can be distinguished from the rest of
the entity and (2) will be eliminated from the ongoing operations of the
entity in a disposal transaction. SFAS 144 is effective for the Company for
all financial statements issued in fiscal 2002. The adoption of SFAS 144
has not had a significant impact on the Company's financial statements.
In November 2001, the Emerging Issues Task Force ("EITF") reached consensus
on EITF No. 01-9, "Accounting for Consideration Given by a Vendor to a
Customer or Reseller of the Vendor's Products." EITF No. 01-9 addresses the
accounting for consideration given by a vendor to a customer and is a
codification of EITF No. 00-14, "Accounting for Certain Sales Incentives",
EITF No. 00-22, "Accounting for 'Points' and Certain Other Time-Based or
Volume-Based Sales Incentives Offers and Offers for Free Products or
Services to be Delivered in the Future", and EITF No. 00-25, "Vendor Income
Statement Characterization of Consideration Paid to a Reseller of the
Vendor's Products." EITF 01-09 presumes that consideration from a vendor to
a customer or reseller of the vendor's products to be a reduction of the
selling prices of the vendor's products and, therefore, should be
characterized as a reduction of revenue when recognized in the vendor's
income statement and could lead to negative revenue under certain
circumstances. Revenue reduction is required unless consideration relates
to a separate identifiable benefit and the benefit's fair value can be
established. This issue should be applied no later than in annual or
interim financial statements for periods beginning after December 15, 2001,
which is the Company's first quarter ended March 31, 2002. Upon adoption,
the Company is required to reclassify all prior period amounts to conform
to the current period presentation. The Company has implemented this
accounting standard in its fiscal quarter ended March 31, 2002 and has
restated its prior year numbers for comparative purposes (see Note 2).
10
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" at the front on this Form 10-Q. The
following discussion should be read in conjunction with the Financial Statements
and the Notes thereto included in Item 1 of this Quarterly Report on Form 10-Q
and in the Company's Form 10-K and Form 10-K/A for the fiscal year ended
December 31, 2001.
Critical Accounting Policies
Castelle's financial statements and accompanying notes are prepared in
accordance with generally accepted accounting principles in the United States.
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 Castelle
include revenue recognition; credit, collection and allowances for doubtful
accounts and inventories and related allowance for obsolete and excess
inventory, which are discussed in more details under the caption "Critical
Accounting Policies" in the Company's Annual Report on Form 10-K and Form 10-K/A
for the fiscal year ended December 31, 2001.
Consolidated Statements of Income - As a Percentage of Net Sales
(unaudited)
THREE MONTHS ENDED
......................................
March 31, 2002 March 30, 2001
------------------ ------------------
Net sales 100% 100%
Cost of sales 33% 30%
------------------ ------------------
Gross profit 67% 70%
------------------ ------------------
Operating expenses:
Research and development 17% 17%
Sales and marketing 32% 47%
General and administrative 17% 19%
Restructuring charges -- 8%
------------------ ------------------
Total operating expense 66% 91%
Income/(loss) from operations * (21%)
Interest income, net * 1%
Other income, net * 2%
------------------ ------------------
Income/(loss) before provision for income taxes 1% (18%)
Provision for income taxes -- *
------------------ ------------------
Net Income/(loss) 1% (18%)
================== ==================
* Less than 1%
11
Results of Operations
Net Sales
Net sales for the first quarter of fiscal 2002 were $2.4 million,
as compared to $2.3 million for the same period in fiscal 2001. This
moderate increase was primarily attributable to an increase in shipments of
our products to domestic channels of $130,000, offset partially by a
decrease in shipments to the international regions of $55,000.
Sales in the first quarter of fiscal 2002 reflected the
implementation of the new accounting rule, EITF No. 01-09, related to the
classification of certain marketing development funds as reductions to
revenue rather than as operating expenses. The effect of this change to
sales was a reduction of $88,000 and $56,000 in the first quarters of
fiscal 2002 and 2001, respectively, with a corresponding reduction in
operating expenses.
Domestic sales in the first quarter of fiscal 2002 were $2.0
million as compared to $1.8 million for the same period in fiscal 2001,
representing 83% and 80%, respectively, of total net sales. Shipments of
both of our fax server products and print server products in the first
quarter of fiscal 2002 increased slightly over the same period last year.
International sales in the first quarter of fiscal 2002 were
$390,000 as compared to $451,000 for the same period in fiscal 2001,
representing 17% and 20%, respectively, of total net sales. The shortfall
was primarily due to lower sales of our fax server products to the European
channels.
Cost of Sales; Gross Profit
Gross profit was $1.6 million, or 67% of net sales, for the first
quarter of fiscal 2002, as compared to $1.6 million, or 70% of net sales
for the same period in fiscal 2001. The lower gross profit percentage in
the first quarter of fiscal 2002 was primarily due to the mix of products
sold at a slightly lower average selling price. The change in gross profit
percentage due to the implementation of EITF No. 01-09 was a reduction of
1.2% and 0.7% in the first quarters of fiscal 2002 and 2001, respectively.
Research & Development
Research and product development expenses were $413,000 or 17% of
net sales for the first quarter of fiscal 2002, as compared to $385,000 or
17% of net sales for the same period in fiscal 2001. The increase was
primarily due to an increase in compensation of $94,000 due to additional
personnel, offset in part by a decrease in outside consulting and other
office expenses of $62,000.
Sales & Marketing
Sales and marketing expenses were $763,000 or 32% of net sales for
the first quarter of fiscal 2002 as compared to $1.1 million or 47% of net
sales for the same period in fiscal 2001. Sales and marketing expenses in
the first quarters of fiscal 2002 and 2001 have been reduced by $88,000 and
$56,000 due to the implementation of EITF 01-09. The other reduction in
sales and marketing expenses were primarily associated with a decrease in
compensation expenses of $121,000 and a decrease in advertising and
promotion expenses of $119,000.
12
General & Administrative
General and administrative expenses were $404,000 or 17% of net
sales for the first quarter of fiscal 2002, as compared to $444,000 or 19%
of net sales for the first quarter of fiscal 2001. The lower general and
administrative expenses were largely attributable to a decrease in employee
compensation of $43,000 and provision for doubtful accounts of $34,000,
offset partially by an increase in legal and accounting fees of $25,000.
Restructuring
In response to the continuing economic slowdown and decrease in demand
for our products, we terminated 17 regular, temporary and contractor
positions in April 2001, which constituted approximately 25% of our
workforce. This action resulted in a severance charge of $239,000 in fiscal
2001 of which $180,000 was incurred in the first quarter. The restructuring
included an asset write-off and other direct expenses associated with the
consolidation of our operations in the United Kingdom and El Dorado Hills,
California. As of March 31, 2002, remaining restructuring costs were
$40,000. The movement of the reserve balance from $89,000 at December 31,
2001 was primarily due to cash payments against severance of $36,000 and
other costs of $13,000. The Company believes that these costs will be
incurred during fiscal 2002.
Liquidity and Capital Resources
As of March 30, 2002, we had approximately $4.5 million of cash and
cash equivalents, an increase of $891,000 from March 31, 2001 and a decrease of
$106,000 from December 31, 2001. The increase in cash and cash equivalents from
March 30, 2001 was mostly attributable to operating cash inflows of $933,000
from improved collection of outstanding balances owed to us by our customers,
reduced inventory to meet the current revenue projections, offset in part by
more timely payments to our vendors. The decrease of cash and cash equivalents
from December 31, 2001 was mainly due to cash used in operating activities of
$99,000. Working capital of $3.6 million at March 31, 2002 was consistent with
the balance at March 30, 2001 and December 31, 2001.
In August 2000, we entered into a lease for a new facility in Morgan
Hill, California and relocated our corporate headquarters in December 2000 after
our former lease at the Santa Clara, California location expired at the same
time. The lease on the Morgan Hill facility has a term of five years, expiring
in December 2005, with one conditional three-year option, which if exercised
would extend the lease to December 2008 commencing with rent at ninety-five
percent of fair market value. As of March 31, 2002, the future minimum payments
under the lease were $979,000.
In December 2000, as a source of capital asset financing, we entered
into a loan and security agreement with a finance company for an amount of
$75,000. This loan is subject to interest of 12.8% and is repayable by December
2006. As of March 31, 2002, the aggregate value of future minimum payments was
$81,000.
In April 2001, as a source of capital asset financing, we entered into
a loan and security agreement with a finance company for an amount of $25,000.
This loan is subject to interest of 12.5% and is repayable by April 2004. As of
March 31, 2002, the aggregate value of future minimum payments was $20,000.
In addition to the commitments shown above, we have a $3.0 million
collateralized revolving line of credit with a bank, which expires in March
2003, pursuant to which we may borrow 100% against pledges of cash at the bank's
prime rate. Borrowings under this line of credit agreement are collateralized by
all of our assets. We are in compliance with the terms of the agreement, and as
of March 31, 2002, had no borrowings under the line of credit.
13
As of March 31, 2002, net accounts receivable were $758,000, slightly
higher than the balance as of December 31, 2001 of $680,000. The increase in net
accounts receivable was primarily attributed to higher sales at the end of the
first quarter of fiscal 2002.
Net inventories as of March 31, 2002 were $774,000, as compared to the
balance of $926,000 as of December 31, 2001. The reduction in inventory was
mainly due to more components being used up in production as compared to
purchases in the same period. Inventory turnover for the first fiscal quarter of
2002 improved to an equivalent of 4.0 turns per year from 3.4 turns per year in
the prior quarter.
Although we believe that our existing capital resources, anticipated
cash flows from operations and available lines of credit will be sufficient to
meet our capital requirements for at least the next 12 months, we may be
required to seek additional equity or debt 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 the
pace of technological change in the networking industry. There can be no
assurance that such additional financing will be available on satisfactory terms
when needed, if at all.
We believe that, for the periods presented, inflation has not had a
material effect on our operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We considered the provision of Financial Reporting Release No. 48
"Disclosure of Accounting Policies for Derivative Financial Instruments and
Derivative Commodity Instruments, and Disclosure of Quantitative and Qualitative
Information about Market Risk Inherent in Derivative Financial Instruments,
Other Financial Instruments and Derivative Commodity Instruments." We had no
holdings of derivative financial or commodity instruments at March 31, 2002.
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 account 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 on this account. The Company
believes that there have been no material changes in the reported market risks
faced by the Company since the fiscal year ended December 31, 2001. These and
other risk factors are discussed below under the caption "Risk Factors" and
elsewhere in this Quarterly Report on Form 10-Q and in our Form 10-K and Form
10-K/A for the fiscal year ended December 31, 2001 under the section "Risk
Factors".
14
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company has been contacted by a third party claiming that the
Company needs to obtain licenses of certain patents held by that party for
certain of the Company's fax server products. The Company is continuing to
assess the validity and strength of the claims, believes it has adequate legal
defenses and that the ultimate outcome of any possible action will not have a
material effect on the Company's financial position, results of operations or
cash flows although there can be no assurance as to the outcome of any possible
litigation.
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
None.
ITEM 5. OTHER INFORMATION
RISK FACTORS
The risks and uncertainties described below are not the only ones
facing the Company. Additional risks and uncertainties not presently known to
the Company or that the Company currently deems immaterial also may impair the
Company's business operations. If any of the following risks or such other risks
actually occur, our business could be adversely affected.
Fluctuations in Operating Results
The Company's revenue and operating results have fluctuated in the past
and the Company's future revenues and operating results are likely to fluctuate
significantly in the future, particularly on a quarterly basis.
The Company's operating results may vary significantly from quarter to
quarter due to a variety of factors, some of which are outside the control of
the Company, including changes in the Company's product and customer mix,
constraints in the Company's manufacturing and assembling operations, shortages
or increases in the prices of raw materials and components, changes in pricing
policy by the Company or its competitors, a slowdown in the growth of the
networking market, seasonality, timing of expenditures and economic conditions
in the United States, Europe and Asia. The Company's sales will often reflect
orders shipped in the same quarter in which they are received. The Company's
backlog at any given time is not necessarily indicative of actual sales for any
succeeding period. In addition, significant portions of the Company's expenses
are relatively fixed in nature, and planned expenditures are based primarily on
sales forecasts. Therefore, if the Company inaccurately forecasts demand for its
15
products, the impact on net income may be magnified by the Company's inability
to adjust spending quickly enough to compensate for the net sales shortfall.
Other factors contributing to fluctuations in the Company's quarterly
operating results include changes in the demand for the Company's products,
customer order deferrals in anticipation of new versions of the Company's
products, the introduction of new products and product enhancements by the
Company or its competitors, the effects of filling the distribution channels
following such introductions, potential delays in the availability of announced
or anticipated products, the mix of product and service revenue, the
commencement or conclusion of significant development contracts, changes in
foreign currency exchange rates, the timing of acquisitions and associated
costs, and the timing of significant marketing and sales promotions. Based on
the foregoing, the Company believes that quarterly operating results are likely
to vary significantly in the future and that period-to-period comparisons of its
results of operations are not necessarily meaningful and should not be viewed
upon as indications of future performance.
History of Losses; Accumulated Deficit
The Company has experienced significant operating losses and, as of
March 31, 2002, had an accumulated deficit of $24.7 million. The development and
marketing by the Company of its current and new products will continue to
require substantial expenditures. There can be no assurance that growth in net
sales or profitability will be achieved or sustained in future years. Related
risk factors are discussed elsewhere in the caption "Management's Discussion and
Analysis of Financial Condition and Results of Operations" in this Quarterly
Report on Form 10-Q and in the Annual Report on Form 10-K and Form 10-K/A for
the fiscal year ended December 31, 2001.
Nasdaq SmallCap Listing; Risk associated with Limited Market
The Company's Common Stock has been listed on the Nasdaq SmallCap
Market since April 1999. In order to maintain it's listing on the Nasdaq
SmallCap Market, the Company must maintain total assets, capital and public
float at specified levels, and generally must maintain a minimum bid price of
$1.00 per share. If the Company fails to maintain the standard necessary to be
quoted on the Nasdaq SmallCap Market, the Company's Common Stock could become
subject to delisting. On March 12, 2002, the Company received a notice from the
Nasdaq Stock Market that its common stock had failed to maintain the minimum bid
price of $1.00 per share required for continued listing on the Nasdaq SmallCap
Market. If the Company's common stock fails to meet the $1.00 bid price per
share for a minimum of ten consecutive trading days prior to September 9, 2002,
the Company's Common Stock will be delisted from the Nasdaq SmallCap Market. If
the Common Stock is delisted, trading in the 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 the Common Stock or to obtain accurate quotations
as to the price of the Common Stock. Lack of any active trading market would
have an adverse effect on a shareholder's ability to liquidate an investment in
the Company's Common Stock easily and quickly at a reasonable price. It might
also contribute to volatility in the market price of the Company's Common Stock
and could adversely affect the Company's 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 the Company's business,
financial condition and results of operations.
Rapid Technological Change; Risks Associated with New Products
The market for the Company's products is affected by rapidly changing
networking technology and evolving industry standards and the emergence of the
Internet and other new communication technologies. The Company believes that its
future success will depend upon its
16
ability to enhance its existing products and to identify, develop, manufacture
and introduce new products which conform to or support emerging network
telecommunications standards, are compatible with a growing array of computer
and peripheral devices, support popular computer and network operating systems
and applications, meet a wide range of evolving user needs and achieve market
acceptance. There can be no assurance that the Company will be successful in
these efforts. The Company has incurred, and the Company expects 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, the Company is dependent upon timely
access to information about new technological developments and standards. There
can be no assurance that the Company will have such access or that it will be
able to develop new products successfully and respond effectively to
technological change or new product announcements by others. Furthermore, the
Company expects that printer and other peripheral manufacturers will add
features to their products that make them more network accessible, which may
reduce demand for the Company's print servers. There can be no assurance that
products or technologies developed by others will not render the Company's
products non-competitive or obsolete. The fax-on-demand market in general has
been negatively affected by the growth of the Internet. Although the Company has
new Web/fax/email products in development, there can be no assurance these
products will compete successfully. Complex products such as those offered by
the Company may contain undetected or unresolved hardware defects or software
errors when they are first introduced or as new versions are released. Changes
in the Company's or its suppliers' manufacturing processes or the inadvertent
use of defective components by the Company or its suppliers could adversely
affect the Company's ability to achieve acceptable manufacturing yields and
product reliability. The Company has in the past discovered hardware defects and
software errors in certain of its new products and enhancements after their
introduction. There can be no assurance that despite testing by the Company and
by third-party test sites, errors will not be found in future releases of the
Company's products, which would result in adverse product reviews and negatively
affect market acceptance of these products.
The introduction of new or enhanced products requires the Company to manage
the transition, both internally and for customers, from the older products to
the new or enhanced products or versions. The Company 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. The Company has from
time to time experienced delays in the shipment of new products. There can be no
assurance that future product transitions will be managed successfully by the
Company.
Key Personnel
The Company's success depends to a significant degree upon the
continued contributions of the Company's key management, marketing, product
development and operational personnel. The success of the Company will depend to
a large extent upon its ability to retain and continue to attract highly skilled
personnel. Competition for employees in the computer industry is intense, and
there can be no assurance that the Company will be able to attract and retain
enough qualified employees. The Company's inability to retain and attract key
employees could have a material adverse effect on the Company's product
development, business, operating results and financial condition. The Company
does not carry key person life insurance with respect to any of its personnel.
On April 22, 2002, the Company announced the retirement of Donald L.
Rich, 60, from the CEO post he has held since November of 1998. Scott C.
McDonald, 48, a member of the Board of Directors since April of 1999 will assume
the CEO position and continue to serve on
17
the Board. Donald L. Rich will continue on as Chairman of the Board, a post he
has held since May 1999 and will stay active with the Company in that role.
Competition and Price Erosion
The network enhancement products and computer software markets are
highly competitive, and the Company believes 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. The Company currently competes principally in the market for network
fax servers and network print servers and fax-on-demand software. Increased
competition, direct and indirect, could adversely affect the Company's business
and operating results through pricing pressure, loss of market share and other
factors. In particular, the Company expects that, over time, average selling
prices for its 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 the Company's products would adversely affect gross
margins. There can be no assurance the Company will be able to maintain the
current average selling prices of its products or the related gross margins.
The principal competitive factors affecting the market for the
Company's 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 the Company's existing
and potential competitors, most notably the Hewlett-Packard Company
("Hewlett-Packard") and Intel Corporation ("Intel"), have substantially greater
financial, engineering, manufacturing and marketing resources than the Company.
The Company also experiences competition from a number of other software,
hardware and service companies. In addition to its current competitors, the
Company may face substantial competition from new entrants into the network
enhancement market, including established and emerging computer, computer
peripherals, communications and software companies. In the fax server market the
Company competes with companies such as Captaris Inc., Omtool, Ltd. and Computer
Associates International, Inc. There can be no assurance that competitors will
not introduce products incorporating technology more advanced than the
technology used by the Company in its 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 the Company's 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 the Company will be able to compete successfully or that competition will
not have a material adverse effect on the Company's business, operating results
and financial condition.
International Sales
Sales to customers located outside Canada and the United States
accounted for approximately 20%, 25% and 31% of the Company's net sales in
fiscal 2001, 2000 and 1999, respectively. The Company sells its products in
approximately 40 foreign countries through approximately 50 international
distributors. Macnica, the Company's principal Japanese distributor, accounted
for approximately 46%, 60% and 60% of the Company's international sales in
fiscal 2001, 2000 and 1999, respectively, and 10%, 15% and 18% of the Company's
total net sales in fiscal 2001, 2000 and 1999, respectively. The Company expects
that international sales will continue to represent a significant portion of the
Company's product revenues and that the Company 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 the Company will not experience difficulties resulting from
changes in foreign laws relating to the
18
export of its products in the future. In addition, because the Company primarily
invoices its foreign sales in U.S. dollars, fluctuations in exchange rates could
affect demand for the Company's products by causing its prices to be out of line
with products priced in the local currency. Additionally, any such difficulties
would have a material adverse effect on the Company's international sales and a
resulting material adverse effect on the Company's business, operating results
and financial condition. In fiscal 2001, the Company consolidated its operations
in the United Kingdom and entered into an agreement with a distributor to
service the region. In addition, the Company entered into a separate agreement
in fiscal 2001 with a Japanese distributor to sell the Company's LANpress
products in Japan, from which the Company is entitled to receive a royalty on
sales of these products. The Company 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 the Company will be able to maintain the
level of international sales in the future. Any fluctuations in international
sales will greatly affect the Company's operating results and financial
condition.
Lack of Product Revenue Diversification
The Company derives substantially all of its sales from its fax and
print server products, with its fax server products accounting for 91% of its
total sales in fiscal 2001. The Company is leveraging its expertise in these
areas to develop new messaging features and products to support greater
integration into corporate network environments and with Internet
communications. The Company expects that its current products will continue to
account for a majority of the Company's sales in the near future. A decline in
demand for these products as a result of competition, technological change or
other factors, or a delay in the development and market acceptance of new
features and products, would have a material adverse effect on the Company's
business, operating results and financial condition.
Product Transition; Risk of Product Returns and Inventory Obsolescence
From time to time, the Company 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 such
inventory becomes obsolete. The Company has 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 the Company's allowance for such returns in the future
and will not have a material adverse effect on the Company's business, operating
results and financial condition.
Concentration of Distributors; Distribution Risks
The Company sells its products primarily through a two-tier domestic
and international distribution network. The Company's distributors sell
Castelle's 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. In addition, an increasing number of companies are competing for
access to these channels. The Company's distributors typically represent other
products that are complementary to, or compete with, those of the Company. In
particular, certain of its competitors, including Hewlett-Packard and Intel,
sell a substantially higher dollar volume of products through several of the
Company's large U.S. distributors, and as a result, the Company believes such
distributors give higher priority to products offered by such competitors. The
Company's distributors are not contractually committed to future purchases of
the Company's products and could discontinue carrying the Company's products at
any time for any reason. In addition, because the Company is dependent
19
on a small number of distributors for a significant portion of the sales of its
products, the loss of any of the Company's major distributors or their inability
to satisfy their payment obligations to the Company could have a significant
adverse effect on the Company's business, operating results and financial
condition. The Company has a stock rotation policy with certain of its
distributors that allows them to return marketable inventory against offsetting
orders. Should the Company reduce its prices, the Company credits certain of its
distributors for the difference between the purchase price of products remaining
in their inventory and the Company's reduced price for such products. In
addition, due to industry conditions or the actions of competitors, inventory
levels of the Company's products held by distributors could become excessive,
resulting in product returns and inventory write-downs. Although the Company
provides an allowance for anticipated returns and for price protection, and
believes its existing policy results in the establishment of an allowance that
is adequate, there can be no assurance that in the future returns and price
protection will not have a material adverse effect on the Company's business,
operating results and financial condition.
Dependence on Third-Party Suppliers and Subcontractors
The Company's products incorporate or require components or
sub-assemblies procured from third-party suppliers. Certain of these components
or sub-assemblies are available only from a single source, and others are
available only from limited sources. Certain key components of the Company's
products, including a modem chip set from Conexant Systems, Inc. ("Conexant")
and a microprocessor from Motorola, Inc. ("Motorola"), are currently available
from single sources. Other product components are currently available from only
a limited number of sources. In addition, the Company subcontracts a substantial
portion of its manufacturing to third parties, and there can be no assurance
that these subcontractors will be able to support the manufacturing requirements
of the Company. Other than an agreement with Sercomm Corporation to manufacture
certain print server products, the Company does not have material long-term
supply contracts with third parties or any other sole or limited source vendors
and subcontractors. The Company purchases components or sub-assemblies on a
purchase order basis. The Company's ability to obtain these components and
sub-assemblies is dependent upon its ability to accurately forecast customer
demand for its products and to anticipate shortages of critical components or
sub-assemblies created by competing demands upon suppliers. If the Company were
unable to obtain a sufficient supply of high-quality components or
sub-assemblies from its current sources, the Company could experience delays in
obtaining such components or sub-assemblies from other sources. Resulting delays
or reductions in product shipments could adversely affect the Company's
business, operating results and financial condition and damage customer
relationships. Furthermore, a significant increase in the price of one or more
of these components or sub-assemblies or the Company's inability to lower
component or sub-assembly prices in response to competitive price reductions
could adversely affect the Company's business, operating results and financial
condition.
The Company augments its product offerings by obtaining access to
third-party products and technologies in areas outside of its core competencies
or where the Company believes internal development of products and technologies
is not cost-effective. The Company's third-party supplier of certain print
server products is SerComm. There can be no assurance that these products will
produce gross margins comparable to those of the Company's internally generated
products or that the parties with which the Company contracts will continue to
provide the quantities and quality of products needed by the Company or that
they will upgrade their respective products on a timely basis. The termination
of the Company's relationships with third-party product suppliers and with
SerComm, in particular, could result in delays or reductions in product
shipments, which could have a material adverse effect on the Company's business,
operating results and financial condition.
20
Government Regulation
Certain aspects of the networking industry in which the Company
competes 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
where telecommunications standards differ from those in the United States, or
the inability to obtain regulatory approvals within a reasonable period of time,
could have a material, adverse effect on the Company's business, operating
results and financial condition. The Company's 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 the Company's business, operating results and
financial condition.
Dependence on Proprietary Rights; Uncertainty of Obtaining Licenses
The Company's success depends to a certain extent upon its
technological expertise and proprietary software technology. The Company relies
upon a combination of contractual rights and copyright, trademark and trade
secret laws to establish and protect its technologies. Despite the precautions
taken by the Company, it may be possible for unauthorized third parties to copy
the Company's products or to reverse engineer or obtain and use information that
the Company regards as proprietary. In addition, the laws of some foreign
countries either do not protect the Company's 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 the Company's 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 to the Company and
divert the efforts of the Company's technical and management personnel, whether
or not such litigation is determined in favor of the Company. In the event of an
adverse result in any such litigation, the Company 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 the Company would be successful in such development or that any
such licenses would be available. The Company also relies on technology licenses
from third parties. There can be no assurance that these licenses will continue
to be available to the Company upon reasonable terms, if at all. Any impairment
or termination of the Company's relationship with third-party licensors could
have a material adverse effect on the Company's business, operating results and
financial condition. There can be no assurance that the Company's precautions
will be adequate to deter misappropriation or infringement of its proprietary
technologies. Furthermore, while the Company has obtained federal registration
for many of its trademarks in the United States, certain of its trademarks have
not been registered in the United States or foreign jurisdictions. There can be
no assurance that the Company's use of such registered trademarks will not be
contested by third parties in the future.
The Company has received, and may receive in the future, communications
asserting that its products infringe the proprietary rights of third parties or
seeking indemnification against such infringement. There can be no assurance
that third parties will not assert infringement claims against the Company with
respect to current or future products or that any such assertion may not require
the Company to enter into royalty arrangements or result in costly litigation.
As the number of software products in the industry increases and the
functionality of these products further overlap, the Company believes that
software developers may become increasingly subject to infringement claims. Any
such claims, with or without merit, can be time consuming and expensive to
defend. There can be no assurance that any such intellectual property litigation
that may be brought in the future will not have a material adverse effect on the
Company's business,
21
operating results and financial condition. As a result of such claims or
litigation, it may become necessary or desirable in the future for the Company
to obtain licenses relating to one or more of its products or relating to
current or future technologies, and there can be no assurance that it would be
able to do so on commercially reasonable terms.
Possible Volatility of the Company's Common Stock Price
The price of the Company's Common Stock has fluctuated widely in the past.
Sales of substantial amounts of the Company's Common Stock, or the perception
that such sales could occur, could adversely affect prevailing market prices for
the Company's Common Stock. The management of the Company believes that such
past fluctuations may have been caused by the factors identified above as well
as announcements of new products, quarterly fluctuations in the results of
operations and other factors, including changes in the condition of the personal
computer industry in general. These fluctuations, as well as general economic,
political and market conditions, such as recessions or international currency
fluctuations, may adversely affect the market price of the Company's Common
Stock. Stock markets have experienced extreme price volatility in recent years.
This volatility has had a substantial effect on the market prices of securities
issued by the Company and other high technology companies, often for reasons
unrelated to the operating performance of the specific companies. The Company
anticipates that prices for Castelle Common Stock may continue to be volatile.
Such future stock price volatility for Castelle Common Stock may provoke the
initiation of securities litigation, which may divert substantial management
resources and have an adverse effect on the Company's business, operating
results and financial condition.
Future Capital Requirements
The development and marketing of products requires significant amounts
of capital. The Company believes that its existing cash balances, anticipated
cash flows from operations and available lines of credit will be sufficient to
meet its anticipated capital requirements for the next 12 months. However, a
decline in future orders and revenues might require us to seek additional
capital to meet our working capital needs during or beyond the next twelve
months if we are unable to reduce expenses to the degree necessary to avoid
incurring losses. 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 the Company's existing and new products
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. 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. Related risk
factors are discussed elsewhere in this Quarterly Report on Form 10-Q and in the
Annual Report on Form 10-K and Form 10-K/A for the fiscal year ended December
31, 2001.
Recent Terrorist Activity in the United States and the Military Action to
Counter Terrorism Could Adversely Impact Our Business
The September 11, 2001 terrorist attacks in the United States, the
ensuing declaration of war on terrorism and the continued threat of terrorist
activity and other acts of war or hostility appear to be having an adverse
effect on business, financial and general economic conditions in the U.S. These
effects may, in turn, result in increased costs due to the need to provide
enhanced security, which would have a material adverse effect on our business
and results of operations. These circumstances may also adversely affect our
ability to attract and retain customers and our ability to raise additional
capital.
22
Voting Control by Officers, Directors and Affiliates
At March 15, 2002, the Company's officers and directors and their
affiliates beneficially owned approximately 29% of the outstanding shares of
Common Stock. Accordingly, together they had the ability to significantly
influence the election of the Company's 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 of the Company.
Certain Charter Provisions
The Company's Board of Directors has authority to issue up to 2,000,000
shares of Preferred Stock and to fix the rights, preferences, privileges and
restrictions, including voting rights, of these shares without any further vote
or action by the shareholders. The rights of the holders of the Company's 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 the
outstanding voting stock of the Company, thereby delaying, deferring or
preventing a change in control of the Company. 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 value of the Company's Common Stock.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
10.1* Employment agreement between the Company and Scott C. McDonald.
10.2* Executive Severance and Transition Benefits Agreement between
the Company and Scott C. McDonald.
99.1 Press Release dated May 1, 2002.
(b) Reports on Form 8-K
The Company filed a Form 8-K Report dated April 22, 2002,
reporting the retirement of Donald L. Rich and the appointment
of Scott C. McDonald as CEO.
------------------
* Indicates management contracts or compensatory plans or arrangements
filed pursuant to Item 601(b)(10) of Regulation S-K.
23
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
CASTELLE
By: /s/ Scott C. McDonald Date: May 14, 2002
Scott C. McDonald
Chief Executive Officer and President
(Principal Executive Officer)
By: /s/ Paul Cheng Date: May 14, 2002
Paul Cheng
Vice President of Finance and Administration
Chief Financial Officer
(Principal Financial and Chief Accounting Officer)
Secretary
24