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 September 30, 2004
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 0-220-20
CASTELLE
(Exact name of Registrant as specified in its charter)
California 77-0164056
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
855 Jarvis Drive, Suite 100, Morgan Hill, California 95037
(Address of principal executive offices, including zip code)
(408) 852-8000
(Registrant's telephone number, including area code)
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 November 08, 2004 was
3,689,831.
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
FORM 10-Q
TABLE OF CONTENTS
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets 2
Condensed Consolidated Statements of Operations 3
Condensed Consolidated Statements of Cash Flows 4
Notes to Condensed Consolidated Financial Statements 5
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS 14
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 15
Item 3Quantitative and Qualitative Disclosures About Market Risk 28
Item 4Controls and Procedures 29
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 30
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 30
Item 3. Defaults Upon Senior Securities 30
Item 4. Submission of Matters to a Vote of Security Holders 30
Item 5. Other Information 30
Item 6. Exhibits 30
Signatures 31
Exhibit 31.1 - Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002 E-1
Exhibit 31.2 - Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002 E-2
Exhibit 32.1 - Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 E-3
Exhibit 32.2 - Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 E-4
1
PART I - FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
CASTELLE
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands)
September 30, 2004 December 31, 2003
---------------------- --------------------
Assets:
Current assets:
Cash and cash equivalents $ 5,032 $ 4,614
Accounts receivable, net of allowance for doubtful accounts
of $37 and $39, respectively 948 873
Inventories 1,532 1,177
Prepaid expenses and other current assets 187 134
Deferred taxes 212 380
---------------------- --------------------
Total current assets 7,911 7,178
Property and equipment, net 243 376
Other non-current assets 103 103
Deferred taxes, non-current -- 146
---------------------- --------------------
Total assets $ 8,257 $ 7,803
====================== ====================
Liabilities and Shareholders' Equity:
Current liabilities:
Long-term debt, current portion $ 14 $ 16
Accounts payable 338 314
Accrued liabilities 1,250 1,759
Deferred revenue 1,114 909
---------------------- --------------------
Total current liabilities 2,716 2,998
Long term debt, net of current portion 18 29
---------------------- --------------------
Total liabilities 2,734 3,027
---------------------- --------------------
Shareholders' equity:
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 3,682 and 3,425, respectively 27,545 27,258
Accumulated deficit (22,022) (22,482)
---------------------- --------------------
Total shareholders' equity 5,523 4,776
---------------------- --------------------
Total liabilities and shareholders' equity $ 8,257 $ 7,803
====================== ====================
See accompanying notes to unaudited condensed consolidated financial statements.
2
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
(in thousands, except per share amounts)
(unaudited)
Three months ended Nine months ended
................................ ...............................
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
---------------- -------------- --------------- ---------------
Net sales:
Products $ 2,079 $ 2,081 $ 6,181 $ 6,232
Services 619 485 1,792 1,345
---------------- -------------- --------------- ---------------
Total net sales 2,698 2,566 7,973 7,577
Cost of sales 674 555 1,905 1,825
---------------- -------------- --------------- ---------------
Gross profit 2,024 2,011 6,068 5,752
---------------- -------------- --------------- ---------------
Operating expenses:
Research and development 470 427 1,312 1,211
Sales and marketing 820 846 2,506 2,341
General and administrative 486 497 1,459 1,463
---------------- -------------- --------------- ---------------
Total operating expenses 1,776 1,770 5,277 5,015
---------------- -------------- --------------- ---------------
Income from operations 248 241 791 737
Interest income, net 10 5 18 13
Other expense, net (21) (3) (35) (32)
---------------- -------------- --------------- ---------------
Income before provision for income taxes 237 243 774 718
Provision for income taxes 95 2 314 6
---------------- -------------- --------------- ---------------
Net income $ 142 $ 241 $ 460 $ 712
================ ============== =============== ===============
Income per share:
Net income per common share - basic $ 0.04 $ 0.07 $ 0.13 $ 0.22
Net income per common share - diluted $ 0.03 $ 0.06 $ 0.10 $ 0.17
Shares used in per share calculation - basic 3,647 3,286 3,573 3,260
Shares used in per share calculation - diluted 4,353 4,344 4,414 4,154
See accompanying notes to unaudited condensed consolidated financial statements.
3
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Nine months ended
......................................
September 30, 2004 September 30, 2003
----------------- ------------------
Cash flows from operating activities:
Net income $ 460 $ 712
Adjustments to reconcile net income to net cash provided by
operating activities:
Loss on disposal of fixed assets 2 --
Depreciation and amortization 155 160
Provision for doubtful accounts and sales returns (10) (227)
Provision for excess and obsolete inventory (32) (139)
Deferred taxes 314 --
Changes in assets and liabilities:
Accounts receivable (65) 80
Inventories (323) 132
Prepaid expenses and other current assets (53) (127)
Accounts payable 24 (2)
Accrued liabilities (509) 119
Deferred revenue 205 277
----------------- ------------------
Net cash provided by operating activities 168 985
Cash flows from investing activities:
Purchase of property and equipment (24) (140)
----------------- ------------------
Net cash used in investing activities (24) (140)
----------------- ------------------
Cash flows from financing activities:
Repayment of long-term debt (13) (16)
Repurchase of common stock - (49)
Proceeds from issuances of common stock, 287 191
----------------- ------------------
Net cash provided by financing activities 274 126
----------------- ------------------
Net increase in cash and cash equivalents 418 971
Cash and cash equivalents at beginning of period 4,614 3,460
----------------- ------------------
Cash and cash equivalents at end of period $ 5,032 $ 4,431
================= ==================
Supplemental Information:
Cash paid during the period for:
Interest $ 4 $ 7
================= ==================
See accompanying notes to unaudited condensed consolidated financial statements.
4
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, 2003.
The condensed balance sheet data as of December 31, 2003 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 nine months of 2004 and 2003,
Ingram Micro and Tech Data, our two largest distributors, collectively
represented approximately 44% and 50% 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 manufacturing our products and believe that we
5
could shift product assembly to alternate suppliers if necessary. Certain
key components of our products, including a modem chip set from Conexant,
microprocessors from Motorola, integrated circuits from Intel and Kendin,
are currently available from single sources. Other components of our
products are currently available from only a limited number of sources. In
addition, certain manufacturers have announced the end-of-life of certain
standard off-the-shelf components which are being used by us in the
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 assure 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.
Certain reclassifications have been made to the prior period's financial
statements to conform to the current period presentation. We have restated
the three and nine months ended September 30, 2003 to show separate
presentation of product and service revenue, to conform with the current
period disclosure.
2. Revenue Recognition:
We recognize revenue based on the provisions of Staff Accounting Bulletin
No. 104 "Revenue Recognition" and Statement of Financial Accounting
Standards ("SFAS") No. 48 "Revenue Recognition When Right of Return
Exists."
Product revenue is recognized upon shipment if a signed contract or
purchase order exists, the fee is fixed or determinable, collection of the
resulting receivable is probable and product returns are reasonably
estimable. Shipment generally occurs and title and risk of loss is
transferred when the product is delivered to a common carrier.
We enter into agreements with some of our distributors that permit limited
stock rotation rights. These stock rotation rights allow the distributor to
return products for credit but require the purchase of additional products
of equal value. Customers who purchase products directly from us also have
limited return rights, which expire 30 days from product shipment. Revenues
subject to stock rotation or other return rights are reduced by our
estimates of anticipated exchanges and returns. We establish our returns
allowance for distributors and direct customers based on historic return
rates. We consider our historical return experience, as products are
tracked by product part number and geographic location, in establishing
returns reserves. If the returns for a period are significantly different
from our historical return experience, revisions to our return allowance
may be required, and the associated expense could change from current
levels.
Pursuant to our agreements with distributors, we also protect our
distributors' exposure related to the impact of price reductions. Price
adjustments are recorded at the time price reductions are communicated to
our distributors. We have not had any such price adjustments for the
periods presented.
We generally provide our distributors the opportunity to earn volume
incentive rebates based upon the amount of point of sales achieved during
the fiscal quarter. These incentive rebates are accrued in the quarter
incurred based on the distributors point-of-sales reports, which are
usually provided to us within 3-5 business days after the close of the
fiscal quarter, and recorded as a deduction in revenue.
We also provide co-op and market development funds to our distributors.
These rebates are
6
accrued at the time revenue is recognized, or based on distributors'
point-of-sales reports, and recorded as a reduction in revenue.
Payment terms to our distributors and customers are generally thirty days.
Revenue for transactions that include multiple elements such as hardware
and post-contract customer support is allocated to each element based on
its relative fair value and recognized for each element when the revenue
recognition criteria have been met for such element. Fair value is
generally determined based on the price charged when the element is sold
separately.
We provide Standard Support to our customers upon initial product sale.
Standard Support includes advance swap of defective hardware and software
within sixty days following new product registration. Hardware is warranted
for an additional ten months if the defective product is returned for
free-of-charge repair. In addition to Standard Support, we also provide
Extended Support to our customers at the time of product purchase or
anytime thereafter. Extended Support covers hardware and software for a
period of one year. We recognize revenue from support or maintenance
contracts, including extended warranty and support programs, ratably over
the period of the contract.
We have a Manufacturer Suggested Retail Price list for all of our products
including support or maintenance contracts. We defer a prorated portion of
our hardware sales for the sixty days product warranty and recognize the
revenue as the liability is fulfilled.
We also record a liability for the estimated future costs associated with
warranty claims, which is based on historical experience and our estimate
of the level of future costs. Warranty costs are reflected in the Statement
of Earnings as a Cost of Sales. If actual warranty costs are different from
our estimated costs, or if the warranty claims were to be significantly
higher than our historical experience, then revisions to the estimated
warranty liability may be required and the warranty expense could change
from current levels.
We do not sell software, which is incorporated into our hardware,
separately, other than for our customers to purchase an upgrade to their
existing products when we announce a major release of the software.
The following table sets forth net sales derived from products and services
for the nine months ended September 30, 2004 and for each of the three
years in the period ended December 31, 2003.
Nine Months Twelve Months Ended
Ended
-------------- -------------------------------------------------------
September December 31, 2003 December 31, December 31, 2001
30, 2004 2002
-------------- ------------------ ----------------- ------------------
Net Sales:
Products $6,181 $ 8,337 $8,617 $8,327
Services 1,792 1,877 1,142 1,027
-------------- ------------------ ----------------- ------------------
Total net sales $ 7,973 $10,214 $9,759 $9,354
============== ================== ================= ==================
We are unable to provide the cost of sales separately for products and
services as our internal financial reporting systems does not track this
information separately, and thus, such information is not available to us.
7
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
third quarter and first nine months of 2004 and 2003 (in thousands, except
per share amounts):
(in thousands, except per share amounts)
.......................................................
(Unaudited)
.......................................................
Three months ended Nine months ended
........................... ...........................
September September September September
30, 2004 30, 2003 30, 2004 30, 2003
--------------------------- ---------------------------
Basic:
Weighted average common shares outstanding 3,647 3,286 3,573 3,260
=========================== ===========================
Net income $ 142 $ 241 $ 460 $ 712
=========================== ===========================
Net income per common share - basic $ 0.04 $0.07 $ 0.13 $ 0.22
=========================== ===========================
Diluted:
Weighted average common shares outstanding 3,647 3,286 3,573 3,260
Common equivalent shares from stock options 706 1,058 840 894
--------------------------- ---------------------------
Shares used in per share calculation - diluted 4,353 4,344 4,414 4,154
=========================== ===========================
Net income $ 142 $ 241 $ 460 $ 712
=========================== ===========================
Net income per common share - diluted $ 0.03 $ 0.06 $ 0.10 $ 0.17
=========================== ===========================
The calculation of diluted shares outstanding for the three months ended
September 30, 2004 excludes 162,750 shares of common stock issuable upon
exercise of outstanding stock options, as their effect was antidilutive in
the period. The calculation of diluted shares outstanding for the nine
months ended September 30, 2004 excludes 25,205 shares of common stock
issuable upon exercise of outstanding stock options, as their effect was
antidilutive in the period. The calculation of diluted shares outstanding
for the nine months ended September 30, 2003 excludes 121,000 shares of
common stock issuable upon exercise of outstanding stock options, as their
effect was antidilutive in the period. The calculation of diluted shares
outstanding for the three months ended September 30, 2003 does not exclude
any shares of common stock that are antidilutive, as there were none for
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, would have been changed to the amounts indicated below
(unaudited, in thousands, except per share data):
8
Three months ended Nine months ended
............................. ...........................
September September 30, September September
30, 2004 2003 30, 2004 30, 2003
----------------------------- ---------------------------
Net Income - as reported $ 142 $ 241 $ 460 $ 712
Fair value of stock-based compensation, net (128) (86) (382) (173)
of taxes
Net income - pro forma 14 155 78 539
Net income per share - basic - as reported $ 0.04 $ 0.07 $ 0.13 $ 0.22
Net income per share - diluted - as reported $ 0.03 $ 0.06 $ 0.10 $ 0.17
Net income per share - basic - pro forma $ 0.00 $ 0.05 $ 0.02 $ 0.17
Net income per share - diluted - pro forma $ 0.00 $ 0.04 $ 0.02 $ 0.13
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 and net of provisions for
excess and obsolete inventory. Inventory details are as follows (unaudited,
in thousands):
September 30, 2004 December 31, 2003
----------------------- -----------------------
Raw material $ 1,072 $ 610
Work in process 104 -
Finished goods 356 567
-----------------------------------------------
Total inventory $ 1,532 $ 1,177
===============================================
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 have purchased approximately two years worth
of these end-of-life components in an effort to guarantee a smooth supply
of our FaxPress Products to our customers. As of September 30, 2004, we
have approximately $600,000 worth of end-of-life components as compared to
$361,000 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):
(Unaudited)
....................................................
Three months ended Nine months ended
......................... .........................
September September September September
30, 2004 30, 2003 30, 2004 30, 2003
------------------------- -------------------------
United States $ 2,195 $ 1,966 $ 6,630 $ 5,974
Europe 186 192 518 520
Pacific Rim 265 297 600 797
Rest of Americas, excluding United States 52 111 225 286
-------------------------- -------------------------
Total Revenues $ 2,698 $ 2,566 $ 7,973 $ 7,577
========================== =========================
Customers that individually accounted for greater than 10% of net sales are
as follows (unaudited, in thousands):
...................................................................................................
Quarter Ended Nine Months Ended
................................................. .................................................
September 30, 2004 September 30, 2003 September 30, 2004 September 30, 2003
Customer Amount Percentage Amount Percentage Amount Percentage Amount Percentage
-------- ------ ---------- ------ ---------- ------ ---------- ------ ----------
A $ 357 13% $ 496 19% $ 1,796 23% $ 1,608 21%
B $ 592 22% $ 874 34% $ 1,668 21% $ 2,188 29%
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
September 30, 2004 (unaudited, in thousands):
10
Capital Lease Total
Operating Leases Obligations Commitments
----------------------------------------------------
Three months ending December 31, 2004 $ 52 $ 4 $ 56
Year ending December 31, 2005 207 18 225
Year ending December 31, 2006 207 15 222
Year ending December 31, 2007 207 - 207
Year ending December 31, 2008 207 - 207
Year ending December 31, 2009 86 - 86
----------------------------------------------------
Total Commitments $ 967 $ 37 $ 1,004
Less amount representing interest - (5) (5)
----------------------------------------------------
Present value of lease $ 967 $ 32 $ 999
obligations
====================================================
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 September
30, 2004, we had $32,000 outstanding under a loan and security agreement,
which is subject to an interest rate of 12.8%.
On August 2, 2004, we secured from Silicon Valley Bank a new revolving line
of credit to replace the previous credit facility. The new revolving line
of credit provides for borrowings of up to $4.0 million and has a one-year
term. 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 September 30, 2004, 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 Earnings as a Cost of
Sales. If actual warranty costs are different from our estimated costs, or
if the warranty claims were to be significantly higher than our historical
experience, then revisions to the estimated warranty liablilty may be
required and the warranty expense could change from current levels. A
reconciliation of the changes in our warranty liability during the periods
presented is as follows (in thousands):
11
(Unaudited)
....................................................
Three months ended Nine months ended
.......................... ........................
September September September September
30, 2004 30, 2003 30, 2004 30, 2003
-------------------------- ------------------------
Balance at beginning of period $22 $ 31 $ 22 $34
Accruals for warranties issued during the - 16 2 49
period
Actual warranty expense (5) (8) (7) (44)
-------------------------- ------------------------
Balance at end of period $17 $ 39 $ 17 $39
========================== ========================
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
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 minimal.
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. Stock Buyback:
In the fourth quarter of 2002, our Board of Directors authorized us, from
time to time, to repurchase at market prices, up to $2.3 million of our
common stock for cash in open market, negotiated or block transactions. The
timing of such transactions will depend on market conditions, other
corporate strategies and will be at the discretion of our management. No
time limit was set for the completion of this program. At the time of the
approval by the Board of Directors, we had approximately 4.8 million shares
of common stock outstanding. During the fourth quarter of 2002, we
repurchased from open market and negotiated transactions a total of
approximately 1.6 million shares for approximately $1.8 million, at an
average per share price of $1.10. During the first quarter of 2003, we
repurchased from open market transactions a total of 46,500 shares for
$49,000, at an average per share price of $1.04. We have not repurchased
any shares since the first quarter of 2003, but intend to continue to
execute our buyback program as we determine necessary. The approximate
dollar value of shares that may yet be repurchased under the plan was
$420,000 as of September 30, 2004.
10. Recent Accounting Pronouncements:
In December 2003, the Financial Accounting Standards Board ("FASB") issued
a revised FASB interpretation No. 46, "Consolidation for Variable Interest
Entities, an interpretation of ARB No. 51" ("FIN 46R"). The FASB published
the revision to clarify and amend some of the original provisions of FIN
46, which was issued in January 2003, and to exempt certain
12
entities from its requirements. A Variable Interest Entity ("VIE") refers
to an entity subject to consolidation according to the provisions of the
Interpretation. FIN 46R applies to entities whose equity investment at risk
is insufficient to finance that entity's activities without receiving
additional subordinated financial support provided by any parties,
including equity holders, or where the equity investors (if any) do not
have a controlling financial interest. FIN 46R provides that if an entity
is the primary beneficiary of a VIE, the assets, liabilities, and results
of operations of the VIE should be consolidated in the entity's financial
statements. In addition, FIN 46R requires that both the primary beneficiary
and all other enterprises with a significant variable interest in a VIE
provide additional disclosures. The Company was required to adopt the
provisions of FIN 46R in the Company's fiscal 2004 first quarter. The
adoption of FIN 46R did not have a material impact on the Company's
financial position or results of operations.
13
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, 2003.
14
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, 2003.
Critical Accounting Policies
Castle's financial statements and accompanying notes are prepared in accordance
with generally accepted accounting principles 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
2003 Annual Report on Form 10-K.
Consolidated Statements of Operations - As a Percentage of Net Sales
Three months ended Nine months ended
................................ ................................
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
--------------- -------------- --------------- --------------
Net sales
Products 77% 82% 78% 82%
Services 23% 18% 22% 18%
--------------- -------------- --------------- --------------
Total net sales 100% 100% 100% 100%
Cost of sales 25% 22% 24% 24%
--------------- -------------- --------------- --------------
Gross profit 75% 78% 76% 76%
--------------- -------------- --------------- --------------
Operating expenses:
Research and development 18% 17% 17% 16%
Sales and marketing 30% 33% 31% 31%
General and administrative 18% 19% 18% 19%
--------------- -------------- --------------- --------------
Total operating expenses 66% 69% 66% 66%
--------------- -------------- --------------- --------------
Income from operations 9% 9% 10% 10%
Interest income, net * * * *
Other expense, net
* * * *
--------------- -------------- --------------- --------------
Income before provision for income taxes 9% 9% 10% 10%
Provision for income taxes 4% * 4% 1%
--------------- -------------- --------------- --------------
Net income 5% 9% 6% 9%
=============== ============== =============== ==============
* Less than 1%
15
Results of Operations
Net Sales
(Unaudited)
....................................................................
Three months ended Nine months ended
................................. .................................
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
---------------- -------------- --------------- ----------------
Net sales
Products $ 2,079 $ 2,081 $ 6,181 $ 6,232
Services 619 485 1,792 1,345
---------------- -------------- --------------- ----------------
Total Net sales $ 2,698 $ 2,566 $ 7,973 $ 7,577
================ ============== =============== ================
Three months ended Nine months ended
......................... ..........................
September September September September
30, 2004 30, 2003 30, 2004 30, 2003
------------------------- --------------------------
Net Sales
United States $2,195 $ 1,966 $ 6,630 $5,974
Europe 186 192 518 520
Pacific Rim 265 297 600 797
Rest of Americas, excluding United States 52 111 225 286
-------------------------- --------------------------
Total Net Sales $2,698 $ 2,566 $ 7,973 $7,577
========================== ==========================
Net sales for the third quarter of 2004 were $2.7 million as
compared to $2.6 million in the same period in 2003. Net sales for the
first nine months of 2004 were $8.0 million as compared to $7.6 million for
the same period in 2003. Sales in the three and nine months ended September
30, 2004 included a benefit of $126,000 from an adjustment of certain
accruals related to a sales development program.
Product sales of $2.1 million and $6.2 million for the three and
nine months ended September 30, 2004, respectively, were relatively
unchanged as compared to the same periods in 2003. .
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 third quarter
of 2004 increased 28% to $619,000 from $485,000 in the same period in 2003.
For the first nine months of 2004, service revenues increased 33% to $1.8
million from $1.3 million in the same period in 2003. The increase in
service revenues was primarily due to increased sales of extended warranty
contracts due to an increase in our installed customer base as well as the
launch of our FaxPress Premier fax server products in the second half of
2003. We anticipate service revenues to increase as more FaxPress Premier
fax servers are sold.
Domestic sales in the third quarter of 2004 were $2.2 million, as
compared to $2.0 million for the same period in 2003, representing 81% and
77% of total net sales in the third quarter of 2004 and 2003, respectively.
Domestic sales for the first nine months of 2004 were $6.6 million, as
compared to $6.0 million for the same period of 2003, which represents 83%
and 79% of total net sales in 2004 and 2003, respectively. The increase in
sales was mostly attributable to sales of the new FaxPress Premier fax
server products and a benefit of $126,000 from a sales development program
adjustment.
International sales (excluding sales to the rest of the Americas)
for the third quarter of 2004 were $451,000 as compared to $489,000 in the
third quarter of 2003. This represents
16
17% and 19% of net sales for 2004 and 2003, respectively. International
sales (excluding sales to the rest of the Americas) were $1.1 million for
the first nine months of 2004, as compared to $1.3 million for the same
period in 2003, which represents 14% and 17% of total net sales for the
first nine months of 2004 and 2003, respectively. The decline in sales was
mostly due to lower sales of our fax server products. We anticipate
international sales to increase as the FaxPress Premier fax servers are
fully introduced to the rest of the world.
Sales to the rest of the Americas (excluding the United States) in
the third quarter of 2004 were $52,000 as compared to $111,000 in the
year-ago quarter, representing 2% and 4% of total net sales, respectively.
The decrease in sales was mostly due to lower sales of our fax server
products. For the nine months ended September 30, sales to the rest of the
Americas were $225,000 and $286,000 for 2004 and 2003, respectively. This
represents 3% and 4% of net sales respectively.
Cost of Sales; Gross Profit
Gross profits were $2.0 million, in both the third quarters of
2004 and 2003, or 75% and 78% of net sales, respectively. Gross profits for
the first nine months of 2004 and 2003 were $6.1 million and $5.8 million,
respectively, or 76% of net sales for both periods. Gross profits for the
three and nine months ended September 30, 2004 included the benefit of
$126,000 from the sales development program adjustment.
We are unable to provide the cost of sales separately for products
and services, as our internal financial reporting systems do not track this
information in the reported periods.
Research & Development
Research and development expenses for the third quarter of 2004
were $470,000, or 17% of net sales, as compared to $427,000 or 17% of net
sales for the same period in 2003. For the first nine months of 2004,
research and development expenses were $1.3 million, as compared to $1.2
million in the same period of 2003, or 16% of net sales for both periods.
The increase for the nine-month period of $101,000 was mostly attributable
to higher outside consulting expenses to enhance our current product
features. The employment of consultants is expected to continue until the
short-term projects are completed.
Sales & Marketing
Sales and marketing expenses for the third quarter of 2004 were
$820,000, or 30% of net sales, as compared to $846,000, or 33% of net
sales, for the same period in 2003. Sales and marketing expenses were $2.5
million for the first nine months of 2004, and $2.3 million for the same
period of 2003, which represents 31% of net sales for both periods. The
increase for the nine-month period of $165,000 was primarily due to an
increase in compensation expense related to headcount additions of $282,000
offset in part by lower advertising and promotional expenses of $114,000.
Sales and marketing expenses are anticipated to remain relatively stable.
General & Administrative
General and administrative expenses were $486,000 for the third
quarter of 2004, or 18% of net sales, as compared to $497,000, or 19% of
net sales for the third quarter of 2003. General and administrative
expenses were $1.5 million for both the first nine months of 2004 and 2003,
or 18% and 19% of net sales, respectively. General and administrative
expenses are anticipated to remain relatively stable.
17
Provision for Income Tax
Prior to the fourth quarter of 2003, we had not reported
significant income tax expenses because we had utilized available net
operating loss (NOL) and tax credit carry-forwards. These NOLs were fully
reserved by a valuation allowance due to uncertainty surrounding the
likelihood of their realization. Due to our continued profitability and a
determination that it is more likely than not that certain future tax
benefits will be realized, a portion of the deferred tax assets were
recognized in the fourth quarter of 2003. Beginning in 2004, for purposes
of financial reporting, we are providing for income taxes at an effective
tax rate of 40%. As a result, $95,000 of income tax expense has been
provided in the third quarter of 2004 as compared to $2,000 in the third
quarter of 2003. For the first nine months of 2004, we have provided
$314,000 for income taxes, as compared to $6,000 in 2003. However, for
income tax purposes, we had $12.9 million of NOLs available at the end of
December 2003 to offset future taxable income, and we do not expect to
utilize significant amounts of cash for income tax payments until these
NOLs have been utilized. If we determine that the amount of the deferred
tax assets to be realized is greater or less than the amount we have
recorded, adjustments may be required.
Liquidity and Capital Resources
September 30, 2004 December 31, 2003 September 30, 2003
------------------ ----------------- ------------------
(dollars in thousands)
Cash and cash equivalents $ 5,032 $ 4,614 $ 4,431
Working capital $ 5,195 $ 4,180 $ 3,296
Working capital ratio 2.9 2.4 2.1
As of September 30, 2004, we had approximately $5.0 million of cash and
cash equivalents. For the nine months ended September 30, 2004, cash generated
from operating activities was $168,000 as compared to $985,000 in the same
period of last year. . This reduction of cash from operating activities of
$817,000 is attributable to a number of factors, including (i) an increase in
inventory of $348,000 due mostly to the purchase of end-of-life components, net
of usage, totaling $239,000 and other components to support production of
FaxPress and FaxPress Premier products of $109,000, (ii) a decrease in total
accrued liabilities of $628,000 due to an adjustment of certain accruals related
to a sales development program of $126,000, a software license settlement of
$50,000, a reduction of unneeded reserve of $61,000 after the software
settlement, and use of co-op and market development funds of $181,000 for
product promotions.
Our investing activities in the first nine months of 2004 for $24,000
and 2003 for $140,000 were for purchases of capital assets to replace obsolete
computer equipment.
We generated $274,000 from financing activities in the first nine
months of 2004 as compared to $126,000 in the same period of 2003 primarily from
proceeds received from issuance of common stock, offset partially by repayment
of debt. In the first three months of 2003, we also used $49,000 to repurchase
common stock.
In the fourth quarter of 2002, our Board of Directors authorized us,
from time to time, to repurchase at market prices, up to $2.3 million shares of
our common stock, for cash in open market, negotiated or block transactions. The
timing of these transactions has depended and will depend on market conditions,
other corporate strategies and has been and will be at the discretion of our
management. No time limit was set for the completion of this program. Since the
beginning of this program, we have repurchased from open market and negotiated
transactions a total of 1.7 million shares for $1.8 million, at an average per
share price of $1.10. We have not repurchased any shares since the first quarter
of 2003, but intend to continue to execute our buyback program, as we deem
appropriate.
18
We have extended our lease for our corporate headquarters in Morgan
Hill, California. The modified lease on the Morgan Hill facility has a term of
five years, commencing on June 1, 2004 and expiring in May 31, 2009, with one
conditional three-year renewal option, which if exercised, would extend the
lease to May 2012 commencing with rent at 95% of fair market value. As of
September 30, 2004, future minimum payments under the lease were $967,000.
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 bears interest at 12.8% and is repayable by December 2006. As
of September 30, 2004, the aggregate value of future minimum payments was
$37,000.
The following represents combined aggregate maturities for all our
financing and commitments as of September 30, 2004:
Payments Due by Period
-------------------------------------------------------------------
Contractual Obligations Total 1 Year 2 - 3 Years 4 - 5 Years More than 5
Years
--------- ------------- -------------- ------------- --------------
Capital (Finance) Lease Obligations $ 37 $ 18 $ 19 - -
Operating Lease Obligations $ 967 $ 207 $ 415 $ 345 -
--------- ------------- -------------- ------------- --------------
Total contractual cash obligations $1,004 $ 225 $ 434 $ 345 -
========= ============= ============== ============= ==============
As of September 30, 2004, we had a $4.0 million collateralized revolving
line of credit with a bank, which is to expire in August 2005. The revolving
line of credit provides for borrowings of up to $4.0 million.
Borrowings under this line of credit agreement are collateralized by all of our
assets and bear interest at the bank's prime rate plus 0.50%. Under the new
facility we are required to maintain certain minimum cash and investment
balances with the bank and meet certain other financial covenants. As of
September 30, 2004, we have not drawn down on the line of credit and were in
compliance with the terms of the agreement.
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 our inability to achieve our long-term business objectives. To the
extent that additional capital is raised through the sale of additional equity
or convertible debt securities, the issuance of such securities would result in
additional dilution to our shareholders.
In addition, because 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.
19
Recent Accounting Pronouncements:
In December 2003, the FASB issued a revised FASB interpretation No. 46,
"Consolidation for Variable Interest Entities, an interpretation of ARB No. 51"
("FIN 46R"). The FASB published the revision to clarify and amend some of the
original provisions of FIN 46, which was issued in January 2003, and to exempt
certain entities from its requirements. A Variable Interest Entity ("VIE")
refers to an entity subject to consolidation according to the provisions of the
Interpretation. FIN 46R applies to entities whose equity investment at risk is
insufficient to finance that entity's activities without receiving additional
subordinated financial support provided by any parties, including equity
holders, or where the equity investors (if any) do not have a controlling
financial interest. FIN 46R provides that if an entity is the primary
beneficiary of a VIE, the assets, liabilities, and results of operations of the
VIE should be consolidated in the entity's financial statements. In addition,
FIN 46R requires that both the primary beneficiary and all other enterprises
with a significant variable interest in a VIE provide additional disclosures.
The provisions of FIN 46R are effective for our fiscal 2004 first quarter. The
adoption of FIN 46R did not have a material impact on our financial position or
results of operations.
20
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, 2003. Additional risks and
uncertainties not presently known to us or that we currently deem immaterial
also may impair our business operations
Our revenue and operating results have fluctuated in the past and are likely to
fluctuate significantly in the future, particularly on a quarterly basis.
Our operating results may vary significantly from quarter to quarter
due to many factors, some of which are outside our control. For example, the
following conditions could all affect our results:
|X| changes in our product sales and customer mix;
|X| constraints in our manufacturing and assembling operations;
|X| shortages or increases in the prices of raw materials and components;
|X| changes in pricing policy by us or our competitors;
|X| a slowdown in the growth of the networking market;
|X| seasonality;
|X| timing of expenditures; and
|X| 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:
|X| changes in the demand for our products;
|X| customer order deferrals in anticipation of new versions of our
products;
|X| the introduction of new products and product enhancements by us or our
competitors;
|X| the effects of filling the distribution channels following intro-
ductions of new products and product enhancements;
|X| potential delays in the availability of announced or anticipated products;
|X| the mix of product and revenue derived from the sale of extended warranty
contracts;
|X| the commencement or conclusion of significant outside consulting
contracts for our product development;
|X| changes in foreign currency exchange
rates; and
|X| 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 September
30, 2004, had an accumulated deficit of $22.0 million. Our development and
marketing of current and new products will continue to require substantial
expenditures. We incurred $591,000 of losses in 2001
21
attributable to a slowdown in demand for our products due in part to
industry-wide adverse economic factors. We have been profitable since the third
quarter of 2001, with total net income of $659,000 in 2002 and $1.6 million in
2003, and $460,000 for the first nine months in 2004. There can be no assurance
that growth in net sales will be achieved or profitability sustained in future
years.
Substantially all of our revenue comes from the sale of fax server products, and
a decline in demand for those products would harm our business, operating
results and financial condition.
We derive substantially all of our revenue from the sale of fax and
print server products, with fax server products accounting for 97% of total
sales in 2003 and almost all sales in the first nine months of 2004. 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.
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:
|X| conform to or support emerging network telecommunications standards;
|X| are compatible with a growing array of computer and peripheral devices;
|X| support popular computer and network operating systems and applications;
|X| meet a wide range of evolving user needs; and
|X| achieve market acceptance.
There can be no assurance that we will be successful in these efforts.
22
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
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.
23
The principal competitive factors affecting the market for our products
include:
|X| product functionality;
|X| performance;
|X| quality;
|X| reliability;
|X| ease of use;
|X| quality of customer training and support;
|X| name recognition;
|X| price; and
|X| 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 19%, 21% and 25% of our net sales in 2003, 2002 and 2001,
respectively and for 18.6% for the first nine months of 2004. We sell our
products in approximately 44 foreign countries through approximately 89
distributors. Our principal Japanese distributor accounted for approximately
38%, 27% and 40% of our international sales in 2003, 2002 and 2001, respectively
and 42% for the first nine months of 2004, and 7%, 6% and 10% of our total net
sales in 2003, 2002 and 2001, respectively and 7% for the first nine months of
2004. 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.
24
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
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.
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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 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
26
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.
Recent FASB Exposure Draft on Share-Based Payments may have a significant effect
on our Results of Operations, if adopted.
During March 2004, the FASB issued a proposed Statement, "Share-Based
Payment, and amendment of FASB Statements No. 123 and 95". The proposed
Statement addresses the accounting for share-based payment transactions in which
a company receives employee services in exchange for equity instruments of the
company that are based on the fair values of the company's equity instruments or
that may be settled by the issuance of such equity instruments. The proposed
statement eliminates the treatment for share-based transactions using APB
Opinion No. 25, "Accounting for Stock Issued to Employees," and generally would
require that such transactions be accounted for using a fair-value-based method
and recognized as expenses in our statement of income. 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.
The effective date the proposed standard is recommending is for fiscal
years beginning after December 15, 2004. Should the proposed statement be
finalized, it will 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 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
27
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.
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 October 31, 2004, our officers and directors and their affiliates
beneficially owned approximately 26% 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
September 30, 2004. 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.
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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 September 30, 2004 that
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
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PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. UNREGISTERED SALES OF EQUITY 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
None.
ITEM 6. EXHIBITS
(a) Exhibits:
Additional Exhibit
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.
31.1 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002, executed by Scott C. McDonald, Chief
Executive Officer and President of Castelle.
31.2 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002, executed by Paul Cheng, Chief Financial
Officer of Castelle.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002, executed by Scott C. McDonald, Chief
Executive Officer and President of Castelle.
32.2 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002, executed by Paul Cheng, Chief Financial
Officer of Castelle.
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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: November 12, 2004
Scott C. McDonald
Chief Executive Officer and President
(Principal Executive Officer)
By: /s/ Paul Cheng Date: November 12, 2004
Paul Cheng
Vice President of Finance and Administration
Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
31