NEOWARE SYSTEMS INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

	(Mark One)

		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarter ended March 31, 2004

		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ________ to _________

Commission File Number: 000-21240

NEOWARE SYSTEMS, INC.
(Exact name of registrant as specified in its charter)


Delaware		23-2705700

(State or other jurisdiction of		(IRS Employer Identification No.)
incorporation or organization)

400 Feheley Drive
King of Prussia, Pennsylvania 19406
(Address of principal executive offices)

(610) 277-8300
(Registrant’s telephone number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes No

As of May 10, 2004, there were 15,769,139 outstanding shares of the Registrant’s Common Stock.

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NEOWARE SYSTEMS, INC.

INDEX

		Page
		Number

PART I.	FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements:

	Consolidated Balance Sheets:
	March 31, 2004 and June 30, 2003	3

	Consolidated Statements of Operations:
	Three and Nine Months Ended March 31, 2004 and 2003	4

	Consolidated Statements of Cash Flows:
	Nine Months Ended March 31, 2004 and 2003	5

	Notes to Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial
	Condition and Results of Operations	11

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23

Item 4.	Controls and Procedures	23

PART II.	OTHER INFORMATION

Item 6.	Exhibits and Reports on Form 8-K	24

Signatures		25

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NEOWARE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)

		(Unaudited)
		March 31,			June 30,
		2004			2003

ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	20,823		$	26,014
Short-term investments		32,185			3,151
Accounts receivable, net		11,183			11,089
Inventories		748			772
Prepaid expenses and other		1,448			798
Deferred income taxes		946			946

Total current assets		67,333			42,770

Property and equipment, net		493			572
Goodwill		17,554			8,943
Intangibles, net		3,835			2,091

	$	89,215		$	54,376


LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	5,523		$	4,206
Accrued expenses		2,981			2,818
Capital lease obligations		7			7
Deferred revenue		975			691

Total current liabilities		9,486			7,722


Capital lease obligations		5			10

Deferred income taxes		17			17


STOCKHOLDERS’ EQUITY:
Preferred stock, $.001 par value, 1,000,000 shares authorized
and none issued and outstanding		—			—
Common stock, $.001 par value, 50,000,000 shares
authorized, 15,769,139 and 14,054,800 shares issued and
15,669,139 and 13,954,800 shares outstanding		16			14
Additional paid-in capital		71,362			44,215
Treasury stock, 100,000 shares at cost		(100	)		(100	)
Other comprehensive income (loss)		987			(27	)
Retained earnings		7,442			2,525

Total stockholders’ equity		79,707			46,627

	$	89,215		$	54,376

See accompanying notes to consolidated financial statements.

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NEOWARE SYSTEMS, INC
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share data)

	Three Months Ended					Nine Months Ended
	March 31,					March 31,

	2004		2003			2004		2003


Net revenues	$	15,750	$	13,468		$	46,086	$	41,699
Cost of revenues		8,326		7,227			23,059		23,217

Gross profit		7,424		6,241			23,027		18,482

Sales and marketing		3,442		2,411			9,785		6,937
Research and development		712		492			2,120		1,301
General and administrative		1,527		1,120			4,462		3,002

Operating expenses		5,681		4,023			16,367		11,240

Operating income		1,743		2,218			6,660		7,242

Loss on investment		—		(300	)		—		(300	)
Interest income, net		109		83			287		264

Income before income taxes		1,852		2,001			6,947		7,206
Income taxes		194		720			2,030		2,594

Net income	$	1,658	$	1,281		$	4,917	$	4,612

Basic earnings per share	$	0.11	$	0.09		$	.31	$	0.34

Diluted earnings per share	$	0.10	$	0.09		$	.31	$	0.31

Weighted average number of common shares
outstanding in basic earnings per share computation		15,769		13,725			15,652		13,485

Weighted average number of common shares
outstanding in diluted earnings per share
computation		16,171		14,704			15,942		14,712

See accompanying notes to consolidated financial statements.

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NEOWARE SYSTEMS, INC
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)

		Nine Months Ended
		March 31,

	2004			2003

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	4,917		$	4,612
Adjustments to reconcile net income to net cash provided by operating activities-
Income tax benefit, primarily from stock option exercises		1,708			2,577
Depreciation		209			175
Amortization of intangibles		782			391
Loss on investment		—			300
Changes in operating assets and liabilities, net of effect from acquisition-
(Increase) decrease in:
Accounts receivable		(94	)		205
Inventories		24			(86	)
Prepaid expenses and other		(650	)		(416	)
Increase (decrease) in:
Accounts payable		1,317			320
Accrued expenses		163			13
Deferred revenue		284			46

Net cash provided by operating activities		8,660			8,137


CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of the TeemTalk software business		(9,995	)		—
Purchases of short-term investments		(50,187	)		—
Sales of short-term investments		21,153			—
Purchase of intangible assets		(125	)		(47	)
Purchases of property and equipment		(129	)		(107	)

Net cash used in investing activities		(39,283	)		(154	)


CASH FLOWS FROM FINANCING ACTIVITIES:
Repayments of capital leases		(5	)		(49	)
Sale of common stock, net of expenses		24,609			—
Expenses for prior issuance of common stock		(3	)		(122	)
Exercise of stock options and warrants		835			1,978
Repayments of officer loans		—			9

Net cash provided by financing activities		25,436			1,816


EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH		(4	)		—


INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(5,191	)		9,799
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		26,014			17,031

CASH AND CASH EQUIVALENTS, END OF PERIOD	$	20,823		$	26,830


SUPPLEMENTAL DISCLOSURES:
Cash paid for income taxes	$	264		$	80
Cash paid for interest		8			26

See accompanying notes to consolidated financial statements.

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NEOWARE SYSTEMS, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1.	BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements of Neoware Systems, Inc. and Subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements. These statements, while unaudited, reflect all normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the consolidated financial statements. The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period. Certain information and footnote disclosures included in financial statements have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements. The consolidated financial statements included in this Form 10-Q should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2003, filed with the Securities and Exchange Commission on September 15, 2003.

2.	RECENT ACCOUNTING PRONOUNCEMENTS

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” This Issue addresses the appropriate accounting for arrangements that will result in the delivery of multiple products, services and/or rights to assets that may occur over a period of time. The Issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF Issue No. 00-21 did not have any impact on the Company’s financial statements.

In December 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (revised December 2003) (FIN 46R), “Consolidation of Variable Interest Entities,” which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and, accordingly, should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, which was issued in January 2003. The Company was required to apply FIN 46R as of March 31, 2004. The adoption of this Interpretation is not expected to have any impact on the Company’s financial statements.

In May 2003, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer of financial statements classifies and measures certain financial instruments that have characteristics of both liabilities and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this statement did not have an impact on the Company’s financial statements.

3.	STOCK-BASED COMPENSATION

The Company applies Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”, and related interpretations for stock options and other stock-based awards while disclosing pro forma net income and earnings per share as if the fair value method had been applied in accordance with SFAS No. 123, “Accounting for Stock-based Compensation.”

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In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition and disclosure provisions of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The Company has determined that it will not make the voluntary change to the fair value based method of accounting at this time. Had compensation cost been recognized consistent with SFAS No. 123, the Company’s consolidated net income and earnings per share would have been as follows (in thousands, except share and per share data):

		Three Months Ended						Nine Months Ended
		March 31,						March 31,

		2004			2003			2004			2003

Net income
As reported	$	1,658		$	1,281		$	4,917		$	4,612
Less:
Total stock-based employee compensation expense determined under the
fair value based method for all awards, net of tax		(871	)		(451	)		(2,369	)		(951	)

Pro forma	$	787		$	830		$	2,548		$	3,661

Basic earnings per share:
As reported	$	0.11		$	0.09		$	0.31		$	0.34

Pro forma	$	0.05		$	0.06		$	0.16		$	0.27

Diluted earnings per share:
As reported	$	0.10		$	0.09		$	0.31		$	0.31

Pro forma	$	0.05		$	0.06		$	0.16		$	0.25

The fair value of the Company’s stock-based awards to employees was estimated at the date of grant using the Black-Scholes option pricing model, assuming an estimated life of five to ten years, no dividends, volatility of 70% -126%, and risk-free interest rates of 2.1% - 6.8%.

4.	ACQUISITION

On July 1, 2003, the Company acquired the host access software business from Pericom Holdings PLC (referred to as “TeemTalk software
business”), for $9.8 million in cash, excluding transaction costs. The Company acquired all of the assets of the software business, including the
TeemTalk host access software, intellectual property and technology, customer lists, customer contracts and distribution channels and also
entered into a non-competition agreement. The acquisition was accounted for using the purchase method of accounting and the purchase price
has been allocated to the assets acquired, including goodwill and intangible assets. The Company has substantially completed the allocation of
the purchase price for this acquisition and does not expect future adjustments to the purchase price allocation to be material. The results of
operations of the TeemTalk software business have been included in the Company’s statements of operations from the date of the acquisition.

The purchase price was allocated, based on an independent valuation, as follows: $7.8 million to goodwill, $1.6 million to acquired technology, $500,000 to customer relationships and $100,000 to tradenames.

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The following unaudited pro forma information presents the results of the Company’s operations as though the acquisition had been completed as of July 1, 2002. The pro forma results have been prepared for comparative purposes only and are not necessarily indicative of the actual results of operations had the acquisition been completed as of July 1, 2002 or the results that may occur in the future (in thousands, except share and per share data):

		Three Months Ended				Nine Months Ended
		March 31,				March 31,

		2004		2003		2004		2003

Total net revenue	$	15,750	$	14,238	$	46,086	$	44,010
Net income		1,658		1,460		4,917		5,189
Basic earnings per share		0.11		0.11		0.31		0.38
Diluted earnings per share		0.10		0.10		0.31		0.35


5.	GOODWILL AND INTANGIBLE ASSETS

The carrying amount of goodwill was $17.6 million and $8.9 million at March 31, 2004 and June 30, 2003, respectively. The increase in goodwill is due to the acquisition of the TeemTalk software business (See Note 4) ($7.8 million) and the impact of changes in foreign exchange rates.

Intangible assets with finite useful lives are amortized over their respective estimated useful lives. The following table provides a summary of the Company’s intangible assets (in thousands):

			March 31, 2004

	Estimated		Gross carrying		Accumulated
	useful life		value		amortization		Net

Tradenames	Indefinite	$	260	$	—	$	260
Customer relationships	2 years		552		207		345
Distributor relationships	5 years		2,325		1,032		1,293
Acquired technology	5-10 years		2,270		333		1,937

		$	5,407	$	1,572	$	3,835

			June 30, 2003

	Estimated		Gross carrying		Accumulated
	useful life		value		amortization		Net

Tradenames	Indefinite	$	150	$	—	$	150
Customer relationships	2 years		—		—		—
Distributor relationships	5 years		2,200		690		1,510
Acquired technologies	10 years		506		75		431

		$	2,856	$	765	$	2,091

In September 2003, the Company acquired certain distribution rights in Europe for $125,000, which was recorded as a distributor relationship. Intangible assets related to the TeemTalk software business fluctuate based on changes in foreign rates.

The amortization expense of intangible assets is set forth below (in thousands):

		Three Months Ended				Nine Months Ended
		March 31,				March 31,

		2004		2003		2004		2003

Customer relationships	$	84	$	15	$	239	$	45
Distributor relationships		108		95		298		286
Acquired technologies		86		13		245		38
Capitalized software		—		7		—		22

	$	278	$	130	$	782	$	391

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Amortization expense for customer relationships and distributor relationships is included in sales and marketing expenses and amortization expense for acquired technologies is included in cost of revenues.

The following table provides estimated future amortization expense related to intangible assets (assuming there is no write down associated with these intangible assets causing an acceleration of expense) (in thousands):

		Future
Year Ending June 30,		Amortization

Remainder of fiscal 2004	$	277
2005		1,085
2006		809
2007		559
2008		369
2009 through 2013		476

	$	3,575


6.	COMPREHENSIVE INCOME

Excluding net income, the Company’s sources of other comprehensive income (loss) are unrealized appreciation (depreciation) on its holdings of short-term investments classified as available-for-sale and unrealized income (loss) relating to foreign exchange rate fluctuations. The following summarizes the components of comprehensive income (in thousands):

		Three Months Ended					Nine Months Ended
		March 31,					March 31,

		2004		2003			2004		2003

Net income	$	1,658	$	1,281		$	4,917	$	4,612
Foreign currency translation adjustment		337		(17	)		1,014		(13	)
Unrealized holding losses in available-for-
sale securities		—		203			—		117

Comprehensive income	$	1,995	$	1,467		$	5,931	$	4,716


7.	REVENUE RECOGNITION

The Company’s products include both a hardware and software component. Software has been deemed to be essential to the functionality of the hardware and, therefore, the Company follows AICPA Statement of Position (SOP) No. 97-2, “Software Revenue Recognition.”. Revenue is recognized on product sales when persuasive evidence of an arrangement exists, delivery of the product has occurred, the fee is fixed or determinable and collectibility is probable. Revenue related to post-contract services is generally recognized with the initial product sale when the fee is included with the initial product fee, post-contract services are typically for one year or less, the estimated cost of providing such services during the arrangement is insignificant, and unspecified upgrades and enhancements offered during the period historically have been and are expected to continue to be minimal and infrequent. Revenue from consulting services is recogni zed as services are performed. In limited circumstances, the Company provides certain distributors with stock rotation rights, which are contractually limited to a maximum amount per quarter and require a corresponding order of equal or greater value at the time of the stock rotation. The Company reserves for these arrangements based on historical experience and the level of inventories in the distribution channel. Product warranty costs are accrued at the time the related revenues are recognized.

From time to time, customers request delayed shipment, usually because of customer scheduling for systems integration and lack of storage space at a customer’s facility during the implementation. In such “bill and hold” transactions, the Company recognizes revenues when the following conditions are met: the equipment is complete, ready for shipment and segregated from other inventory; the Company has no further performance obligations in connection with the completion of the transaction; the commitment and delivery schedule is fixed; the customer requested the transaction be completed on this basis; the billing and credit terms for the customer have not been modified from the Company’s normal policies; and the risks of ownership have passed to the customer. There were no “bill and hold” transactions for the three months ended March 31, 2004 and 2003.

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8.	MAJOR CUSTOMERS

For the three months ended March 31, 2004, sales directly to IBM accounted for 18% of total revenues and sales to one European distributor accounted for 14% of total revenues. Accounts receivable from IBM and the European distributor as of March 31, 2004 amounted to $1.8 million and $2.0 million, respectively. For the nine months ended March 31, 2004, sales directly to IBM accounted for 16% of total revenues. For the three months ended March 31, 2003, sales directly to IBM accounted for 13% of total revenues and sales to one European distributor constituted 16% of total revenues. Each of these customers resells the Company’s products to individual resellers and/or end-users, none of whom contributed sales of more than 10% of the Company’s net revenues for the three and nine months ended March 31, 2004 or 2003. The percentage of revenue derived from individual distributors, resellers or end-users can vary significantly from quarter to quarter.

In addition to the Company’s direct sales to IBM, IBM can purchase the Company’s products through individual distributors and/or resellers. The Company estimates that indirect sales to IBM and its customers have ranged from zero to 10% of revenue in this and prior quarters, and may continue to vary significantly from quarter to quarter.

9.	INVENTORIES

Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out method and consists of the following (in thousands):

		March 31,		June 30,
		2004		2003

Purchased components and subassemblies	$	234	$	172
Finished goods		514		600

	$	748	$	772

10.

INCOME TAXES

The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” Under the asset-and-liability method of SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

During the three months ended March 31, 2004, the Company recorded an income tax benefit of $332,000 from the recovery of prior year’s Extraterritorial Income Exclusions (“EIE”). The EIE provides a tax benefit by excluding a portion of income from qualified foreign sales from gross income. During the nine months ended March 31, 2004 and 2003, the income tax benefit from the exercise of employee and director stock options was $1.7 million and $2.6 million, respectively. This benefit was recorded as an increase in additional paid-in capital.

11.

SALE OF COMMON STOCK

On July 10, 2003, the Company sold 1,500,000 shares of common stock at $17.50 per share, which represented a premium of 10% on the average closing price for the 15-day period immediately preceding the sale. Net proceeds to the Company were $24.6 million after transaction costs. The Company used a portion of the net proceeds to replenish the cash used to acquire the TeemTalk software business (See Note 4). The Company intends to use the remaining net proceeds of the financing for general corporate purposes and to fund potential future acquisitions.

12.

LINE OF CREDIT

The Company has a line of credit agreement with a bank, which provides for borrowing up to $2 million subject to certain limitations, as defined. The line of credit matures on December 31, 2004. Borrowings under the credit agreement bear interest at the Libor Market Index rate plus 2.5% (3.59% at March 31, 2004). At March 31, 2004 and 2003, $2 million was available for borrowing under the line. During the three months ended March 31, 2004 and 2003, there were no borrowings under the line.

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The line of credit is unsecured and requires the Company to maintain a minimum balance of $3,000,000 in cash and cash equivalents with the bank. The Company is in compliance with this condition at March 31, 2004.

13.

EARNINGS PER SHARE

The Company applies SFAS No. 128, “Earnings per Share,” which requires dual presentation of basic and diluted earnings per share (“EPS”) for complex capital structures on the face of the statement of operations. Basic EPS is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution from the exercise or conversion of securities into common stock, such as stock options and warrants. The following table sets forth the computation of basic and diluted earnings per share (in thousands, except share and per share data):

		Three Months Ended				Nine Months Ended
		March 31,				March 31,

		2004		2003		2004		2003

Net income	$	1,658	$	1,281	$	4,917	$	4,612

Weighted average shares outstanding:
Basic		15,769		13,725		15,652		13,485
Effect of dilutive employee stock options		389		979		277		1,212
Effect of dilutive warrants		13		—		13		15

Diluted		16,171		14,704		15,942		14,712

Earnings per common share:
Basic	$	0.11	$	0.09	$	0.31	$	0.34

Diluted	$	0.10	$	0.09	$	0.31	$	0.31

For the three and nine months ended March 31, 2004 and 2003, an aggregate of 1,168 and 475, respectively, compared to 327 and 166, respectively, of stock options and warrants were excluded from the calculation of dilutive earnings per share because their inclusion would have been anti-dilutive.

14.

INDEMNIFICATIONS

In the ordinary course of business, from time-to-time the Company enters into contractual arrangements under which it may agree to indemnify its customer for losses incurred by the customer arising from certain events as defined within the particular contract, which may include, for example, litigation or intellectual property infringement claims.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Overview

Neoware provides software, services and solutions to enable thin client appliance computing, which is a computing architecture targeted at business customers as an easier to manage, more secure, more reliable, and more cost-effective solution than traditional PC-based, client server computing. Our software and management tools secure, power and manage a new generation of smart thin client appliances that utilize the benefits of open, industry-standard technologies used in the PC industry to create new alternatives to full-function personal computers used in business, as well as green-screen terminals.

Our software runs on thin client appliances and personal computers, and enables these devices to be secured and centrally managed, as well as to connect to mainframes, midrange, UNIX, Linux and legacy systems. We generate revenues primarily from sales of thin client appliance systems, which include the appliance device and related software marketed under the brand names Eon, Capio, ThinSTAR and Voyager, and to a lesser extent from ThinPC thin client software for PCs, TeemTalk host access software for servers, PCs and UNIX workstations, ezRemote Manager central management software, and services such as training and integration.

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The market for thin client appliances is a subset of the enterprise PC market. We intend to actively seek to stimulate demand for thin client appliances as alternatives to personal computers in our target markets by realigning certain of our sales and marketing resources to penetrate target accounts and by introducing new products that will more effectively compete with PC based solutions. Our strategy is to focus on increasing sales to large enterprise customers, through resellers, directly, and through the IBM relationship, to execute new market initiatives to grow the thin client segment of the PC industry and to introduce new products such as the $199 thin client device introduced in April 2004. The combination of these events is expected to result in increased revenues with overall gross profit margins in the 40% to 45% range over the next several quarters. To date we are experiencing positive initial results from these actions including the receipt of orders from three new large enterprise customers in April 2004.

International Sales

We sell our products and services worldwide through our direct sales force, distributors, our alliance with IBM and other indirect channels, such as VARs and systems integrators. International sales are primarily made through distributors and resellers and are collectable primarily in US dollars, while the associated operating expenses are payable in foreign currencies. In addition to our headquarters in the United States, we maintain offices in the UK, Germany, France, Austria, Sweden, Australia, and the Netherlands. International revenues have increased as we have invested in additional sales and marketing staff and targeted marketing programs in these markets.

International revenues, primarily from Europe, were as follows (in thousands):

	Three Months Ended March 31,									Nine Months Ended March 31,
	Three Months Ended March 31,									Nine Months Ended March 31,

		2004			2003		% Change			2004			2003		% Change

International revenues	$	6,833		$	6,458		6	%	$	18,283		$	17,120		7	%
Percentage of net revenues		43	%		48	%				40	%		41	%

Critical Accounting Estimates

Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements. The Notes to the Consolidated Financial Statements contained in our most recent annual report on Form 10-K describes our significant accounting policies used in the preparation of the consolidated financial statements. The preparation of financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, the reported amounts of revenues and expenses during the reporting period, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including, but not limited to, those related to bad debts, sales returns and allowances, goodwill, intangible assets and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be 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 could differ from these estimates under different assumptions or conditions.

We believe we make significant judgments and estimates related to the following in the preparation of our consolidated financial statements’.

Valuation of Long-Lived and Intangible Assets and Goodwill. In connection with acquisitions, we determine the estimated useful lives of intangible assets and allocated portions of the purchase price to intangible assets, consisting of acquired technology, distributor and customer relationships and trade names, with the remainder to goodwill based on independent appraisals received after each acquisition.

We are required to test our goodwill annually, or sooner if events or changes in circumstances indicate that the carrying amount may not be recoverable, for impairment at the reporting unit level, which we have determined is our sole operating segment. The test for goodwill is a two-step process:

First, we compare the carrying amount of our reporting unit, which is the book value of our entire company, to the fair value of our reporting unit, which corresponds to our market capitalization. If the carrying amount of our reporting unit exceeds its fair value, we have to perform the second step of the process. If not, no further testing is needed.

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For the second prong of the analysis, we allocate the fair value of our reporting unit to all assets and liabilities of our reporting units as if the reporting unit had been acquired in a business combination at the date of the impairment test. We then compare the implied fair value of our reporting unit’s goodwill to its carrying amount. If the carrying amount of our reporting unit’s goodwill exceeds its fair value, an impairment loss will be recognized in an amount equal to that excess.

We review our long-lived assets including intangibles, for impairment when events indicate that their carrying amount may not be recoverable. When we determine that one or more impairment indicators are present for an asset, we compare the carrying amount of the asset to net future undiscounted cash flows that the asset is expected to generate. If the carrying amount of the asset is greater than the net future undiscounted cash flows that the asset is expected to generate, we compare the fair value to the book value of the asset. If the fair value is less than the book value, we recognize an impairment loss. The impairment loss is the excess of the carrying amount of the asset over its fair value.

Some of the events that we consider as impairment indicators for our long-lived assets, including goodwill, are:

	•	Significant underperformance of the company relative to expected operating results;
	•	Our net book value compared to our market capitalization;
	•	Significant adverse economic and industry trends;
	•	Significant decrease in the market value of the asset;
	•	The extent that we use an asset or changes in the manner that we use it; and
	•	Significant changes to the asset since we acquired it.

We have not recorded an impairment loss on goodwill or other long-lived assets.

Results of Operations

*Net Revenues* (in thousands):

		Three Months Ended						Nine Months Ended
		March 31,						March 31,

		2004		2003	% Change			2004		2003	% Change

Net Revenue	$	15,750	$	13,468	17	%	$	46,086	$	41,699	11	%

We derive revenues primarily from the sale of thin client appliances, which include an appliance device and related software. The increase in net revenues in the third quarter of fiscal 2004 over the same period in fiscal 2003 reflects increases in revenue from the Company’s thin client appliance products (10%) and software (7%). The increase in net revenues in the first nine months of fiscal 2004 over the same period in fiscal 2003 reflects increases in revenue from our thin client appliance products (7%) and software (6%), partially offset by a reduction in revenues from services and third party products (2%). The increases were driven by sales growth from increasing market acceptance of thin client products and the Company’s alliance with IBM, our acquisition of the TeemTalk software business and increasing sales of other software products. Decreases in sales from services and third party products were due to fluctuations in the timing and receipt of orders for such services and third party products.

We anticipate that growth of the thin client market for the balance of fiscal 2004 will be consistent with the growth levels experienced during calendar 2003, resulting in revenues in absolute dollars for the fourth quarter of fiscal 2004 to remain at comparable levels with similar periods in the first nine months of fiscal 2004.

*Cost of Revenues and Gross Profit Margin* (in thousands):

		Three Months Ended								Nine Months Ended
		March 31,								March 31,

		2004			2003		% Change			2004			2003		% Change

Cost of Revenues	$	8,326		$	7,227		15	%	$	23,059		$	23,217		(1	)%
Gross Profit Margin		47	%		46	%				50	%		44	%

Cost of revenues consists primarily of the cost of thin client appliances, which include an appliance device and related software, and, to a lesser extent overhead including salaries and related benefits for personnel who fulfill product orders, deliver services and distribution costs.

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The increase in cost of revenues in the third quarter of fiscal 2004 over the same period in 2003 is primarily the result of sales growth and higher material costs (21%) and amortization of intangibles related to technologies acquired in our acquisition of the TeemTalk software business (1%), partially offset by lower warranty costs (4%), transportation costs (2%), and third-party license costs (1%). Higher material costs are due to changes in product mix and certain component price increases incurred in the third quarter of fiscal 2004.

The change in cost of revenues in the first nine months of fiscal 2004 over the same period in 2003 is primarily the result of lower third-party license costs (1%) and warranty costs (2%), partially offset by sales growth and lower material costs (2%). Lower material costs are due to changes in product mix and certain component price decreases incurred in the first six months of fiscal 2004.

We have benefited from manufacturing efficiencies and component cost reductions achieved through our outsourced offshore manufacturing model. This model depends on high volume production of our thin client appliance products using components commonly used in personal computers. We have also benefited from licensee fee expense reductions due to the acquisition of the TeemTalk software, which we previously licensed under a royalty fee agreement, and reductions in other software license fees.

The change in gross profit margin in the third quarter of fiscal 2004 over the same period in fiscal 2003 is attributable to changes in net revenues and cost of revenues as previously discussed. We expect gross margins to fluctuate or decline in the future, reflecting changes in product mix, the mix of revenues from thin client appliance systems and software, reduction in sales prices due to increased sales to large enterprise customers and increased price competition and changes in the cost of thin client appliances, memory and other components. Accordingly, in future periods we expect gross margin to be in the range of 40% to 45%.

*Selling and Marketing* (in thousands):

		Three Months Ended								Nine Months Ended
		March 31,								March 31,

		2004			2003		% Change			2004			2003		% Change

Selling and marketing	$	3,442		$	2,411		43	%	$	9,785		$	6,937		41	%
As a percentage of net revenues		22	%		18	%				21	%		17	%

Selling and marketing expenses consist primarily of salaries, related benefits, commissions, amortization of intangibles related to customer and distribution relationships and other costs associated with our sales and marketing efforts. The increase in selling and marketing expense in the third quarter and the first nine months of fiscal 2004 over the same periods in 2003 is primarily the result of increasing our organizational investments in Europe and the United States including personnel additions and targeted marketing initiatives designed to stimulate growth in the thin client segment of the PC market. The increase in the third quarter of fiscal 2004 also reflects amortization of intangibles related to customer relationships related to the acquisition of the TeemTalk software business.

We expect selling and marketing expenses to increase moderately in absolute dollars over the next several quarters as a result of continued marketing efforts to simulate demand for thin client appliances, amortization of intangibles related to customer relationships and spending in international sales and marketing. Spending levels in any one quarter will vary depending upon the timing of individual marketing initiatives.

*Research and Development* (in thousands):

		Three Months Ended								Nine Months Ended
		March 31,								March 31,

		2004			2003		% Change			2004			2003		% Change

Research and development	$	712		$	492		45	%	$	2,120		$	1,301		63	%
As a percentage of net revenues		5	%		4	%				5	%		3	%

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Research and development expenses consist primarily of salaries, related benefits, and other engineering related costs. The increase in research and development expense in the third quarter and the first nine months of fiscal 2004 over the same periods in 2003 is primarily the result of an increase in staff levels, including additional personnel from the acquisition of the TeemTalk software business.

We believe that a significant level of research and development investment is required to remain competitive and expect research and development expenses in absolute dollars in the next several quarters will be consistent with the first nine months of fiscal 2004.

*General and Administrative* (in thousands):

		Three Months Ended								Nine Months Ended
		March 31,								March 31,

		2004			2003		% Change			2004			2003		% Change

General and administrative	$	1,527		$	1,120		36	%	$	4,462		$	3,002		49	%
As a percentage of net revenues		10	%		8	%				10	%		7	%

General and administrative expenses consist primarily of salaries, related benefits, corporate insurance, such as director and officer liability insurance, fees related to the obligations of a public company and fees for legal, audit and tax services. The increase in general and administrative expenses in the third quarter and the first nine months of fiscal 2004 over the same periods in 2003 is primarily the result of an increase in staffing levels, and, to a lesser extent, increases in compensation levels and in director and officer liability insurance. The increase in staffing levels reflects additional personnel related to our organizational investments in executive management and other positions. The increase in the third quarter of fiscal 2004 also reflects $120,000 of fees associated with the creation of a more efficient international tax structure discussed below.

We expect general and administrative expenses in absolute dollars in the next several quarters to remain at comparable levels with the first nine months of fiscal 2004.

*Income Taxes* (in thousands):

		Three Months Ended								Nine Months Ended
		March 31,								March 31,

		2004			2003		% Change			2004			2003		% Change

Income taxes	$	194		$	720		(73	)%	$	2,030		$	2,594		(22	)%
As a percentage of net revenues		1	%		5	%				4	%		6	%
Effective tax rate		10	%		36	%				29	%		36	%

The Company’s income tax provision is comprised primarily of federal and state taxes.

The Company provides for income taxes on an interim basis using an estimated annual effective income tax rate. The Company’s estimated tax rate was 36% for the first six months ended December 31, 2003 and for fiscal 2003. During the three months ended March 31, 2004, the Company adjusted the estimated annual effective tax rate for fiscal 2004 downward to 34%. This reduction is due to an increased estimated benefit from the Extraterritorial Income Exclusion (“EIE”). The EIE provides a tax benefit by excluding a portion of income from qualified foreign sales from gross income. Also during the three months ended March 31, 2004, the Company recorded an income tax benefit of $332,000 from the recovery of prior years Extraterritorial Income Exclusion. This resulted in a one-time reduction for the Company’s effective tax rate to 10% and 29% for the three and nine months ended March 31, 2004, respectively.

Liquidity and Capital Resources

As of March 31, 2004, we had net working capital of $57.8 million consisting primarily of cash and cash equivalents, short-term investments and accounts receivable. Our principal sources of liquidity include $53.0 million of cash and cash equivalents and short-term investments and a $2.0 million line of credit facility with Wachovia Bank, all of which was available as of March 31, 2004. The credit facility requires us to maintain a minimum cash balance of $3.0 million with the bank. Interest on the line of credit facility accrues at the Libor Market Index rate plus 2.5% and the facility matures on December 31, 2004. We had no borrowings under the line of credit during the three months ended March 31, 2004 or 2003.

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Cash and cash equivalents and short-term investments increased by $23.8 million during the nine months ended March 31, 2004, primarily as a result of the $24.6 million net proceeds from the sale of common stock in a private placement transaction and $8.7 million in cash provided by operating activities, partially offset by the $10.0 million used to acquire the TeemTalk software business.

Cash flows provided by operating activities: The Company’s largest source of operating cash flows are payments from our customers for the purchase of the Company’s products. The Company’s primary uses of cash from operating activities are for the purchase of thin client appliances, software licenses, personnel related expenditures and marketing expenses. Cash flows from operating activities increased in the first nine months of fiscal 2004 compared to the same period in 2003 primarily due to higher profits, increased amounts due to vendors, increased intangibles amortization due to the purchase of the TeemTalk software business, and partially offset by the decreased income tax benefit from the exercise of stock options.

Cash flows used in investing activities: The negative cash flows from investing activities in the first nine months of fiscal 2004 primarily relates to an increase in the purchase of short-term investments. We typically purchase short-term investments with surplus cash. Additionally, in the first quarter of fiscal 2004, we acquired the TeemTalk software business for $10.0 million.

Cash flows provided by financing activities: The positive cash flows from financing activities in the first nine months of fiscal 2004 was primarily the result of the sales 1,500,000 shares of common stock.

Contractual Obligations

The following is a summary of our contractual obligations as of March 31, 2004 (in thousands):

				Year Ending June 30,

		Total		2004		2005		2006		2007

Inventory purchase obligations	$	8,491	$	8,491	$	—	$	—	$	—
Other purchase obligations		109		109		—		—		—
Operating and capital leases		880		135		427		316		2

Total contractual obligations	$	9,480	$	8,735	$	427	$	316	$	2

We expect to fund current operations and other cash expenditures through the use of available cash, cash from operations, funds available under our credit facility and, potentially, new debt or equity financings. Management believes that we will have sufficient funds from current cash, operations and available financing to fund operations and cash expenditures for the foreseeable future; however, we may seek additional sources of funding, including equity and/or debt financing, in order to fund potential acquisitions, including our ability to issue debt and equity securities under our $100 million shelf registration, which was declared effective by the SEC on September 29, 2003.

Factors Affecting the Company and Future Operating Results

Operating results for a particular future period are difficult to predict and, therefore, prior results are not necessarily indicative of results to be expected in future periods. Factors that could have a material adverse effect on our business, results of operations, and financial condition include, but are not limited to, the following:

Our future results may be affected by industry trends and specific risks in our business. Some of the factors that could materially affect our future results include those described below.

During the past year, we have increased operating expenses significantly as a foundation for us to stimulate growth in our market, and we expect to continue incurring these expenses. If we do not increase revenues or appropriately manage further increases in operating expenses, including expenses associated with the integration of recently hired employees and executive officers, our profitability will suffer.

Our business has grown during the past three years through both internal expansion and business acquisitions, and has put pressure on our infrastructure, internal systems and managerial resources. The number of our employees increased from 51 employees at March 31, 2001 to 124 employees at March 31, 2004. Our new employees include a number of senior executive officers and other key managerial, technical, sales and marketing personnel. To manage our growth effectively, we must continue to improve and expand our infrastructure, including operating and administrative systems and controls, and continue managing and integrating our personnel in an efficient manner. Our business may be adversely affected if we do not integrate and train our new employees quickly and effectively and coordinate among our executive, engineering, finance, marketing, sales, operations and customer support organizations, all of which add to the complexity of our organization and increase our operating expenses, which may grow at a faster rate than our sales. In addition, because of the growth of our foreign operations, we now have facilities located in multiple locations, and we have limited experience coordinating a geographically separated organization.

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Although we have generated operating profits for the past two fiscal years, we have a prior history of losses and may experience losses in the future, which could result in the market price of our common stock declining.

Although we have generated operating profits in the past two fiscal years and through the nine months ended March 31, 2004, we have incurred net losses in prior periods. We expect to continue to incur significant operating expenses. Our operating expenses increased during the three months ended March 31, 2004 reflecting the hiring of additional key personnel as we continue to implement our growth strategy, including our plan to introduce new products to compete with PC-based solutions and other thin client competitors. As a result, we will need to generate significant revenues to maintain profitability. If we do not maintain profitability, the market price for our common stock may decline.

Our financial resources may not be enough for our capital and corporate development needs, and we may not be able to obtain additional financing. A failure to maintain and increase our revenues would likely cause us to incur losses and negatively impact the price of our common stock.

We may not be able to successfully integrate future acquisitions we may complete, which may materially adversely affect our growth and our operating results.

Since June 2001, we have made four acquisitions and entered into an alliance with IBM, and we may make additional acquisitions as part of our growth strategy. There is no assurance that we will successfully integrate future acquisitions into our business. We may be unable to retain key employees or key business relationships of the acquired businesses, consolidate the corporate IT infrastructure, combine administrative, research and development and other operations and combine product offerings, and integration of the businesses may divert the attention and resources of our management. Our failure to successfully integrate acquired businesses into our operations could have a material adverse effect on our business, operating results and financial condition. Even if future acquisitions are successfully integrated, we may not receive the expected benefits of the transactions if we find that the business does not further o ur business strategy or that we paid more than what the assets were worth. Managing acquisitions and alliances requires management resources, which may divert our attention from other business operations. As a result, the effects of any completed or future transactions on financial results may differ from our expectations.

Our ability to accurately forecast our quarterly sales is limited, although our costs are relatively fixed in the short term and we expect our business to be affected by rapid technological change, which may adversely affect our quarterly operating results.

Our ability to accurately forecast our quarterly sales is limited, which makes it difficult to predict the quarterly revenues that we will recognize. In addition, most of our costs are for personnel and facilities, which are relatively fixed in the short term. If we have a shortfall in revenues in relation to our expenses, we may be unable to reduce our expenses quickly enough to avoid losses. As a result, our quarterly operating results could fluctuate.

Future operating results will continue to be subject to quarterly fluctuations based on a wide variety of factors, including:

	•	Linearity - Our quarterly sales have historically reflected a pattern in which a disproportionate percentage of sales occur in the last month of the quarter. This pattern makes prediction of revenues and earnings for each financial period especially difficult and uncertain and increases the risk of unanticipated variations in quarterly results and financial condition; and

	•	Significant Orders - We are subject to variances in our quarterly operating results because of the fluctuations in the timing of our receipt of large orders. If even a small number of large orders are delayed until after a quarter ends, our operating results could vary substantially from quarter to quarter and net income could be substantially less than expected. Conversely, if even a small number of large orders are pulled into a quarter from a future quarter, our revenues and net income could be substantially higher than expected, making it possible that sales and net income in future periods may decline sequentially.

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There are factors that may affect the market acceptance of our products, some of which are beyond our control, including the following:

	•	the growth and changing requirements of the thin client segment of the PC market;

	•	the quality, price, performance and total cost of ownership of our products compared to personal computers;

	•	the availability, price, quality and performance of competing products and technologies; and

	•	the successful development of our relationships with software providers, original equipment manufacturers and existing and potential channel partners.

We may not succeed in developing and marketing our software and thin client appliance products and our operating results may decline as a result.

Our gross margins can vary significantly, based upon a variety of factors. If we are unable to sustain adequate gross margins we may be unable to reduce operating expenses in the short term, resulting in losses.

Our gross margins can vary significantly from quarter to quarter depending on average selling prices, fixed costs in relation to revenue levels and the mix of our business, including the percentage of revenues derived from thin client appliances, software, third party products and consulting services. Our gross profit margin also varies in response to competitive market conditions as well as periodic fluctuations in the cost of memory and other significant components. The PC market in which we compete remains very competitive, and although we intend to continue our efforts to reduce the cost of our products, there can be no certainty that we will not be required to reduce prices of our products without compensating reductions in the cost to produce our products in order to increase our market share or to meet competitors’ price reductions. Our new marketing strategy is targeted at increasing the size of the thin cl ient segment of the PC industry, in part by lowering prices to make thin clients more competitive with personal computers, and in addition by selling a larger percentage of products to large enterprise customers, who typically demand lower prices because of their volume purchases. This strategy is expected to result in a decline in our gross margins. If our sales do not increase as a result of these new strategies, our profitability will decline, and we may experience losses.

Our business is dependent on customer adoption of thin client appliances as an alternative to personal computers, and a decrease in their rates of adoption could adversely affect our ability to increase our revenues.

We are dependent on the growing use of thin client appliances to perform discrete tasks for corporate and Internet-based networks to increase our revenues. If thin client appliances are not accepted by corporations as an alternative to personal computers, the result would be slower than anticipated revenue growth or even a decline in our revenues.

Thin client appliances have historically represented a very small percentage of the overall PC market, and if sales do not grow as a percentage of the PC market, or if the overall PC market were to decline, our revenues may not grow or may decline.

Because some of our products use embedded versions of Microsoft Windows as their operating system, an inability to license these operating systems on favorable terms could impair our ability to introduce new products and maintain market share.

We may not be able to introduce new products on a timely basis because some of our products use embedded versions of Microsoft Windows as their operating system. Microsoft Corporation provides Windows to us, and we do not have access to the source code for certain versions of the Windows operating system. If Microsoft fails to continue to enhance and develop its embedded operating systems, or if we are unable to license these operating systems on favorable terms, our operations may suffer.

Because some of our products use Linux as their operating system, the failure of Linux developers to enhance and develop the Linux kernel could impair our ability to release new products and maintain market share.

We may not be able to release new products on a timely basis because some of our products use Linux as their operating system. The heart of Linux, the Linux kernel, is maintained by third parties. Linus Torvalds, the original developer of the Linux kernel, and a small group of independent engineers are primarily responsible for the development and evolution of the Linux kernel. If this group of developers fails to further develop the Linux kernel, we would have to either rely on another party to further develop the kernel or develop it ourselves. To date, we have optimized our Linux-based operating system based on a version of Red Hat Linux. If we were unable to access Red Hat Linux, we would be required to spend additional time to obtain a tested, recognized version of the Linux kernel from another source or develop our own operating system internally, which could significantly increase our costs.

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Actions taken by the SCO Group (SCO) could impact the sale of Linux as an operating system, negatively affecting sales of some of our products.

SCO has taken legal action against IBM and sent a letter to 1,500 Linux customers alleging that certain Linux kernels infringe on SCO’s Unix intellectual property and other rights, and that SCO intends to aggressively protect those rights. While we are not a party to any legal proceeding with SCO, since some of our products use Linux as their operating system, SCO’s allegations, regardless of merit, could adversely affect sales of such products. SCO has brought claims against certain end user customers of the Linux operating system and threatened to bring claims against other end users of Linux for copyright violations arising out of the facts alleged in SCO’s lawsuit against IBM. Some of these claims could be indemnified under indemnities we have given or may give to certain customers. In the event that claims for indemnification are brought against the customers that we have indemnified, we could incur expenses reimbursing the customers for their costs, and if the claims were successful, for damages.

Because we depend on sole source, limited source and foreign source suppliers for key components in our thin client appliance products, we are susceptible to supply shortages that could prevent us from shipping customer orders on time, if at all, and result in lost sales.

We depend upon single source suppliers for our thin client appliance products and for several of the components in them. We also depend on limited sources to supply several other industry standard components. We also rely on foreign suppliers which subject us to risks associated with foreign operations such as the imposition of unfavorable governmental controls or other trade restrictions, changes in tariffs, political instability and currency fluctuations. A weakening dollar could result in greater costs to us for our components. Severe Acute Respiratory Syndrome and similar medical crises could also disrupt manufacturing processes and result in quarantines being imposed in the future.

We have in the past experienced and may in the future experience shortages of, or difficulties in acquiring, these components. A significant portion of our revenues is derived from the sale of thin client appliances that are bundled with our software. Third parties produce these thin client appliances for us, and we typically do not have long-term supply contracts with them obligating them to continue producing products for us. If we experience shortages of these products, or of their components, we may not be able to deliver our products to our customers, and our revenues would decline.

If we are unable to continue generating substantial revenues from international sales our business could be adversely affected.

Approximately 43% of our revenues were derived from international sales during the three months ended March 31, 2004. Our ability to sell our products internationally is subject to a number of risks. General economic and political conditions in each country could adversely affect demand for our products and services in these markets. Although most of our international sales are denominated in US Dollars, currency exchange rate fluctuations could result in lower demand for our products or lower pricing resulting in reduced revenue and margins, as well as currency translation losses. In addition, a weakening dollar has resulted in increased costs for our international operations, and could result in greater costs for our international operations in the future. Changes to and compliance with a variety of foreign laws and regulations may increase our cost of doing business in these jurisdictions. Trade protection measures and import and export licens ing requirements subject us to additional regulation and may prevent us from shipping products to a particular market, and increase our operating costs.

Because we rely on channel partners, including IBM, to sell our products, our revenues could be negatively impacted if our existing channel partners, including IBM, do not continue to purchase products from us.

We cannot be certain that we will be able to attract channel partners that market our products effectively or provide timely and cost-effective customer support and service. None of our current channel partners, including IBM, is obligated to continue selling our products or to sell our new products. We cannot be certain that any channel partner will continue to represent our products or that our channel partners will devote a sufficient amount of effort and resources to selling our products in their territories. We need to expand our direct and indirect sales channels, and if we fail to do so, our growth could be limited.

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Approximately 67% of our revenues for the three months ended March 31, 2004 were derived from sales made directly to IBM and through our other channel partners. If our channel partners were to discontinue sales of our products or reduce their sales efforts, it could adversely affect our operating results. In addition, there can be no assurance as to the continued viability and financial condition of our channel partners, one of which has accounted for 14% of our net sales during the three months ended March 31, 2004.

As a result of our alliance with IBM, we rely on IBM for distribution of our products to IBM’s customers. Sales directly to IBM accounted for 18% of our net sales during the three months ended March 31, 2004. IBM is under no obligation to continue to actively market our products. In addition to the Company’s direct sales to IBM, IBM can purchase the Company’s products through individual distributors and/or resellers. The Company estimates that indirect sales to IBM and its customers have ranged from zero to 10% of revenue in this and prior quarters, and may continue to vary significantly from quarter to quarter. If IBM were to discontinue sales of our products or reduce its sales efforts, our operating results would be adversely affected.

Our business may suffer if it is alleged or found that we have infringed the intellectual property rights of others.

Although we have not received any claims that our products infringe on the proprietary rights of third parties, if we were to receive such claims in the future, responding to such claims, regardless of their merit, could be time consuming, result in costly litigation, divert management’s attention and resources and cause us to incur significant expenses. There is no assurance, in the event of such claims, that we would be able to enter into a licensing arrangement on acceptable terms or that litigation would not occur. In the event that there were a temporary or permanent injunction entered prohibiting us from marketing or selling certain of our products, or a successful claim of infringement against us requiring us to pay royalties to a third party, and we failed to develop or license a substitute technology, our business, results of operations or financial condition could be materially adversely affected.

We may not be able to effectively compete against PC and thin client providers as a result of their greater financial resources and brand awareness.

In the desktop PC market, we face significant competition from makers of traditional personal computers, many of which are larger companies that have greater name recognition than we have. In addition, we face significant competition from thin client providers, including Hewlett Packard, Wyse Technology and other smaller companies. Increased competition may negatively affect our business and future operating results by leading to price reductions, higher selling expenses or a reduction in our market share. Our strategy to seek to increase our share of the overall PC market by targeting our core markets may create increased pressure, including pricing pressure, on certain of our thin client appliance products.

Our future competitive performance depends on a number of factors, including our ability to:

	•	continually develop and introduce new products and services with better prices and performance than offered by our competitors;

	•	offer a wide range of products; and

	•	offer high-quality products and services.

If we are unable to offer products and services that compete successfully with the products and services offered by our competitors, including PC manufacturers, our business and our operating results would be harmed. In addition, if in responding to competitive pressures, we are forced to lower the prices of our products and services and we are unable to reduce our costs, our business and operating results would be harmed.

Thin client appliance products, like personal computers, are subject to rapid technological change due to changing operating system software and network hardware and software configurations, and our products could be rendered obsolete by new technologies.

The PC market is characterized by rapid technological change, frequent new product introductions, uncertain product life cycles, changes in customer demands and evolving industry standards. Our products could be rendered obsolete if products based on new technologies are introduced or new industry standards emerge.

We may not be able to preserve the value of our products’ intellectual property because we do not have any patents and other vendors could challenge our other intellectual property rights.

Our products are differentiated from those of our competitors by our internally developed technology that is incorporated into our products. If we are unable to protect our intellectual property, other vendors could sell products with features similar to ours, and this could reduce demand for our products, which would harm our operating results.

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We may not be able to attract software developers to bundle their products with our thin client appliances.

Our thin client appliances include our own software, plus software from other companies for specific markets. If we are unable to attract software developers, and are unable to include their software in our products, we may not be able to offer our thin client appliances for certain important target markets, and our financial results will suffer.

In order to continue to grow our revenues, we may need to hire additional personnel.

In order to continue to develop and market our line of thin client appliances, we may need to hire additional personnel. Competition for employees is significant and we may experience difficulty in attracting qualified people.

Future growth that we may experience will place a significant strain on our management, systems and resources. To manage the anticipated growth of our operations, we may be required to:

	•	improve existing and implement new operational, financial and management information controls, reporting systems and procedures;

	•	hire, train and manage additional qualified personnel; and

	•	establish relationships with additional suppliers and partners while maintaining our existing relationships.

We rely on the services of certain key personnel, and those persons’ knowledge of our business and technical expertise would be difficult to replace.

Our products, technologies and operations are complex and we are substantially dependent upon the continued service of our existing personnel. The loss of any of our key employees could adversely affect our business and profits and slow our product development processes. We generally do not have employment agreements with our key employees. Further, we do not maintain key person life insurance on any of our employees.

Recent and proposed regulations related to equity compensation could adversely affect our ability to attract and retain key personnel.

We have historically used stock options as a key component of our employee compensation program. We believe that stock options and other long-term equity incentives directly motivate our employees to maximize long-term stockholder value, and, through the use of vesting, encourage employee retention and allow us to provide competitive compensation packages. The Financial Accounting Standards Board has announced that it will propose changes to US GAAP that, if implemented, would require us and other companies to record a charge to earnings for employee stock option grants. This pending regulation would negatively impact our earnings. In addition, new regulations implemented by The Nasdaq National Market requiring stockholder approval for all stock option plans, as well as new regulations implemented by the New York Stock Exchange prohibiting NYSE member organizations from voting on equity-compensation plans unless the beneficial owner of the shares has given voting instructions, could make it more difficult for us to grant options to employees in the future. To the extent that new regulations make it more difficult or expensive to grant options to employees, we may incur increased compensation costs, change our equity compensation strategy or find it difficult to attract, retain and motivate employees, each of which could materially and adversely affect our business.

We license our TeemTalk software to other thin client providers who may choose to license alternative products from other suppliers who are not their competitors.

We license our TeemTalk software, which enables thin clients to connect to legacy systems, to certain of our competitors, including Wyse Technology and Hewlett Packard. Although it is our strategy to continue to generate sales of this software by licensing it to other thin client vendors, these vendors may seek alternative products from suppliers who are not their direct competitors. If we were to lose one or more of these customers, our revenue and profits would decline.

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Errors in our products could harm our business and our operating results.

Because our software and thin client appliance products are complex, they could contain errors or bugs that can be detected at any point in a product’s life cycle. Although many of these errors may prove to be immaterial, any of these errors could be significant. Detection of any significant errors may result in:

	•	the loss of or delay in market acceptance and sales of our products;

	•	diversion of development resources;

	•	injury to our reputation; or

	•	increased maintenance and warranty costs.

These problems could harm our business and future operating results. Occasionally, we have warranted that our products will operate in accordance with specified customer requirements. If our products fail to conform to these specifications, customers could demand a refund for the purchase price or assert claims for damages.

Moreover, because our products are used in connection with critical distributed computing systems services, we may receive significant liability claims if our products do not work properly. Our agreements with customers typically contain provisions intended to limit our exposure to liability claims. However, these limitations may not preclude all potential claims. Liability claims could require us to spend significant time and money in litigation or to pay significant damages. Any such claims, whether or not successful, could seriously damage our reputation and our business.

If our contracts with Citrix and other vendors of software applications were terminated, our IT services business would be materially adversely affected.

We depend on third-party suppliers to provide us with key software applications in connection with our IT services business. If such contracts and relationships were terminated, our revenues would be negatively affected.

Our prior use of Arthur Andersen LLP as our independent auditor may pose risks to us and limit our ability to seek potential recoveries from them related to their work.

Our consolidated financial statements as of and for each of the three years in the period ended June 30, 2001 were audited by Arthur Andersen LLP (Andersen). On March 14, 2002, Andersen was indicted on federal obstruction of justice charges arising from the government’s investigation of Enron Corporation. On June 15, 2002, a jury convicted Andersen of these charges. On July 23, 2002, we dismissed Andersen and retained KPMG LLP as our independent auditors beginning for our fiscal year ended June 30, 2002. SEC rules require us to present historical audited financial statements in various SEC filings, such as registration statements, along with Andersen’s consent to our inclusion of its audit report in those filings. Since our former engagement partner and audit manager left Andersen and in light of the cessation of Andersen’s SEC practice, we will not be able to obtain the consent of Andersen to the inclusion of its audit report in our relevant current and future filings. The SEC has provided regulatory relief designed to allow companies that file reports with the SEC to dispense with the requirement to file a consent of Andersen in certain circumstances, but purchasers of securities sold under our registration statements, which were not filed with the consent of Andersen to the inclusion of its audit report, will not be able to sue Andersen pursuant to Section 11(a)(4) of the Securities Act and, therefore, their right of recovery under that section may be limited as a result of the lack of our ability to obtain Andersen’s consent.

Our stock price can be volatile.

Our stock price, like that of other technology companies, can be volatile. For example, our stock price can be affected by many factors such as quarterly increases or decreases in our revenues or earnings, changes in revenues or earnings estimates or publication of research reports by analysts; speculation in the investment community about our financial condition or results of operations and changes in revenue or earnings estimates, announcement of new products, technological developments, alliances, acquisitions or divestitures by us or one of our competitors or the loss of key management personnel. In addition, general macroeconomic and market conditions unrelated to our financial performance may also affect our stock price.

Provisions in our charter documents and Delaware law may delay or prevent acquisition of us, which could decrease the value of your shares.

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it harder for a third party to acquire us without the consent of our board of directors. These provisions include advance notice procedures with respect to stockholder proposals and the nomination of candidates for election as directors. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock.

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The issuance of additional equity securities may have a dilutive effect on our existing stockholders and could lead to a decline in the price of our common stock.

Any additional issuance of equity securities, including for acquisitions, may have a dilutive effect on our existing stockholders. In addition, the perceived risk associated with the possible sale of a large number of shares could cause some of our stockholders to sell their stock, thus causing the price of our stock to decline. Subsequent sales of our common stock in the open market or the private placement of our common stock or securities convertible into common stock could also have an adverse effect on the market price of the shares. If our stock price declines, it may be more difficult or we may be unable to raise additional capital.

Forward-Looking Statements

This quarterly report on Form 10-Q contains statements that are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, such as statements regarding: our expectations regarding revenues, the growth of the thin client segment of the PC market, gross margins and fluctuations and decreases in gross margins, changes in product mix, fluctuations in sales prices, selling and marketing expenses, and general and administrative expenses for the next several quarters; the introduction of new products; cost benefits and other advantages of our products; our acquisition of businesses and technologies; the availability of cash or other financing sources to fund future operations, cash expenditures and acquisitions, our potential issuance of issuance of debt and equity securities under our $100 million shelf registration and the development of new products. These forward-looking statements involve risks and uncertainties. The factors set forth below, and those contained in “Factors Affecting the Company and Future Operating Results” and set forth elsewhere in this report, could cause actual results to differ materially from those predicted in any such forward-looking statement. Factors that could affect our actual results include the timing and receipt of future orders, our timely development and customers’ acceptance of our products, pricing pressures, rapid technological changes in the industry, growth of overall thin client sales through the capture of a greater portion of the PC market, increased competition, our ability to attract and retain qualified personnel, the economic viability of our channel partners, adverse changes in customer order patterns, our ability to identify and successfully consummate and integrate future acquisitions, adverse changes in general economic conditions in the U. S. and internationally, risks associated with foreign operations and political and economic uncertainties associated with current world events.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company earns interest income from its balances of cash and cash equivalents and short-term investments. This interest income is subject to market risk related to changes in interest rates which primarily affects the investment portfolio. The Company invests in instruments that meet high credit quality standards, as specified in its investment policy.

As of March 31, 2004 and June 30, 2003, cash equivalents and short-term investments consisted primarily of certificates of deposit, commercial paper and money market funds maturing over the following three months. Due to the average maturity and conservative nature of the Company’s investment portfolio, a sudden change in interest rates would not have a material effect on the value of the portfolio.

Management estimates that if the average yield of the Company’s investments decreased by 100 basis points, interest income for the three months ended March 31, 2004 would have decreased by less that $343,000. This estimate assumes that the decrease occurred on July 1, 2003 and reduced the yield of each investment instrument by 100 basis points.

Item 4. Controls and Procedures

(a)

Disclosure Controls and Procedures.

The Company, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of its disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of March 31, 2004 (the “Evaluation Date”). Based on the evaluation performed, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, the Company’s disclosure controls and procedures were effective in recording, processing, summarizing and reporting in the periods specified in the SEC’s rules and forms the information required to be disclosed by the Company in its reports filed or furnished under the Exchange Act.

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(b)

Changes in Internal Control Over Financial Reporting

There have not been any changes in the Company’s internal control over financial reporting during the fiscal quarter ended March 31, 2004 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

a.	Exhibits

	The following exhibits are being filed as part of this quarterly report on Form 10-Q:

	Exhibit
	Numbers	Description


	31.1	Certification of Michael Kantrowitz as Chairman, President and Chief Executive Officer of Neoware Systems, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

	31.2	Certification of Keith D. Schneck as Executive Vice President and Chief Financial Officer of Neoware Systems, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

	32.1	Certification of Michael Kantrowitz as Chairman, President and Chief Executive Officer of Neoware Systems, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

	32.2	Certification Keith D. Schneck as Executive Vice President and Chief Financial Officer of Neoware Systems, Inc pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

b.	Reports on Form 8-K

	On February 2, 2004, the Company furnished a Form 8-K pursuant to Item 12 relating to its fiscal 2004 second quarter conference call.

	On January 26, 2004, the Company filed (excluding the portion furnished pursuant to Item 12) a Form 8-K relating to a press release announcing earnings for the three months ended December 31, 2003.

	On January 5, 2004, the Company filed (excluding the portion furnished pursuant to Item 12) a Form 8-K relating to a press release announcing preliminary earnings for the three months ended December 31, 2003.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunder duly authorized.


	NEOWARE SYSTEMS, INC.


Date: May 17, 2004	By:	/s/ MICHAEL KANTROWITZ

		Michael Kantrowitz
		Chairman, President and Chief Executive Officer



Date: May 17, 2004	By:	/s/ KEITH D. SCHNECK

		Keith D. Schneck
		Executive Vice President and Chief Financial Officer