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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, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File No.: 0-27878
NORTHGATE INNOVATIONS, INC.
(Exact name of registrant as specified in its charter)
Delaware 13-3779546
(State or other jurisdiction (IRS Employer
of incorporation or organization) Identification No.)
801 Sentous Street, City of Industry, California 91748
(Address of principal executive offices)(Zip code)
Registrant's telephone number, including area code: (626) 923-6000
Indicate by check whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12
months (or for such shorter period that the registrant was required to file such
reports) and (2) has been subject to such filing requirements for the past 90
days. Yes [X] No [ ]
Indicate by check whether the registrant is an accelerated filer (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
The number of shares outstanding of each of the issuer's classes of common
stock, as of May 14, 2004, was 18,942,808 shares of Common Stock, $0.03 par
value.
NORTHGATE INNOVATIONS, INC.
INDEX TO FORM 10-Q
PART I - FINANCIAL INFORMATION Page
----
Item 1. Financial Statements
Consolidated Balance Sheets................................................ 3
Consolidated Statements of Operations...................................... 4
Consolidated Statement of Stockholders' Equity............................. 5
Consolidated Statements of Cash Flows...................................... 6
Notes to Condensed Consolidated Financial Statements....................... 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................................. 14
Item 3. Quantitative and Qualitative Disclosures About Market Risks........ 32
Item 4. Controls and Procedures............................................ 32
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K................................... 33
SIGNATURES................................................................. 34
NORTHGATE INNOVATIONS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
March 31, December 31,
2004 2003
------------------- -----------------
------------------- -----------------
(unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 814 $ 464
Accounts receivable, net of allowance for doubtful
accounts of $682 and $911 in 2004 and 2003,
respectively 8,539 6,597
Inventories, net 2,719 3,480
Prepaid expenses and other current assets 593 573
--------------- ------------
Total current assets 12,665 11,114
Equipment, net 624 709
Goodwill 3,492 3,492
Other assets 82 82
--------------- ------------
Total assets $ 16,863 $ 15,397
=============== ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 5,705 $ 5,710
Accrued expenses 555 328
Short-term financing 1,247 -
Accrued royalties 1,431 1,431
Convertible notes payable 100 100
Dividends payable 186 186
Advances from ESOP 210 210
Advances from related party 1,000 1,000
Notes payable - current portion 4 16
--------------- ------------
Total current liabilities 10,438 8,981
Notes payable, net of current portion 1,322 1,355
--------------- ------------
Total liabilities 11,760 10,336
--------------- ------------
Commitments and contingencies
Stockholders' equity:
Preferred stock, $0.01 par value; 5,000 shares authorized,
1,350 shares issued and outstanding, liquidation
preference of $1,350 14 14
Common stock, $0.03 par value; 50,000 shares authorized,
18,943 shares issued and outstanding 568 568
Additional paid-in capital 14,585 14,572
Accumulated deficit (3,501) (3,530)
--------------- ------------
11,666 11,624
Less: Unearned ESOP shares (6,563) (6,563)
--------------- ------------
Total stockholders' equity 5,103 5,061
--------------- ------------
Total liabilities and stockholders' equity $ 16,863 $ 15,397
=============== ============
See accompanying notes to condensed consolidated financial statements
3
NORTHGATE INNOVATIONS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(in thousands, except per share data)
For The Three Months Ended
March 31, March 31,
2004 2003
------------------- --------------------
Net sales $ 19,348 $ 20,065
Cost of sales 16,911 19,227
--------------- ------------
Gross profit 2,437 838
Operating expenses 2,268 1,879
--------------- ------------
Operating profit (loss) 169 (1,041)
--------------- ------------
Other expense:
Interest expense 127 133
Other 13 34
--------------- ------------
Total other expense 140 167
--------------- ------------
Income (loss) before provision for income taxes 29 (1,208)
Provision for (benefit from) income taxes - (79)
--------------- -------------
Net income (loss) $ 29 $ (1,129)
=============== ============
Basic income (loss) per share $ - $ (0.08)
=============== ============
Diluted income (loss) per share $ - $ (0.08)
=============== ============
Weighted average shares of common stock outstanding:
Basic 18,943 14,694
=============== ============
Diluted 20,246 14,694
=============== ============
See accompanying notes to condensed consolidated financial statements
4
NORTHGATE INNOVATIONS, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(unaudited)
(in thousands)
Preferred Stock Common Stock Additional Unearned Total
----------------------- --------------------- Paid-in ESOP Accumulated Stockholders'
Shares Amount Shares Amount Capital Shares Deficit Equity
----------- --------- -------- --------- -------------- ----------- -------------- --------------
Balance,
January 1,
2004 1,350 $ 14 18,943 $ 568 $ 14,572 $ (6,563) $ (3,530) $ 5,061
Stock-based
compensation - - - - 13 - - 13
Net income - - - - - - 29 29
----- ----- ----- ------ ------ -------- --------- ---------
Balance,
March 31,
2004 1,350 $ 14 18,943 $ 568 $ 14,585 $ (6,563) $ (3,501) $ 5,103
===== ====== ====== ====== ======== ======== ======== ==========
See accompanying notes to condensed consolidated financial statements
5
NORTHGATE INNOVATIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
For The Three Months Ended
March 31, March 31,
2004 2003
------------------- --------------------
Cash flows from operating activities:
Net income (loss) $ 29 $ (1,129)
Adjustments to reconcile net income (loss)
to net cash used in operating activities:
Depreciation 87 67
Loss on disposal of fixed assets 19 -
Stock-based compensation 13 -
Provision for losses on accounts receivable 22 -
Changes in operating assets and liabilities:
Accounts receivable (1,964) (7,597)
Inventories 761 (2,506)
Prepaid expenses and other current assets (20) (37)
Accounts payable (5) 7,933
Accrued expenses 227 16
ESOP interest payable - 101
Accrued royalties - (9)
--------------- ---------------
Net cash used in operating activities (831) (3,161)
--------------- ---------------
Cash flows from investing activities:
Purchases of equipment (62) (17)
--------------- ---------------
Net cash used in investing activities (62) (17)
--------------- ---------------
Cash flows from financial activities:
Borrowings on line of credit - 1,994
Payments on note payable to bank (4) -
Advances from related party 500 -
Payments on advances from related party (500) -
Borrowings under short-term financing, net 1,247 -
--------------- ---------------
Net cash provided by financing activities 1,243 1,994
--------------- ---------------
Net increase (decrease) in cash and cash equivalents 350 (1,184)
Cash and cash equivalents, beginning of period 464 1,837
--------------- ---------------
Cash and cash equivalents, end of period $ 814 $ 653
=============== ===============
The Company paid $57 and $1 for interest and $0 and $0 for taxes, during the
three months ended March 31, 2004 and 2003, respectively.
See accompanying notes to condensed consolidated financial statements
6
NORTHGATE INNOVATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - BASIS OF PRESENTATION
- ------------------------------
The accompanying consolidated financial statements include the accounts of
Northgate Innovations, Inc. (formerly Mcglen Internet Group, Inc.) and its
wholly owned subsidiaries and have been prepared, without audit, pursuant to the
rules and regulations of the Securities and Exchange Commission (SEC). We have
eliminated all significant intercompany transactions. We have condensed or
omitted certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles in the United States of America pursuant to such regulations. These
financial statements should be read in conjunction with the audited financial
statements and the notes thereto included in our Annual Report on Form 10-K for
the year ended December 31, 2003.
In the opinion of our management, the accompanying financial statements contain
all adjustments necessary to present fairly our financial position at March 31,
2004 and December 31, 2003, and the results of operations and cash flows for the
three months ended March 31, 2004 and March 31, 2003. The results of operations
for the interim periods are not necessarily indicative of the results of
operations for the full year.
The preparation of financial statements in accordance with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
As defined by Statement of Financial Accounting Standards (SFAS) No. 131,
"Disclosures about Segments of an Enterprise and Related Information," we
operate in one business segment, using one measurement of profitability for our
business.
NOTE 2 - OVERVIEW AND RECENT DEVELOPMENTS
- -----------------------------------------
We are a Delaware corporation headquartered in the City of Industry, California.
We are a distributor of personal computers, notebooks, accessories and software
products. We specialize in selling these products through television shopping
networks, mail order catalog companies and large electronic and office supply
chain stores, principally in the United States. We are organized and operate as
one business segment.
In December 2003, an investor group acquired a majority of our outstanding
common stock and appointed a majority of the members of our board of directors.
In connection with this transaction, we sold 4,000,000 shares of our common
stock to this investor group at $0.25 per share, or a total of $1,000,000. Also
in connection with this transaction, we agreed to issue warrants to purchase a
total of 2,500,000 shares of our common stock to a member of the investor group
as consideration for certain consulting services to be provided for six months
following the date of the stock purchase. The warrants were issued in three
equal installments of 833,333, the first of which occurred on December 9, 2003.
The warrants are exercisable over a five-year period at $0.50 per share. Since
the change in control resulting from this transaction only involved 50.5% of our
outstanding common stock, on a fully diluted basis, "push-down accounting"
treatment does not apply. Therefore, we accounted for the acquisition on a
historical basis and did not apply purchase accounting.
7
NORTHGATE INNOVATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2 - OVERVIEW AND RECENT DEVELOPMENTS, continued
- ----------------------------------------------------
In January and February of 2004, our new board of directors employed new members
of our management team, including a new chief executive officer. Under the
direction of our restructured management team, we began implementing a new
strategic focus designed to complement our existing business. We are now
developing a business plan to launch a hardware and software offering targeted
at the youth market, which we believe is an underserved segment of the personal
computer and Internet market.
Our new product initiative will require significant capital to fund operating
expenses, including research and development expenses and sales and marketing
expenses, capital expenditures and working capital needs until we achieve
positive cash flows from that initiative. We expect to seek between $5,000,000
and $10,000,000 in external equity financing by the end of our current fiscal
year to fund our new product initiative. We have yet to come to an agreement
with potential investors regarding the terms of any such equity financing. In
order to fund our current working capital needs, we have entered into a purchase
and sale agreement with a financial institution under which we may assign
certain of our accounts receivable for immediate cash. We are currently in
discussions with other financial institutions regarding alternatives to this
funding source. We may decide to continue with our existing arrangement or seek
other arrangements on terms that we believe would be more beneficial to meet our
long-term requirements, including funding a portion of the requirements
necessary to implement our new product initiative. We cannot give any assurance
that any additional financing will be available, that we can ever achieve
positive operating cash flows from our new product initiative or that we will
have sufficient cash from any source to meet our needs. It is possible that we
will exhaust all available funds before we reach positive cash flow from our new
product initiative. If we are not able to raise sufficient external financing,
we will have to curtail our efforts to implement our new product initiative.
NOTE 3 - SIGNIFICANT ACCOUNTING POLICIES
- ----------------------------------------
Inventories
- -----------
We state inventories at the lower of cost or market. We determine cost using
average cost. Inventory costs include raw materials, labor and overhead. When
required, we make provisions to reduce excess and obsolete inventories to their
estimated net realizable value.
From time to time we also maintain at our facilities consigned inventory that
remains the property of the vendors supplying the inventory ("consigned
inventory") until such time as we elect to use the inventory. At the time that
we elect to use the consigned inventory, the cost of such inventory is reflected
in our inventory accounts and a corresponding account payable to the vendor is
recorded.
Inventories, net, consists of the following (in thousands):
March 31, December 31
-------------------------------------------
2004 2003
------------------- --------------------
Raw material $ 2,547 $ 2,995
WIP and finished goods 172 485
--------------- ----------------
$ 2,719 $ 3,480
=============== ================
8
NORTHGATE INNOVATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3 - SIGNIFICANT ACCOUNTING POLICIES, continued
- ---------------------------------------------------
Goodwill and Other Intangible Assets
- ------------------------------------
We have adopted SFAS No. 142 "Goodwill and Other Intangible Assets." Under SFAS
No. 142, goodwill associated with acquisitions consummated after June 30, 2001
is not to be amortized, and effective January 1, 2002, goodwill and other
intangible assets with indefinite lives are no longer subject to periodic
amortization but are instead reviewed annually for impairment, or more
frequently if impairment indicators arise. We decided to perform an impairment
test on goodwill as of December 31, 2003. We determined that $590,000 of the
recorded goodwill balance was impaired and we wrote down that amount in 2003.
There can be no assurance, however, that market conditions will not change or
demand for our services will continue, which could result in additional
impairment of goodwill and other intangible assets in the future.
We record identifiable assets and liabilities acquired in connection with
business combinations accounted for under the purchase method at their
respective fair values. We have recorded deferred income taxes to the extent of
differences between the fair value and the tax basis of the assets acquired and
liabilities assumed.
Revenue Recognition
- -------------------
We derive revenue primarily from sales of our personal computers, and to a
lesser extent, from software, peripherals and accessories. Generally, we will
recognize revenue when persuasive evidence of an arrangement exists, delivery
has occurred, the fee is fixed or determinable and collection is probable. We
record discounts provided to resellers for achieving purchasing targets as a
reduction of revenue on the date of sale.
For sales of merchandise owned and warehoused by us, we recognize revenue when
title to products sold has transferred to the customer in accordance with
shipping terms. We also sell merchandise from suppliers on a "drop-ship" basis.
We take title to this merchandise from the time it is shipped by the supplier
until the time it is received by the customer
Stock-Based Compensation
- ------------------------
We have adopted SFAS No. 123, "Accounting for Stock-Based Compensation." SFAS
No. 123 requires disclosure of the compensation cost for stock-based incentives
granted after January 1, 1995 based on the fair value at grant date for awards.
At March 31, 2004, we have one stock-based employee compensation plan, the
Mcglen Internet Group 2000 Stock Option Plan, which is described more fully in
Note 10 to the Financial Statements contained in our Annual Report on Form 10-K.
We have also adopted a second stock-based employee compensation plan, the
Northgate Innovations, Inc. 2004 Stock Incentive Plan, subject to approval by
our stockholders. We account for these plans under the recognition and
measurement principles of Accounting Principles Board Opinion No. 25 ("APB 25"),
"Accounting for Stock Issued to Employees," and related interpretations.
Approximately $13,000 of stock-based employee compensation cost related to these
plans is reflected in the statement of operations for the three months ended
March 31, 2004, in connection with certain options granted under those plans
which had exercise prices less than the market value of the underlying common
stock on the dates of grant. The following table illustrates the effect on net
income (loss) and earnings (loss) per share if we had applied the minimum value
recognition provisions of SFAS No. 123 to stock-based employee compensation
(amounts in thousands, except per share data):
9
NORTHGATE INNOVATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3 - SIGNIFICANT ACCOUNTING POLICIES, continued
- ---------------------------------------------------
March 31,
-------------------------------------------
2004 2003
-------------------- ----------------
Net income (loss), as reported $ 29 $ (1,129)
Add:
Total stock-based compensation under APB 25 13 -
Deduct:
Total stock-based compensation
expense under fair value based
method for all awards, net of
related tax effects (33) (10)
---------------- ---------------
Pro forma net income (loss) $ 9 $ (1,139)
=============== ===============
Basic EPS - as reported $ - $ (0.08)
=============== ===============
Diluted EPS - as reported $ - $ (0.08)
=============== ===============
Basic EPS - pro forma $ - $ (0.08)
=============== ===============
Diluted EPS - pro forma $ - $ (0.08)
=============== ===============
Net Income (Loss) Per Share
- ---------------------------
Basic net income (loss) per share excludes dilution and is computed by dividing
net income by the weighted average number of common shares outstanding during
the reported periods. Diluted net income (loss) per share reflects the potential
dilution that could occur if other rights to require us to issue common stock
were exercised. Each share of ESOP preferred stock is convertible into 3.16582
shares of common stock. Allocated ESOP shares (including shares released for
allocation) are considered dilutive for all periods presented. The computation
of basic and diluted shares outstanding is as follows for the three months ended
March 31 (in thousands):
March 31,
-----------------------------------------
2004 2003
-------------------- --------------
Weighted average shares - basic 18,943 14,694
Effect of dilutive shares 1,303 -
--------------- -------
Weighted average shares - dilutive 20,246 14,694
Since we reported a loss for the three months ended March 31, 2003, basic and
diluted weighted average shares are the same for that period, as the effect of
stock options and warrants per share are anti-dilutive and thus not included in
the diluted loss per share calculation. There were no additional potential
dilutive shares at March 31, 2003.
10
NORTHGATE INNOVATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - CONCENTRATIONS
- -----------------------
Financial instruments that potentially subject us to a concentration of credit
risk consist primarily of cash and cash equivalents and accounts receivable.
Sales are primarily concentrated in the United States. We have primarily offered
consumers personal computers and related products through distribution channels
that include large electronic and office supply retailers, television shopping
networks and mail order catalogues. We perform credit evaluations on our
customers and we provide allowances for potential credit losses and product
sales returns. Some key components included in our line of products are
currently available only from single or limited sources. The loss of a major
customer or the inability of one or more of our suppliers to meet our demand for
components in a timely and cost-effective manner could have a material adverse
impact on our financial condition or results of operations.
Historically, we have relied upon sales to a few customers. During the first
quarter of 2004, approximately 53% of our revenues were from one customer. This
customer had an accounts receivable balance of approximately $6.1 million at
March 31, 2004. During the first quarter of 2003, approximately 25% of our
revenues were from that customer. We believe that we could locate other
customers that would purchase merchandise on comparable terms; however, the
establishment of new customer relationships could take several months.
For the three months ended March 31, 2004 and 2003, one supplier accounted for
approximately %19 and 13%, respectively, of our total purchases. Management
believes that other suppliers could provide similar merchandise on comparable
terms.
We had an Internet access and portal co-marketing agreement with Microsoft
Corporation and the Microsoft Network (MSN) to provide Internet access to our
end users, for which we paid MSN a royalty. Under the agreement, MSN also had
the obligation to pay us for our end users that continued as subscribers to MSN.
This agreement was terminated in July 2001. We have maintained an accrual
balance of $1,400,000 related to this program pending final settlement of the
matter with Microsoft and MSN.
NOTE 5 - SHORT-TERM FINANCING
- -----------------------------
At December 31, 2003, we had a $2,500,000 revolving credit facility with a
commercial bank. The facility expired in January 2004.
In February 2004 we entered into a purchase and sale agreement with a financial
institution. Under the terms of that agreement, we may assign certain of our
accounts receivable to the financial institution for immediate cash in the
amount of 75% of the assigned receivables. We also receive a portion of the
remaining balance of the assigned accounts receivable, depending on how soon
after assignment the financial institution receives payment on those accounts.
Under this arrangement we have an effective interest rate of approximately 3.0%
to 4.0% per month. Under the purchase and sale agreement, the financial
institution has certain rights of recourse against us for uncollected accounts
receivable. The arrangement expires in August 2004, with automatic annual
extensions unless either party gives 60 days prior written notice to the
contrary. The financial institution may terminate the arrangement at any time
with 60 days prior written notice. We expect to keep this arrangement in place
until we can obtain another facility on more favorable terms to us. We are in
discussions with several financial institutions regarding alternative financing
arrangements, but we do not currently have any binding commitments regarding
such a facility.
11
NORTHGATE INNOVATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6 - RELATED PARTY TRANSACTIONS
- -----------------------------------
During 2003, we recorded approximately $2,506,000 in advances from our former
chief executive officer, Andy Teng. We recorded approximately $1,506,000 in
repayment of these recorded advances during 2003. During January 2004, we
recorded an additional $500,000 in repayments to Mr. Teng. These payments were
in violation of certain restrictions in connection with our line of credit. In
addition, the payments were in violation of a subordination agreement that Mr.
Teng executed for the benefit of the bank. Mr. Teng paid us $500,000 on February
2, 2004. The outstanding recorded advances of $1,000,000 are due on demand. The
advances from Mr. Teng recorded by us, and the payments to Mr. Teng on the
recorded advances, were not approved by our board of directors.
On October 27, 2003, we received an advance of approximately $200,000 from a
trust account in the name of our employee stock ownership plan, or ESOP. At the
instruction of Mr. Teng, we recorded that advance as an advance from Mr. Teng,
individually. In January 2004, we received another advance of $10,000 from a
trust account in the name of the ESOP. We have set aside the amount of those
advances in a separate bank account, for the benefit of the ESOP, and we are
holding that amount pending receipt of guidance from governmental authorities.
During March 2004, we received a demand from Mr. Teng for repayment of
$1,210,000 in advances. In April 2004, Mr. Teng filed suit to collect this
amount (see Note 7).
NOTE 7 - COMMITMENTS AND CONTINGENCIES
- --------------------------------------
On or about December 16, 2002, we were informed that the Pension and Welfare
Benefits Administration of the United States Department of Labor ("DOL") had
selected our ESOP for review, which is described more fully in Note 15 to the
Financial Statements included in our Annual Report on Form 10-K for the year
ended December 31, 2003. The DOL has raised issues regarding the December 1999
transaction between Mr. Teng and the ESOP, in which Mr. Teng sold shares of our
preferred stock to the ESOP in connection with the establishment of the plan.
The DOL has indicated that this transaction may have been a prohibited
transaction because the purchase price of the shares may have been above fair
market value at the time of the transaction, which would require the unwinding
or correction of the transaction. Although Mr. Teng is primarily responsible for
remedying any prohibited transaction, we may have some liability as a
co-fiduciary of the ESOP. However, Mr. Teng has agreed to indemnify us against
any costs or damages incurred by us in connection with the ESOP, including any
cost or damages relating to the DOL investigation. We intend to cooperate with
the DOL in its review of our ESOP, and to bring such review to conclusion as
quickly as possible.
In April 2004, Mr. Teng filed suit to collect the recorded advances described in
Note 6. In his collection suit, we believe that Mr. Teng, the sole trustee of
our ESOP, is seeking the repayment of the initial advance we received from our
ESOP described in Note 6 to himself, individually, under the premise that the
money was owed to him under a loan agreement between our ESOP and Mr. Teng. We
have not been able to confirm or deny that premise. We intend to defend the
collection suit by Mr. Teng to protect the assets of our ESOP, to require Mr.
Teng to account for amounts he advanced to us while he was in control of our
12
accounting function, to assert our right to set off amounts owed to us by Mr.
Teng against amounts we otherwise owe to Mr. Teng, if any, and to assert other
claims that we have against Mr. Teng.
At this time, we are not involved in any other legal proceedings that our
management currently believes would be material to our business, financial
condition or results of operations. We could be forced to incur material
expenses with respect to these legal proceedings, and in the event there is an
outcome in any that is adverse to us, our financial position and prospects could
be harmed.
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This report contains "forward-looking statements" within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934, both as amended. All statements other than statements of historical
fact are "forward-looking statements" for purposes of federal and state
securities laws, including: any projections of earnings, revenues or other
financial items; any statements of the plans, strategies and objectives of
management for future operations; any statements concerning proposed new
products, services or developments; any statements regarding future economic
conditions or performance; any statements of belief; and any statements of
assumptions underlying any of the foregoing. Forward-looking statements may
include the words "may," "will," "estimate," "intend," "continue," "believe,"
"expect," "plan" or "anticipate" and other similar words.
Although we believe that the expectations reflected in our forward-looking
statements are reasonable, actual results could differ materially from those
projected or assumed. Our future financial condition and results of operations,
as well as any forward-looking statements, are subject to change and to inherent
risks and uncertainties, such as those disclosed in this report. We do not
intend, and undertake no obligation, to update any forward-looking statement.
The following discussion and analysis of our financial condition and results of
operations should be read in conjunction with the unaudited condensed
consolidated financial statements and the notes thereto included elsewhere in
this report.
The information contained below is subject to the "Factors Affecting Operating
Results" and other risks detailed in this report and our other reports filed
with the Securities and Exchange Commission. We urge you to review carefully the
section "Factors Affecting Operating Results" included in this report for a more
complete discussion of the risks associated with an investment in our
securities.
Executive Overview
Since 1992, when our predecessor was formed, we have primarily offered consumers
personal computers and related products through distribution channels that
include television shopping networks, mail order catalog companies and large
electronic and office supply chain stores. In December 2003, new investors in
the Company acquired a majority of our outstanding common stock and appointed a
majority of the members of our board of directors. In January and February of
2004, our new board of directors employed new members of our management team,
including a new chief executive officer. Under the direction of our restructured
management team, we began implementing a new strategic focus designed to
complement our existing business. We are now developing a business plan to
launch a hardware and software offering targeted at the youth market, which we
believe is an untapped segment of the personal computer and Internet market.
Our operating results have been subject to seasonality and to quarterly and
annual fluctuations. Factors involved in that seasonality include new product
developments or introductions, availability of components, changes in product
mix and pricing and product reviews and other media coverage. Historically, our
sales have increased in the third and fourth calendar quarters due, in part, to
back-to-school and holiday spending, respectively. We expect that the sales of
our new product line will have similar seasonality patterns.
14
On March 20, 2002, we completed a merger with Lan Plus Corporation, a
manufacturer of branded turnkey computer products and services. In that merger,
the shareholders of Lan Plus acquired approximately 75% of our outstanding
common stock as of that date. In addition, upon the closing of the merger, we
completed a one-for-ten reverse stock split and changed our name from Mcglen
Internet Group, Inc. to Northgate Innovations, Inc. As a result of the merger,
for financial accounting purposes, we treat the merger as a purchase of us by
Lan Plus. Therefore, we present the historical financial statements of Lan Plus
for comparison purposes for all periods presented.
In the consumer electronics industry, and particularly with respect to the
distribution of personal computers, financial performance is closely tied to the
ability of the distributor to receive adequate gross profit margins. Since our
operating expenses are relatively fixed, we must increase our gross margins in
order to generate more income, and cash. Competition has driven down the selling
prices for personal computers. Due primarily to the competitive pressures on our
selling prices, over the last two fiscal years our gross profit margins have
decreased significantly. As a result, we have experienced operating losses and
net losses in each of the past two fiscal years. These losses have been the
primary reason for a decrease in our cash and cash equivalents from
approximately $8.6 million at the end of 2001 to approximately $814,000 at March
31, 2004. We expect that there will be continued pressure on our margins in the
foreseeable future.
In order to improve our gross profit margins, we have adopted our new product
initiative to try to decrease the competitive pressures on our margins. Our new
product initiative is designed to increase demand for our products, so that we
can charge a higher price for, and thereby increase the profit margin on, those
products. If we are unsuccessful in increasing the demand for our new products,
and receiving a higher price for those products, we will probably not be
successful in improving our profit margins. We are also trying to increase the
profit margins on both our new products and our existing product line by
lowering our component costs, which decreases our cost of goods sold. However,
lowering component costs has proven difficult in the past. If we cannot improve
our margins through our new product initiative, or by lowering our component
costs, our financial performance is likely to continue to suffer in 2004 and
beyond.
Critical Accounting Policies and Estimates
Management's discussion and analysis of financial condition and results of
operations is based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities
and expenses, and related disclosure of contingent assets and liabilities. On an
on-going basis, we evaluate our estimates, including those related to our
revenue recognition, deferred taxes, impairment of long-lived assets and
inventory. We base our estimates on historical experience and on various other
assumptions that we believe are reasonable under the circumstances, the results
of which form the basis for making judgments about the carrying values of assets
and liabilities that are not readily apparent from other sources. Actual results
may differ from these estimates.
Our critical accounting policies are as follows:
Revenue Recognition. We derive revenue primarily from sales of our personal
computers, and to a lesser extent, from software, peripherals and accessories.
Generally, we will recognize revenue when persuasive evidence of an arrangement
exists, delivery has occurred, the fee is fixed or determinable and collection
is probable. We provide for estimated costs of doubtful accounts and product
15
warranties as a reduction in earnings at the time we recognize revenue. Our
estimate of costs of doubtful accounts is based upon our historical collection
experience. If our collections decrease due to the deterioration of the
financial condition of our customers, or otherwise, we would have to increase
the doubtful account allowance, which would reduce earnings. Securities and
Exchange Commission Staff Accounting Bulletin No. 101 - Revenue Recognition in
Financial Statements requires us to estimate returns and warranty expenses prior
to recognizing revenue. While certain of the products we sell are covered by
third party manufacturer warranties, we may have products returned by customers
the costs of which we may not be able to recover from the manufacturer. Returns
of this nature have been immaterial in the past; however, should actual product
failure rates increase, or if the manufacturers go out of business or refuse to
honor their warranty obligations, we may be forced to cover these warranty costs
and the costs may differ from our estimates. We will record discounts provided
to resellers for achieving purchasing targets as a reduction of revenue on the
date of sale.
Vendor Rebates. We earn rebates from our vendors that are based on various
quantitative contract terms. Amounts we expect to receive from vendors relating
to the purchase of merchandise inventories are recognized as a reduction of cost
of goods sold at the time the merchandise is sold. If the amounts of those
rebates we actually receive are less than we expected, our cost of sales will be
understated for the period covered. We record rebates received that represent a
reimbursement of incremental costs, such as advertising, as a reduction to the
related expense in the period that the related expense is incurred. We have
several controls in place that we believe allow us to ensure that these amounts
are recorded in accordance with the terms of the applicable contracts. Should
the vendors paying the rebates reach different judgments regarding the terms of
these contracts, they may seek to recover all or a portion of the rebates from
us.
Deferred Taxes. As part of the process of preparing our financial statements, we
are required to estimate our income taxes. This process involves estimating our
actual current tax exposure together with assessing temporary differences
resulting from differing treatment of items for tax and accounting purposes.
These differences result in deferred tax assets and liabilities, which are
included within our balance sheet. We must then assess the likelihood that our
deferred tax assets will be recovered from future taxable income and to the
extent we believe that recovery is not likely, we must establish a valuation
allowance. To the extent we establish a valuation allowance or increase this
allowance in a period, we must include an expense within the tax provision in
our statement of operations.
Significant judgment involving multiple variables is required in determining our
deferred tax assets and liabilities and any valuation allowance recorded against
our net deferred tax assets. In assessing the potential realization of deferred
tax assets, we consider whether it is more likely than not that some portion or
all of the deferred tax assets will be realized. The ultimate realization of
deferred tax assets is dependent upon achieving future taxable income during the
period in which our deferred tax assets are recoverable. If our estimates
regarding our future taxable income prove to be incorrect, we may have to write
down the value of the deferred tax assets.
Impairment of Long-Lived Assets. We evaluate the recoverability of our
long-lived assets and review these assets for recoverability when events or
circumstances indicate a potential impairment. Factors we consider important
that could trigger an impairment review include the following:
1. significant underperformance relative to historical or projected
operating results;
16
2. significant changes in the manner or use of the assets or the strategy
for our overall business; and
3. significant negative industry or economic trends.
When we determine that the carrying value of these assets may not be recoverable
based on the existence of one or more of the above indicators of impairment, we
measure any impairment by estimating the undiscounted cash flows to be generated
from the use and ultimate disposition of these assets. We record assets to be
disposed of at the lower of the carrying amount or fair market value less
anticipated costs of sales.
Impairment of Goodwill and Other Intangible Assets. As a result of our adoption
of Statement of Financial Accounting Standards No. 142 "Goodwill and Other
Intangible Assets", we now annually review goodwill and other intangible assets
that have indefinite lives for impairment and whether events or changes in
circumstances indicate the carrying value of these assets might exceed their
current fair values. These reviews require us to estimate the fair value of our
identified reporting units and compare those estimates against the related
carrying values. For each of the reporting units, the estimated fair value is
determined as compared to our stock price.
Inventory. We adjust our inventory values so that the carrying value does not
exceed net realizable value. We estimate net realizable value based upon
forecasted demand. However, forecasted demand is subject to revisions and actual
demand may differ. This difference may require a write-down of our inventory,
which could have a material effect on our financial condition and results of
operations. From time to time, we maintain at our facilities component parts
inventory that remains the property of our vendors supplying the inventory until
such time as we elect to use the inventory. At the time we elect to use the
inventory, we reflect the cost of that inventory in our inventory account, and
generate a corresponding account payable.
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated the percentage of net
sales represented by certain items reflected in the Company's condensed
statements of operations. There can be no assurance that the trends in sales
growth or operating results will continue in the future.
PERCENTAGE OF NET SALES
-----------------------
PERIOD ENDED MARCH 31,
2004 2003
---- ----
Net sales 100.0% 100.0%
Cost of sales 84.4 95.8
------ ------
Gross profit 12.6 4.2
Operating expenses 11.7 9.4
------ ------
Income (loss) from operations 0.9 (5.2)
Interest expense, net 0.7 0.7
Other expense 0.1 0.1
------ ------
Loss before income taxes 0.1 (6.0)
Provision for income taxes 0.0 (0.4)
------ ------
Net income (loss) 0.1% (5.6)%
====== =======
THREE MONTHS ENDED MARCH 31, 2004 COMPARED TO THE THREE MONTHS ENDED MARCH 31,
2003
During the three months ended March 31, 2003, approximately 15% of our revenue
was derived through television shopping networks, compared to 4% in 2004. In
addition, sales to our largest customer went from approximately 25% of total
17
sales during the three months ended March 31, 2003 to approximately 53% in 2004.
This shift in customer and product mix had a significant impact on the results
of operations for the three months ended March 31, 2004 when compared to the
comparable period in 2003. Our net sales decreased by approximately $717,000, or
3.6%, to approximately $19.4 million for the three months ended March 31, 2004,
compared to approximately $20.1 million for the three months ended March 31,
2003, while our gross profit increased by approximately $1.6 million, or 190%,
to approximately $2.4 million for the three months ended March 31, 2004,
compared to approximately $838,000 for the three months ended March 31, 2003.
Our gross profit as a percentage of net sales increased to 12.6% for the three
months ended March 31, 2004 from 4.2% for the comparable period in 2003. The
relative decrease in distribution and Internet sales allowed us to achieve
better margins in the first three months of 2004. Other factors contributing to
improved margins include favorable component pricing in 2004 and a $250,000
provision for slow moving inventory recorded during the three months ended March
31, 2003. We did not record an additional provision for slow moving inventory
during the three months ended March 31, 2004.
Our future gross profit margins may fluctuate significantly from recent levels
as the result of competitive pressures on revenues or higher component costs.
The preceding statement concerning our future gross margins is a forward looking
statement that involves certain risks and uncertainties that could result in a
fluctuation of gross margins below those achieved for the three months ended
March 31, 2004 or year ended December 31, 2003. Although we believe that we
provide a high level of value and added services, pricing and gross profit could
be negatively impacted by the activities of larger computer manufacturers.
Our operating expenses increased by approximately $389,000, or 20.7%, to
approximately $2.3 million for the three months ended March 31, 2004, from
approximately $1.9 million for the same period in 2003. The increase in
operating expenses was attributable to an increase of approximately $234,000 in
professional fees related to regulatory filings and audit fees, an increase of
approximately $100,000 in marketing costs related to outsourced product
development and design relating to our new product initiative, an increase of
approximately $67,000 in travel related costs associated with new members of our
management team who do not live near our principal offices and the opening of
our administrative office in Austin, Texas.
Our other expense decreased by approximately $27,000, or 16.2%, to approximately
$140,000 for the three months ended March 31, 2004, from approximately $167,000
for same period in the prior year. The decrease was due primarily to a decrease
in interest expense related to certain debt of our ESOP that we paid and a net
decrease in borrowings on our revolving line of credit or through assignment of
accounts receivable during the three months ended March 31, 2004.
We did not make a provision for income taxes in the three months ended March 31,
2004. We had a benefit from income taxes of approximately $79,000 in the same
period in the prior year. We currently have sufficient net operating loss
carryforwards to offset any potential incomes taxes on our taxable income in the
current period.
INCOME TAXES
For the periods ended March 31, 2004 and 2003, the difference between the amount
of income tax recorded and the amount of income tax expense calculated using the
federal statutory rate of 34% is due to state income taxes and other permanent
differences.
18
We have federal and state net operating loss carryforwards of approximately $16
million and $10 million, respectively. The net operating loss carryforwards will
expire at various dates beginning in 2012 through 2023 for federal purposes and
2004 through 2013 for state purposes, if not utilized. Utilization of the net
operating loss carryforwards is subject to a substantial annual limitation due
to the ownership change limitations provided by the Internal Revenue Code of
1986, as amended, and similar state provisions. The annual limitation will
result in us being able to only utilize approximately $3.8 million and $0.5
million, to offset federal and state income, respectively, as of March 31, 2004.
The remaining net operating loss carryforwards will go unused.
LIQUIDITY AND CAPITAL RESOURCES
Historically, our primary financing need has been the funding of working capital
requirements. We financed our operations and met our capital expenditure
requirements primarily from cash provided by operations, borrowings from private
individuals, including our former chief executive officer and majority
stockholder, and financial institutions. As of March 31, 2004, we had
approximately $814,000 in cash, cash equivalents and short-term investments,
compared to approximately $464,000 and $653,000 at December 31, and March 31,
2003, respectively. Our new product initiative will require significant capital
to fund operating expenses, including research and development expenses and
sales and marketing expenses, capital expenditures and working capital needs
until we achieve positive cash flows from that initiative. We expect to seek
between $5.0 million and $10.0 million in external equity financing by the end
of our current fiscal year to fund our new product initiative. We have yet to
enter into an agreement with potential investors regarding the terms of any such
equity financing. In order to fund our current working capital needs, we have
entered into a purchase and sale agreement with a financial institution under
which we assign certain of our accounts receivable for immediate cash. We are
currently in discussions with other financial institutions regarding
alternatives to this funding source. We may decide to continue with our existing
arrangement or seek other arrangements on terms that we believe would be more
beneficial to meet our long-term requirements, including funding a portion of
the requirements necessary to implement our new product initiative. We cannot
give any assurance that any additional financing will be available, that we can
ever achieve positive operating cash flows from our new product initiative or
that we will have sufficient cash from any source to meet our needs. It is
possible that we will exhaust all available funds before we reach positive cash
flow from our new product initiative. If we are not able to raise sufficient
external financing, we will have to curtail our efforts to implement our new
product initiative.
During the year ended December 31, 2003, we had a revolving credit facility with
a commercial bank. The facility was collateralized by a first priority lien on
substantially all of our assets and the personal guarantee of our former chief
executive officer and majority stockholder. Under the facility, we could borrow
up to $2.3 million for working capital purposes, subject to availability under a
borrowing base. As of December 31, 2003, we had no borrowings under the
facility. The revolving credit facility terminated and all amounts borrowed
thereunder and not previously repaid were due and payable in full (including any
accrued interest) on January 31, 2004. Advances under the facility accrued
interest at a rate equal to the bank's prime rate plus 0.75% per annum.
In January 2004 we repaid $500,000 of the approximately $1.0 million in advances
we had recorded from our former chief executive officer and majority
stockholder, which was in violation of certain restrictions in connection with
our revolving credit facility. In addition, that payment was in violation of a
19
subordination agreement that our former chief executive officer and majority
stockholder executed for the benefit of the bank. Our former chief executive
officer and majority stockholder repaid the $500,000 to us on February 2, 2004.
On December 9, 2003, we closed a private placement of 4 million shares of our
common stock for a purchase price of $0.25 per share, and realized gross
proceeds of approximately $1 million. The investor in the private placement was
a limited liability company, which is controlled by Samuel J. Furrow, Jr. and
Marc B. Crossman, each of whom joined our board of directors as a result of that
private placement. We used the proceeds of the private placement for working
capital needs.
On or about February 6, 2004, we entered into a purchase and sale agreement with
a financial institution. Under the terms of that agreement, we may assign
certain of our accounts receivable to the financial institution for immediate
cash in the amount of 75% of the assigned receivables. We also receive a portion
of the remaining balance of the assigned accounts receivable, depending on how
soon after assignment the financial institution receives payment on those
accounts. Under this arrangement we have an effective interest rate of
approximately 3.0% to 4.0% per month. Under the purchase and sale agreement, the
financial institution has certain rights of recourse against us for uncollected
accounts receivable. The arrangement expires in August 2004, with automatic
annual extensions unless either party gives 60 days prior written notice to the
contrary. The financial institution may terminate the arrangement at any time
with 60 days prior written notice. We expect to keep this financing purchase
line in place until we can obtain another facility on more favorable terms to
us. We are in discussions with several financial institutions regarding
alternative financing arrangements, but we do not currently have any binding
commitments regarding such a facility.
Our net cash used in operating activities for the three months ended March 31,
2004 was approximately $831,000, as compared to net cash used in operating
activities of $3.2 million for the comparable period during 2003. This decrease
was primarily the result of net income of approximately $29,000 for the three
months ended March 31, 2004 compared to a net loss of approximately $1.1 million
for the comparable period in 2003.
Our net cash used in investing activities was approximately $62,000 for the
three months ended March 31, 2004, compared to net cash used in investing
activities of approximately $17,000 for the comparable period in 2003. Cash used
in investing activities consists of the purchase of property and equipment.
Our net cash provided by financing activities was approximately $1.2 million for
the three months ended March 31, 2004, compared to approximately $2.0 million
for the comparable period in 2003. Our net borrowings during the three months
ended March 31, 2003 were approximately $2.0 million under our revolving credit
facility compared to the assignment of approximately $1.2 million of accounts
receivable under our purchase and sale agreement with a financial institution
during the comparable period in 2004.
FACTORS AFFECTING OPERATING RESULTS
There are numerous risks affecting our business, some of which are beyond our
control. An investment in our common stock involves a high degree of risk and
may not be appropriate for investors who cannot afford to lose their entire
investment. In addition to the risks outlined below, risks and uncertainties not
presently known to us or that we currently consider immaterial may also impair
our business operations. Our future operating results and financial condition
are heavily dependent on our ability to successfully develop, manufacture and
20
market technologically innovative solutions in order to meet customer demands
for personal computers and related products. Inherent in this process are a
number of factors that we must successfully manage if we are to achieve positive
operating results in the future. Potential risks and uncertainties that could
affect our operating results and financial condition include, without
limitation, the following:
We cannot predict our future results because we have recently implemented a new
strategic initiative and have no operating history with that line of business.
Although we have over ten years of operating history, we have no history
operating our new business model. We began exploring our new product initiative
in December 2003. Our new product initiative is still in the early planning
stage and is a new strategic focus for us. There are significant risks and costs
inherent in our efforts to undertake our new product initiative. These include
the risk that we may not be able to develop viable products, achieve market
acceptance for our proposed line of products or earn adequate revenues from the
sale of such products, that our new business model, if started at all, may not
be profitable and other significant risks related to the implementation of a new
business model described below. Our prospects must be considered in light of the
uncertainties and difficulties frequently encountered by companies in their
early stages of development. We will devote a great deal of our resources to
implementing our new product initiative. Therefore, if that initiative is not
successful, we may not be able to continue to operate our existing business. It
is possible that we will exhaust all available funds before we reach the
positive cash flow phase of our proposed business model, which would hurt our
existing business.
We may have difficulty in raising capital because our common stock is not traded
on a recognized public market.
In order to implement our new product growth strategy, we will need to raise
significant amounts of additional capital. In April 2001, our common stock was
de-listed from trading on the Nasdaq SmallCap Market. Our common stock is
presently traded in the over-the-counter market, which is viewed by most
investors as a less desirable, and less liquid, marketplace. As a result, an
investor may find it more difficult to purchase, dispose of and obtain accurate
quotations as to the value of our common stock.
In addition, since the trading price of our common stock is less than $5.00 per
share, trading in our common stock is also subject to the requirements of Rule
15g-9 of the Exchange Act. Our common stock is also considered a penny stock
under the Securities Enforcement Remedies and Penny Stock Reform Act of 1990,
which defines a penny stock, generally, as any equity security not traded on an
exchange or quoted on the Nasdaq SmallCap Market that has a market price of less
than $5.00 per share. Under Rule 15g-9, brokers who recommend our common stock
to persons who are not established customers and accredited investors, as
defined in the Exchange Act, must satisfy special sales practice requirements,
including requirements that they:
o make an individualized written suitability determination for the
purchaser; and
o receive the purchaser's written consent prior to the transaction.
The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 also
requires additional disclosures in connection with any trades involving a penny
stock, including the delivery, prior to any penny stock transaction, of a
disclosure schedule explaining the penny stock market and the risks associated
with that market. Such requirements may severely limit the market liquidity of
21
our common stock and the ability of purchasers of our equity securities to sell
their securities in the secondary market. For all of these reasons, an
investment in our equity securities may not be attractive to our potential
investors.
The implementation of our new product initiative is risky and expensive, and it
is possible that we may never become profitable.
Successful implementation of our new product initiative continues to involve
several risks. These risks include:
o reliance upon unproven products;
o our unproven and evolving business model;
o unknown market acceptance of our new product line and any additional
products that we may be able to develop;
o our ability to anticipate and adapt to a rapidly developing market and
to changing technologies;
o the effect of competitive pressures in the marketplace;
o our need to structure our internal resources to support the
development, marketing and future growth of our proposed product
offerings;
o uncertainties concerning our strategic direction and financial
condition;
o our need to introduce additional reliable products that meet the
demanding needs of our target market; and
o our need to enhance our business development, research and
development, product development and support organizations, and to
expand our distribution channels, to develop our new product
initiative.
In addition, although we believe that the actions that we are taking will help
us become profitable, we cannot assure you that such actions will succeed in the
long or short term.
Internal and external changes resulting from our financial condition may concern
our prospective customers, investors, suppliers and employees, and produce a
prolonged period of uncertainty, which could have a material adverse affect on
our business. Our growth strategy requires substantial changes, including
pursuing new strategic relationships, increasing our research and development
expenditures, adding employees who possess the skills we believe we will need
going forward, establishing leadership positions in what we believe will be new
high-growth markets, establishing distribution channels for our new products and
realigning and enhancing our sales and marketing departments. Many factors may
impact our ability to successfully implement our growth strategy, including our
ability to finalize agreements with other companies, sustain the productivity of
our workforce, introduce innovative new products in a timely manner, manage
operating expenses and quickly respond to, and recover from, unforeseen events
associated with our strategy.
As a result of our new growth strategy, it is extremely difficult to forecast
our future financial performance. We are now in the initial stages of pursuing
our new business plan. Therefore, we do not expect to achieve profitability with
22
our new product line, and expect to incur net losses, at least through the end
of 2004. We expect to incur significant product development, administrative and
operating expenses relating to our new product initiative in the future. Only if
we are able to successfully develop our proposed products, bring them to market
before our competitors, and gain the acceptance of our products by our target
market, will we be able to generate any significant revenues from our new
business model. It is possible that we will exhaust all available funds before
we reach the positive cash flow phase of that business model.
If we are unable to develop our new line of products and services, our business
will suffer.
We hope to develop and then deliver to market an offering of hardware, software
and services focused on the youth market, a segment of the personal computer and
online market that we believe is currently underserved. If we are unsuccessful
in developing these new products, we will have no new products or services to
bring to market and, therefore, will never be able to generate revenues from our
new product initiative, and our business will suffer. Also, if we exhaust all
available funds before we can develop our new line of products and services, our
new business model will fail, and our existing business will suffer.
The market potential for our new products is unproven, and may not develop as we
hope, which could result in our failure to achieve sales and profits from our
new product initiative.
Our business model involves competing in a dynamic, but mature, market.
Therefore, our financial performance and any future growth will depend, in large
part, upon our ability to obtain market share from existing competitors. We
intend to invest a significant portion of our resources in the market segment we
have targeted, which we anticipate will grow at a significantly higher rate than
the broader consumer electronics industry on average. The markets for consumer
electronics products are highly competitive, and we are not certain that our
target customers will widely adopt our new products. Our target customers may
not choose to use our products for technical, style, cost, support or other
reasons. If we are incorrect in our assumption that our target market is
underserved, and that market does not develop as we hope, or if our new products
and services do not meet the demand in that market, we may never achieve
significant revenues and profits from our new product initiative. We cannot be
certain that a market for our new products or services will ever emerge or be
sustainable if it does emerge. If this market does not develop, or develops more
slowly than we expect, our business, results of operations and financial
condition will be seriously harmed.
If we are unable to develop and introduce our new product line quickly, our
business will suffer.
The market for consumer electronics products is characterized by rapid
technological change, frequent new product introductions and changes in customer
requirements. We believe that we have identified a segment of the personal
computer market that is currently underserved. Therefore, our success will
depend upon our ability to develop and introduce our new products in a timely
manner and to gain market acceptance of any products developed, before a
competitor can introduce competing products aimed at our target market segment.
In developing our new line of products, we have made, and will continue to make,
assumptions with respect to which features and performance criteria our target
customers will require. If we implement features and performance criteria that
are different from those required by our target customers, market acceptance of
our products may be significantly reduced or delayed and our business would be
seriously harmed.
23
Competition in the personal computer market may reduce the demand for, or price
of, our products.
We are considered one of the second tier personal computer manufacturers, which
include Systemax, Sys Technologies and Acer, among others. Although we compete
with these manufacturers, we also compete with a number of large, national
brand, personal computer manufacturers, including Dell, Inc., Gateway,
Inc./e-Machines, Hewlett-Packard Company, Apple Computer, Inc., Sony and
Toshiba. We may also face additional competition from new entrants into the
personal computer market that we have not yet identified. The market for
personal computers and related products is highly competitive, and we expect
competition to intensify in the future. Our competitors may introduce new
competitive products aimed at the same markets targeted by our line of products.
These products may have better performance, lower prices and broader acceptance
than our products. Competition may reduce the overall market for our products.
Most of these current and potential competitors have longer operating histories,
greater name recognition, larger customer bases and significantly greater
financial, technical, sales, marketing and other resources than we do. In
addition, because of the higher volume of components that many of our
competitors purchase from their suppliers, they are able to keep their costs of
supply relatively low and, as a result, may be able to recognize higher margins
on their personal computer sales than we do. Many of our competitors may also
have existing relationships with the resellers who we use to sell our products,
or with our existing or potential customers. This competition may result in
reduced prices, reduced margins and longer sales cycles for our products. The
introduction of lower-priced personal computers, combined with the brand
strength, extensive distribution channels and financial resources of the larger
vendors, would cause us to lose market share and would reduce our margins on
those personal computers we sell. If any of our larger competitors were to
commit greater technical, sales, marketing and other resources to our markets,
our ability to compete would be adversely affected.
We are dependent on Staples for a substantial portion of our revenues.
We are dependent upon our relationship with Staples the Office Superstore, Inc.
for a substantial portion of our existing and anticipated revenues. For the year
ended December 31, 2003, sales to Staples represented approximately 36.5% of our
total net sales for the year. For the three months ended March 31, 2004, sales
to Staples represented approximately 52% of our total sales for the quarter. We
expect that we will continue to be dependent upon Staples for a significant
portion of our revenues in future periods. As a result of this concentration of
sales, our business, operating results or financial condition would suffer as a
result of the termination of, or an adverse change in, our relationship with
Staples. In addition, we cannot assure you that our relationship with Staples
will continue, or if continued, will not decrease in any future period. Staples
may also use this concentration of sales to negotiate lower prices for our
products, which would result in lower margins on the products we sell to
Staples. Our agreement with Staples expires at the end of 2004. The agreement is
renewable annually upon mutual agreement between Staples and us. Therefore, we
cannot assure you that we will generate significant revenues in future periods
from Staples. The loss of all or any significant part of our relationship with
Staples would seriously harm our business.
We will not be able to develop or continue our business if we fail to attract
and retain key personnel.
Our future success depends on our ability to attract, hire, train and retain a
number of highly skilled employees and on the service and performance of our
senior management and other key personnel. The loss of the services of our
24
executive officers or other key employees could adversely affect our business.
Competition for qualified personnel possessing the skills necessary for success
in the competitive consumer electronics industry is intense, and we may fail to
attract or retain the employees necessary to execute our business model
successfully. Because we have experienced operating losses, and because our
common stock is not traded on a recognized national market, we may have a more
difficult time in attracting and retaining the employees we need. Our
relationships with most of these key employees are "at will." Moreover, we do
not have "key person" life insurance policies covering any of our employees.
Some members of our management team have joined us only recently. Our success
depends to a significant degree upon the continued contributions of our key
management, business development and marketing, engineering, research and
development and other personnel, many of whom would be difficult to replace. In
particular, we believe that our future success is highly dependent on Kent A.
Savage, our chairman and chief executive officer.
The brand for our new product initiative may not achieve the broad recognition
necessary to grow our customer base.
We believe that recognition and a favorable perception of our new products and
services by our target market is essential to the success of our new product
initiative. If we are unsuccessful in establishing or maintaining a favorable
perception of our products and services, we may not be able to grow our customer
base. Our success in promoting and maintaining the brand that we use in
connection with the new business model, will depend largely on:
o the success of our brand-enhancement strategy, including marketing and
advertising, promotional programs and public relations activities;
o the quality and ease-of-use of our products, services and
applications;
o our ability to provide high quality customer service; and
o our ability to enhance and improve the quality and features of our
products and services.
We cannot assure you that we will be able to achieve success in any of these
areas. In addition, in order to attract and retain customers and to promote and
maintain our brands, we will need to substantially increase our marketing
expenditures. If we incur excessive expenses in promoting and maintaining our
brands, our financial results could be seriously harmed.
If we are unable to acquire key components or are unable to acquire them on
favorable terms, our business will suffer.
Some key components included in our line of products are currently available
only from single or limited sources. In addition, some of the suppliers of these
components are also supplying certain of our competitors. We cannot be certain
that our suppliers will be able to meet our demand for components in a timely
and cost-effective manner. We expect to carry little inventory of some of our
products and product components, and we will rely on our suppliers to deliver
necessary components to our contract manufacturers in a timely manner based upon
forecasts we provide. We may not be able to develop an alternate source of
supply in a timely manner, which could hurt our ability to deliver our products
to our customers. If we are unable to buy these components on a timely and a
cost-efficient basis, we may not be able to deliver products to our customers,
or the margins we receive for our products may suffer, which would negatively
25
impact our future financial performance and, in turn, seriously harm our
business.
We purchase a substantial portion of our products from a single manufacturer.
Purchases from this manufacturer accounted for more than 11% of our aggregate
merchandise purchases for 2003 and approximately 19% for the first quarter of
2004. We have no long-term contracts or arrangements with this manufacturer, or
our other suppliers, that guarantee the availability of components. If we lose
our relationship with this manufacturer, we may not be able to find an alternate
supplier on a timely basis, or on reasonable terms.
At various times, some of the key components for our products have been in short
supply. Delays in receiving components would harm our ability to deliver our
products on a timely basis. In addition, because we expect to rely on purchase
orders rather than long-term contracts with our suppliers, we cannot predict
with certainty our ability to procure components in the longer term. If we
receive a smaller allocation of components than is necessary to manufacture
products in quantities sufficient to meet our customers' demand, those customers
could choose to purchase competing products.
Our reliance on third parties to manufacture and assemble our products could
cause a delay in our ability to fill orders, which might cause us to lose sales.
We currently use third parties to manufacture sub-assemblies of our products and
we purchase our components on a purchase order basis. We expect to continue this
method of procurement indefinitely, at least with respect to our existing
business. If we cannot continue our arrangement with our contract manufacturers,
and if we cannot establish an arrangement with at least one contract
manufacturer who agrees to manufacture our sub-assemblies on terms acceptable to
us, we may not be able to produce and ship our products, and our business will
suffer. If we fail to manage our relationships with our contract manufacturers
effectively, or if they experience delays, disruptions or quality control
problems in their manufacturing operations, our ability to ship products to our
customers could be delayed.
The absence of dedicated capacity with our contract manufacturers means that,
with little or no notice, they could refuse to continue manufacturing, or
increase the pricing of, some or all of our products. Qualifying new contract
manufacturers and commencing volume production would be expensive and
time-consuming. If we are required or choose to change contract manufacturers,
we could lose revenues and damage our customer relationships.
Our reliance on third-party manufacturers also exposes us to the following risks
that are outside our control:
o unexpected increases in manufacturing and repair costs;
o interruptions in shipments if one of our manufacturers is unable to
complete production;
o inability to control delivery schedules;
o unpredictability of manufacturing yields; and
o inability of a manufacturer to maintain the financial strength to meet
our procurement and manufacturing needs.
26
We may not be able to compete effectively if we are not able to protect our
intellectual property.
We rely, and intend to rely, on a combination of trademark, trade secret and
copyright law and contractual restrictions to protect the proprietary aspects of
our products. We have applied to register, or intend to apply to register,
various trademarks relating to our existing business and our new product
initiative. Although we have yet to file any patent applications for inventions
related to our new line of products, we anticipate filing patent applications
for inventions relating to that product line that we determine will be key to
our new product initiative. If we are not successful in obtaining the patent
protection we need, our competitors may be able to replicate our technology and
compete more effectively against us. We also enter, and plan to continue to
enter, into confidentiality or license agreements with our employees,
consultants and other parties with whom we contract, and control access to and
distribution of our software, documentation and other proprietary information.
The legal protections described above would afford only limited protection.
Unauthorized parties may attempt to copy aspects of our products, or otherwise
attempt to obtain and use our intellectual property. Monitoring unauthorized use
of our products will be difficult, and the steps we have taken may not prevent
unauthorized use of our technology, particularly in foreign countries where the
laws may not protect our proprietary rights as fully as in the United States.
Undetected product errors or defects could result in loss of revenues, delayed
market acceptance and claims against us.
We offer a warranty on all of our products, allowing the end user to have any
defective unit repaired or to receive a replacement product within a certain
period after the date of sale. Our products may contain undetected errors or
defects. If one of our products fails, we may have to replace all affected
products without being able to record any revenue for the replacement units, or
we may have to refund the purchase price for the defective units. Some errors
are discoverable only after a product has been installed and used by end users.
Any errors discovered after our products have been widely used could result in
loss of revenues and claims against us.
If we are unable to fix errors or other problems that later are identified after
installation, in addition to the consequences described above, we could
experience:
o failure to achieve market acceptance;
o loss of customers;
o loss of market share;
o diversion of development resources;
o increased service and warranty costs; and
o increased insurance costs.
If we fail to predict our manufacturing requirements accurately, we could incur
additional costs or experience manufacturing delays, which could reduce our
gross margins or cause us to lose sales.
We provide forecasts of our demand to our contract manufacturers prior to the
scheduled delivery of products to our customers. If we overestimate our
27
requirements, our contract manufacturers may have excess component inventory,
which would increase our costs. If we underestimate our requirements, our
contract manufacturers may have an inadequate component inventory, which could
interrupt the manufacturing of our products and result in delays in shipments
and revenues. In addition, lead times for materials and components that we order
vary significantly and depend on factors such as the specific supplier, contract
terms and demand for each component at a given time. We may also experience
shortages of components from time to time, which also could delay the
manufacturing of our products or increase the costs of our products.
We could become subject to litigation regarding intellectual property rights
that could be costly and result in the loss of significant rights.
In recent years, there has been a significant increase in litigation in the
United States involving patents and other intellectual property rights. In the
future, we may become a party to litigation to protect our intellectual property
or to defend against an alleged infringement by us of another party's
intellectual property. Claims for alleged infringement and any resulting
lawsuit, if successful, could subject us to significant liability for damages
and invalidation of our intellectual property rights. These lawsuits, regardless
of their success, would likely be time-consuming and expensive to resolve and
would divert management time and attention. Any potential intellectual property
litigation could also force us to do one or more of the following:
o stop or delay selling, integrating or using products that use the
challenged intellectual property;
o obtain from the owner of the infringed intellectual property right a
license to sell or use the relevant technology, which license might
not be available on reasonable terms, or at all; or
o redesign the products that use that technology.
If we are forced to take any of these actions, our business might be seriously
harmed. Our business insurance may not cover potential claims of this type or
may not be adequate to indemnify us for all liability that could be imposed.
The inability to obtain any third-party license required to develop new products
and product enhancements could seriously harm our business, financial condition
and results of operations.
From time to time, we are required to license technology from third parties to
develop new products or product enhancements. Third-party licenses may not be
available to us on commercially reasonable terms, or at all. Our inability to
obtain any third-party license necessary to develop new products or product
enhancements could require us to obtain substitute technology of lower quality
or performance standards, or at greater cost, which could seriously harm our
business, financial condition and results of operations.
Our management and other related parties own a large percentage of our
outstanding stock and could significantly influence the outcome of actions.
As of April 23, 2004, our executive officers and directors beneficially owned
approximately 86.4% of our common stock. On December 9, 2003, Glenbrook Group,
LLC purchased 7,600,000 shares of common stock from our former chief executive
officer and majority stockholder and 4,000,000 shares of common stock directly
from us. In connection with those transactions we issued warrants to purchase
2,500,000 shares of common stock to J&M Interests, LLC and J&M Interests
received the right to nominate at least five members of our seven member board.
Marc B. Crossman and Samuel J. Furrow, Jr., each current members of our board,
28
are the managing members of J&M Interests, which is a controlling member of
Glenbrook.
Because of their stock ownership and other relationships with us, Mr. Crossman
and Mr. Furrow have been and will continue to be in a position to greatly
influence the election of our board, and thus control our affairs. Additionally,
our bylaws limit the ability of stockholders to call a meeting of the
stockholders. These bylaw provisions could have the effect of discouraging a
takeover of us, and therefore may adversely affect the market price and
liquidity of our securities. We are also subject to a Delaware statute
regulating business combinations that may hinder or delay a change in control.
The anti-takeover provisions of the Delaware statute may adversely affect the
market price and liquidity of our securities.
Shares of common stock eligible for public sale could cause our stock price to
decline.
The market price of our common stock could decline as a result of sales by our
existing stockholders of a large number of shares of our common stock in the
market, or the perception that such sales could occur. This circumstance may be
more significant because of the relatively low volume of our common stock that
is traded on any given day. As of May 14, 2004, 18,942,808 shares of our common
stock were issued and outstanding. All of our outstanding common stock that was
issued in private placements prior to December 2003 may currently be resold in
reliance on Rule 144 of the Securities Act.
We have filed a registration statement registering the resale of up to
15,943,600 shares of our common stock, which includes the 4,000,000 shares we
issued in our December 2003 private placement, the 7,600,000 shares purchased
from our former majority stockholder on the same day, 2,500,000 shares issuable
upon exercise of certain warrants issued in connection with the private
placement and 1,843,600 shares issuable upon conversion of shares of our
preferred stock that may be purchased from our former majority stockholder. That
registration statement must be declared effective prior to June 21, 2004. We are
unable to predict the potential effect that sales into the market of 15,943,600
shares may have on the then prevailing market price of our common stock. On May
14, 2004, the last reported sale price of our common stock on the
Over-the-Counter Bulletin Board was $[0.65]. During the three months prior to
May 14, 2004, the average daily trading volume of our common stock was [23,306]
shares. It is likely that market sales of the 15,943,600 shares (or the
potential for those sales even if they do not actually occur) may have the
effect of depressing the market price of our common stock. As a result, the
potential resale and possible fluctuations in trading volume of such a
substantial amount of our stock may affect the share price negatively beyond our
control.
We have a substantial number of authorized common and preferred shares available
for future issuance that could cause dilution of our stockholder's interest and
adversely impact the rights of holders of our common stock.
We have a total of 50,000,000 shares of common stock and 5,000,000 shares of
"blank check" preferred stock authorized for issuance. As of May 14, 2004, we
had 31,057,192 shares of common stock and 3,650,000 shares of preferred stock
available for issuance. We have reserved 4,273,857 shares of common stock for
issuance upon the conversion of the 1,350,000 shares of our outstanding
preferred stock, 8,729,835 shares for issuance upon the exercise of outstanding
options and warrants, and 2,779,752 additional shares available for future
grants under our option plans. In fiscal 2003, we raised gross proceeds of
approximately $1,000,000 through the sale, in a private placement transaction,
of 4,000,000 shares of our common stock. We expect to continue to seek financing
that could result in the issuance of additional shares of our capital stock
29
and/or rights to acquire additional shares of our capital stock. Those
additional issuances of capital stock would result in a reduction of our
existing stockholders' percentage interest in us. Furthermore, the book value
per share of our common stock may be reduced. This reduction would occur if the
exercise price of any issued warrants or the conversion ratio of any issued
preferred stock is lower than the book value per share of our common stock at
the time of such exercise or conversion.
The addition of a substantial number of shares of our common stock into the
market or by the registration of any of our other securities may significantly
and negatively affect the prevailing market price for our common stock. The
future sales of shares of our common stock issuable upon the exercise of
outstanding warrants and options may have a depressive effect on the market
price of our common stock, as such warrants and options would be more likely to
be exercised at a time when the price of our common stock is greater than the
exercise price.
Our board has the power to establish the dividend rates, preferential payments
on any liquidation, voting rights, redemption and conversion terms and
privileges for any series of our preferred stock. The sale or issuance of any
shares of our preferred stock having rights superior to those of our common
stock may result in a decrease in the value or market price of our common stock.
The issuance of preferred stock could have the effect of delaying, deferring or
preventing a change of ownership without further vote or action by our
stockholders and may adversely affect the voting and other rights of the holders
of our common stock.
We may be unable to obtain the additional capital required to grow our business,
which could seriously harm our proposed business. If we raise additional funds,
our current stockholders may suffer substantial dilution.
As of March 31, 2004, we had approximately $814,000 in cash and cash equivalents
on hand. We currently do not have a traditional revolving credit facility with a
commercial bank. We may need to raise additional funds at any time and, given
our history, we cannot be certain that we will be able to obtain additional
financing on favorable terms, if at all. Due to the recent volatility of the
U.S. equity markets, particularly for smaller technology companies, we may not
have access to new capital investment when we need to raise additional funds.
Our future capital requirements will depend upon several factors, including
whether we are successful in developing our products, and our level of operating
expenditures. Our expenditures are likely to rise as we continue our technology
and business development efforts. If our capital requirements vary materially
from those we currently plan, we may require additional financing sooner than
anticipated. If we cannot raise funds on acceptable terms, we may not be able to
develop our new products and services, take advantage of future opportunities or
respond to competitive pressures or unanticipated requirements, any of which
could have a material adverse effect on our ability to develop and grow our
business.
Further, if we issue equity securities, our existing stockholders will
experience dilution of their ownership percentages, and the new equity
securities may have rights, preferences or privileges senior to those of our
common stock. If we do not obtain additional funds when needed, we could quickly
cease to be a viable going concern.
30
We do not intend to declare dividends and our stock could be subject to
volatility.
We have never declared or paid any cash dividends on our common stock. We
presently intend to retain all future earnings, if any, to finance the
development of our business and do not expect to pay any dividends on our common
stock in the foreseeable future.
The market price of our common stock may fluctuate significantly in response to
a number of factors, some of which are beyond our control, including:
o variations in the magnitude of our losses from operations from quarter
to quarter;
o changes in market valuations of companies in the consumer electronics
industry;
o changes in the dynamics of the market segment that we are targeting
with our new product initiative;
o announcements by us or our competitors of new technology, products,
services, significant contracts, acquisitions, strategic
relationships, joint ventures, capital commitments or other material
developments that affect our prospects and our relative competitive
position in our prospective markets;
o our inability to locate or maintain suppliers of components of our
line of consumer electronics products at prices that will allow us to
attain profitability;
o product or design flaws, or our inability to bring functional products
to market, product recalls or similar occurrences, or failure of a
substantial market to develop for our planned products;
o additions or departures of key personnel;
o sales of capital stock in the future;
o stock liquidity or cash flow constraints; and
o fluctuations in stock market prices and volume, which are particularly
common for the securities of highly volatile technology companies
pursuing untested markets and new technologies.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not use derivative financial instruments to hedge interest rate and
foreign currency exposure. We do not believe that we have any material exposure
to interest rate risk. We did not experience a material impact from interest
rate risk during the first quarter of fiscal 2004.
Currently, we do not have any significant investments in financial instruments
for trading or other speculative purposes, or to manage our interest rate
exposure.
ITEM 4. CONTROLS AND PROCEDURES
The term "disclosure controls and procedures" is defined in Rules 13a-15(e) and
15d-15(e) of the Exchange Act. This term refers to the controls and procedures
of a company that are designed to ensure that information required to be
disclosed by a company in the reports it files or submits under the Exchange Act
is recorded, processed, summarized and reported within the time periods
specified by the Securities and Exchange Commission. Our management, including
our chief executive officer and chief financial officer, each of whom joined us
during the period covered by this report, has evaluated the effectiveness of our
disclosure controls and procedures as of the end of the period covered by this
report. Based upon that evaluation, our chief executive officer and chief
financial officer have concluded that our disclosure controls and procedures
were not effective in all material respects as of the end of our last fiscal
year, and that our disclosure controls and procedures are still not effective in
all material respects as of the end of the period covered by this report.
During the first fiscal quarter of 2004 we took corrective actions with regard
to significant deficiencies and material weaknesses that our management
discovered in its evaluation of the effectiveness of our disclosure controls and
procedures. Included in our new management team, all of whom were employed in
the first quarter of 2004, is (i) our chief executive officer, who has
experience in management of various reporting companies, including as chief
executive officer, (ii) our chief financial officer, a position that was not
filled for most of 2003 and early 2004, and (iii) our general counsel, who has
experience representing a number of reporting companies. In the first quarter we
also retained a consultant to act as our director of finance, who has experience
in financial reporting positions with a number of reporting companies. During
the quarter, we began implementing supervisory controls, primarily in our
accounting function, formed a disclosure committee to implement and support our
disclosure controls and procedures and adopted a corporate code of conduct. Our
board of directors also formed a new audit committee and a new nominating and
corporate governance committee that, among other things, will periodically
review and assess our code of conduct. Each of these committees is composed of
independent directors. In the second quarter of 2004, so far, we have (i)
employed a new director of our IT and MIS functions, who has begun to implement
controls and procedures in those systems and (ii) agreed to employ a new
principal accounting officer, who will continue to implement controls and
procedures for our accounting function. We also expect to begin an internal
control review in the second quarter of 2004. We expect to have implemented our
corrective actions regarding our disclosure controls and procedures by the end
of our fiscal year ending December 31, 2004.
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PART II - OTHER INFORMATION
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
--------------------------------
a. Exhibits
31.1 - Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.
31.2 - Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.
32 - Section 1350 Certifications.
b. Reports on Form 8-K
On January 22, 2004, we filed a Current Report on Form 8-K, under Item 5,
disclosing that we had issued a press release announcing that Kent A. Savage had
been appointed as our chief executive officer. No financial statements were
filed with that report.
On March 5, 2004, we filed a Current Report on Form 8-K, under Item 5,
disclosing that we had issued a press release announcing that Theodore B. Muftic
had been appointed as our chief financial officer. No financial statements were
filed with that report.
33
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.
Northgate Innovations, Inc.
Date: May 17, 2004 By /s/ Theodore B. Muftic
--------------------------
Chief Financial Officer
(Principal Financial and
Accounting Officer)
34