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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark one)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended October 31, 2003
OR
[ ] 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 000-30362
CROSSROADS SYSTEMS, INC.
(Exact name of Registrant as Specified in its Charter)
Delaware 74-2846643
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
8300 North MoPac Expressway, Austin, Texas 78759
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (512) 349-0300
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.001 per share
Preferred Stock Purchase Rights
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. [X] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). [ ] Yes [X] No
Aggregate market value of registrant's common stock held by non-affiliates of
the registrant, based upon the closing price of a share of registrant's common
stock on April 30, 2003, as reported by The NASDAQ Stock Market on that date:
$24.1 million.
Number of shares of the registrant's common stock outstanding as of January 21,
2004: 25,147,288
DOCUMENTS INCORPORATED BY REFERENCE.
Portions of the registrant's Proxy statement relating to the
registrant's 2004 Annual Meeting of Stockholders are incorporated by reference
into Part III of this Annual Report on Form 10-K where indicated.
CROSSROADS SYSTEMS, INC.
FORM 10-K
Unless otherwise indicated, "we," "us," "our" and the "Company" mean
Crossroads Systems, Inc. We own the trademark "Crossroads." All other trademarks
or tradenames referred to in this document are the property of their respective
owners. References in this document to "$" or "dollars" are to United States of
America currency. Our fiscal year ends October 31.
TABLE OF CONTENTS
PART I
Item 1. Business.......................................................................................... 1
Item 2. Properties........................................................................................ 22
Item 3. Legal Proceedings................................................................................. 22
Item 4. Submission of Matters to a Vote of Security Holders............................................... 23
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity
Securities...................................................................................... 24
Item 6. Selected Consolidated Financial Data.............................................................. 25
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations............. 27
Item 7A. Quantitative and Qualitative Disclosures About Market Risk........................................ 39
Item 8. Financial Statements and Supplementary Data....................................................... 40
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.............. 40
Item 9A. Controls and Procedures........................................................................... 40
PART III
Item 10. Directors and Executive Officers of the Registrant................................................ 42
Item 11. Executive Compensation............................................................................ 42
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.... 42
Item 13. Certain Relationships and Related Transactions.................................................... 42
Item 14. Principal Accounting Fees and Services............................................................ 42
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.................................. 43
NOTE ON INCORPORATION BY REFERENCE
Throughout this report, various information and data are incorporated by
reference to portions of our Proxy Statement for our 2004 Annual Meeting of
Stockholders. Any reference in this report to disclosures in our Proxy Statement
shall constitute incorporation by reference of that specific material into this
Form 10-K.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. All statements
other than historical or current facts, including, without limitation,
statements about our business strategy, plans and objectives of management and
our future prospects, are forward-looking statements. Although we believe that
the expectations reflected in such forward-looking statements are reasonable,
such forward-looking statements are subject to risks and uncertainties that
could cause actual results to differ materially from these expectations. Such
risks and uncertainties include, without limitation, the following:
- industry trends;
- customer demand for our products;
- growth and future operating results;
- developments in our markets and strategic focus;
- expansion of and enhancements to our manufacturing and engineering
facilities and product offerings;
- customer benefits attributable to our products;
- potential acquisitions and joint ventures and the integration of
acquired businesses;
- technologies and operations;
- strategic relationships with third parties; and
- future economic, business and regulatory conditions.
You can identify these forward looking statements by the use of words such
as "may," "will," "expect," "intend," "anticipate," "believe," "estimate," and
"continue". You should read statements that contain these and other similar
words carefully because they discuss our future expectations, making projections
of our future results of operations, our future financial condition, or other
"forward-looking" information. We believe that it is important to communicate
our future expectations to our investors. However, there may be events in the
future that we are not able to accurately predict or control. The factors listed
in the sections captioned "Additional Factors That May Affect Future Results" in
Item 1 of this report and "Management's Discussion and Analysis of Financial
Condition and Results of Operations" in Item 7 of this report, as well as any
cautionary language in this annual report, provide examples of risks,
uncertainties and events that may cause our actual results to differ materially
from the expectations we described in our forward-looking statements.
iii
PART I
ITEM 1. BUSINESS.
OVERVIEW
We are a leading provider of enterprise data routing solutions for open
system storage area networks (SANs), based on our market share of storage
routers shipped. Our storage routers serve as the interconnect between SANs and
the other devices in a computer network and allow organizations to more
effectively and efficiently store, manage and ensure the integrity and
availability of their data. Specifically, when used in SANs our storage routers:
- improve data transfer speeds within a network;
- reduce the time required to back up and restore data;
- improve utilization of storage resources; and
- preserve and enhance existing server and storage system investments.
We provide our products in a variety of configurations including both a
stand-alone box and an embedded product with varying port counts. Our products
are installed at companies, institutions and other entities, ranging from large
enterprises to small businesses. Our products and services are marketed and sold
to end users through our distribution partners, including original equipment
manufacturers (OEMs), distributors and value-added resellers (VARs).
We were incorporated on September 26, 1996 as Crossroads Holding
Corporation and are the successor to operations of our predecessor Texas
corporation, Crossroads Systems (Texas), Inc. We are headquartered in Austin,
Texas. The mailing address for our headquarters is 8300 North MoPac Expressway,
Austin, Texas, 78759, telephone number: (512) 349-0300. We can also be reached
at our Web site at www.crossroads.com. We had 127 employees at October 31, 2003.
INDUSTRY BACKGROUND
Information Growth and Data Management Challenge
The volume of data storage that companies utilize and process continues to
increase significantly and this growth has dramatically increased the cost of
administering that data. This challenge has driven many organizations to
reassess the way they manage their storage environments. Until the advent of
SANs, the connection between data storage devices and servers had been
facilitated by a direct connection through small computer system interface
(SCSI) or other interfaces. SANs have become effective and efficient ways for an
enterprise to manage an expanding storage infrastructure. Today, thousands of
enterprise organizations use SANs as the method of storage interconnection.
SANs Solve Data Growth Problems
SANs provide a wide range of benefits and advantages for the storage
administrator. Many of these advantages relate to consolidated and centralized
storage, improved manageability, reduction in local area network (LAN) traffic
and ease of incremental storage additions. Existing storage assets can also be
consolidated with SANs which allows administrators to effectively utilize more
of their storage assets, reduce administrative workloads and increase
flexibility in server access of consolidated storage.
1
One critical problem with data growth is the reduction in the time
available for the back up and recovery functions needed to protect data. By
utilizing a SAN, the backup and recovery processes are now performed on a
dedicated machine, optimized for storage network. This combined with the added
performance of SANs, results in significant reductions in the overall backup and
recovery window.
Other storage requirements that SANs deliver are simple, cost-effective
ways to back up their data, scale for growth and manage their storage systems.
Companies have increasing demand for secured methods to manage their data and
provide for disaster recovery. Finally, as organizations continue to add storage
over time, SANs provide the most flexible architecture to manage their storage
infrastructure.
SANs Continue to Expand in Size and Function
The number of SANs are increasing along with the number of devices in any
given SAN. SANs have now become essential and are now mission critical
components of a business' infrastructure. IP SANs are emerging as new protocols
such as iSCSI (Internet SCSI) are introduced and adopted. IP SANs utilize
Ethernet connectivity, which could potentially drive lower equipment and
operation costs. SAN utilization is expected to grow within the enterprise as
departmental servers are now able to connect to corporate SAN resources, thus
creating a whole new class of end users, such as small to medium size businesses
and workgroups.
Growth in Storage System Capabilities Continues
Disk and tape systems continue to grow in multiples in terms of capacity
and throughput year over year. With this increase, storage costs continue to
decline as storage becomes commoditized. This growth in capabilities and
capacities has also created corresponding problems of complexity. Customers are
seeking tools and solutions that reduce this complexity, improve operating
efficiency and assure availability. Storage vendors are responding to the added
complexity of larger, mission critical SANs by continuing to address
interoperability problems that have plagued SANs in the past as well as seeking
ways to provide additional functionality to their products that simplify the
time and overall resource requirements of the customer.
OUR SOLUTION
We are responding to these changes with products that improve the utility
of networked storage. Our products provide expanded solution options for
connectivity such as Fibre Channel or iSCSI, or multiple media types such as
tape, disk and optical. Our router products operate in any SAN environment and
help our customers improve and reduce their total cost of information
management. Our products increase the availability and functionality of storage
networks by providing the ability to dynamically manage SAN devices.
We are focused on delivering products to our customers that enable them to
leverage their existing investments in servers and storage devices. Our products
deliver value by reducing complexity and overhead for the storage administrator.
This is accomplished through our easy to manage multi-protocol platform that
provides connectivity to new and existing storage architectures.
Our routers undergo extensive testing in many SAN configurations with a
wide range of SAN hardware components and software applications. Leading
independent software vendors and independent hardware vendors, including
Brocade, Computer Associates, Legato and VERITAS Software, have verified our
products.
ServerAttach Product Line
The ServerAttach product line allows customers to connect their SCSI server
resources into the SAN. Many customers have SCSI server resources that are still
underutilized from a processing perspective but are experiencing slow
application performance due to slow direct attached SCSI (DAS) storage devices.
The result is
2
an underutilized server resource without access to the much greater cost
effective resources on the SAN. ServerAttach allows customers to implement a
data migration and consolidation strategy by giving them full utilization of
this processing power and provides for the movement of data from these DAS
devices to newer, higher performing storage devices in the SAN. The result, in
many cases, is improved application performance and better utilization of
available central processing unit processing capabilities. ServerAttach helps
customers get more out of their existing resources rather than spending
resources on costly server replacement strategies or disruptive Fibre Channel
upgrades. Our ServerAttach product line also brings a number of added benefits,
including:
- secured storage access;
- data movement capabilities for future systems migration;
- ease of manageability;
- simple installation with offline pre-configuration; and
- minimal impact to server availability because no hardware or software
modifications are required to servers or applications.
Storage Router Product Line
Our storage router product line delivers the ability to attach SCSI storage
devices into a Fibre Channel fabric. The product line delivers both an
entry-level solution, the 6000, as well as a highly available modular,
enterprise-level solution, the 10000. Our storage routers deliver a number of
added benefits, including:
- industry leading, patented, shared storage access controls;
- multi-protocol connectivity, including recently announced FC-to-FC
Storage Routing;
- ease of manageability, setup and configuration; and
- LAN-free and Server-free back up functionality in the SAN.
OUR STRATEGY AND IMPLEMENTATION
FISCAL 2003
In fiscal 2003, we delivered on these key initiatives:
Stronger Partnerships. In fiscal 2003, in order to improve product margin
to sustain long-term growth, we entered into a new agreement with our largest
partner, Hewlett-Packard (HP), which resulted in a royalty model for the sale of
our embedded products. This arrangement allows us to generate more value for our
intellectual property and higher gross margin. Pursuant to this new agreement,
we have outsourced the manufacturing of our embedded routers to HP. As a result,
we do not incur the inventory and overhead costs of the hardware, and we receive
a royalty from HP for licensing our technology, which has resulted in less
aggregate revenue, but higher gross margin.
New Products and Sales Team. We expanded our market base through the
release of the ServerAttach product family, which enables server resources to
take advantage of the SAN. We also hired additional sales personnel with a focus
on driving product growth. In addition, we signed a key OEM agreement with EMC
that established Crossroads as a qualified solutions provider for embedded Fibre
Channel connectivity and began shipping product in fiscal 2003.
3
Customer Base Expansion. We delivered our latest generation products to our
existing customers as well as expanded our storage routing customer base. During
the year, HP and StorageTek released new products using our next generation
technology. We also added to our customer base by partnering with Quantum and
EMC.
Intellectual Property Value. During fiscal 2003 we continued to add
industry-leading companies to a growing list of corporations who have licensed
our patented technology. More specifically, we have entered into agreements with
Adaptec, ADIC, XioTech and Hitachi to license our technology. We have also
strengthened our patent portfolio as we now have 16 issued patents and 53
pending patents worldwide.
FISCAL 2004 AND BEYOND
For 2004 and beyond, our goal is to continue to differentiate ourselves
from competitors by providing storage solutions that enable legacy, current and
future storage resources. We will continue to provide proven interoperability
with major storage vendors while delivering multiple connectivity solutions for
protocol independence. The key elements of our strategy to achieve this goal
includes the following:
Grow Our Current Market Position by Solving Customer Storage Issues
As storage networking evolves, new technologies and solutions are
introduced. In order to ensure that businesses can access information regardless
of the technology they use, we will remain protocol agnostic to the type of
technology a customer chooses to implement. We will continue to:
- increase efficiency, availability and manageability of valuable
storage assets;
- ensure storage protocol independence (FC, SCSI, iSCSI);
- provide solutions enabling faster data back ups and restores;
- reduce storage management requirements;
- improve storage solution economics;
- expand storage routing connection and media options;
- add intelligence to our storage router products; and
- expand into higher value storage markets.
Increase Our Market Leadership by Investment in Intellectual Property
As we develop our products, we continue to identify and develop
intellectual property that we believe will provide us with a competitive
advantage and allow us to expand our markets. We believe that our patent
licensing program will be a key component in our market share growth. In
addition, we utilize our intellectual property to set standards for the
industry.
4
OUR PRODUCTS
FIRST DEVICE
PRODUCT SHIPMENT CONFIGURATION BENEFITS
- ---------- ---------- ------------------------------------------ ---------------------------------------------
Storage Routers
6000 May 2002 - 1U Form Factor - Connects existing SCSI devices to
- 1 2Gb/s Fibre Channel Port Fibre Channel SANs.
- 2 LVD/SE (Ultra 160) or HVD SCSI Buses - Easy to install and manage using
- 1 Ethernet Management Port Crossroads Visual Manager (CVM)
- 1 Serial Management Port web-based software application.
- Access Controls for added security and
device sharing between multiple hosts.
- Supports LAN-free and Server-free Backup.
10000 April 2002 - Modular 1U Form Factor - Designed for enterprise environments.
- 2 to 8 2Gb/s Fibre Channel Ports - Includes above features of the
- 4, 8, or 12 LVD/SE (Ultra 160) and/or Crossroads 6000.
HVD SCSI Buses - Modular design allows flexible port
- 1 Ethernet Management Port configurations.
- 1 Serial Management Port - Best-in-class throughput performance
and management features.
- Redundant, hot swappable fans and
power supplies.
Embedded July 2003 - Embedded Router Product - Connects existing SCSI devices to
Products - 1 or 2 2Gb/s Fibre Channel Ports Fibre Channel SANs.
- 2 SCSI LVD (Ultra 2) Buses - Customized Crossroads Visual Manager
- 4 SCSI LVD (Ultra 160) Buses (CVM) web-based software application.
- 1 Ethernet Management Port
- 1 Serial Management Port
ServerAttach Appliances
SA20 April 2003 - 1U Form Factor - Economical balance of connectivity and
- 1 2Gb/s Fibre Channel Port price.
- 2 LVD/SE (Ultra 160) or HVD SCSI Buses - Extends life of existing mid-range
- 1 Ethernet Management Port SCSI servers by bringing them into
- 1 Serial Management Port Fibre Channel SAN architectures.
SA40 December - Modular 1U Form Factor - Designed for enterprise environments.
2004 - 2 or 4 2Gb/s Fibre Channel Ports - Includes above features of the
- 4 or 8 LVD/SE (Ultra 160) or HVD SCSI Crossroads SA20.
Buses - Modular design allows flexible port
- 1 Ethernet management Port configurations.
- 1 Serial Management Port - Best-in-class throughput performance
and management features.
- Redundant, hot swappable fans and
power supplies.
- Field replaceable I/O modules
5
OUR CUSTOMERS
We market, sell, and support our products through a wide range of
distribution partners, including OEM partners, distributors, systems
integrators, and value-added resellers. Our OEM partners offer our products
under their own private label or as Crossroads branded solutions. Sales through
OEM partners comprise the majority of our business. Crossroads-authorized
value-added distributors, systems integrators and value-added resellers are
authorized by us to market, sell and support our storage routers. Some of these
distribution partners also sell product education and other value-added
services. We have OEM or distribution agreements with many of the companies that
sell storage systems and subsystems.
Prior to offering our products for sale through OEMs, our OEM customers
require that each of our products undergo an extensive qualification process,
which involves interoperability testing of our product in the OEM's system as
well as rigorous reliability testing. This qualification process may continue
for a year or longer. However, qualification of a product by an OEM does not
assure any sales of the product to the OEM. Despite this uncertainty, we devote
substantial resources, including sales, marketing and management efforts, toward
qualifying our products with OEMs in anticipation of future sales opportunities.
If we are unsuccessful or delayed in qualifying any products with an OEM, such
failure or delay would preclude or delay sales of that product to the OEM.
Historically, we have had strong relationships with our OEM customers and
continue to develop our existing relationships and look for new OEM
opportunities. During fiscal 2003, we added new OEM relationships with Quantum
and EMC.
We simplified our channel distribution model and implemented these changes
at the beginning of fiscal 2004. Our new model focuses on distributors for order
fulfillment. We will continue our strong relationships with existing and new
value-added resellers, but will fulfill orders through our distribution channel,
giving us better vendor management and leverage with our direct partners.
Our products are in solutions from ACAL, ACS, Arrow, ATL, Bell Micro,
Cranel/Adexis, Datalink, EMC, Fujitsu-Siemens, Groupe Bull, HP, Overland
Storage, StorageTek, Sun Microsystems, TidalWire, Quantum and Unisys.
Our marketing organization coordinates strategic product planning and
tactical adoption activities with our major OEM customers and channel partners.
This helps us to determine which market segments to pursue and to understand the
size and growth characteristics of those markets. It also allows us to analyze
competition, define product features, construct business analyses to measure
expected return on investments, and to enhance the indirect distribution process
for our products by provisioning the sales and marketing tools needed. Our
marketing efforts are intended to:
- develop key relationships with OEMs, distributors, and independent
software vendors;
- conduct targeting demand generation activities to promote and launch
our products; and
- coordinate our involvement in various industry standards
organizations, including the Storage Networking Industry Association.
Our customer support organization provides comprehensive training programs
and telephone, e-mail and Web-based direct support to our customers and end
users. These programs allow us to minimize the need for a large end-user support
organization by enabling our OEMs to provide installation, service and primary
technical support to their customers while we focus on high-level secondary
support. We actively assist our OEM customers and distributors to solve end-user
problems.
6
OUR COMPETITION
The market for SAN products generally, and storage routers in particular,
is increasingly competitive. Our products are differentiated from traditional
router competitors by virtue of our product features and patented technology. We
anticipate that the market for our products will continue to evolve and will
remain subject to rapid technological change. We currently face direct
competition primarily from ADIC, ATTO and Chaparral Network Storage. We also
expect to face competition in the future from one or more of the following
sources:
- other OEMs, including our customers and potential customers;
- native Fibre Channel storage device vendors;
- LAN switch manufacturers;
- SAN switch manufacturers;
- future iSCSI vendors;
- storage system industry suppliers, including manufacturers and vendors
of other SAN products or entire SAN systems; and
- current and future start-up companies.
As the market for SAN products grows, we also may face competition from
traditional networking companies and other manufacturers of networking products.
These networking companies may enter the storage router market by introducing
their own products or by entering into strategic relationships with or acquiring
other existing SAN product providers. The release of ServerAttach into the
marketplace creates a new pool of competitors; server manufacturers and Host
Business Adaptor (HBA) companies. We believe the competitive factors in the
storage router and ServerAttach markets include the following:
- market share and position;
- OEM endorsement;
- product reliability and verified interoperability;
- customer service and technical support;
- product performance and features;
- brand awareness and credibility;
- strength of distribution channel;
- ease-of-use and manageability; and
- price.
RESEARCH AND DEVELOPMENT
The storage networking industry we compete in is subject to rapid
technological developments, evolving industry standards, changes in customer
requirements, and new product introductions. As a result, we believe that our
research and development efforts are essential to successfully deliver
innovative products that address the needs of our customers. Our research and
development team works closely with our marketing and sales team and our OEM
customers to develop product features and enhance performance. Development
activities are conducted with extensive validation testing both internally and
at our major OEM customers.
7
We have invested heavily in research and development to support current and
future product development. We continue to enhance and extend our products to
anticipate and meet customer requirements. We continue to increase the speed and
performance of our storage routing products to deliver higher port density and
more cost-optimized solutions. Our products are designed to support current
industry standards and will continue to be designed to support emerging
standards that are consistent with our product strategy. Members of our senior
engineering team are also actively engaged in the development of industry
standards, which allows us to focus our product strategies in areas that are
aligned with the latest industry standards.
Our storage router products are based on an architecture that combines our
operating system and hardware designs using industry standard components. Our
proprietary packet routing software intelligently examines data packet traffic
to prioritize transmission and minimize network congestion in the flow of
transactions between servers and storage systems. This routing software also:
- manages delays in data transmissions that result from variances in
speeds;
- provides accurate communication of transmission status to connected
devices;
- provides critical interoperability between diverse protocols;
- enables sharing of storage resources by multiple servers; and
- can adapt to new protocols as they emerge.
Additionally, our embedded software is configurable and can be quickly
adapted to varying customer requirements and computing environments. While our
software architecture serves as the foundation for our current products, it is
also designed to be able to accommodate several planned generations of new
designs. Our hardware is the "engine" that provides basic performance and
functionality such as operating speed, data movement, external device
connectivity, network management interfaces and the ability to operate in
extreme environmental conditions of temperature and humidity.
We possess a high level of multi-disciplinary expertise encompassing
technologies, software design, operating systems, hardware and application
specific integrated circuit design and SAN technologies. We utilize these skills
to design, develop, manufacture and deliver our products. We believe that our
combined expertise in each of these technologies provides us with a competitive
advantage in the ability to develop new products on a timely basis, verify
interoperability, expand our product features and integrate additional
interfaces and functions.
We design, develop and test all of our own embedded software. As of October
31, 2003, our engineering staff included software engineers with expertise in
embedded software, management tools, software applications and graphical user
interface development. We have considerable expertise in error detection and
recovery and support. The flexibility to modify our software to varying system
configurations has enhanced our ability to rapidly achieve verified
interoperability.
MANUFACTURING
We use Solectron Corporation and Celestica Corporation, third-party
contract manufacturers, to assemble the printed circuit board for our current
products. Our manufactured products contain printed circuit board assemblies,
which consist of the electronics that control the function of our product. The
contract manufacturers purchase the required components for our printed circuit
board to meet demand in accordance with our purchase orders and our forecast.
During product final assembly and test, the printed circuit board is assembled
with the remaining components, the power supply, cables and enclosures, and is
tested to create the final product.
8
The contract manufacturers invoice us based on prices and payment terms
mutually agreed upon and set forth in purchase orders we issue to them. The
pricing takes into account component costs, manufacturing costs and margin
requirements. Although the purchase orders we place with the contract
manufacturers are cancelable, the terms of our manufacturing agreement with them
would require us to purchase all excess or obsolete material not returnable or
usable by other customers. As the needs of our customers continue to evolve, we
plan to reassess our manufacturing requirements on a periodic basis and effect
appropriate changes to our manufacturing processes.
Although we use standard parts and components for our products where
possible, we currently purchase several key components used in the manufacture
of our products from single or limited sources. Our principal single-source
components include application specific integrated circuits, licensed software
and the chassis. We have an obligation to our contract manufacturers for
portions of excess inventory arising from a sudden reduction in purchase orders
by us to the extent it differs from the forecast, which we supply to our
contract manufacturers.
During fiscal 2003, we have maintained our ISO 9002 registration.
PATENTS, INTELLECTUAL PROPERTY AND LICENSING
In July 2003, XioTech licensed our `972 patent, which provides access
controls vital to networked storage systems. In September 2003, we entered into
an agreement with Hitachi Ltd. under which both companies cross-licensed their
patented access control technology.
As of October 31, 2003, we had 16 patents issued and 53 patents pending
worldwide. 29 patent applications are pending in the United States Patent and
Trademark Office with respect to our technology. We have 17 pending
international patent applications (primarily in the European and Japanese Patent
Offices). We also have 7 international patent applications pending under the
Patent Cooperation Treaty.
We rely on a combination of patents, copyrights, trademarks, trade secrets,
confidentiality agreements, and other contractual restrictions with employees
and third parties to establish and protect our proprietary rights. We maintain a
program to identify and obtain patent protection for our inventions. It is
possible that we will not receive patents for every application we file.
Furthermore, our issued patents may not adequately protect our technology from
infringement or prevent others from claiming that our products infringe their
patents. Failure to protect our intellectual property could materially harm our
business. In addition, our competitors may independently develop similar or
superior technology. It is possible that litigation may be necessary in the
future to enforce our intellectual property rights, to protect our trade
secrets, or to determine the validity and scope of the proprietary rights of
others. Litigation could result in substantial costs and diversion of resources
and could materially harm our business.
Some of our products are designed to include software or other intellectual
property licensed from third parties. While it may be necessary in the future to
seek or renew licenses relating to various aspects of our products, we believe
that such licenses generally could be obtained on commercially reasonable terms.
We have registered the trademark "CROSSROADS", "CROSSROADS SYSTEMS", "iBOD"
and "ServerAttach" in the United States. All other trademarks, service marks or
trade names referred to in this Annual Report on Form 10-K are the property of
their respective owners.
9
EMPLOYEES
At January 21, 2004, we had 128 employees, with 68 engaged in research and
development and customer support, 20 in manufacturing, 21 in sales and
marketing, and 19 in administration, information technology, human resources and
finance. None of our employees are represented by a labor union. We have not
experienced any work stoppages and consider our relations with our employees to
be good. Competition for technical personnel in the computing industry continues
to be significant. We believe that our success depends in part on our ability to
hire, assimilate, and retain qualified personnel. We cannot assure you that we
will continue to be successful at hiring, assimilating, and retaining employees
in the future.
10
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth, as of January 16, 2004, certain information
concerning our executive officers:
NAME AGE POSITION(S)
---- --- -----------
Brian R. Smith........................ 38 Chairman of the Board
Robert C. Sims........................ 36 President and Chief Executive Officer
Andrea Wenholz........................ 38 Vice President, Chief Financial Officer, Secretary and Treasurer
John C. Cummings...................... 50 Vice President, Sales and Marketing
BRIAN R. SMITH is our co-founder and has served as our Chairman of the
Board since our inception in April 1995. Mr. Smith served as our Chief Executive
Officer from our inception until October 31, 2001 and from May 2002 to September
2003, and as our President from our inception until October 1997 and from May
2002 to September 2003. From November 2001 to December 2002, Mr. Smith served as
the managing partner of Convergent Investors, a venture capital firm located in
Austin, Texas. Mr. Smith holds a B.S.E.E from the University of Cincinnati and
an M.S.E.E. from Purdue University.
ROBERT C. SIMS has served as our President and Chief Executive Officer
since October 2003 and as a member of our Board of Directors since November
2003. From May 2002 to September 2003, Mr. Sims served as our Chief Operating
Officer. From April 2001 to May 2002, Mr. Sims served as our Vice President of
Engineering and Operations. From July 2000 to April 2001, Mr. Sims served as our
Vice President of Operations and Corporate Quality. From March 1999 to July
2000, Mr. Sims served as our Director of Operations. Prior to joining
Crossroads, from January 1998 to March 1999, Mr. Sims managed the advanced
manufacturing and product test organizations at Kentek Corp. From 1990 to 1998,
Mr. Sims served in various capacities at Exabyte, including manager of the
manufacturing engineering and quality organizations for the high-end tape drive
division. Mr. Sims received a B.S.E.E. from Colorado State University.
ANDREA WENHOLZ has served as our Vice President, Chief Financial Officer,
Secretary and Treasurer since January 2003. From May 2001 to December 2002, Ms.
Wenholz served as the Controller for U.S. Operations at Parthus Technologies,
plc, a provider of application-specific platform IP, which eventually became
ParthusCeva, following its merger with Ceva. From September 2000 to May 2001,
Ms. Wenholz was Chief Financial Officer at Chicory Systems, Inc., a
semiconductor intellectual property company, which was acquired by Parthus. From
April 1998 to September 2000, Ms. Wenholz served as a Business Unit Controller
at Cisco Systems, Inc. From August 1996 to April 1998, Ms. Wenholz served as
Controller at NetSpeed, Inc., until its acquisition by Cisco Systems, Inc. Ms.
Wenholz is a certified public accountant who started her career in public
accounting at KPMG and holds a Bachelors of Business Administration from Texas
A&M University.
JOHN C. CUMMINGS has served as our Vice President, Sales and Marketing
since May 2003. From May 2002 to April 2003, Mr. Cummings served as the
Worldwide Senior Vice President of Sales and Business Development for
ProvisionSoft, Inc. From December 1998 to May 2002, Mr. Cummings held executive
sales management and operations positions at SunGard Business Integration, an
operating group of SunGard, and Sangate Systems, Inc., a developer of data
replication solutions for the enterprise data center. From May 1985 to December
1998, Mr. Cummings served as the Director of Sales for Financial Services (North
East U.S.) at Sun Microsystems. Mr. Cummings received a BA from the University
of Massachusetts.
Further information required by this Item is incorporated by reference to
our Proxy Statement under the sections captioned "Election of Directors" and
"Compliance with Section 16(a) of the Securities Exchange Act of 1934."
11
ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS
In addition to the other information in this Annual Report on Form 10-K,
the following factors should be considered in evaluating Crossroads and our
business. These factors include, but are not limited to the factors listed
below. Additional risks and uncertainties that we are unaware of or that we
currently deem immaterial also may become important factors that affect us.
WE HAVE INCURRED SIGNIFICANT LOSSES AND NEGATIVE CASH FLOW, WE EXPECT FUTURE
LOSSES AND WE MAY NEVER MAINTAIN CONSISTENT PROFITABILITY OR A CASH FLOW
POSITIVE POSITION.
We have incurred significant losses in every fiscal quarter since fiscal
1996 and expect to continue to incur losses in the future. As of October 31,
2003, we had an accumulated deficit of $147.5 million. We cannot be certain that
we will be able to generate sufficient revenue to achieve profitability or
become consistently cash flow positive. Although we restructured our
organization in 2002 which significantly reduced our expense structure, we still
expect to incur significant sales and marketing, research and development and
general and administrative expenses and, as a result, we expect to continue to
incur losses. Moreover, we were cash flow positive in the fourth quarter of
fiscal 2003, but cash flow negative for the year ended 2003. We expect
fluctuations in our cash flow position to continue in future quarters.
WE HAVE EXPERIENCED AND EXPECT TO CONTINUE TO EXPERIENCE SIGNIFICANT
PERIOD-TO-PERIOD FLUCTUATIONS IN OUR REVENUE AND OPERATING RESULTS, WHICH MAY
RESULT IN VOLATILITY IN OUR STOCK PRICE.
We have experienced and expect to continue to experience significant
period-to-period fluctuations in our revenue and operating results due to a
number of factors, and any such variations and factors may cause our stock price
to fluctuate. Accordingly, you should not rely on the results of any past
quarterly or annual periods as an indication of our future performance.
It is likely that in some future period our operating results will be below
the expectations of public market analysts or investors. If this occurs, our
stock price may drop, perhaps significantly.
A number of factors, some of which are beyond our control, may particularly
contribute to fluctuations in our revenue and operating results, including:
- changes in general economic conditions and specific economic
conditions in the computer, storage, and networking industries;
- timing and amount of intellectual property licenses;
- the timing of orders from, and product integration by, our customers,
particularly our original equipment manufacturer (OEM)customers, and
the tendency of these customers to change their order requirements
frequently with little or no advance notice to us;
- the rate of adoption of storage area networks (SANs) as an alternative
to existing data storage and management systems;
- the ongoing need for storage routing products in storage area network
architectures;
- the deferrals of customer orders in anticipation of new products,
services or product enhancements from us or our competitors or from
other providers of storage area network products;
- the rate at which new markets emerge for products we are currently
developing;
- the deferrals of customer orders based on budgetary restrictions;
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- the successful launch and customer acceptance of our new products;
- disruptions or downturns in general economic activity resulting from
terrorist activity and armed conflict;
- increases in prices of components used in the manufacture of our
products; and
- variations in the mix of our products sold and the mix of distribution
channels through which they are sold.
In addition, potential and existing OEM customers often place initial
orders for our products for purposes of qualification and testing. As a result,
we may report an increase in sales or a commencement of sales of a product in a
quarter that will not be followed by similar sales in subsequent quarters as
OEMs conduct qualification and testing. This order pattern could lead to
fluctuations in quarterly revenue and gross profits.
GLOBAL ECONOMIC CONDITIONS MAY CONTINUE TO NEGATIVELY IMPACT US AND THE PRICE OF
OUR COMMON STOCK.
The macroeconomic environment and capital spending on information
technology in the past two fiscal years resulted in continued uncertainty in our
revenue expectations. The operating results of our business depend on the
overall demand for storage area network products. Because our sales are
primarily to major corporate customers whose businesses fluctuate with general
economic and business conditions, continued soft demand for storage area network
products caused by budgetary constraints has resulted in decreased revenue. We
may be especially prone to this as a result of the relatively high percentage of
revenue we have historically derived from the high-tech industry, which has been
more adversely impacted by the economic environment. In particular, continuing
economic uncertainty has resulted in a general reduction in information
technology spending. This reduction in information technology spending has led
to a decline in our growth rates compared to historical trends. Customers may
continue to defer or reconsider purchasing products if they continue to
experience a lack of growth in their business or if the general economy fails to
significantly improve, resulting in a continued decrease in our product revenue.
THE STORAGE TECHNOLOGY MARKET IS CHARACTERIZED BY RAPID TECHNOLOGICAL EVOLUTION,
AND OUR SUCCESS DEPENDS ON OUR ABILITY TO DEVELOP NEW PRODUCTS.
The market for our products is characterized by rapidly changing technology
and evolving industry standards and is highly competitive with respect to timely
innovation. The introduction of new products embodying new or alternative
technology or the emergence of new industry standards could render our existing
products obsolete or unmarketable. Our future success will depend in part on our
ability to anticipate changes in technology, to gain access to such technology
for incorporation into our products and to develop new and enhanced products on
a timely and cost-effective basis. Risks inherent in the development and
introduction of new products include:
- delay in our initial shipment of new products;
- the difficulty in forecasting customer demand accurately;
- our inability to expand production capacity fast enough to meet
customer demand;
- the possibility that new products may erode demand for our current
products;
- the possibility that we release new products with undetected errors;
13
- competitors' responses to our introduction of new products; and
- the desire by customers to evaluate new products for longer periods of
time before making a purchase decision.
In addition, we must be able to maintain the compatibility of our products
with future device technologies, and we must rely on producers of new device
technologies to achieve and sustain market acceptance of those technologies.
Development schedules for high-technology products are subject to uncertainty,
and we may not meet our product development schedules. If we are unable, for
technological or other reasons, to develop products in a timely manner or if the
products or product enhancements that we develop do not achieve market
acceptance, our business will be harmed.
FAILURE TO MANAGE OUR BUSINESS EFFECTIVELY COULD SERIOUSLY HARM OUR BUSINESS,
FINANCIAL CONDITION, AND PROSPECTS.
Our ability to successfully implement our business plan, develop and offer
products, and manage our business in a rapidly evolving market requires a
comprehensive and effective planning and management process. We continue to
change the scope of our operations, including managing our headcount
appropriately. Changes in our business, headcount, organizational structure and
relationships with customers and other third parties has placed, and will
continue to place, a significant strain on our management systems and resources.
Our failure to continue to improve upon our operational, managerial and
financial controls, reporting systems, and internal control procedures, and our
failure to continue to train and manage our work force, could seriously harm our
business and financial results.
AN ADVERSE DECISION IN THE VARIOUS SECURITIES CLASS ACTION LAWSUITS FILED
AGAINST US MAY HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS AND FINANCIAL
PERFORMANCE.
We and several of our officers and directors, were named as defendants in
several class action lawsuits filed in the United States District Court for the
Western District of Texas. The plaintiffs in the actions purport to represent
purchasers of our common stock during various periods ranging from January 25,
2000 through August 24, 2000. On November 22, 2002, the court granted our motion
for summary judgment, concluding that the plaintiffs failed to demonstrate an
essential element to their claim of securities fraud. On February 26, 2003, the
plaintiffs filed a notice of appeal to the Fifth Circuit Court of Appeals. On
December 3, 2003, the parties conducted oral argument on plaintiffs' appeal
before the United States Circuit Court for the Fifth Circuit. The Fifth Circuit
has not yet issued its ruling on plaintiffs' appeal. The plaintiffs are seeking
unspecified amounts of compensatory damages, interest and costs, including legal
fees. It is not possible at this time to predict whether we will incur any
liability or to estimate the damages, or the range of damages, that we might
incur in connection with such actions. An adverse judgment may have a material
adverse effect on our business and financial performance.
OUR BUSINESS IS DEPENDENT ON THE STORAGE AREA NETWORK MARKET, WHICH IS
UNPREDICTABLE, AND IF THIS MARKET DOES NOT DEVELOP AND EXPAND AS WE ANTICIPATE,
OUR BUSINESS WILL SUFFER.
Fibre Channel SANs, were first deployed in 1997. However, the market for
SANs and related storage router products is slowly evolving. Because this market
is growing at a relatively slow pace, it is difficult to predict its potential
size or future growth rate. Substantially all of our products are used
exclusively in SANs and, therefore, our business is dependent on the SAN market.
Accordingly, the widespread adoption of SANs for use in organizations' computing
systems is critical to our future success. Most of the organizations that would
be likely to purchase our products have invested substantial resources in their
existing computing and data storage systems and, as a result, may be reluctant
or slow to adopt a new approach like SANs, particularly in the current economic
environment. SANs are often implemented in connection with the deployment of new
storage systems and servers. Therefore, our future success is also substantially
dependent on the market for new storage systems and servers. Furthermore, the
ability of the different components used in a SAN to function effectively, or
14
interoperate, with each other when placed in a computing system has not yet been
achieved on a widespread basis. Until greater interoperability is achieved,
customers may be reluctant to deploy SANs. Our success in generating revenue in
the emerging SAN market will depend on, among other things, our ability to:
- educate potential OEM customers, distributors, system integrators,
storage service providers and end-user organizations about the
benefits of SANs and storage router technology, including, in
particular, the ability to use storage routers with SANs to improve
system back up and recovery processes;
- maintain and enhance our relationships with OEM customers,
distributors, system integrators, storage system providers and
end-user organizations;
- predict and base our products on standards which ultimately become
industry standards; and
- achieve interoperability between our products and other SAN components
from diverse vendors.
WE HAVE LIMITED PRODUCT OFFERINGS AND OUR SUCCESS DEPENDS ON OUR ABILITY TO
DEVELOP IN A TIMELY MANNER NEW AND ENHANCED PRODUCTS THAT ACHIEVE MARKET
ACCEPTANCE.
We currently have a limited number of products that we sell in commercial
quantities. Our future growth and competitiveness will depend greatly on the
market acceptance of our newly introduced product lines, including the 6000 and
10000 storage routers as well as the ServerAttach line of products, all of which
we released in 2002. We have received revenue from the sale of our 6000, 10000
and ServerAttach line of products; however, the market acceptance of our
ServerAttach line of products remains uncertain. If the ServerAttach line of
products does not achieve sufficient market acceptance, our future growth
prospects could be seriously harmed. Moreover, even if we are able to develop
and commercially introduce new products and enhancements, these new products or
enhancements may not achieve market acceptance.
Factors that may affect the market acceptance of our products, some of
which are beyond our control, include the following:
- growth of the SAN market;
- changing requirements of customers within the SAN market;
- performance, quality, price and total cost of ownership of our
products;
- availability, performance, quality and price of competing products and
technologies;
- our customer service and support capabilities and responsiveness; and
- successful development of our relationships with existing and
potential OEM, distributor, system integrator and storage system
provider customers.
WE DEPEND ON A LIMITED NUMBER OF CUSTOMERS FOR THE VAST MAJORITY OF OUR REVENUE.
THE LOSS OF OR SIGNIFICANT REDUCTION IN ORDERS FROM ANY KEY CUSTOMERS WOULD
SIGNIFICANTLY REDUCE OUR REVENUE AND WOULD SUBSTANTIALLY HARM OUR FUTURE RESULTS
OF OPERATIONS.
In fiscal 2001, 2002, and 2003, 51%, 75% and 75% of our total revenue,
respectively, was derived from two OEM customers (information for 2001 and 2002
assumes the subsequent merger of HP and Compaq). In fiscal 2003, HP and
StorageTek represented 54% and 21% of our total revenue, respectively. In May
2002, the merger of HP and Compaq significantly increased our customer
concentration as both HP and Compaq had been
15
significant customers to that point. Our operating results in the foreseeable
future will continue to depend on sales to a relatively small number of OEM
customers. Therefore, the loss of any of our key OEM customers, or a significant
reduction in sales to any one of them, would significantly reduce our revenue.
OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.
Prior to offering our products for sale, our OEM customers require that
each of our products undergo an extensive qualification process, which involves
interoperability testing of our product in the OEM's system as well as rigorous
reliability testing. This qualification process may continue for a year or
longer. However, qualification of a product by an OEM does not assure any sales
of the product to the OEM. Despite this uncertainty, we devote substantial
resources, including sales, marketing and management efforts, toward qualifying
our products with OEMs in anticipation of future sales opportunities. If we are
unsuccessful or delayed in qualifying any products with an OEM, such failure or
delay would preclude or delay sales of that product to the OEM, which may impede
our ability to grow our business.
DEMAND FOR OUR PRODUCTS DEPENDS SIGNIFICANTLY UPON THE NEED TO INTERCONNECT
SMALL COMPUTER SYSTEM INTERFACE (SCSI) TAPE STORAGE SYSTEMS WITH FIBRE CHANNEL
SANS, AND WE EXPECT TO FACE COMPETITION FROM MANUFACTURERS OF TAPE STORAGE
SYSTEMS THAT INCORPORATE FIBRE CHANNEL INTERFACES INTO THEIR PRODUCTS.
In traditional computer networks, system back up is accomplished by
transferring data from applications and databases over the servers used in the
network to tape drives or other media where the data is safely stored. Tape
storage devices generally rely on a SCSI connection to interface with the
network in receiving and transmitting data. Our routers enable these SCSI-based
storage devices to interface with the Fibre Channel-based components of the SAN.
Because our routers allow communication between SCSI storage devices and a Fibre
Channel SAN, organizations are able to affect their back up processes over the
SAN rather than through the computer network, enabling the servers of the
network to remain available for other computing purposes. We currently derive
the majority of our revenue from sales of storage routers that are used to
connect SCSI-based tape storage systems with SANs. The introduction of tape
storage systems that incorporate Fibre Channel interfaces would enable tape
storage devices to communicate directly with SANs, without using storage
routers. We are aware that a number of manufacturers of storage systems,
including several of our current customers, are developing tape storage systems
with embedded Fibre Channel interfaces, with products expected to be introduced
to market in the near future. If these or other manufacturers are successful in
introducing Fibre Channel-based storage systems, demand for our storage router
products would be materially reduced and our revenue would decline.
OUR RESEARCH AND DEVELOPMENT EFFORTS ARE FOCUSED ON UTILIZING EMERGING
TECHNOLOGIES AND STANDARDS AND ANY DELAY OR ABANDONMENT OF EFFORTS TO DEVELOP
THESE TECHNOLOGIES OR STANDARDS, BY INDUSTRY PARTICIPANTS, OR FAILURE OF THESE
TECHNOLOGIES OR STANDARDS TO ACHIEVE MARKET ACCEPTANCE, COULD COMPROMISE OUR
COMPETITIVE POSITION.
Our products are intended to complement other SAN products to improve the
performance of computer networks by addressing the input/output bottlenecks that
have emerged between the storage systems and the servers within a computing
system. We have devoted and expect to continue to devote significant resources
to developing products based on emerging technologies and standards that reduce
input/output bottlenecks, such as internet SCSI (iSCSI). A number of large
companies in the computer hardware and software industries are actively involved
in the development of new technologies and standards that we expect to
incorporate in our new products. Should any of these companies delay or abandon
their efforts to develop commercially available products based on these new
technologies and standards, our research and development efforts with respect to
such technologies and standards likely would have no appreciable value. In
addition, if we do not correctly anticipate new technologies and standards, or
if our products based on these new technologies and standards fail to achieve
market acceptance, our competitors may be better able to address market demand
than would we. Furthermore, if
16
markets for these new technologies and standards develop later than we
anticipate, or do not develop at all, demand for our products that are currently
in development would suffer, resulting in less revenue for these products than
we currently anticipate.
UNCERTAINTIES INVOLVING SALES AND DEMAND FORECASTS FOR OUR PRODUCTS COULD
NEGATIVELY AFFECT OUR BUSINESS.
We have limited ability to forecast the demand for our products. In
preparing sales and demand forecasts, we rely largely on input from our
distribution partners. If our distribution partners are unable to accurately
forecast demand, or we fail to effectively communicate with our distribution
partners about end-user demand or other time sensitive information, sales and
demand forecasts may not reflect the most accurate, up-to-date information.
Because we make business decisions based on our sales and demand forecasts, if
these forecasts are inaccurate, our business and financial results could be
negatively impacted. Furthermore, we may not be able to identify these forecast
differences until late in our fiscal quarter. Consequently, we may not be able
to make adjustments to our business model without negatively impacting our
business and results of operations.
WE ARE SUBJECT TO INCREASED INVENTORY RISKS AND COSTS BECAUSE WE MANUFACTURE
PRODUCTS IN ADVANCE OF BINDING COMMITMENTS FROM OUR CUSTOMERS TO PURCHASE OUR
PRODUCTS.
In order to assure availability of our products for some of our largest OEM
customers, we manufacture products in advance of purchase orders from these
customers based on forecasts provided by them. However, these forecasts do not
represent binding purchase commitments and we do not recognize revenue for such
products until the product is shipped and risk of loss has passed to the OEM. As
a result, we incur inventory and manufacturing costs in advance of anticipated
revenue. Because demand for our products may not materialize, this product
delivery method subjects us to increased risks of high inventory carrying costs
and increased obsolescence and may increase our operating costs.
THE LOSS OF OUR PRIMARY CONTRACT MANUFACTURERS, OR THE FAILURE TO FORECAST
DEMAND ACCURATELY FOR OUR PRODUCTS OR TO MANAGE OUR RELATIONSHIP WITH OUR
PRIMARY CONTRACT MANUFACTURERS SUCCESSFULLY, WOULD NEGATIVELY IMPACT OUR ABILITY
TO MANUFACTURE AND SELL OUR PRODUCTS.
We rely on a limited number of contract manufacturers, primarily Solectron
and Celestica, to assemble the printed circuit board for our current shipping
programs, including our 6000 and 10000 and ServerAttach line of products. We
generally place orders for products with Solectron and Celestica approximately
four months prior to the anticipated delivery date, with order volumes based on
forecasts of demand from our customers. Accordingly, if we inaccurately forecast
demand for our products, we may be unable to obtain adequate manufacturing
capacity from Solectron or Celestica to meet our customers' delivery
requirements, or we may accumulate excess inventories. We have on occasion in
the past been unable to adequately respond to unexpected increases in customer
purchase orders, and therefore were unable to benefit from this incremental
demand. Solectron and Celestica have not provided assurance to us that adequate
capacity will be available to us within the time required to meet additional
demand for our products.
OUR PLANS TO INTRODUCE NEW PRODUCTS AND PRODUCT ENHANCEMENTS TO MARKET REQUIRE
COORDINATION ACROSS OUR SUPPLIERS AND MANUFACTURERS, WHICH EXPOSES US TO RISKS
OF DELAY OR POOR EXECUTION FROM A VARIETY OF SOURCES.
We have recently introduced new products and product enhancements, which
requires that we coordinate our efforts with those of our component suppliers
and our contract manufacturers to rapidly achieve volume production. In
addition, we transitioned the manufacturing of our embedded router products to
HP. If we should fail to effectively manage our relationships with our component
suppliers, our contract manufacturers and other manufacturers of our products or
if any of our suppliers or our manufacturers experience delays, disruptions,
capacity constraints or quality control problems in their manufacturing
operations, our ability to ship products to
17
our customers could be delayed, and our competitive position and reputation
could be harmed. Qualifying a new component supplier or contract manufacturer
and commencing volume production can be expensive and time consuming. If we are
required to change or choose to change suppliers, we may lose revenue and damage
our customer relationships.
WE DEPEND ON SOLE SOURCE AND LIMITED SOURCE SUPPLIERS FOR CERTAIN KEY
COMPONENTS, AND IF WE ARE UNABLE TO BUY THESE COMPONENTS ON A TIMELY BASIS, OUR
DELAYED ABILITY TO DELIVER OUR PRODUCTS TO OUR CUSTOMERS MAY RESULT IN REDUCED
REVENUE AND LOST SALES.
We currently purchase Fibre Channel application specific integrated
circuits and other key components for our products from sole or limited sources.
To date, most of our component purchases have been made in relatively small
volumes. As a result, if our suppliers receive excess demand for their products,
we likely will receive a low priority for order fulfillment, as large volume
customers will use our suppliers' available capacity. If we are delayed in
acquiring components for our products, the manufacture and shipment of our
products will also be delayed, which will reduce our revenue and may result in
lost sales. We generally use a rolling nine-month forecast of our future product
sales to determine our component requirements. Lead times for ordering materials
and components vary significantly and depend on factors such as specific
supplier requirements, contract terms and current market demand for such
components. If we overestimate our component requirements, we may have excess
inventory which would increase our costs. If we underestimate our component
requirements, we may have inadequate inventory that would delay our
manufacturing and render us unable to deliver products to customers on a
scheduled delivery date. We also may experience shortages of certain components
from time to time, which also could delay our manufacturing. Manufacturing
delays could negatively impact our ability to sell our products and damage our
customer relationships.
COMPETITION WITHIN OUR MARKETS MAY REDUCE SALES OF OUR PRODUCTS AND REDUCE OUR
MARKET SHARE.
The market for SAN products generally, and storage routers in particular,
is increasingly competitive. We anticipate that the market for our products will
continually evolve and will be subject to rapid technological change. We
currently face direct competition primarily from ADIC,,ATTO and Chaparral
Network Storage. In addition, other OEM customers could develop products or
technologies internally, or by entering into strategic relationships with or
acquiring other existing SAN product providers that would replace their need for
our products and would become a source of competition. We may face competition
in the future from OEMs, including our customers and potential customers, local
area network router manufacturers, storage system industry suppliers, including
manufacturers and vendors of other SAN products or entire SAN systems, and
innovative start-up companies. For example, manufacturers of Fibre Channel
switches or directors could seek to include router functionality within their
SAN products that would obviate the need for our storage routers. As the market
for SAN products grows, we also may face competition from traditional networking
companies and other manufacturers of networking products. These networking
companies may enter the storage router market by introducing their own products
or by entering into strategic relationships with or acquiring other existing SAN
product providers. This could introduce additional competition in our markets,
especially, if one of our OEMs begins to manufacture our higher end storage
routers. While we do not currently face significant direct competition for our
ServerAttach products, we anticipate we will see increased competition as this
market develops.
WE ARE A RELATIVELY SMALL COMPANY WITH LIMITED RESOURCES COMPARED TO SOME OF OUR
CURRENT AND POTENTIAL COMPETITORS.
Some of our current and potential competitors have longer operating
histories, significantly greater resources, broader name recognition and a
larger installed base of customers than Crossroads. As a result, these
competitors may have greater credibility with our existing and potential
customers. They also may be able to adopt more aggressive pricing policies and
devote greater resources to the development, promotion and sale of their
products
18
than we can to ours, which would allow them to respond more quickly than us to
new or emerging technologies or changes in customer requirements. In addition,
some of our current and potential competitors have already established supplier
or joint development relationships with decision makers at our current or
potential customers. These competitors may be able to leverage their existing
relationships to discourage these customers from purchasing products from us or
to persuade them to replace our products with their products. Increased
competition could decrease our prices, reduce our sales, lower our margins, or
decrease our market share. These and other competitive pressures may prevent us
from competing successfully against current or future competitors, and may
materially harm our business.
WE HAVE LICENSED OUR STORAGE ROUTER TECHNOLOGY TO A KEY CUSTOMER, WHICH MAY
ENABLE THIS CUSTOMER TO COMPETE WITH US.
In November 2002, we amended our existing licensing agreement with HP.
Pursuant to this amendment we have outsourced the manufacturing of our embedded
routers to HP. As a result, we do not incur the inventory and overhead costs of
the hardware, and we will receive a royalty from HP for licensing our
technology, which will result in less aggregate revenue for us. However, even
though total revenue from the sale of our embedded routers will be less in the
future, our arrangement will have a positive impact on gross margin. We believe
this agreement will allow us to leverage the strengths of both companies,
including HP's economies of scale in manufacturing and systems integration
expertise and our software, value-added applications and intellectual property.
We have been working under this new agreement since the fiscal second quarter of
2003. HP has vastly greater resources and distribution capabilities than we do,
and therefore, it could establish market acceptance in a relatively short time
frame for any competitive products that it may introduce using our licensed
technologies, which, in turn, would reduce demand for our products from HP and
could reduce demand for our products from other customers.
UNIT PRICES OF SOME OF OUR PRODUCTS HAVE DECREASED OVER TIME, AND IF WE CANNOT
INCREASE OUR SALES VOLUMES, OUR REVENUE WILL DECLINE.
As storage networking continues to mature as an industry, we have seen a
trend towards simplification of devices. The impact of this trend on our
business has been the push for, and subsequent ramp of embedded routers being
shipped with tape libraries. These embedded routers are lower cost than the
stand-alone box routers and this lower cost is passed on to our OEM customers.
As our mix shifts from box routers to embedded routers, we will see a reduction
in average price per unit and revenue will decline if volume does not increase.
To date, some of our agreements with OEM customers, including our largest
customer, provide for quarterly reductions in pricing on a product-by-product
basis, with the actual discount determined according to the volume potential
expected from the customer, the OEM's customer base, the credibility the OEM may
bring to our solution, additional technology the OEM may help us incorporate
with our product, and other Crossroads products the OEM supports.
Notwithstanding, the decreases in our average selling prices of our older
generation products generally have been partially offset by higher average
selling prices for our newer products, as well as sales to distributors and
system integrators where price decreases are not generally required.
Nonetheless, we could experience declines in our average unit selling prices for
our products in the future, especially if our newer products do not receive
broad market acceptance. In addition, declines in our average selling prices may
be more pronounced should we encounter significant pricing pressures from
increased competition within the storage router market.
OUR PRODUCTS ARE COMPLEX AND MAY CONTAIN UNDETECTED SOFTWARE OR HARDWARE ERRORS
THAT COULD LEAD TO AN INCREASE IN OUR COSTS OR A REDUCTION IN OUR REVENUE.
Networking products such as ours may contain undetected software or
hardware errors when first introduced or as new versions are released. Our
products are complex and errors have been found in the past and may be found
from time to time in the future. In addition, our products include components
from a number of third-party vendors. We rely on the quality testing of these
vendors to ensure the adequate operation of their products. Because our products
are manufactured with a number of components supplied by various third-party
sources,
19
should problems occur in the operation or performance of our products, it may be
difficult to identify the source. In addition, our products are deployed within
SANs from a variety of vendors. Therefore, the occurrence of hardware and
software errors, whether caused by our or another vendor's SAN products, could
adversely affect sales of our products. Furthermore, defects may not be
discovered until our products are already deployed in the SAN. These errors also
could cause us to incur significant warranty, diagnostic and repair costs,
divert the attention of our engineering personnel from our product development
efforts and cause significant customer relations and business reputation
problems.
WE DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A RAPIDLY
CHANGING MARKET, AND IF WE ARE UNABLE TO RETAIN OUR CURRENT PERSONNEL AND HIRE
ADDITIONAL PERSONNEL, OUR ABILITY TO SELL OUR PRODUCTS COULD BE HARMED.
We believe our future success will depend in large part upon our ability to
attract and retain highly skilled managerial, engineering and sales and
marketing personnel. Moreover, we maintain a relatively small staff of executive
management. The loss of the services of any of our key employees or key
management would harm our business. Additionally, our inability to attract or
retain qualified personnel in the future or any delays in hiring required
personnel, particularly engineers and sales personnel, could delay the
development and introduction of, and negatively impact our ability to sell, our
products.
WE MAY BE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, WHICH WOULD NEGATIVELY
AFFECT OUR ABILITY TO COMPETE.
Our products rely on our proprietary technology, and we expect that future
technological advancements made by us will be critical to sustain market
acceptance of our products. Therefore, we believe that the protection of our
intellectual property rights is and will continue to be important to the success
of our business. We rely on a combination of patent, copyright, trademark and
trade secret laws and restrictions on disclosure to protect our intellectual
property rights. We also enter into confidentiality or license agreements with
our employees, consultants and business partners, and control access to and
distribution of our software, documentation and other proprietary information.
Despite these efforts, unauthorized parties may attempt to copy or otherwise
obtain and use our products or technology. Monitoring unauthorized use of our
products is difficult, and we cannot be certain that the steps we have taken
will prevent unauthorized use of our technology, particularly in foreign
countries where applicable laws may not protect our proprietary rights as fully
as in the United States.
OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED
IN COSTLY AND LENGTHY LITIGATION WHICH COULD SERIOUSLY HARM OUR BUSINESS.
In recent years, there has been significant litigation in the United States
involving patents, trademarks and other intellectual property rights. Legal
proceedings could subject us to significant liability for damages or invalidate
our intellectual property rights. Any litigation, regardless of its outcome,
would likely be time consuming and expensive to resolve and would divert
management's time and attention. Any potential intellectual property litigation
against us could force us to take specific actions, including:
- cease selling our products that use the challenged intellectual
property;
- obtain from the owner of the infringed intellectual property right a
license to sell or use the relevant technology or trademark, which
license may not be available on reasonable terms, or at all; or
- redesign those products that use infringing intellectual property or
cease to use an infringing trademark.
20
As we have discussed elsewhere in this report, we have engaged in lengthy
and costly litigation regarding our `972 patent. While we have prevailed to date
in these cases, we cannot assure you that we would prevail in any future effort
to enforce our rights in the `972 patent.
ANY ACQUISITIONS WE MAKE COULD DISRUPT OUR BUSINESS AND HARM OUR FINANCIAL
CONDITION.
As part of our growth strategy, we intend to review opportunities to
acquire other businesses or technologies that would complement our current
products, expand the breadth of our markets or enhance our technical
capabilities. This would entail a number of risks that could materially and
adversely affect our business and operating results, including:
- problems integrating the acquired operations, technologies or products
with our existing business and products;
- diversion of management's time and attention from our core business;
- difficulties in retaining business relationships with suppliers and
customers of the acquired company;
- risks associated with entering markets in which we lack prior
experience; and
- potential loss of key employees of the acquired company.
OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKET.
Our products comprise only a part of a SAN. All components of a SAN must
uniformly comply with the same industry standards in order to operate
efficiently together. We depend on companies that provide other components of
the SAN to support prevailing industry standards. Many of these companies are
significantly larger and more influential in effecting industry standards than
we are. Some industry standards may not be widely adopted or implemented
uniformly, and competing standards may emerge that may be preferred by OEM
customers or end users. If larger companies do not support the same industry
standards that we do, or if competing standards emerge, our products may not
achieve market acceptance, which would adversely affect our business.
PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW, COULD PREVENT, DELAY OR
IMPEDE A CHANGE IN CONTROL OF US AND MAY REDUCE THE MARKET PRICE OF OUR COMMON
STOCK.
Provisions of our certificate of incorporation and bylaws could have the
effect of discouraging, delaying or preventing a merger or acquisition that a
stockholder may consider favorable. We also are subject to the anti-takeover
laws of the State of Delaware that may discourage, delay or prevent someone from
acquiring or merging with us, which may adversely affect the market price of our
common stock. Further, in August 2002, our Board of Directors approved, adopted
and entered into a Stockholder Rights Plan which also may have the effect of
discouraging, delaying or preventing an acquisition which stockholders otherwise
may desire to support.
OUR STOCK PRICE IS VOLATILE.
The market price of our common stock has been volatile in the past and may
be volatile in the future. For example, since November 1, 2002, the intra-day
market price of our common stock as quoted on The NASDAQ Stock Market fluctuated
between $0.50 and $3.81. The market price of our common stock may be
significantly affected by the following factors:
- actual or anticipated fluctuations in our operating results;
21
- changes in financial estimates by securities analysts or our failure
to perform in line with such estimates;
- changes in market valuations of other technology companies,
particularly those that sell products used in SANs;
- announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint ventures or
capital commitments;
- sale of or distribution by Austin Ventures of our common stock to
their limited partners or substantial sales by other significant
stockholders;
- introduction of technologies or product enhancements that reduce the
need for storage routers;
- the loss of one or more key OEM customers; and
- departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
ITEM 2. PROPERTIES.
Our corporate headquarters facility consists of approximately 63,500 square
feet in Austin, Texas. We lease our headquarters facility pursuant to a lease
agreement that expires in April 2006. The lease represents a commitment of $1.8
million per year through April 2006. In conjunction with entering into the lease
agreement, we signed an unconditional, irrevocable letter of credit with a bank
for $250,000, which is secured by a $3.0 million line of credit.
Our final assembly and test facility of approximately 11,250 square feet is
also located in Austin, Texas. The lease agreement on this facility expires on
May 31, 2004.
ITEM 3. LEGAL PROCEEDINGS.
Intellectual Property Litigation
On November 4, 2003, we filed a lawsuit against Dot Hill Systems, Inc.
("Dot Hill") alleging that Dot Hill has infringed two of our patents, U.S.
Patent No. 5,941,972 (hereinafter "the '972 patent") and U.S. Patent No.
6,425,035 (hereinafter "the '035 Patent"), with some of Dot Hill's products. Dot
Hill filed an answer on December 17, 2003 denying infringement and alleging the
'972 and '035 Patents are invalid and unenforceable. We plan to vigorously
defend our patents against these counterclaims.
Securities Class Action Litigation
We and several of our officers and directors, were named as defendants in
several class action lawsuits filed in the United States District Court for the
Western District of Texas. The plaintiffs in the actions purport to represent
purchasers of our common stock during various periods ranging from January 25,
2000 through August 24, 2000. On November 22, 2002, the court granted our motion
for summary judgment. On February 26, 2003, the plaintiffs filed a notice of
appeal. On December 3, 2003, the parties conducted oral argument on plaintiffs'
appeal before the
22
United States Circuit Court for the Fifth Circuit. The Fifth Circuit has not yet
issued its ruling on plaintiffs' appeal. The plaintiffs are seeking unspecified
amounts of compensatory damages, interest and costs, including legal fees. We
deny the allegations in the complaint and intend to defend ourself vigorously.
It is not possible at this time to predict whether we will incur any liability
or to estimate the damages, or the range of damages, if any, that we might incur
in connection with this lawsuit. Our inability to prevail in this action could
have a material adverse effect on our future business, financial condition and
results of operations.
In addition, we are involved in various legal proceedings and claims that
arise in the normal course of our business. While many of these matters involve
inherent uncertainty, our management believes that the amount of the liability,
if any, ultimately incurred by us with respect to any existing proceedings and
claims, net of applicable reserves and available insurance, will not materially
harm our business, financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
23
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES.
Our common stock has been quoted on The NASDAQ Stock Market under the
symbol "CRDS" since our initial public offering on October 20, 1999. Prior to
the initial public offering, there had been no public market for our common
stock. The following table lists the high and low per share closing market
prices for our common stock as reported by The NASDAQ Stock Market for the
periods indicated:
HIGH LOW
------ ------
FISCAL YEAR ENDED OCTOBER 31, 2003
First Quarter .................... $ 1.57 $ 0.55
Second Quarter ................... $ 1.46 $ 1.05
Third Quarter .................... $ 2.10 $ 1.42
Fourth Quarter ................... $ 3.28 $ 1.75
FISCAL YEAR ENDED OCTOBER 31, 2002
First Quarter .................... $ 6.75 $ 2.70
Second Quarter ................... $ 6.07 $ 2.85
Third Quarter .................... $ 3.19 $ 0.78
Fourth Quarter ................... $ 0.85 $ 0.38
On January 21st, 2004, the last reported sales price of our common stock on
The NASDAQ Stock Market was $3.56 per share.
As of January 5, 2004, there were 25,049,221 shares of our common stock
outstanding held by approximately 278 stockholders of record (not including
beneficial holders of stock held in street name).
We have never declared or paid cash dividends on our capital stock. We
currently intend to retain any earnings for use in our business and do not
anticipate paying any cash dividends in the foreseeable future. Future
dividends, if any, will be determined by our board of directors.
The Securities and Exchange Commission on October 19, 1999 declared
effective our registration statement on Form S-1 (File No. 333-85505) relating
to the initial public offering of our common stock. As of October 31, 2003, we
have used all of the net offering proceeds for the purchase of temporary
investments, consisting of cash, cash equivalents, and short-term investments.
We currently intend to use the net proceeds of the offering for working capital
and general corporate purposes, including financing accounts receivable and
capital expenditures made in the ordinary course of business. We also may apply
a portion of the proceeds of the offering to acquire businesses, products and
technologies, or enter into joint venture arrangements such as our joint
development agreement with NexQL, that are complementary to our business and
product offerings. We also may apply a portion of the proceeds to the payment of
cash dividends or for additional stock repurchases or other similar
transactions.
We did not repurchase any shares of our common stock during the fourth
quarter of fiscal 2003.
The information concerning our equity compensation plans appearing under
"Equity Compensation Plan Information" is incorporated by reference to our Proxy
Statement.
24
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
The following selected consolidated financial data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations," in Item 7 of this Annual Report and other financial
information appearing elsewhere in this Annual Report. The consolidated balance
sheet data as of October 31, 2002 and 2003 and the consolidated statement of
operations data for the years ended October 31, 2001, 2002 and 2003 set forth
below are derived from, and qualified by reference to, our audited consolidated
financial statements appearing elsewhere in this Annual Report. The consolidated
balance sheet data for the years ended October 31, 1999, 2000 and 2001 and the
consolidated statement of operations data for the years ended October 31, 1999
and 2000 are derived from audited consolidated financial statements not included
herein.
FOR THE YEARS ENDED OCTOBER 31,
--------------------------------------------------------
1999 2000 2001 2002 2003
-------- -------- -------- -------- --------
(IN THOUSANDS)
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenue:
Product .................................... $ 18,859 $ 32,486 $ 35,896 $ 33,429 $ 25,955
Royalty and other .......................... 65 562 1,434 559 7,188
-------- -------- -------- -------- --------
Total revenue .......................... 18,924 33,048 37,330 33,988 33,143
Cost of revenue(1) ............................. 11,079 19,104 22,013 22,661 17,433
-------- -------- -------- -------- --------
Gross profit ................................... 7,845 13,944 15,317 11,327 15,710
-------- -------- -------- -------- --------
Operating expenses(1):
Sales and marketing ........................ 4,781 16,007 15,202 6,126 4,508
Research and development ................... 5,551 13,143 18,118 16,520 11,929
General and administrative ................. 3,017 31,242 16,043 9,158 6,209
Business restructuring ..................... - - - 3,666 (432)
Impairment of intangibles and other assets.. - - 25,007 2,047 -
Amortization of intangibles ................ - 8,808 9,680 278 173
Litigation settlement ...................... - - (15,000) - -
-------- -------- -------- -------- --------
Total operating expenses ............... 13,349 69,200 69,050 37,795 22,387
-------- -------- -------- -------- --------
Loss from operations ........................... (5,504) (55,256) (53,733) (26,468) (6,677)
Total other income ............................. 319 4,228 2,776 979 540
Income tax expense ............................. - - - - (310)
-------- -------- -------- -------- --------
Loss before cumulative effect
of accounting change ........................... (5,185) (51,028) (50,957) (25,489) (6,447)
Cumulative effect of accounting change ......... - - (130) - -
-------- -------- -------- -------- --------
Net loss ....................................... $ (5,185) $(51,028) $(51,087) $(25,489) $ (6,447)
-------- -------- -------- -------- --------
Accretion on redeemable convertible
preferred stock ............................ (247) - - - -
-------- -------- -------- -------- --------
Net loss attributable to common stock .......... $ (5,432) $(51,028) $(51,087) $(25,489) $ (6,447)
======== ======== ======== ======== ========
Basic and diluted net loss per share ........... $ (0.74) $ (1.93) $ (1.86) $ (0.95) $ (0.26)
-------- -------- -------- -------- --------
Shares used in computing basic
and diluted net loss per share ............. 7,378 26,467 27,414 26,878 24,443
-------- -------- -------- -------- --------
(1) Stock-based compensation for the periods
indicated was allocated as follows:
Cost of revenue ............................ $ 133 $ 288 $ 123 $ 84 $ 36
Sales and marketing ........................ 372 4,373 215 481 116
Research and development ................... 280 528 440 369 294
General and administrative ................. 420 22,501 6,283 3,640 1,017
-------- -------- -------- -------- --------
Total stock-based compensation ......... $ 1,205 $ 27,690 $ 7,061 $ 4,574 $ 1,463
======== ======== ======== ======== ========
25
AS OF OCTOBER 31,
1999 2000 2001 2002 2003
-------- -------- -------- -------- --------
(IN THOUSANDS)
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and short-term
investments ............................ $ 80,820 $ 60,038 $ 53,686 $ 34,311 $ 31,377
Working capital ........................... 83,165 62,287 51,271 34,855 31,671
Total assets .............................. 91,730 118,048 75,403 50,459 40,865
Long-term debt, net of current portion .... 1,325 - - - -
Total stockholders' equity ................ $ 84,885 $108,752 $ 64,246 $ 41,559 $ 35,258
26
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following discussion and analysis of financial condition and results of
operations should be read in conjunction with the selected consolidated
financial data in Item 6 of Part II of this Annual Report and our consolidated
financial statements and notes thereto in Item 15 of Part IV of this Annual
Report.
This discussion 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. Please see the "Cautionary Statement" and "Additional
Factors that may Affect Future Results" under Item 1 of Part I for a discussion
of the uncertainties, risks and assumptions associated with these statements.
OVERVIEW
We are a leading provider of enterprise data routing solutions for open
system storage area networks (SANs), based on our market share of storage
routers shipped. Our storage routers serve as the interconnect between SANs and
the other devices in a computer network and allow organizations to more
effectively and efficiently store, manage and ensure the integrity and
availability of their data. Specifically, when used in SANs, our storage
routers:
- improve data transfer speeds within a network;
- reduce the time required to back up and restore data;
- improve utilization of storage resources; and
- preserve and enhance existing server and storage system investments.
We provide our products in a variety of configurations including both
stand-alone box and library-embedded router form factors with varying port
counts. Our products are installed at companies, institutions, and other
entities ranging from large enterprises to small businesses. Our products and
services are marketed and sold to end users through our distribution partners,
including original equipment manufacturers (OEMs), distributors and value-added
resellers (VARs). For the fiscal years ended 2001, 2002 and 2003, sales to our
OEM customers accounted for 64%, 81% and 80% of our total revenue, respectively.
Our objective is to maintain our position as the leading provider of
storage routing solutions as storage, server, and network technologies and
markets continue to grow and evolve. The key elements of our strategy to achieve
this objective are:
- grow our current market position by solving customer storage issues;
- build on our core storage networking technologies to offer intelligent
networking solutions;
- expand our reach into other storage markets; and
- increase our market leadership by investment in intellectual property.
During fiscal 2003, we delivered on the following key initiatives we set
forth at the beginning of the fiscal year:
- Stronger Partnerships. In fiscal 2003, in order to improve product
margin to sustain long term growth, we entered into a new agreement
with our largest partner, HP, which resulted in a royalty model for
the sale of our embedded products. This arrangement allows us to
generate more value for our intellectual property and higher gross
margin. Pursuant to this new agreement, we have outsourced the
27
manufacturing of our embedded routers to HP. As a result, we do not
incur the inventory and overhead costs of the hardware, and we receive
a royalty from HP for licensing our technology, which has resulted in
less aggregate revenue, but higher gross margin.
- New Products and Expanded Sales Team. We expanded into new markets
with the launch of our ServerAttach product family, which enables
server resources to take advantage of the storage area network. We
also hired additional sales personnel with a focus on driving product
growth. In addition, we signed a key OEM agreement with EMC that
established Crossroads as a qualified solutions provider for embedded
Fibre Channel connectivity and began shipping product in fiscal 2003.
- Customer Base Expansion. We delivered our latest generation products
to our existing customers as well as expanded our storage routing
customer base. Our customer base expansion was validated in fiscal
2003 by HP and StorageTek, through their new product releases, as well
as the addition of Quantum and EMC to our customer base.
- Intellectual Property Value. During fiscal 2003 we continued to add
industry-leading companies to a growing list of corporations who have
licensed our patented technology. In addition, we have entered into
agreements with Adaptec, ADIC, XioTech and Hitachi to license our
technology. We have also strengthened our patent portfolio as we now
have 16 issued patents and 53 pending patents worldwide.
28
RESULTS OF OPERATIONS
The following table sets forth our consolidated financial data for the
periods indicated in thousands and expressed as a percentage of our total
revenue.
FOR THE YEAR ENDED OCTOBER 31,
--------------------------------------------------------------------
2001 2002 2003
-------------------- ------------------ ------------------
(DOLLARS IN THOUSANDS)
Product revenue............................... $ 35,896 96.2% $ 33,429 98.4% $ 25,955 78.3%
Royalty and other revenue..................... 1,434 3.8 559 1.6 7,188 21.7
--------- ------ -------- ----- -------- -----
Total revenue............................ 37,330 100 33,988 100.0 33,143 100.0
Cost of revenue:
Product.................................. 21,898 58.7 22,486 66.2 16,598 50.1
Royalty and other........................ 115 0.3 175 0.5 835 2.5
--------- ------ -------- ----- -------- -----
Total cost of revenue.................... 22,013 59.0 22,661 66.7 17,433 52.6
--------- ------ -------- ----- -------- -----
Gross profit.................................. 15,317 41.0 11,327 33.3 15,710 47.4
Operating expenses:
Sales and marketing...................... 15,202 40.7 6,126 18.0 4,508 13.6
Research and development................. 18,118 48.5 16,520 48.6 11,929 36.0
General and administrative............... 16,043 43.0 9,158 27.0 6,209 18.7
Business restructuring expense........... - - 3,666 10.8 (432) (1.3)
Impairment of assets..................... 25,007 67.0 2,047 6.0 - -
Amortization of intangibles.............. 9,680 25.9 278 0.8 173 0.5
Litigation settlement.................... (15,000) (40.2) - - - -
--------- ------ -------- ----- -------- -----
Total operating expenses................. 69,050 184.9 37,795 111.2 22,387 67.5
--------- ------ -------- ----- -------- -----
Loss from operations.......................... (53,733) (143.9) (26,468) (77.9) (6,677) (20.1)
Other, net............................... 2,776 7.4 979 2.9 540 1.6
--------- ------ -------- ----- -------- -----
Loss before income taxes
and accounting change......................... (50,957) (136.5) (25,489) (75.0) (6,137) (18.5)
Income tax expense....................... - - - - (310) (1.0)
--------- ------ -------- ----- -------- -----
Loss before accounting change................. (50,957) (136.5) (25,489) (75.0) (6,447) (19.5)
Cumulative effect of accounting change... (130) (0.4) - - - -
--------- ------ -------- ----- -------- -----
Net loss...................................... $ (51,087) (136.9)% $(25,489) (75.0)% $ (6,447) (19.5)%
========= ====== ======== ===== ======== =====
Product Revenue
Product revenue consists of sales of our storage router and our
ServerAttach line of products. Product revenue decreased 6.9% from $35.9 million
in fiscal 2001 to $33.4 million in fiscal 2002 and further decreased 22.4% to
$26.0 million in fiscal 2003.
The decrease in product revenue from fiscal 2001 to fiscal 2002 resulted
from various product and customer transitions, overall unfavorable economic
conditions and reduced IT spending rates. The transition to lower margin
embedded products led to a decrease in revenue in fiscal 2002. Therefore, in
order to improve product margin on embedded products, we transitioned to a
royalty model in fiscal 2003. In addition, sales of our next generation products
have resulted in higher gross margin.
29
The decrease in product revenue in 2003 primarily resulted from our
successful transition to a royalty model for embedded products with HP. Under
this model, our product revenue declined, as expected, because we have
outsourced the manufacturing of our embedded routers to HP and the royalty
revenue we receive is now classified under royalty and other revenue.
Our storage router sales are sustaining through our OEM and channel
partners. However, we believe that an opportunity exists with our ServerAttach
technology in both the channel and with our new OEM relationship with EMC.
ServerAttach technology allows customers to connect their SCSI server resources
into the SAN. The result, in many cases, is improved application performance and
better utilization of available central processing unit capabilities.
ServerAttach technology helps customers get more out of their existing resources
rather than spending resources on costly server replacement strategies or
disruptive fiber channel upgrades. Our sales organization has been deployed to
educate the direct end user of the features and cost savings that our
ServerAttach technology has to offer.
On a product basis, sales have shifted to our next generation products and
to our ServerAttach family of products. We anticipate that sales of our older
generation products as a percentage of our total revenue will continue to
decrease as we successfully transition our customers to our newer product
platforms.
A significant portion of our revenue is still concentrated among a
relatively small number of OEM customers, and the merger of HP and Compaq in May
2002 has resulted in substantial additional concentration. Fluctuations in
revenue have resulted from, among other things, product and customer
transitions, OEM qualification and testing, reduced IT spending rates by our
customers and potential customers and our transition to the royalty model with
HP which is described more herein. We expect that a significant portion of our
future revenue will continue to come from sales of products to a relatively
small number of customers.
Royalty and Other Revenue
Royalty and other revenue includes revenue from the licensing of
intellectual property (IP), royalty payments from HP and sales of service
contracts. IP licensing arrangements typically consist of upfront nonrefundable
fees. These fees are collected as consideration for either past sales of
licensee products or a lifetime patent license. When a license agreement is
signed, delivery of the license has occurred and there are no remaining
obligations outstanding, we record revenue from upfront nonrefundable IP
licensing arrangements. Royalty revenue is recognized monthly based on shipment
reports received from HP's contract manufacturer and service revenue is
recognized over the service period. Royalty and other revenue decreased 61.0%
from $1.4 million in fiscal 2001 to $0.6 million in fiscal 2002 and then
increased significantly to $7.2 million in fiscal 2003.
The decrease in royalty and other revenue in fiscal 2002 was primarily due
to non-recurring licensing revenue from our former Oregon subsidiary for sale of
its technology. The increase in royalty and other revenue in fiscal 2003 was due
to the transition to a royalty model with HP and the receipt of IP licensing
revenue.
We entered into patent license agreements in fiscal 2003, which represented
50.1% of our royalty and other revenue for the year. Our potential to generate
patent license revenue in the future will be largely dependent upon our ability
to identify and pursue additional, potential licensees. Our business model
includes entering into royalty agreements with other potential licensees.
Licensees currently incorporating our technology into their products are not
contractually obligated to continue doing so.
Given the nature of patent license agreements, the timing of license
revenue is difficult to forecast and therefore is expected to cause fluctuations
in royalty and other revenue. However, based on forecasts from HP, royalty
revenue from embedded products is expected to continue under this model.
30
Cost of Revenue
Product
Cost of product revenue consists primarily of contract manufacturing costs,
material costs, manufacturing overhead, third party software licenses, warranty
costs and stock-based compensation. Cost of product revenue increased 2.7% from
$21.9 million in fiscal 2001 to $22.5 million in fiscal 2002 and subsequently
decreased 26.2% to $16.6 million in fiscal 2003.
The increase in cost of product revenue in fiscal 2002 was primarily due to
sales of lower margin products and corresponding increases in manufacturing
costs. The decrease in cost of product revenue in fiscal 2003 was expected as a
result of the manufacturing cost savings with the transition to the royalty
model with HP. Under this model, HP manufactures our embedded products, which
has resulted in lower manufacturing costs to us. We expect to continue to see
the benefits from the royalty model; however, the cost of product revenue may
fluctuate based on the introduction of new products and changes in product mix.
Royalty and Other
Cost of revenue relating to royalty and other revenue consists primarily of
legal costs associated with the negotiation of patent licensing contracts. Cost
of revenue relating to royalty and other revenue increased from $0.1 million in
fiscal 2001 to $0.2 million is fiscal 2002 and subsequently increased to $0.8
million in fiscal 2003.
The increase in fiscal 2002 was related to an increase in service revenue.
The increase in fiscal 2003 was primarily due to legal costs associated with new
IP license revenue.
Given the nature of IP revenue and more specifically, patent license
agreements, it is difficult to forecast cost of revenue relating to royalty and
other revenue. Therefore, we expect cost of revenue relating to royalty and
other revenue to fluctuate as royalty and other revenue fluctuates.
Gross Profit
Gross profit decreased 26.0% from $15.3 million in fiscal 2001 to $11.3
million in fiscal 2002 and subsequently increased 38.7% to $15.7 million in
fiscal 2003. Gross profit margin decreased from 41% to 33% and then increased to
47% in fiscal 2001, 2002 and 2003, respectively.
The decrease in gross profit in fiscal 2002 was primarily due to lower
product revenue and lower margin product mix. Increases in manufacturing costs
also contributed to lower gross profit in fiscal 2002.
The increase in gross profit in fiscal 2003 was attributable to our
transition to a royalty model with HP, higher margin product mix and IP
licensing revenue. A higher proportion of product revenue in 2003 was comprised
of sales of our next generation products. These next generation products provide
a higher margin as compared to our older generation product lines due to their
enhanced features and functionalities.
Gross margin percentage from patent license revenue was approximately 83%.
We anticipate that our potential to generate patent license revenue in the
future will be largely dependent upon our ability to identify and pursue
potential licensees. Given the nature of patent license revenue, we anticipate
fluctuations in gross profit and gross profit margin from period to period.
31
Sales and Marketing Expenses
Sales and marketing expenses consist primarily of salaries, commissions,
travel, advertising programs, other promotional activities and stock-based
compensation expenses. Sales and marketing expenses decreased 59.7% from $15.2
million in fiscal 2001 to $6.1 million in fiscal 2002 and further decreased
another 26.4% to $4.5 million in fiscal 2003. Stock-based compensation expense
for sales and marketing was $0.2 million, $0.5 million and $0.1 million during
fiscal 2001, 2002 and 2003, respectively. Sales and marketing personnel totaled
37, 13 and 23 at October 31, 2001, 2002 and 2003, respectively.
The decrease in sales and marketing expenses in fiscal 2002 was primarily
due to our restructuring efforts in May of 2002, which resulted in approximately
$5.2 million of decreased compensation expense, including stock-based
compensation. The reduction in force also resulted in decreased travel and
entertainment expenses, professional fees, evaluation unit costs, tradeshow
expenses and depreciation expense.
Sales and marketing expenses further decreased in fiscal 2003 as we
realized continued cost savings, primarily due to the restructuring effort made
in May of 2002. In fiscal 2003, compensation expense decreased approximately
$1.2 million despite an increase in headcount at October 31, 2003 as we hired
the majority of our new sales force at the end of the fiscal year. Depreciation
related to sales and marketing has decreased $0.3 million in fiscal 2003 as a
result of the restructuring efforts in fiscal 2002.
We anticipate that sales and marketing expenses may increase due to our
added sales force hired in the latter half of fiscal 2003. We expect sales and
marketing expense as a percentage of total revenue to be higher in the first
half of fiscal 2004 due to the timing of the initial sales cycle.
Research and Development Expenses
Research and development expenses consist primarily of salaries and other
personnel-related costs, product development costs and stock-based compensation
expenses. Research and development expenses decreased 8.8% from $18.1 million in
fiscal 2001 to $16.5 million in fiscal 2002 and further decreased 27.8% to $11.9
million in fiscal 2003. Research and development stock-based compensation
expense was $0.4 million, $0.4 million and $0.3 million during fiscal 2001, 2002
and 2003, respectively. Research and development personnel totaled 93, 66 and 66
at October 31, 2001, 2002 and 2003, respectively.
The decrease in research and development expenses during fiscal 2002 was
primarily due to our restructuring efforts in May of 2002, which resulted in
approximately $0.7 million of decreased overhead allocations and $0.6 million of
decreased prototype expenses.
Research and development expenses further decreased in fiscal 2003 as we
realized a full fiscal year of cost reductions, due to the restructuring effort
made in May of 2002. We also continued our cost control efforts over research
and development expenses. In fiscal 2003, compensation expense decreased $1.0
million, including stock-based compensation, and overhead costs decreased $1.6
million. As we began entering into contracts for nonrecurring engineering
("NRE") services on behalf of certain customers, development expenses decreased
approximately $1.2 million in fiscal 2003. Under the terms of these NRE
contracts, we are reimbursed for personnel and pre-production product costs
incurred on behalf of our customers.
We anticipate that research and development expenses may increase due to
continued development of our technologies and the expansion of our product
offerings. Also, we may enter into additional joint technology development
agreements. In addition, due to the fluctuating nature of our NRE services, we
could experience an increase in research and development expenses.
32
General and Administrative Expenses
General and administrative expenses consist primarily of salaries and other
personnel-related costs, costs of our administrative, executive and information
technology departments, as well as legal and accounting, insurance and
stock-based compensation expenses. General and administrative expenses decreased
42.9% from $16.0 million in fiscal 2001 to $9.2 million in fiscal 2002 and
further decreased 32.2% to $6.2 million in fiscal 2003. Stock-based compensation
expense for general and administrative expenses was $6.3 million, $3.6 million
and $1.0 million during fiscal 2001, 2002 and 2003, respectively. General and
administrative personnel totaled 37, 17 and 18 at October 31, 2001, 2002 and
2003, respectively.
The decrease in general and administrative expenses during fiscal 2002 was
primarily due to our restructuring efforts in May of 2002, which resulted in
approximately $5.0 million of decreased compensation expense, including
stock-based compensation. In addition, professional fees decreased approximately
$1.7 million primarily due to a reduction in litigation expenses.
General and administrative expenses further decreased in fiscal 2003 as we
realized a full fiscal year of cost reductions, due to the restructuring effort
made in May of 2002. We also continued our cost control efforts over general and
administrative expenses. In fiscal 2003, compensation expense decreased
approximately $3.4 million, including stock-based compensation. This decrease
was offset by compensation expense of $0.9 million related to former executive
officers. In addition, professional fees decreased approximately $0.6 million.
We anticipate that general and administrative expenses may increase due to
additional costs associated with the Sarbanes-Oxley Act of 2002 and other
related legislative and regulatory changes.
INCOME TAXES
We recorded no income tax expense or benefit during the years ended October
31, 2001 and 2002. The income tax expense of approximately $0.3 million recorded
in 2003 resulted from withholdings on income generated in a foreign country. We
have provided a full valuation allowance against our deferred tax assets because
the realization of related tax benefits is not considered more likely than not.
BUSINESS RESTRUCTURING EXPENSES AND ASSET IMPAIRMENT
In May 2002, we completed a restructuring plan that reduced our workforce
by approximately 25%, or 40 people (primarily in the sales, marketing and
general and administrative areas), to scale down our infrastructure and to
consolidate operations. Components of business restructuring expenses, asset
impairments and the remaining restructuring accruals as of October 31, 2003 are
as follows (in thousands):
EMPLOYEE
FACILITY LEASE ASSET SEPARATION &
ABANDONMENT IMPAIRMENTS OTHER COSTS TOTAL
----------- ----------- ----------- -----
Effect of restructuring plan and impact to accrued
liabilities......................................... $2,114 $ 1,208 $ 1,552 $ 4,874
Cash activity....................................... (157) - (1,051) (1,208)
Non-cash activity................................... - (1,208) (175) (1,383)
------ ------- ------- -------
Balance as of October 31, 2002...................... 1,957 - 326 2,283
Cash activity....................................... (561) - (326) (887)
Non-cash activity................................... (432) - - (432)
------ ------- ------- -------
Balance as of October 31, 2003...................... $ 964 $ - $ - $ 964
====== ======= ======= =======
33
In March 2003, the Company signed an agreement to sublease a portion of its
abandoned facilities. The anticipated rent payments from this sublease are
approximately $0.5 million through January 2006. A second agreement to sublease
a portion of its abandoned properties was signed in May 2003. The anticipated
rent payments from the second sublease are approximately $0.1 million through
January 2006.
We reduced the restructuring accrual by approximately $0.4 million during
the fiscal year ended October 31, 2003 principally for rent payments on
subleases to be received through October 31, 2004. The Company will assess
recoverability of these sublease payments on a quarterly basis. We have
substantially completed our restructuring efforts initiated in conjunction with
the restructuring announcement made during fiscal 2002; however, there can be no
assurance that future restructuring efforts will not be necessary.
LIQUIDITY AND CAPITAL RESOURCES
The following table presents selected financial statistics and information
(dollars in thousands):
OCTOBER 31,
-----------------------
2002 2003
-------- --------
Cash and cash equivalents................................. $ 14,723 $ 14,707
Short-term investments.................................... $ 19,588 $ 16,670
Working capital........................................... $ 34,855 $ 31,671
Current ratio............................................. 4.9:1 6.6:1
Days of sales outstanding - for the quarter ended......... 64 30
Our principal sources of liquidity at October 31, 2003 consisted of $14.7
million in cash and cash equivalents and $16.7 million in short-term
investments.
In June 2003, we extended our existing line of credit with Silicon Valley
Bank. The committed revolving line is an advance of up to $3.0 million with a
borrowing base of 80% of eligible accounts receivable. The line of credit
contains provisions that prohibit the payment of cash dividends and require the
maintenance of specified levels of tangible net worth and certain financial
performance covenants measured on a monthly basis. The line of credit matures in
June of 2004 at which time we will review the terms. As of October 31, 2003,
there were no borrowings outstanding under the revolving line of credit and no
term loans outstanding.
In February 2003, we extended a $250,000 letter of credit in connection
with the lease requirements of our headquarters.
During fiscal 2003, cash utilized in operating activities was $1.5 million,
compared to $15.7 million utilized in fiscal 2002 and $33,000 in fiscal 2001.
The decrease in net cash utilized during fiscal 2003 primarily reflects a
decrease in net loss due to improved gross margins, and decreases in inventory
spending. The improvement in gross margin resulted from the royalty model with
HP and IP license revenue. In addition, the transition to the royalty model
reduced our inventory purchase requirements. During fiscal 2001, we received
proceeds from a $15.0 million litigation settlement, which significantly reduced
cash utilized in operating activities for fiscal 2001. Net of this effect, cash
utilized during fiscal 2002 increased by approximately $0.6 million from fiscal
2001. This increase was due to several factors including an increase in accounts
receivable and a decrease of cash utilized for accounts payable and accrued
expenses.
34
During fiscal 2003, cash provided by investing activities was $2.1 million,
compared to $11.4 million utilized in fiscal 2002 and $1.9 million provided in
fiscal 2001. The increase in net cash provided in fiscal 2003 reflected the
maturity of held-to-maturity investments, net of purchases, of $2.9 million as
compared to the purchase of held-to-maturity investments, net of maturities, of
$9.6 million in fiscal 2002. The increase in net cash utilized in fiscal 2002
reflected the purchase of held-to-maturity investments, net of maturities, of
$9.6 million. Capital expenditures were $5.6 million, $1.9 million and $0.8
million in fiscal 2001, 2002 and 2003, respectively. These expenditures reflect
our investments in computer equipment and software, test equipment, software
development tools and leasehold improvements. We will continue to monitor our
capital requirements but we expect capital spending to increase as required to
support new product offerings.
During fiscal 2003, cash utilized in financing activities was $0.6 million,
compared to $1.9 million in fiscal 2002 and $0.6 million in fiscal 2001.
Financing activities during fiscal 2003 includes an increase in book
overdrafts, of $0.8 million, compared to fiscal 2002 due to the timing of
vendor payments. In addition, we repurchased and retired less common stock
through our stock repurchase program in fiscal 2003, as compared to fiscal 2002.
The increase in cash utilized in fiscal 2002 reflected an increase in the
repurchase and retirement of common stock through our stock repurchase program.
In fiscal 2001, 2002 and 2003, we repurchased and retired common stock in the
amount of $1.4 million, $2.3 million and $2.0 million, respectively.
We have funded our operations to date primarily through sales of preferred
stock and our initial public offering, resulting in aggregate gross proceeds to
us of $98.2 million. We believe our existing cash balances and our credit
facilities will be sufficient to meet our capital requirements beyond the next
12 months. However, we could be required or could elect to seek additional
funding prior to that time. Our future capital requirements will depend on many
factors, including the rate of revenue growth, including licensing revenue, if
any, the timing and extent of spending to support product development efforts
and expansion of sales and marketing activities, the timing of introductions of
new products and enhancements to existing products, and market acceptance of our
products. Subsequent to fiscal 2003, we entered into a technology development
agreement with NexQL Corporation for the joint development of advanced data
management solutions. During the term of this and other strategic agreements, we
will provide funding up to $2.5 million to NexQL. Additionally, we may enter
into additional strategic arrangements or acquisitions in the future that could
require us to seek additional equity or debt financing. We cannot assure that
additional equity or debt financing, if required, will be available to us on
acceptable terms, or at all.
STOCK REPURCHASE PROGRAM
In September 2001, our board of directors authorized a stock repurchase
program pursuant to which we were authorized to repurchase up to $5.0 million of
our common stock in the open market. From September 2001 to April 2002, we
repurchased 661,300 shares of our common stock at an aggregate purchase price of
$2.1 million. In May 2002, our board of directors authorized the extension of
our stock repurchase program and authorized the repurchase up to an additional
$5.0 million worth of our common stock, for an aggregate amount of up to $7.1
million. From May 2002 through October 31, 2002, we repurchased 1,714,465 shares
of our common stock at an aggregate purchase price of $1.7 million. In October
2002, our board of directors authorized the further extension of our stock
repurchase program through the end of 2003. From November 2002 to October 31,
2003, we repurchased 1,772,300 shares of our common stock at an aggregate
purchase price of $2.0 million. As of October 31, 2003, we had repurchased an
aggregate of 4,148,065 shares of our common stock for an aggregate purchase
price of $5.7 million under our stock repurchase program representing a total of
approximately 15% of the Company.
Under the repurchase program, the stock will be purchased in the open
market or privately negotiated transactions from time to time in compliance with
the SEC's Rule 10b-18, subject to market conditions, applicable legal
requirements and other factors. The timing and amounts of any purchases will be
as determined by our
35
management from time to time or may be suspended at any time without prior
notice, depending on market conditions and other factors they deem relevant. The
timing and size of any future stock repurchases are subject to market
conditions, stock prices, cash position and other cash requirements.
STOCKHOLDER RIGHTS PLAN
On August 21, 2002, our board of directors approved, adopted and entered
into a Stockholder Rights Plan ("The Plan"). The Plan is similar to plans
adopted by many other companies and was not adopted in response to any attempt
to acquire us, nor were we aware of any such efforts at the time of adoption.
The Plan is designed to enable our stockholders to realize the full value
of their investment by providing for fair and equal treatment of all
stockholders in the event that an unsolicited attempt is made to acquire the
company. Adoption of the Plan is intended to deter coercive takeover tactics
including the accumulation of shares in the open market or through private
transactions and to prevent an acquiror from gaining control of the company
without offering a fair price to all of our stockholders.
Under the Plan, we declared and paid a dividend of one right for each share
of common stock held by stockholders of record as of the close of business on
September 3, 2002. Each right initially entitles stockholders to purchase one
unit of a share of our preferred stock at $12 per share. However, the rights are
not immediately exercisable and will become exercisable only upon the occurrence
of certain events. If a person or group acquires or announces a tender or
exchange offer that would result in the acquisition of 15 percent or more of our
common stock while the Plan remains in place, then, unless the rights are
redeemed by us for $0.01 per right, all rights holders except the acquirer will
be entitled to acquire our common stock at a significant discount. The rights
are intended to enable all stockholders to realize the long-term value of their
investment in the company. The rights will not prevent a takeover attempt, but
should encourage anyone seeking to acquire us to negotiate with the board prior
to attempting a takeover. The rights will expire on September 3, 2012.
CONTRACTUAL CASH OBLIGATIONS AND COMMITMENTS
We lease office space and equipment under long-term operating lease
agreements that expire on various dates through April 15, 2006. In April 2000,
we relocated our headquarters in accordance with an agreement to lease
approximately 63,500 square feet of administrative office space in Austin,
Texas. The term of the lease agreement is approximately six years, from April 1,
2000 through April 15, 2006, and represents a lease commitment of approximately
$1.8 million per year through the lease term. In conjunction with entering into
the lease agreement, we signed an unconditional, irrevocable letter of credit
with a bank for $250,000, which is secured by a $3.0 million line of credit.
The following summarizes our contractual cash obligations as of October 31,
2003 (in thousands):
PAYMENTS DUE BY PERIOD
----------------------------------------------------------------
LESS THAN MORE THAN
TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS
----- ------ --------- --------- -------
Operating leases....................... $ 5,083 $ 2,121 $ 2,960 $ 2 $ -
Subleases.............................. (629) (230) (399) - -
------- ------- ------- --- ---
Operating leases, net.................. $ 4,454 $ 1,891 $ 2,561 $ 2 $ -
======= ======= ======= === ===
Our other manufacturing commitments relating to open purchase orders was
approximately $84,000 at October 31, 2003.
36
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's discussion and analysis of our 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. The preparation of these financial statements requires management
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenue and expenses, and related disclosure of contingent assets
and liabilities. On an ongoing basis, we evaluate our estimates, including those
related to revenue recognition, deferred taxes, warranty obligations, excess and
obsolete inventories, allowance for doubtful accounts, facility lease
abandonment losses associated with our restructuring and litigation. We base our
estimates on historical experience and on various other assumptions that are
believed 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 may differ from
these estimates under different assumptions or conditions.
We believe the following critical accounting policies, among others, affect
our more significant judgments and estimates used in the preparation of our
Consolidated Financial Statements:
- Revenue recognition;
- Deferred taxes;
- Warranty obligations;
- Excess and obsolete inventories;
- Allowance for doubtful accounts;
- Facility lease abandonment losses; and
- Litigation.
Revenue recognition. With respect to sales of our products to the OEMs, we
recognize product revenue when persuasive evidence of an arrangement exists,
delivery has occurred, the price is fixed or determinable, collectibility is
probable and risk of loss has passed to the OEM. Product sales to distributors,
VARs and system integrators who do not have return rights are recognized upon
shipment. To the extent that we sell products to distributors, VARs and system
integrators that have rights of return, we defer revenue and the related cost of
revenue associated with such sales and recognize these amounts when that
customer sells our products to its customers. Management's judgments and
estimates must be made and used in connection with the revenue recognized in any
given accounting period. Material differences may result in the amount and
timing of our revenue, in any given accounting period, if our management alters
the method by which they derive such judgments or estimates.
Royalty and other revenue includes licensing of intellectual property (IP),
royalty payments and sales of service contracts. IP licensing arrangements
typically consist of upfront nonrefundable fees including payments related to
past sales of licensee products or payments related to a paid-up license in
which the licensee makes a single payment for a lifetime patent license. Once a
license agreement is signed, delivery of the license has occurred and there are
no remaining obligations outstanding, the Company records revenue from upfront
nonrefundable IP license fees. Service revenue is recognized over the applicable
service period.
Deferred taxes. In preparing our financial statements, we are required to
estimate our income tax obligations. This process involves estimating our actual
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
37
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. If
we change this valuation allowance in a period, we must include an expense or
benefit within the tax provision in our statement of operations.
Judgment is required in determining our deferred tax assets and liabilities
and our 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 us attaining future taxable income during the period in which our deferred
tax assets are recoverable. Due to uncertainty surrounding our ability to
generate taxable income in the future, we have determined that it is more likely
than not that we will not be able to utilize any of the benefits of our deferred
tax assets, including net operating loss carry forwards, before they expire.
Therefore, we have provided a 100% valuation allowance on our deferred tax
assets, and our net deferred tax assets as of October 31, 2003 is zero.
Warranty obligations. We provide for the estimated cost of product
warranties at the time revenue is recognized. These estimates are developed
based on historical information. While we engage in extensive product quality
programs and processes, including actively monitoring and evaluating the quality
of our component suppliers, our warranty obligation is affected by product
failure rates, material usage and service delivery costs incurred in correcting
a product failure. Should actual product failure rates, material usage or
service delivery costs differ from our estimates, revisions to the estimated
warranty liability would be required.
Excess and obsolete inventory. We write-down our inventory for estimated
obsolescence or unmarketable inventory based on the difference between the cost
of inventory and the estimated market value derived by assumptions about future
demand and market conditions. If actual demand and/or market conditions are less
favorable than those projected by management, additional inventory write-downs
may be required.
Allowance for doubtful accounts. We continuously assess the collectibility
of outstanding customer invoices and in doing such, we maintain an allowance for
estimated losses resulting from the non-collection of customer receivables. In
estimating this allowance, we consider factors such as:
- historical collection experience;
- a customer's current credit-worthiness;
- customer concentrations;
- age of the receivable balance, both individually and in the aggregate;
and
- general economic conditions that may affect a customer's ability to
pay.
Actual customer collections could differ from our estimates. For example,
if the financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required.
Facility lease abandonment losses. We vacated excess leased facilities as a
result of the restructuring plan we completed during fiscal 2002. We estimated
costs of vacating these leased facilities, including estimated costs to
sublease, based on market information and trend analysis. Any sublease payments
received by us are recorded as a reduction to this accrual based on the
specified sublease terms. Actual results may differ from these estimates in the
near term, and such differences could be material to our financial statements.
Litigation. We evaluate contingent liabilities, including threatened or
pending litigation in accordance with SFAS No. 5, "Accounting for Contingencies"
and record accruals when the outcome of these matters is deemed
38
probable and the liability is reasonably estimable. We make these assessments
based upon the facts and circumstances, and in some instances based in part upon
the advice of outside legal counsel. As of October 31, 2003, we have not accrued
any material costs associated with any pending or threatened litigation as no
amounts have been deemed probable or reasonably estimable. However, any changes
in the threatened or pending litigation could result in revisions to our
estimates of the potential liability and could materially impact our results of
operations and financial position.
RECENT ACCOUNTING PRONOUNCEMENTS
In May 2003, the Financial Accounting Standards Board (FASB) issued SFAS
No. 150, "Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity." SFAS No. 150 states that companies that issue
financial instruments that have characteristics of both liabilities and equity
will have to determine if the instrument should be classified as a liability or
equity for financial instruments entered into or modified after May 31, 2003.
The adoption of FASB No. 150 did not have a material effect on our operating
results or financial condition.
In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46),
"Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51."
FIN 46 requires certain variable interest entities to be consolidated by the
primary beneficiary of the entity if the equity investors in the entity do not
have the characteristics of a controlling financial interest or do not have
sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. FIN 46 is
effective for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN 46 must be applied for the first interim
or annual period beginning after June 15, 2003. The adoption of FIN 46 did not
have a material effect on our operating results or financial condition.
In November 2002, the Emerging Issues Task Force (EITF) reached a consensus
on Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables." EITF
Issue No. 00-21 provides guidance on how to account for arrangements that
involve the delivery or performance of multiple products, services and/or rights
to use assets. The provisions of EITF Issue No.00-21 apply to revenue
arrangements entered into in fiscal periods beginning after June 15, 2003. The
adoption of EITF Issue No. 00-21 did not have a material effect on our operating
results or financial condition.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISKS.
All of our investments are entered into for other than trading purposes.
Our interest income is sensitive to changes in the general level of U.S.
interest rates, particularly since the majority of our investments are in
short-term instruments. Due to the nature of our short-term investments, we have
concluded that there is no material market risk exposure. Therefore, no
quantitative tabular disclosures are required.
We invest our cash in a variety of financial instruments, including money
market deposits, certificates of deposits, high-grade auction rate securities,
municipal debt instruments, corporate obligations and local, state and national
U.S. government agency debt. These investments are denominated in U.S. dollars.
We account for our investment instruments in accordance with SFAS No. 115,
"Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No.
115"). All of the cash equivalents and short-term investments are treated as
held to maturity under SFAS No. 115.
39
Investments in both fixed rate and floating rate interest earning
instruments carry a degree of interest rate risk. Fixed rate securities may have
their fair market value adversely impacted due to a rise in interest rates,
while floating rate securities may produce less income than expected if interest
rates fall. Due in part to these factors, our future investment income may fall
short of expectations due to changes in interest rates or we may suffer losses
in principal if forced to sell securities that have seen a decline in market
value due to changes in interest rates. While certain of the investment
securities had maturities in excess of 90 days, we intend to liquidate such
securities within one year. The weighted-average interest on investment
securities at October 31, 2003 was 1.56%. The fair value of securities held at
October 31, 2003 was approximately $16.7 million, which approximates the
amortized cost of short-term investments. We believe that our investment policy
is conservative, both in terms of the average maturity of our investments and
the credit quality of the investments we hold.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required by this item is included in Part IV, Item 15
(a)(1) and (2).
Unaudited consolidated quarterly financial data included herein:
FISCAL QUARTER
---------------------------------------------------- FISCAL
FIRST SECOND THIRD FOURTH YEAR 2002
----- ------ ----- ------ ---------
Total revenue ............ $ 9,197 $ 9,064 $ 7,495 $ 8,232 $ 33,988
Gross profit ............. $ 3,321 $ 3,079 $ 2,405 $ 2,522 $ 11,327
Net loss ................. $ (6,394) $ (5,479) $ (8,229) $ (5,387) $(25,489)
Basic and diluted net loss
per share ............ $ (0.23) $ (0.20) $ (0.31) $ (0.21) $ (0.95)
FISCAL QUARTER
---------------------------------------------------- FISCAL
FIRST SECOND THIRD FOURTH YEAR 2003
----- ------ ----- ------ ---------
Total revenue ............ $ 9,672 $ 8,579 $ 5,617 $ 9,275 $ 33,143
Gross profit ............. $ 3,243 $ 3,391 $ 2,979 $ 6,097 $ 15,710
Net loss ................. $ (2,577) $ (1,818) $ (1,735) $ (317) $ (6,447)
Basic and diluted net loss
per share ............ $ (0.10) $ (0.08) $ (0.07) $ (0.01) $ (0.26)
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
ITEM 9A. CONTROLS AND PROCEDURES.
(a) Evaluation of disclosure controls and procedures.
40
We carried out an evaluation, under the supervision and with the
participation of our management, including the Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures pursuant to Rule 13a-15 of the Securities
Exchange Act of 1934 (the "Exchange Act"). Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that as of October 31,
2003, the end of the period covered by this report, our disclosure controls and
procedures were effective at the reasonable assurance level in timely alerting
them to material information relating to Crossroads (including its consolidated
subsidiaries) required to be included in our Exchange Act filings.
(b) Changes in internal control over financial reporting.
During the quarter ended October 31, 2003, there have been no significant
changes in our internal control over financial reporting that materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
41
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by this section is incorporated by reference from
the information in the section entitled "Election of Directors" in the Proxy
Statement. Item 405 of Regulation S-K calls for disclosure of any known late
filing or failure by an insider to file a report required by Section 16 of the
Exchange Act. This disclosure is contained in the section entitled "Section
16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement and is
incorporated by reference herein. The information required by this Item with
respect to the Company's executive officers is contained in Item 1 of Part I of
this Annual Report under the heading "Executive Officers of the Registrant."
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this Item is incorporated by reference to our
Proxy Statement under the sections captioned "Executive Compensation and Other
Information" and "Certain Transactions."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
The information required by this Item is incorporated by reference to our
Proxy Statement under the section captioned "Ownership of Securities."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this Item is incorporated by reference to our
Proxy Statement under the section captioned "Certain Transactions."
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The information about principal accountant fees and services as well as
related pre-approval policies appears under "Audit Matters" in the Proxy
Statement to be filed with the Securities and Exchange Commission in connection
with the 2004 Annual Meeting of Stockholders. This portion of the Proxy
Statement is incorporated by reference into this report.
42
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this Form 10-K:
1. Consolidated Financial Statements. The following consolidated
financial statements of Crossroads Systems, Inc. are filed as a part
of this Form 10-K on the pages indicated:
PAGE
----
Report of Independent Accountants - KPMG LLP.................................... F-1
Report of Independent Accountants - PricewaterhouseCoopers LLP.................. F-2
Consolidated Balance Sheets as of October 31, 2002 and 2003..................... F-3
Consolidated Statements of Operations for each of the three years in the
period ended October 31, 2003................................................ F-4
Consolidated Statements of Changes in Stockholders' Equity for each of the three
years in the period ended October 31, 2003................................... F-5
Consolidated Statements of Cash Flows for each of the three years in the
period ended October 31, 2003................................................ F-6
Notes to Consolidated Financial Statements...................................... F-7
2. Exhibits.
EXHIBIT
NUMBER DESCRIPTION
3.1* Sixth Amended and Restated Certificate of Incorporation (filed as Exhibit 3.1 to the
Registrant's Registration Statement on Form S-1 (SEC File No. 333-85505) (the "IPO
Registration Statement") and incorporated herein by reference)
3.2* Amended and Restated Bylaws (filed as Exhibit 3.2 to the IPO Registration Statement and
incorporated herein by reference)
4.1* Specimen certificate for shares of common stock (filed as Exhibit 4.1 to the IPO Registration
Statement and incorporated herein by reference)
4.2 See Exhibits 3.1 and 3.2 for provisions of the Certificate of Incorporation and Bylaws of the
Registrant defining the rights of holders of common stock
10.1* Form of Indemnity Agreement between Registrant and each of its directors and executive
officers (filed as Exhibit 10.1 to the IPO Registration Statement and incorporated herein by
reference)
10.2* Crossroads Systems, Inc. 1999 Employee Stock Purchase Plan (filed as Exhibit 10.3 to the IPO
Registration Statement and incorporated herein by reference)
10.3* Fourth Amended and Restated Investors Rights Agreement dated August 6, 1999 by and among
Registrant and certain purchasers of Registrant's preferred stock (filed as Exhibit 10.4 to
the IPO Registration Statement and incorporated herein by reference)
10.4*+ OEM Agreement dated April 23, 1998 by and between Registrant and Storage Technology
Corporation (filed as Exhibit 10.5 to the IPO Registration Statement and incorporated herein
by reference)
43
EXHIBIT
NUMBER DESCRIPTION
10.5* Loan Modification Agreement dated December 31, 2000 by and between Registrant and Silicon
Valley Bank (filed as Exhibit 10.9 to Registrant's Annual Report on Form 10-K for the fiscal
year ended October 31, 2001 and incorporated herein by reference)
10.6* Office Building Lease dated October 8, 1999 by and between Registrant and Maplewood
Associates, L.P. (filed as Exhibit 10.15 to the IPO Registration Statement and incorporated
herein by reference)
10.7* Crossroads Systems, Inc. Amended and Restated 1999 Stock Incentive Plan (filed as Exhibit 99.
(d)(2) to the Registrant's Schedule TO/I (SEC File No. 5-57603) and incorporated herein by
reference)
10.8* Rights Agreement, dated as of August 21, 2002, by and between Registrant and American Stock
Transfer & Trust Company, which includes the form of Certificate of Designation for the Series
A junior participating preferred stock as Exhibit A, the form of Rights Certificate as Exhibit
B and the Summary of Rights to Purchase Series A Preferred Stock as Exhibit C (field as
Exhibit 4 to the Registrant's Current Report on Form 8-K dated August 21, 2002 and
incorporated herein by reference)
10.9* Employment Agreement, dated as of January 6, 2003 by and between Registrant and Andrea Wenholz
10.10* Fiscal Year 2003 Stock Bonus Incentive Program Letter Agreement, dated November 4, 2002 from
Registrant to Rob Sims
10.11* Fiscal Year 2003 Stock Bonus Incentive Program Letter Agreement, dated January 6, 2003, from
Registrant to Andrea Wenholz
10.12 Employment Agreement dated as of October 13, 2003 between Registrant and Rob Sims
10.13 Letter Agreement dated as of October 30, 2003 between Registrant and Brian R. Smith regarding
Termination, Severance Offer and General Release
21.1 Subsidiaries of the Registrant
23.1 Consent of KPMG LLP
23.2 Consent of PricewaterhouseCoopers LLP
24.1 Power of Attorney, pursuant to which amendments to this Form 10-K may be filed, is included on
the signature page contained on Part IV of this Form 10-K
31.1 Certification of Rob Sims, President and Chief Executive Officer of the Company, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Andrea Wenholz, Vice President and Chief Financial Officer of the Company, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of Rob Sims, President and Chief Executive Officer of the Company, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Andrea Wenholz, Vice President and Chief Financial Officer of the Company, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
44
* Incorporated herein by reference to the indicated filing
+ Confidential treatment previously granted
(b) Reports on Form 8-K filed during the last quarter of the period covered
by this report.
During the three months ended October 31, 2003, we filed the following
Current Reports on Form 8-K:
- We filed a Form 8-K dated August 21, 2003 announcing our earnings for
the third fiscal quarter of 2003.
45
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) 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.
CROSSROADS SYSTEMS, INC.
By: /s/ Rob Sims
--------------------------------
Rob Sims,
President and Chief Executive
Officer
DATE: JANUARY 21, 2004
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below hereby severally constitutes and appoints, Rob Sims and Andrea
Wenholz, and each or any of them, his or her true and lawful attorney-in-fact
and agent, each with the power of substitution and resubstitution, for him in
any and all capacities, to sign any and all amendments to this Annual Report on
Form 10-K and to file the same, with exhibits thereto and other documents in
connection therewith, with the Securities and Exchange Commission, hereby
ratifying and confirming all that each said attorney-in-fact and agent, or his
substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
NAME TITLE DATE
- ---- ----- -----
/s/ ROB SIMS President and Chief Executive Officer January 21, 2004
- ------------------------------- (principal executive officer)
Rob Sims
/s/ ANDREA WENHOLZ Vice President, Chief Financial Officer, January 21, 2004
- ------------------------------- Secretary and Treasurer (principal
Andrea Wenholz financial and accounting officer)
/s/ BRIAN R. SMITH Director January 21, 2004
- -------------------------------
Brain R. Smith
/s/ RICHARD D. EYESTONE Director January 21, 2004
- -------------------------------
Richard D. Eyestone
/s/ DAVID L. RIEGEL Director January 21, 2004
- -------------------------------
David L. Riegel
/s/ WILLIAM P. WOOD Director January 21, 2004
- -------------------------------
William P. Wood
/s/ PAUL S. ZITO Director January 21, 2004
- -------------------------------
Paul S. Zito
46
REPORT OF INDEPENDENT ACCOUNTANTS
The Board of Directors and Stockholders
Crossroads Systems, Inc and Subsidiaries:
We have audited the accompanying consolidated balance sheet of Crossroads
Systems, Inc. and Subsidiaries as of October 31, 2003 and the related
consolidated statements of operations, changes in stockholders' equity and cash
flows for the year then ended. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the consolidated financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Crossroads Systems,
Inc. and Subsidiaries as of October 31, 2003, and the results of their
operations and their cash flows for the year then ended, in conformity with
accounting principles generally accepted in the United States of America.
/s/ KPMG LLP
Austin, Texas
November 25, 2003, except as to note 15, which
is as of December 17, 2003
F-1
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Crossroads Systems, Inc.:
In our opinion, the consolidated balance sheet as of October 31, 2002 and the
related consolidated statements of operations, changes in stockholders' equity
and cash flows for each of the two years in the period ended October 31, 2002
present fairly, in all material respects, the financial position, results of
operations and cash flows of Crossroads Systems, Inc. and Subsidiaries at
October 31, 2002, and for each of the two years in the period ended October 31,
2002 in conformity with accounting principles generally accepted in the United
States of America. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally accepted in the
United States of America, which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
/s/ PRICEWATERHOUSECOOPERS LLP
Austin, Texas
November 26, 2002
F-2
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
OCTOBER 31,
----------------------
2002 2003
--------- ---------
ASSETS
Current assets:
Cash and cash equivalents ............................................... $ 14,723 $ 14,707
Short-term investments .................................................. 19,588 16,670
--------- ---------
Total cash, cash equivalents and short-term investments ............. 34,311 31,377
Accounts receivable, net of allowance for doubtful
accounts of $277 and $164, respectively ............................... 5,721 2,994
Inventories, net ........................................................ 2,767 1,633
Prepaids and other current assets ....................................... 956 1,274
--------- ---------
Total current assets ................................................ 43,755 37,278
Property and equipment, net .................................................. 6,106 3,299
Intangibles, net ............................................................. 173 -
Other assets ................................................................. 425 288
--------- ---------
Total assets ........................................................ $ 50,459 $ 40,865
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ........................................................ $ 3,839 $ 1,953
Accrued expenses ........................................................ 3,719 2,470
Accrued warranty costs .................................................. 615 802
Deferred revenue ........................................................ 727 382
--------- ---------
Total current liabilities ........................................... 8,900 5,607
Commitments and contingencies
Stockholders' equity:
Common stock, $.001 par value, 175,000,000 shares authorized,
25,870,508 and 24,368,144 shares issued and outstanding, respectively .. 26 24
Additional paid-in capital .............................................. 183,253 182,831
Deferred stock-based compensation ....................................... (311) (126)
Notes receivable from stockholders ...................................... (126) -
Accumulated deficit ..................................................... (141,024) (147,471)
Treasury stock at cost (469,237 and 0 shares, respectively) ............. (259) -
--------- ---------
Total stockholders' equity .......................................... 41,559 35,258
--------- ---------
Total liabilities and stockholders' equity .......................... $ 50,459 $ 40,865
========= =========
See accompanying notes to the consolidated financial statements.
F-3
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
YEAR ENDED OCTOBER 31,
--------------------------------------------
2001 2002 2003
------------ ------------ ------------
Revenue:
Product ........................................ $ 35,896 $ 33,429 $ 25,955
Royalty and other .............................. 1,434 559 7,188
------------ ------------ ------------
Total revenue ........................ 37,330 33,988 33,143
Cost of revenue:
Product ........................................ 21,898 22,486 16,598
Royalty and other .............................. 115 175 835
------------ ------------ ------------
Total cost of revenue ................ 22,013 22,661 17,433
------------ ------------ ------------
Gross profit ........................................ 15,317 11,327 15,710
------------ ------------ ------------
Operating expenses:
Sales and marketing ............................ 15,202 6,126 4,508
Research and development ....................... 18,118 16,520 11,929
General and administrative ..................... 16,043 9,158 6,209
Business restructuring ......................... - 3,666 (432)
Impairment of intangibles and other assets ..... 25,007 2,047 -
Amortization of intangibles .................... 9,680 278 173
Litigation settlement .......................... (15,000) - -
------------ ------------ ------------
Total operating expenses ............. 69,050 37,795 22,387
------------ ------------ ------------
Loss from operations ................................ (53,733) (26,468) (6,677)
Other income:
Interest income ................................ 2,763 979 540
Other income ................................... 13 - -
------------ ------------ ------------
Total other income ......................... 2,776 979 540
------------ ------------ ------------
Loss before income taxes and
cumulative effect of accounting change ......... (50,957) (25,489) (6,137)
Income tax expense ............................. - - (310)
------------ ------------ ------------
Loss before cumulative effect of accounting change .. (50,957) (25,489) (6,447)
Cumulative effect of accounting change .............. (130) - -
------------ ------------ ------------
Net loss ............................................ $ (51,087) $ (25,489) $ (6,447)
============ ============ ============
Basic and diluted net loss per share:
Before cumulative effect of accounting change .. $ (1.85) $ (0.95) $ (0.26)
Cumulative effect of accounting change ......... (0.01) - -
------------ ------------ ------------
Basic and diluted net loss per share ....... $ (1.86) $ (0.95) $ (0.26)
============ ============ ============
Shares used in computing basic and
diluted net loss per share ..................... 27,414,078 26,878,387 24,443,141
============ ============ ============
See accompanying notes to the consolidated financial statements.
F-4
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE DATA)
NOTES
COMMON STOCK ADDITIONAL DEFERRED RECEIVABLE TOTAL
---------------------- PAID-IN STOCK-BASED FROM ACCUMULATED TREASURY STOCKHOLDERS'
SHARES AMOUNT CAPITAL COMPENSATION STOCKHOLDERS DEFICIT STOCK EQUITY
----------- -------- ---------- ------------ ------------ ----------- -------- ------------
Balance at October 31,
2000 ...................... 27,690,673 $ 28 $ 183,390 $ (9,734) $ (249) $ (64,448) $ (235) $ 108,752
Issuance of common
stock upon exercise
of stock options ........ 174,440 - 160 - - - - 160
Issuance of common
stock for employee
stock purchase plan ..... 149,851 - 665 - - - - 665
Purchase of treasury
stock (61,833 shares) ... - - - - - - (22) (22)
Stock-based compensation .. - - 1,241 5,820 - - - 7,061
Payments on notes
receivable .............. - - - - 140 - - 140
Accrued interest on
notes receivable ........ - - - - (9) - - (9)
Retirement of shares
purchased under
stock buy-back program .. (472,300) - (1,414) - - - - (1,414)
Net loss .................. - - - - - (51,087) - (51,087)
----------- -------- --------- -------- ---------- --------- -------- ---------
Balance at October 31,
2001 ...................... 27,542,664 $ 28 $ 184,042 $ (3,914) $ (118) $(115,535) $ (257) $ 64,246
Issuance of common
stock upon exercise
of stock options ........ 94,522 - 102 - - - - 102
Issuance of common
stock for employee
stock purchase plan ..... 136,787 - 342 - - - - 342
Purchase of treasury
stock (1,443 shares) .... - - - - - - (2) (2)
Stock-based compensation .. - - 1,105 3,603 - - - 4,708
Accrued interest on
notes receivable ........ - - - - (8) - - (8)
Retirement of shares
purchased under
stock buy-back program .. (1,903,465) (2) (2,338) - - - - (2,340)
Net loss .................. - - - - - (25,489) - (25,489)
----------- -------- --------- -------- ---------- --------- -------- ---------
Balance at October 31,
2002 ...................... 25,870,508 $ 26 $ 183,253 $ (311) $ (126) $(141,024) $ (259) $ 41,559
Issuance of common
stock upon exercise
of stock options ........ 639,138 1 450 - - - - 451
Issuance of common
stock for employee
stock purchase plan ..... 100,035 - 89 - - - - 89
Retirement of treasury
stock ................... (469,237) (1) (258) - - - 259 -
Stock-based compensation .. - - 1,278 185 - - - 1,463
Payments on notes
receivable .............. - - - - 126 - - 126
Retirement of shares
purchased under
stock buy-back program .. (1,772,300) (2) (1,981) - - - - (1,983)
Net loss .................. - - - - - (6,447) - (6,447)
----------- -------- --------- -------- ---------- --------- -------- ---------
Balance at October 31,
2003 ...................... 24,368,144 $ 24 $ 182,831 $ (126) $ - $(147,471) $ - $ 35,258
=========== ======== ========= ======== ========== ========= ======== =========
See accompanying notes to the consolidated financial statements.
F-5
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED OCTOBER 31,
------------------------------
2001 2002 2003
-------- -------- --------
Cash flows from operating activities:
Net loss ...................................................... $(51,087) $(25,489) $ (6,447)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation ............................................... 4,640 5,559 3,589
Business restructuring expenses ............................ - 2,283 (432)
Impairment of intangibles and other assets ................. 25,007 2,047 -
Amortization of intangibles ................................ 9,680 278 173
Stock-based compensation ................................... 7,061 4,574 1,463
Loss on disposal of property and equipment ................. 24 - 62
Provision for doubtful accounts receivable ................. 157 (111) (16)
Provision for excess and obsolete inventory ................ (309) (791) 407
Changes in assets and liabilities:
Accounts receivable ..................................... 1,665 (1,842) 2,743
Inventories ............................................. 1,147 1,104 727
Prepaids and other assets ............................... 143 938 (318)
Accounts payable ........................................ 2,218 (3,231) (2,692)
Accrued expenses ........................................ (189) (1,053) (817)
Accrued warranty costs .................................. 183 18 187
Deferred revenue and other .............................. (373) 26 (82)
-------- -------- --------
Net cash used in operating activities ................ (33) (15,690) (1,453)
-------- -------- --------
Cash flows from investing activities:
Purchase of property and equipment ............................ (5,623) (1,866) (844)
Proceeds from sale of property and equipment .................. - 14 -
Purchase of held-to-maturity investments ...................... (11,967) (52,537) (14,111)
Maturity of held-to-maturity investments ...................... 19,558 42,950 17,029
Payment of note receivable from related party ................. 140 64 -
Other assets .................................................. (225) - -
-------- -------- --------
Net cash provided by (used in) investing activities .. 1,883 (11,375) 2,074
-------- -------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock ........................ 825 444 540
Repurchase and retirement of common stock ..................... (1,414) (2,340) (1,983)
Change in book overdraft ...................................... - - 806
Purchase of treasury stock .................................... (22) (2) -
-------- -------- --------
Net cash used in financing activities ................ (611) (1,898) (637)
-------- -------- --------
Net increase (decrease) in cash and cash equivalents .............. 1,239 (28,963) (16)
Cash and cash equivalents, beginning of year ...................... 42,447 43,686 14,723
-------- -------- --------
Cash and cash equivalents, end of year ............................ $ 43,686 $ 14,723 $ 14,707
======== ======== ========
See accompanying notes to the consolidated financial statements.
F-6
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND BASIS OF PRESENTATION
The accompanying financial statements include the accounts of Crossroads
Systems, Inc. ("Crossroads" or the "Company") and its wholly-owned subsidiaries.
Headquartered in Austin, Texas, Crossroads, a Delaware corporation, is a leading
global provider of connectivity for storage networking solutions. Crossroads
sells its products and services primarily to leading storage system and server
original equipment manufacturers, distributors, system integrators and storage
service providers. The Company is organized and operates as one business
segment.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All significant intercompany transactions
have been eliminated in consolidation.
Use of Estimates
The preparation of the consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the consolidated
financial statements and the reported amounts of revenue and expenses during the
reporting periods. Actual results could differ from those estimates and such
differences may be material to the financial statements.
Cash and Cash Equivalents
Cash and cash equivalents consist of cash on hand, cash on deposit and all
highly liquid investments with original maturities at the date of purchase less
than three months. Cash equivalents consist primarily of cash deposited in money
market accounts and high-grade auction rate securities. While the Company's cash
and cash equivalents are on deposit with high quality FDIC insured financial
institutions, at times such deposits exceed insured limits. The Company has not
experienced any losses in such accounts.
Short-Term Investments
Short-term investments consist primarily of U.S. government agency debt,
municipal debt instruments, high-grade auction rate securities, corporate
obligations and certificates of deposit with original maturities at the date of
purchase greater than three months and less than twelve months. All short-term
investments have been classified as held-to-maturity and are carried at
amortized cost, which approximates fair value, due to the short period of time
to maturity. As of October 31, 2002 and 2003, the fair value and amortized cost
of short-term investments were approximately $19.6 million and $16.7 million,
respectively.
Fair Value of Financial Instruments
The fair values of the Company's cash equivalents, accounts receivable,
accounts payable and accrued expenses approximate their carrying values due to
the short-term nature of the instruments.
F-7
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Inventories
Inventories are stated at the lower of cost or market. Cost is determined
using standard cost, which approximates the first-in, first-out method.
Provisions, when required, are made to reduce excess and obsolete inventories to
their estimated net realizable values.
Property and Equipment
Property and equipment are stated at cost and depreciated using the
straight-line method over the estimated useful lives of the respective assets.
Expenditures for repairs and maintenance are charged to expense when incurred.
Leasehold improvements are amortized on a straight-line basis over the shorter
of the estimated useful life of the related asset or the remaining life of the
lease. Upon retirement or disposition of property and equipment, the cost and
related accumulated depreciation are removed from the accounts and any resulting
gain or loss is reflected in operations.
Goodwill and Intangible Assets
In June 2001, the Financial Accounting Standards Board (the "FASB") issued
SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No.142 addresses the
accounting and reporting for acquired goodwill and other intangible assets. SFAS
No. 142 discontinues amortization of acquired goodwill and instead requires
annual impairment testing of acquired goodwill. Intangible assets are amortized
over their useful economic life and periodically tested for impairment.
The Company adopted SFAS No.142 effective November 1, 2002. During the
fiscal years ended October 31, 2001, 2002 and 2003, the Company had goodwill
amortization of approximately $9.2 million, $0, and $0, respectively.
During fiscal 2001, in response to uncertain macroeconomic conditions and
the resulting decline in demand and product revenue, management reassessed the
Company's product strategy, initiated a market sizing exercise on its core
business and examined the expense structure in an attempt to realign its
business plan to achieve profitability. The strategic review triggered a
reduction in force and an impairment evaluation of the intangible assets related
to the Polaris acquisition. Based on a valuation prepared by an independent
third party appraisal company, the Company recorded a write-down of these
intangible assets totaling $25.0 million, including all remaining unamortized
goodwill.
During fiscal 2002, a further write-down of unamortized intangible assets
relating to the Polaris acquisition was made in the amount of $0.5 million,
based on an evaluation of future undiscounted cash flows.
F-8
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table reflects the effect of SFAS No. 142 on net loss and net
loss per share as if SFAS No. 142 had been in effect for all periods presented
(in thousands except per share amounts):
YEAR ENDED OCTOBER 31,
-----------------------------------
2001 2002 2003
---------- ---------- ---------
Net loss:
Reported net loss ............... $ (51,087) $ (25,489) $ (6,447)
Add back goodwill amortization .. 9,195 - -
---------- ---------- ---------
Adjusted net loss ............... $ (41,892) $ (25,489) $ (6,447)
========== ========== =========
Basic and diluted net loss per share:
Reported net loss per share ..... $ (1.86) $ (.95) $ (.26)
Add back goodwill amortization .. .33 - -
---------- ---------- ---------
Adjusted net loss per share ..... $ (1.53) $ (.95) $ (.26)
========== ========== =========
Long-Lived Assets
In the event that facts and circumstances indicate that property and
equipment or other long-lived assets may be impaired, an evaluation of
recoverability would be performed. If an evaluation is required, the estimated
future discounted cash flows associated with the asset are compared to the
asset's carrying amount to determine if an impairment charge is necessary. The
effect of any impairment would be to expense the difference between the
estimated fair value of such asset and its carrying value. Impairment charges
related to long-lived assets other than goodwill were approximately $0, $2.0
million and $0 for the years ended October 31, 2001, 2002 and 2003,
respectively.
Investments
The Company accounted for its investment in Banderacom Corporation
(formerly INH Semiconductor Corporation) ("Banderacom") using the cost method
because the Company's investment represents less than a 20% ownership interest
and the Company is not able to exert significant influence over Banderacom. In
fiscal 2002, the Company wrote off its remaining $292,000 investment in
Banderacom, due to a perceived more than temporary decline in the estimated fair
value of the investment.
Concentrations
Financial instruments that potentially expose the Company to concentrations
of credit risk consist primarily of cash and cash equivalents and short-term
investments and accounts receivable. The Company invests only in high credit
quality short-term debt instruments.
The Company's sales are primarily concentrated in the United States and are
primarily derived from sales to original equipment manufacturers in the computer
storage and server industry. Revenue is concentrated with several major
customers. The loss of a major customer, a change of suppliers or significant
technological change in the industry could affect operating results adversely.
The Company had trade accounts receivable from its top four customers and top
three customers, which comprised 58% and 86% of total trade accounts receivable
at
F-9
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
October 31, 2002 and 2003, respectively. The Company performs credit evaluations
of its customers and generally does not require collateral on accounts
receivable balances and provides allowances for potential credit losses and
product sales returns. The Company has established reserves for credit losses
and sales returns and other allowances. The Company has not experienced material
credit losses in any of the years presented.
The Company's business is concentrated in the storage area networking
industry, which has been impacted by unfavorable economic conditions and reduced
information technology (IT) spending rates. Accordingly, the Company's future
success depends upon the buying patterns of customers in the storage area
networking industry, their response to current and future IT investment trends,
and the continued demand by such customers for the Company's products. The
Company's continued success will depend upon its ability to enhance its existing
products and to develop and introduce, on a timely basis, new cost-effective
products and features that keep pace with technological developments and
emerging industry standards. The Company's supplier arrangement for the
production of certain vital components of its storage routers is concentrated
with a small number of key suppliers.
Additionally, the Company relies on a limited number of contract
manufacturers to provide manufacturing services for its products. The inability
of any contract manufacturer or supplier to fulfill supply requirements could
materially impact future operating results.
The percentage of sales to significant customers was as follows:
YEAR ENDED OCTOBER 31,
----------------------
2001 2002 2003
---- ---- ----
Compaq (pre-merger)* .. 2.0% 6.0% 0.0%
StorageTek ............ 23.0% 24.0% 21.0%
HP (pre-merger)* ...... 26.0% 16.0% 0.0%
HP* ................... 0.0% 29.0% 54.0%
* In May 2002, HP completed its acquisition of Compaq. These percentages
reflect sales to HP and Compaq prior to the merger and sales to the combined
company after the merger.
The level of sales to any customer may vary from year to year. However, we
expect that significant customer concentration will continue for the foreseeable
future. The loss of any one of these customers, or a decrease in the level of
sales to any one of these customers, could have a material adverse impact on the
Company's financial condition or results of operations.
Revenue Recognition
Product revenue is recognized when persuasive evidence of an arrangement
exists, delivery has occurred, the price is fixed or determinable,
collectibility is probable and the risk of loss has passed to the customer.
Revenue from product sales to customers that do not have rights of return,
including product sales to Original Equipment Manufacturers (OEMs) and certain
distributors, Value Added Resellers (VARs) and system integrators, are
recognized upon shipment. Sales and cost of sales related to customers that have
rights of return are deferred and subsequently recognized upon sell-through to
end-users.
Royalty and other revenue includes, licensing of intellectual property
(IP), royalty payments and sales of service contracts. IP licensing arrangements
consist of upfront nonrefundable fees including payments relating to
F-10
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
past sales of licensee products or payments related to a paid-up license in
which the licensee makes a single payment for a lifetime patent license. Once a
license agreement is signed, delivery of the license has occurred and there are
no remaining obligations outstanding, the Company records revenue from upfront
nonrefundable IP license arrangements. Royalty revenue is recognized monthly
based on shipment reports received from HP's contract manufacturer and service
revenue is recognized over the service period.
In December 1999, the Securities and Exchange Commission staff released
Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial
Statements," which provides guidance on the recognition, presentation and
disclosure of revenue in financial statements. Effective November 1, 2000, the
Company adopted SAB No. 101. The adoption of SAB No. 101 resulted in a change in
method of revenue recognition for certain product shipments due to the specified
shipping terms for these shipments. The cumulative effect of this accounting
change was $130,000, which was included in net loss for the year ended October
31, 2001.
Guarantees and Warranty Reserve
In November 2002, the FASB issued FIN 45, "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others." FIN 45 requires a company that is a guarantor to make
specific disclosures about its obligations under certain guarantees that it has
issued. FIN 45 also requires a company (the Guarantor) to recognize, at the
inception of a guarantee, a liability for the obligations it has undertaken in
issuing the guarantee.
Generally, the Company indemnifies, under pre-determined conditions and
limitations, its customers for infringement of third-party intellectual property
rights by its products or services. The Company seeks to limit its liability for
such indemnity to an amount not to exceed the sales price of the products or
services. The Company does not believe, based on information available, that it
is probable that any material amounts will be paid under these guarantees.
The Company provides for the estimated cost to repair or replace products
under warranty and technical support costs when the related product revenue is
recognized. The Company warrants products for a period from 12 to 39 months
following the sale of its products. A reserve for warranty costs is recorded
based upon the historical level of warranty claims and management's estimate of
future costs.
Comprehensive Income
Comprehensive income refers to revenue, expenses, gains and losses that, in
accordance with SFAS No. 130, "Reporting Comprehensive Income", are included in
comprehensive income but are excluded from net income as these amounts are
recorded directly as an adjustment to stockholders' equity. The Company has had
no items of other comprehensive income (loss) for each of the three years
presented and accordingly, comprehensive loss for all periods presented equaled
the net loss.
Income Taxes
The Company accounts for income taxes in accordance with the asset and
liability method. Under the asset and liability method, deferred tax assets and
liabilities are recognized for the expected future tax consequences of temporary
differences between the financial reporting and tax bases of assets and
liabilities using enacted tax rates that are expected to apply to taxable income
in the periods in which the deferred tax asset or liability is expected to
F-11
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
be realized or settled. Valuation allowances are established when necessary to
reduce deferred tax assets to the amounts expected to be realized. The Company
has provided a full valuation allowance against its deferred tax assets because
the realization of the related tax benefits is not considered more likely than
not.
The Company recorded no income tax expense or benefit during the years
ended October 31, 2001 and 2002. The income tax expense recorded in 2003
resulted from withholdings on income generated in a foreign country.
Computation of Net Loss Per Share
In accordance with SFAS No. 128, "Earnings Per Share," basic earnings per
share is computed by dividing income available to common stockholders by the
weighted average number of common shares outstanding for the period, less shares
subject to repurchase. Diluted earnings per share is computed by giving effect
to all dilutive potential common shares that were outstanding during the period.
Basic earnings per share excludes the dilutive effect of common stock
equivalents such as stock options, while earnings per share, assuming dilution,
includes such dilutive effects. Future weighted-average shares outstanding
calculations will be impacted by the following factors, among others: (i) the
ongoing issuance of common stock associated with stock option exercises; (ii)
the issuance of common shares associated with our employee stock purchase
program; (iii) any fluctuations in our stock price, which could cause changes in
the number of common stock equivalents included in the earnings per share,
assuming dilution computation; and (iv) the issuance of common stock to effect
business combinations should we enter into such transactions.
The Company has excluded all outstanding common stock equivalents from the
calculation of diluted net loss per share because all such common stock
equivalents are antidilutive for all periods presented. The total number of
common stock equivalents excluded from the calculations of diluted net loss, per
common share were 4,980,563, 6,149,369 and 5,670,792 for the years ended October
31, 2001, 2002 and 2003, respectively.
Advertising Costs
The Company expenses all advertising costs as incurred. Advertising costs
for the year ended October 31, 2001, 2002 and 2003 were approximately $228,000,
$22,000 and $10,000, respectively.
Research and Development Costs
The Company expenses research and development costs as incurred. The
Company began entering into contracts relating to nonrecurring engineering
("NRE") services on behalf of certain of its customers. Under the terms of the
contracts, the Company is reimbursed for personnel and product expenses relating
to pre-production costs incurred on behalf of its customers. Amounts received by
the Company under the NRE contracts are recorded as an offset to research and
development expenses and approximated $0.2, $0.4 million and $1.6 million in
fiscal 2001, 2002 and 2003, respectively.
F-12
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Stock-based Compensation
Stock-based compensation is recognized using the intrinsic value method
prescribed in Accounting Principles Board ("APB") Opinion No. 25, "Accounting
for Stock Issued to Employees," and related interpretations. Accordingly,
compensation cost for stock options is measured as the excess, if any, of the
fair value of the Company's stock at the date of grant over the amount an
employee must pay to acquire the stock amortized over the vesting period.
The Company allocates stock-based compensation to specific line items
within the consolidated statement of operations based on the classification of
the employees who receive the benefit. Stock-based compensation was recorded as
follows (in thousands):
YEAR ENDED OCTOBER 31,
------------------------------
2001 2002 2003
-------- -------- --------
Cost of revenue ................................................. $ 123 $ 84 $ 36
Sales and marketing ............................................. 215 481 116
Research and development ........................................ 440 369 294
General and administrative ...................................... 6,283 3,640 1,017
------ ------ ------
Total stock-based compensation ............................. $7,061 $4,574 $1,463
====== ====== ======
The following table illustrates the effect on net loss and loss per share if
the Company had applied the fair value recognition provisions of FASB Statement
No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure," to
stock-based employee compensation (in thousands, except share data):
YEAR ENDED OCTOBER 31,
------------------------------
2001 2002 2003
-------- -------- --------
Net loss, as reported ........................................... $(51,087) $(25,489) $ (6,447)
Stock-based employee compensation expense
included in reported net loss .............................. 7,061 4,574 1,463
Stock-based employee compensation expense
determined under fair value based method for all awards .... (5,604) (12,226) (14,537)
-------- -------- --------
Pro forma net loss .............................................. $(49,630) $(33,141) $(19,521)
======== ======== ========
Net loss per share:
Basic and diluted - as reported ............................ $ (1.86) $ (0.95) $ (0.26)
Basic and diluted - pro forma .............................. $ (1.81) $ (1.23) $ (0.80)
Reclassifications
Certain amounts in prior years have been reclassified to conform to the
current year presentation.
F-13
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS
Inventory, net consists of the following (in thousands):
OCTOBER 31,
-----------------
2002 2003
------- -------
Raw materials .......................................... $ 2,089 $ 1,219
Finished goods ......................................... 1,667 862
------- -------
3,756 2,081
Less: Allowance for excess and obsolete inventory .. (989) (448)
------- -------
$ 2,767 $ 1,633
======= =======
Property and equipment, net consists of the following (in thousands):
OCTOBER 31,
------------------
2002 2003
-------- -------
LIFE
--------
Equipment ............................................. 1-3 $ 16,534 $17,025
Furniture and fixtures ................................ 5 1,367 1,217
Leasehold improvements ................................ 3 707 721
-------- -------
18,608 18,963
Less: Accumulated depreciation and amortization .. (12,502) (15,664)
-------- -------
$ 6,106 $ 3,299
======== =======
Accrued expenses consist of the following (in thousands):
OCTOBER 31,
--------------
2002 2003
------ ------
Restructuring ................ $2,283 $ 964
Professional services ........ 577 373
Payroll related .............. 519 844
Other ........................ 340 289
------ ------
$3,719 $2,470
====== ======
F-14
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. BALANCE SHEET RESERVE ACCOUNTS
Warranty Reserve
Activity in the warranty reserve during the years ended October 31, 2001,
2002 and 2003 was as follows (in thousands):
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END OF
OF PERIOD EXPENSES DEDUCTIONS PERIOD
---------- ---------- ---------- ----------
Year ended October 31, 2001:
Warranty reserve ........... $ 414 $ 430 $ (247) $ 597
========== ========== ========== ==========
Year ended October 31, 2002:
Warranty reserve ........... $ 597 $ 542 $ (524) $ 615
========== ========== ========== ==========
Year ended October 31, 2003:
Warranty reserve ........... $ 615 $ 300 $ (113) $ 802
========== ========== ========== ==========
Allowance for Doubtful Accounts
Activity in the allowance for doubtful accounts during the years ended
October 31, 2001, 2002 and 2003 was as follows (in thousands):
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END OF
OF PERIOD EXPENSES DEDUCTIONS PERIOD
---------- ---------- ---------- ----------
Year ended October 31, 2001:
Allowance for doubtful accounts ... $ 231 $ 157 $ - $ 388
========== ========== ========== ==========
Year ended October 31, 2002:
Allowance for doubtful accounts ... $ 388 $ (125) $ 14 $ 277
========== ========== ========== ==========
Year ended October 31, 2003:
Allowance for doubtful accounts ... $ 277 $ (16) $ (97) $ 164
========== ========== ========== ==========
F-15
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Allowance for Excess and Obsolete Inventory
Activity in the allowance for excess and obsolete inventory account during
the years ended October 31, 2001, 2002 and 2003 was as follows (in thousands):
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END OF
OF PERIOD EXPENSES DEDUCTIONS PERIOD
---------- ---------- ---------- ----------
Year ended October 31, 2001:
Allowance for excess and obsolete inventory ...... $ 2,089 $ 997 $ (1,306) $ 1,780
========== ========== ========== ==========
Year ended October 31, 2002:
Allowance for excess and obsolete inventory ...... $ 1,780 $ 478 $ (1,269) $ 989
========== ========== ========== ==========
Year ended October 31, 2003:
Allowance for excess and obsolete inventory ...... $ 989 $ 407 $ (948) $ 448
========== ========== ========== ==========
5. BUSINESS RESTRUCTURING EXPENSES AND ASSET IMPAIRMENT
In May 2002, the Company completed a restructuring plan that reduced its
workforce by approximately 25%, or 40 people (primarily in the sales, marketing
and general and administrative areas), to scale down its infrastructure and to
consolidate operations. Components of business restructuring expenses and the
remaining restructuring accruals as of October 31, 2003 are as follows (in
thousands):
EMPLOYEE
FACILITY LEASE ASSET SEPARATION &
ABANDONMENT IMPAIRMENTS OTHER COSTS TOTAL
-------------- ------------ ------------ --------
Effect of restructuring plan and impact
to accrued liabilities .............. $ 2,114 $ 1,208 $ 1,552 $ 4,874
Cash activity ......................... (157) - (1,051) (1,208)
Non-cash activity ..................... - (1,208) (175) (1,383)
-------------- ----------- ------------ --------
Balance as of October 31, 2002 ........ 1,957 - 326 2,283
Cash activity ......................... (561) - (326) (887)
Non-cash activity ..................... (432) - - (432)
-------------- ----------- ------------ --------
Balance as of October 31, 2003 ........ $ 964 $ - $ - $ 964
============== =========== ============ ========
Facility Lease Abandonment. Facility lease abandonment losses relate to
lease obligations for excess office space we have vacated as a result of the
restructuring plan. We recorded $2.1 million in business restructuring expenses
in relation to a site consolidation during fiscal 2002. Total lease commitments
include the remaining lease liabilities, leasehold improvements required to sub
lease the vacated space and brokerage commissions. The estimated costs of
vacating these leased facilities, including estimated costs to sublease, were
based on market information and trend analysis as estimated by management. Of
the $2.1 million charge recorded during fiscal 2002, approximately $1.8 million
relates to the base rent and fixed operating expenses of the vacated space
through the lease term, which ends April 15, 2006.
F-16
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In March 2003, the Company signed an agreement to sublease a portion of
its abandoned facilities. The anticipated rent payments from this sublease are
approximately $0.5 million through January 2006. A second agreement to sublease
a portion of its abandoned properties was signed in May 2003. The anticipated
rent payments from the second sublease are approximately $0.1 million through
January 2006.
The Company reduced the restructuring accrual by approximately $0.4
million during the fiscal year ended October 31, 2003 principally for rent
payments to be received on subleases through October 31, 2004. The Company will
assess recoverability of these sublease payments on a quarterly basis.
Asset Impairments. Asset impairments recorded pursuant to Statement of
Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets To Be Disposed Of", relate to the
impairment of computer equipment, software, furniture and fixtures and certain
leasehold improvements. The majority of fixed assets were impaired as a direct
result of the restructuring plan, reducing our workforce by 25%, and decision to
vacate certain office space, resulting in an impairment of approximately
$836,000 during fiscal 2002. The remaining fixed assets considered impaired in
fiscal 2002 of approximately $372,000 relate to IT infrastructure and unique
test equipment that can no longer be utilized based on the current product
roadmap and business environment.
Employee Separation and Other Costs. Employee separation and other
costs, which include severance, related taxes, outplacement and other benefits,
payable to approximately 40 terminated employees, totaled approximately $1.6
million during fiscal 2002. Employee groups impacted by the restructuring plan
include personnel in positions throughout the company, primarily in the sales,
marketing and general administrative functions. The Company completed its
restructuring plan and is not currently planning any further restructuring
efforts, however, there can be no assurance future restructuring efforts will
not be necessary.
6. LINE OF CREDIT
The Company carries a line of credit with its bank. The committed
revolving line provides for an advance of up to $3.0 million with a borrowing
base of 80% of eligible accounts receivable. The line of credit will mature on
June 14, 2004. As of October 31, 2002 and 2003, there were no borrowings
outstanding under this revolving line of credit.
7. COMMITMENTS AND CONTINGENCIES
Leases
The Company leases office space and equipment under long-term operating
lease agreements that expire on various dates through April 15, 2006. Rental
expense under these agreements was approximately $2.3 million, $2.2 million and
$2.3 million for the years ended October 31, 2001, 2002 and 2003, respectively.
In April 2000, Crossroads relocated its headquarters in accordance with an
agreement to lease approximately 63,500 square feet of general office,
laboratory, and administrative space in Austin, Texas. The term of the lease
agreement is six years, from April 1, 2000 through April 15, 2006, and
represents a lease commitment of $1.8 million per year through the lease term.
F-17
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On August 1, 2002, the Company abandoned 18,180 square feet of its
headquarter facility pursuant to the execution of our business restructuring
plan. The site consolidation resulted in a $2.1 million facility lease loss
charge, of which $1.8 million relates to the base rent and fixed operating
expenses of the vacated space through the end of the lease term on April 15,
2006.
In conjunction with entering into the lease agreement, Crossroads
signed an unconditional, irrevocable letter of credit with a bank for $250,000,
which is secured by a $3.0 million line of credit.
The minimum annual future rentals under the terms of these leases at
October 31, 2003 are as follows (in thousands):
OPERATING NET LEASE
FISCAL YEAR LEASES SUB-LEASES AMOUNTS DUE
- ----------------- --------- ---------- -----------
2004.............. $2,121 $ (230) $ 1,891
2005.............. 1,995 (307) 1,688
2006.............. 965 (92) 873
2007.............. 2 - 2
Thereafter........ - - -
------ ------- -------
$5,083 $ (629) $ 4,454
====== ======= =======
Legal Proceedings
Intellectual Property Litigation
On November 4, 2003, the Company filed a lawsuit against Dot Hill
Systems, Inc. ("Dot Hill") alleging that Dot Hill has infringed two of the
Company's patents, U.S. Patent No. 5,941,972 (hereinafter "the '972 patent") and
U.S. Patent No. 6,425,035 (hereinafter "the '035 Patent"), with some of Dot
Hill's products. Subsequently, Dot Hill filed an answer denying infringement and
alleging the '972 and '035 Patents are invalid and unenforceable. Crossroads
plans to vigorously defend its patents against these counterclaims.
On March 31, 2000, the Company filed a lawsuit against Chaparral
Network Storage, Inc. ("Chaparral") alleging that Chaparral had infringed one of
its patents (5,941,972, hereinafter the 972 patent) with some of their products.
In September 2001, the jury found that the '972 patent was valid and that all of
Chaparral's RAID and router products that contained LUN Zoning had infringed all
claims of the Crossroads '972 patent. The federal judge in this matter issued a
permanent injunction against Chaparral from manufacturing any RAID or router
product that contained LUN Zoning or access controls and assessed punitive
damages. As a result, the Company was awarded damages with a royalty amount of
5% for Chaparral's router product line and 3% for their RAID product line.
Chaparral appealed the judgment against it, contending that the '972 patent is
invalid and not infringed. In February 2003, the Federal Circuit Court of
Appeals affirmed the lower court ruling that Crossroads' patent was valid and
willfully infringed by Chaparral, which must stop shipping all products that
contain the Crossroads technology and pay Crossroads a royalty for prior
shipments. On May 19, 2003, the Company received a payment from Chaparral of
approximately $0.2 million to substantially satisfy the damages judgment.
F-18
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On April 14, 2000, the Company filed a lawsuit against Pathlight
Technology, Inc. alleging that Pathlight has infringed one of its patents with
their SAN Data Gateway Router. Pathlight was subsequently acquired by ADIC on
May 11, 2001. In June 2001, ADIC paid the Company $15.0 million in connection
with the settlement of this lawsuit, this payment was recognized as contra
operating expense in the statement of operations for the year ended October 31,
2001. In connection with the settlement of the lawsuit, the Company granted ADIC
a non-exclusive license under the '972 patent.
Securities Class Action Litigation
The Company and several of its officers and directors were named as
defendants in several class action lawsuits filed in the United States District
Court for the Western District of Texas. The plaintiffs in the actions purport
to represent purchasers of the Company's common stock during various periods
ranging from January 25, 2000 through August 24, 2000. On November 22, 2002, the
court granted the Company's motion for summary judgment. On February 26, 2003,
the plaintiffs filed a notice of appeal. On December 3, 2003, the parties
conducted oral argument on plaintiffs' appeal before the United States Circuit
Court for the Fifth Circuit. The Fifth Circuit has not yet issued its ruling on
plaintiffs' appeal. The plaintiffs are seeking unspecified amounts of
compensatory damages, interest and costs, including legal fees. The Company
denies the allegations in the complaint and intends to defend itself vigorously.
It is not possible at this time to predict whether the Company will incur any
liability or to estimate the damages, or the range of damages, if any, that the
Company might incur in connection with this lawsuit.
Other
From time to time, the Company may be involved in litigation relating
to claims arising out of its ordinary course of business. Management believes
that, other than the matters described above, there are no claims or actions
pending or threatened against the Company, the ultimate disposition of which
would have a material impact on the Company's financial position, results of
operations or cash flows. If the Company reduces or cancels production orders
with its third party contract manufacturer, the Company may be required to
reimburse its contract manufacturer for materials purchased on its behalf in the
normal course of business.
Employment Contracts
The Company has entered into Employment Agreements with its President
and Chief Executive Officer and, its Vice President and Chief Financial Officer.
Both executives are employed on an "at will" basis and may be terminated at any
time, with or without cause.
The Company has also entered into Severance Benefit Plans with both its
Chief Executive Officer and Chief Financial Officer. Pursuant to the terms of
these plans, to the extent these executive officers are terminated prior to a
change of control involving the Company (i) they will receive a cash payment
equal to one month of salary for each quarter of service they have provided to
the Company, up to a maximum of twelve months salary and (ii) the vesting all
options held by such executive officer will accelerate by a period of one year.
During fiscal 2003, upon the transition of the former Chief Financial
Officer and former Chief Executive Officer, the Company recorded approximately
$0.9 million of general and administrative expense relating to the acceleration
of stock options and the payment of severance. At October 31, 2003 the Company
accrued approximately $0.3 million of remaining severance expense relating to
these agreements.
F-19
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. STOCKHOLDERS' EQUITY
Treasury Stock
Treasury stock purchases are accounted for under the cost method
whereby the entire cost of the acquired stock is recorded as treasury stock.
Gains and losses on the subsequent reissuance of shares are credited or charged
to capital in excess of par value using the average-cost method.
During the fiscal second quarter of 2003, the Company elected to retire
all outstanding shares of treasury stock. Therefore, as of October 31, 2003,
there was no treasury stock outstanding.
Stock Option Exchange Program
On February 10, 2003, the Company completed a stock option exchange
program offered to all eligible option holders. Under the exchange offer,
eligible employees and non-employee members of the board of directors had the
opportunity to tender for cancellation certain eligible stock options in
exchange for new options to be granted at least six months and one day after the
cancellation of the tendered options. The number of shares subject to each new
option was based on the exercise price of the exchanged option. If the exercise
price per share of a returned option was $3.99 or less, the number of shares
that will be subject to the new option will be determined by dividing the number
of shares subject to the returned option by 3. If the exercise price per share
of a returned option was at least $4.00 but not more than $49.99, the number of
shares that will be subject to the new option will be determined by dividing the
number of shares subject to the returned option by 4. If the exercise price per
share of a returned option was $50.00 or more, the number of shares that will be
subject to the new option will be determined by dividing the number of shares
subject to the returned option by 5.
The Company accepted approximately 498,806 options for cancellation and
exchange, which equals approximately 10.7% of the total number of options
eligible for exchange. While the executive officers and members of the board of
directors were eligible to participate in the exchange program, none of them
elected to participate in the program. The Company granted 97,601 new options on
August 12, 2003 after taking into consideration employee terminations since the
cancellation date. The exercise price per share of the new options is $1.85,
which is equal to the closing price of the Company's common stock on The NASDAQ
National Market on August 12, 2003. Crossroads did not record any compensation
expense as a result of the exchange program.
9. STOCK INCENTIVE/PURCHASE PLANS
1999 Stock Incentive Plan
The 1999 Stock Incentive Plan (the "1999 Plan") is the successor
program to the Company's 1996 Stock Option/Stock Issuance Plan (the "1996
Plan"). The 1999 Plan became effective in October 1999. At that time, all
outstanding options under the 1996 Plan transferred to the 1999 Plan, and no
further options will be granted under the 1996 Plan.
The 1999 Plan provides for a maximum number of common shares to be
issued of 9,838,160. Accordingly, the Company has reserved a sufficient number
of shares of common stock to permit exercise of options or issuance of common
shares in accordance with the terms of the 1999 Plan. The shares reserved under
the 1999 Plan will
F-20
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
automatically increase on the first trading day in January of each calendar
year, beginning with calendar year 2001, by an amount equal to four percent (4%)
of the total number of shares of common stock outstanding on the last trading
day of December in the prior calendar year, but in no event will this annual
increase exceed 1,000,000 shares. Non-Statutory stock options may be granted to
Company employees, members of the board, and consultants at the exercise price
determined by the board of directors or by the Company's compensation committee.
Options granted under the plan may have a term of no more than 10 years.
Stock appreciation rights may be issued to certain officers subject to
Section 16 of the Securities Exchange Act of 1934 under the discretionary option
grant program. These rights will provide the holders with the election to
surrender their outstanding options for a payment from us equal to the fair
market value of the shares subject to the surrendered options less the exercise
price payable for those shares. The Company may make the payment in cash or in
shares of common stock. None of the options originally issued under the 1996
Plan have any stock appreciation rights. To date, the Company has not issued any
stock appreciation rights.
The following tables summarize stock option activity under all of the
Plans for all periods presented:
YEAR ENDED OCTOBER 31,
-------------------------------------------------------------------------------------
2001 2002 2003
---------------------------- ------------------------- -------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
------ ----- ------ ----- ------ -----
Outstanding at beginning
of period.................. 3,432,571 $ 36.27 4,396,063 $ 11.16 5,389,385 $ 5.64
Granted....................... 2,924,400 4.64 3,306,837 2.46 2,743,883 1.21
Exercised..................... (117,039) 1.30 (94,547) 1.08 (639,138) 0.70
Forfeited..................... (1,843,869) 48.20 (2,218,968) 12.03 (2,831,372) 6.97
---------- ---------- ----------
Outstanding at end of
Period..................... 4,396,063 $ 11.16 5,389,385 $ 5.64 4,662,758 $ 2.89
========== ========== ==========
Options exercisable at the
End of the period.......... 1,215,635 $ 16.06 2,744,818 $ 6.57 2,531,844 $ 3.32
========== ========== ==========
YEAR ENDED OCTOBER 31,
---------------------------------------
2001 2002 2003
---- ---- ----
Weighted average grant-date fair value of options granted:
Exercise price equal to market price of stock on the grant date:
Aggregate value.............................................. $ 7,204 $ 4,969 $ 2,345
=========== =========== ===========
Per share value.............................................. $ 3.39 $ 1.84 $ 1.16
=========== =========== ===========
Exercise price less than the market price of stock on the grant date:
Aggregate value.............................................. $ 2,719 $ 1,797 $ 968
=========== =========== ===========
Per share value.............................................. $ 5.44 $ 2.06 $ 0.64
=========== =========== ===========
Exercise price greater than the market price of stock on the grant date:
Aggregate value.............................................. $ 1,538 $ --- $ ---
=========== =========== ===========
Per share value.............................................. $ 5.13 $ --- $ ---
=========== =========== ===========
F-21
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted average
assumptions used for grants in 2001, 2002 and 2003: no dividend yield; risk-free
interest rate of 4.64%, 3.87% and 2.66%, respectively; expected volatility of
120%, 105% and 100%, respectively; expected lives of four years.
The option valuation models were developed for use in estimating the
fair value of traded options, which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions. Because the Company's employee stock options have
characteristics significantly different from those of traded options and because
changes in the subjective input assumptions can materially affect the fair value
estimate, in management's opinion, the existing models do not necessarily
provide a reliable single measure of the fair value of its employee stock
options.
The following table summarizes information with respect to stock
options outstanding under all plans at October 31, 2003:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
---------------------------------------------------- -------------------------------
NUMBER WEIGHTED-AVERAGE WEIGHTED-AVERAGE NUMBER WEIGHTED-AVERAGE
RANGE OF EXERCISE PRICES OUTSTANDING REMAINING YEARS EXERCISE PRICE EXERCISABLE EXERCISE PRICE
- ------------------------ ----------- ---------------- ---------------- ----------- ---------------
$ 0.23 - $ 0.23..... 13,125 4.5 $ 0.23 13,125 $ 0.23
$ 0.50 - $ 0.71..... 337,095 8.7 $ 0.68 324,269 $ 0.69
$ 0.79 - $ 1.14..... 446,323 8.7 $ 0.93 213,010 $ 0.82
$ 1.23 - $ 1.69..... 1,266,410 8.6 $ 1.52 883,510 $ 1.52
$ 1.85 - $ 2.70..... 1,652,170 9.0 $ 2.23 471,696 $ 2.54
$ 3.03 - $ 3.54..... 211,350 9.6 $ 3.19 27,812 $ 3.50
$ 4.56 - $ 6.49..... 603,665 7.6 $ 5.23 490,501 $ 5.21
$ 6.94 - $ 10.00..... 68,100 7.0 $ 8.19 53,655 $ 8.31
$ 11.25 - $ 13.81..... 6,530 6.8 $ 12.82 5,055 $ 12.77
$ 18.00 - $ 18.00..... 4,850 5.9 $ 18.00 4,850 $ 18.00
$ 39.88 - $ 39.88..... 34,140 6.6 $ 39.88 27,736 $ 39.88
$ 64.88 - $ 70.63..... 19,000 6.4 $ 66.09 16,625 $ 66.09
--------- ---- ------- --------- ---------
$ 0.23 - $ 70.63...... 4,662,758 8.61 $ 2.89 2,531,844 $ 3.32
========= ==== ======= ========= =========
Options granted to non-employees are recorded at fair value in
accordance with SFAS No. 123. These options were issued pursuant to the 1996
Plan and 1999 Plan and are reflected in the disclosures above. The Company did
not grant any options to non-employees for consulting services in fiscal 2001,
2002 and 2003.
The 1999 Plan includes change in control provisions that may result in
the accelerated vesting of outstanding option grants and stock issuances.
Stock Bonus Incentive Program
The Company entered into agreements with certain employees which
resulted in 259,788 and 1,008,034 of outstanding shares of restricted common
stock at $0 per share as of October 31, 2002 and 2003, respectively. The initial
grants relating to these agreements were 372,586 and 1,501,126 as of October 31,
2002 and October 31, 2003, resulting in deferred stock-based compensation of
approximately $1.2 million and $1.0 million. This deferred stock-based
compensation is being amortized to expense as the restrictions on the shares of
common
F-22
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
stock lapse. The restrictions generally lapse in individual tranches over
a two-year period, assuming continued employment of the recipient. However, the
lapsing of these restrictions may be accelerated in accordance with the original
agreements if the recipient meets certain predefined individual performance
objectives and/or the Company accomplishes specific predefined entity wide
goals.
Employee Stock Purchase Plan
The Company's Employee Stock Purchase Plan (the "ESPP") became
effective immediately upon the effective date of the Company's initial public
offering. The ESPP is designed to allow eligible employees to purchase shares of
common stock, at semi-annual intervals, with their accumulated payroll
deductions. The Company has reserved 450,000 shares of common stock for issuance
under the ESPP. The reserve will automatically increase on the first trading day
of January in each calendar year, beginning in calendar year 2001, by an amount
equal to one percent (1%) of the total number of outstanding shares of common
stock on the last trading day of December in the prior calendar year. In no
event in this plan will any such annual increase exceed 250,000 shares.
Eligible employees may contribute up to 15% of his or her base salary
through payroll deductions, and the accumulated deductions will be applied to
the purchase of shares on each semi-annual purchase date. The purchase price per
share will be equal to 85% of the fair market value per share on the
participant's entry date into the eligible offering period or, if lower, 85% of
the fair market value per share on the semi-annual, purchase date. Semi-annual
purchase dates will occur on the last business day of May and November each
year. However, a participant may not purchase more than 750 shares on any one
semi-annual purchase date, and no more than 75,000 shares may be purchased in
total, by all participants on any one semi-annual purchase date.
Should the Company be acquired by merger, sale of substantially all of
our assets or more than fifty percent of its voting securities, then all
outstanding purchase rights will automatically be exercised immediately prior to
the effective date of the acquisition. The purchase price will be equal to 85%
of the market value per share on the participant's entry date into the offering
period in which an acquisition occurs or, if lower, 85% of the fair market value
per share immediately prior to the acquisition.
The ESPP will terminate no later than the last business day of November
2009. The board may at any time amend, suspend or discontinue the ESPP. However,
certain amendments may require stockholder approval.
10. INCOME TAXES
As of October 31, 2002 and 2003, the Company had federal net operating
loss carryforwards of approximately $70.4 million and $76.1 million,
respectively, and research and experimentation tax credit carryforwards of
approximately $1.2 and $1.6 million, respectively. The Company's net operating
loss carryforward is subject to a limitation on its utilization.
F-23
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Under the provisions of SFAS No. 109, "Accounting for Income Taxes,"
the components of the net deferred tax amounts recognized in the accompanying
balance sheets are as follows (in thousands):
OCTOBER 31,
-----------------------
2002 2003
---- ----
Deferred tax assets:
Net operating losses............................... $ 26,752 $ 28,894
Inventory and other reserves....................... 8,362 8,771
Basis of property and equipment.................... 832 1,014
Research and experimentation credit................ 1,196 1,577
----------- ---------
Net deferred tax assets before valuation allowance... 37,142 40,256
Valuation allowance.................................. (37,142) (40,256)
----------- ---------
Net deferred tax asset............................... $ --- $ ---
=========== =========
Due to the uncertainty surrounding the realization of the benefits of
its favorable tax attributes in future tax returns, the Company has placed a
valuation allowance against the otherwise recognizable net deferred tax asset.
The Company's provision for income taxes for 2003 consists of
approximately $310,000 of withholdings on income generated in a foreign country.
The provision for income taxes differs from the expected tax benefit amount
computed by applying the statutory federal income tax rate of 34% to the net
loss before income taxes as a result of the following:
YEAR ENDED OCTOBER 31,
----------------------------------
2001 2002 2003
---- ---- ----
Tax benefit at statutory rate of 34%... $ 18,391 $ 8,666 $ 2,192
Research and experimentation credit.... 276 445 381
Non-deductible goodwill................ (12,487) (297) (58)
Foreign withholdings................... --- --- 310
Other.................................. 2,191 634 599
Net increase in valuation allowance.... (8,371) (9,448) (3,114)
---------- -------- --------
$ --- $ --- $ 310
========== ======== ========
Under the Tax Reform Act of 1986, the amount of and the benefit from
net operating losses that can be carried forward may be impaired in certain
circumstances. Events that may cause changes in the Company's tax carryovers
include, but are not limited to, a cumulative ownership change of more than 50%
over a three-year period. Certain of the Company's operating losses that can be
utilized in any one taxable year for federal tax purposes have been limited by
one or more such ownership changes. For federal income tax purposes, net
operating loss carryforwards begin to expire in 2011.
11. RELATED PARTY TRANSACTIONS
During May 1999, the Company's board of directors approved the
acceptance of full recourse notes in the amount of approximately $442,000 from
certain of the Company's officers as consideration for the exercise of 1,014,999
options. The notes accrue interest at 7% per year, compounded semi-annually and
principal and accrued interest is due in one lump sum in 2003. In March 2000,
the Company repurchased 232,500 unvested shares for approximately $123,000 and
subsequently collected $114,000 in principal and interest upon the retirement of
the Company's former president and chief operating officer. In June 2000, the
Company repurchased 88,125 unvested
F-24
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
shares for approximately $52,000 and collected approximately $59,000 in
principal and interest upon the retirement of the Company's former
vice-president of sales. In January 2001, the Company repurchased 13,594
unvested shares for approximately $9,000 and collected approximately $16,000 in
principal and interest upon the retirement of the Company's former
vice-president of engineering. The balance of these full recourse notes was
approximately $126,000 as of October 31, 2002 and was paid in full in January
2003.
In October 1999, the Company loaned an officer of the Company $100,000
for personal reasons, not equity related, in exchange for a full recourse
promissory note due in full, with accrued interest, in 6 years or upon the date
in which the officer ceases to remain in service. The note accrues interest at
7% per year, compounded annually and principal and accrued interest is due in
one lump sum on December 31, 2006. During fiscal 2002, the Company forgave the
balance of this note of approximately $120,000 due under this note as part of a
severance agreement entered into as a result of the Company's restructuring
plan.
In July 2000, the Company loaned an employee of the Company $50,000 for
personal reasons, not equity related, in exchange for a full recourse promissory
note due in full, with accrued interest, in 2 years or upon the date in which
the employee ceases to remain in service. The note accrues interest at 10.5% per
year, compounded semi-annually. The principal and accrued interest was due in
one lump sum on July 1, 2002. The balance of this note was approximately $63,000
as of October 31, 2002. The terms on this note have been extended to July 1,
2004 and the balance is approximately $70,000 as of October 31, 2003.
In April 2001, the Company loaned an officer of the Company $45,000 for
personal reasons, not equity related, in exchange for a full recourse promissory
note due in full, with accrued interest, in 6 months or upon the date in which
the officer ceases to remain in service. The note accrues interest at 7.5% per
year, compounded semi-annually and principal and accrued interest was due in one
lump sum on October 16, 2001. During fiscal 2002, the Company collected the
balance of approximately $47,000 due under this note.
In May 2001, the Company loaned an employee of the Company $25,000 for
personal reasons, not equity related, in exchange for a full recourse promissory
note due in full, with accrued interest, in 18 months or upon the date in which
the employee ceases to remain in service. The note accrues interest at 7.5% per
year, compounded semi-annually and principal and accrued interest was due in one
lump sum on November 14, 2002. During fiscal 2002, the Company collected the
balance of approximately $26,000 due under this note.
In fiscal 2003, due to the transition of the Company's former Chief
Financial Officer and Chief Executive Officer, the Company accelerated 483,696
options and agreed to pay one year of severance to each officer. As a result,
the Company recorded approximately $0.9 million of general and administrative
expense.
12. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
The Company did not make any interest payments during fiscal years
2001, 2002 and 2003.
Cash paid for taxes totaled approximately $97,000, $114,000 and
$436,000 during fiscal years 2001, 2002 and 2003, respectively.
F-25
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. EMPLOYEE BENEFITS
In 1996, the Company established the Crossroads Systems, Inc. 401(k)
Savings Plan (the "Savings Plan"), which is a qualified plan under section
401(k) of the Internal Revenue Code. All employees who have attained 18 years of
age are eligible to enroll in the Savings Plan. The Company may make matching
contributions to those employees participating in the Savings Plan based upon
Company productivity and profitability. Company contributions vest over a period
of six years. In October 2000, the Company adopted a new 401(k) Savings Plan
that meets all of the criteria set forth above in the Savings Plan. The Company
made no matching contributions under any plan for the years ended October 31,
2001, 2002 and 2003.
14. STOCKHOLDER RIGHTS PLAN
On August 21, 2002, the Company's Board of Directors approved, adopted
and entered into a Stockholder Rights Plan ("Rights Plan"). The Rights Plan is
similar to plans adopted by many other companies, and was not adopted in
response to any attempt to acquire the Company, nor was the Company aware of any
such efforts at the time of adoption.
The Rights Plan is designed to enable the Company's stockholders to
realize the full value of their investment by providing for fair and equal
treatment of all stockholders in the event that an unsolicited attempt is made
to acquire the Company. Adoption of the Rights Plan is intended to deter
coercive takeover tactics including the accumulation of shares in the open
market or through private transactions and to prevent an acquirer from gaining
control of the Company without offering a fair price to all of the Company's
stockholders.
Under the Rights Plan, the Company declared and paid a dividend of one
right for each share of common stock held by stockholders of record as of the
close of business on September 3, 2002 (the "Rights"). Each Right initially
entitles stockholders to purchase one unit of a share of the Company's preferred
stock at $12 per share. However, the Rights are not immediately exercisable and
will become exercisable only upon the occurrence of certain events. If a person
or group acquires or announces a tender or exchange offer that would result in
the acquisition of 15% or more of the Company's common stock while the Rights
Plan remains in place, then, unless the Rights are redeemed by the Company for
$0.01 per right, all Rights holders except the acquirer will be entitled to
acquire the Company's common stock at a significant discount. The Rights are
intended to enable all stockholders to realize the long-term value of their
investment in the Company. The Rights will not prevent a takeover attempt, but
should encourage anyone seeking to acquire the Company to negotiate with the
Board of Directors prior to attempting a takeover. The Rights will expire on
September 3, 2012.
F-26
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
15. SUBSEQUENT EVENTS
On December 17, 2003, Crossroads announced it has entered into a
technology development agreement with NexQL Corporation for the joint
development of advanced data management solutions. During the term of this and
other strategic agreements, Crossroads will provide funding up to $2.5 million
to NexQL.
NexQL, a privately held development stage company, is developing data
management solutions built on patented technologies addressing the needs of
real-time, complex, high-volume analytical processing. The result will be
real-time access to data with an improvement of several orders of magnitude in
performance over traditional approaches. This technology will provide real-time
access across all databases using a scalable, non- invasive system that also
preserves existing systems and business processes.
F-27
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
3.1* Sixth Amended and Restated Certificate of Incorporation (filed
as Exhibit 3.1 to the Registrant's Registration Statement on
Form S-1 (SEC File No. 333-85505) (the "IPO Registration
Statement") and incorporated herein by reference)
3.2* Amended and Restated Bylaws (filed as Exhibit 3.2 to the IPO
Registration Statement and incorporated herein by reference)
4.1* Specimen certificate for shares of common stock (filed as
Exhibit 4.1 to the IPO Registration Statement and incorporated
herein by reference)
4.2 See Exhibits 3.1 and 3.2 for provisions of the Certificate of
Incorporation and Bylaws of the Registrant defining the rights
of holders of common stock
10.1* Form of Indemnity Agreement between Registrant and each of its
directors and executive officers (filed as Exhibit 10.1 to the
IPO Registration Statement and incorporated herein by
reference)
10.2* Crossroads Systems, Inc. 1999 Employee Stock Purchase Plan
(filed as Exhibit 10.3 to the IPO Registration Statement and
incorporated herein by reference)
10.3* Fourth Amended and Restated Investors Rights Agreement dated
August 6, 1999 by and among Registrant and certain purchasers
of Registrant's preferred stock (filed as Exhibit 10.4 to the
IPO Registration Statement and incorporated herein by
reference)
10.4*+ OEM Agreement dated April 23, 1998 by and between Registrant
and Storage Technology Corporation (filed as Exhibit 10.5 to
the IPO Registration Statement and incorporated herein by
reference)
10.5* Loan Modification Agreement dated December 31, 2000 by and
between Registrant and Silicon Valley Bank (filed as Exhibit
10.9 to Registrant's Annual Report on Form 10-K for the fiscal
year ended October 31, 2001 and incorporated herein by
reference)
10.6* Office Building Lease dated October 8, 1999 by and between
Registrant and Maplewood Associates, L.P. (filed as Exhibit
10.15 to the IPO Registration Statement and incorporated
herein by reference)
10.7* Crossroads Systems, Inc. Amended and Restated 1999 Stock
Incentive Plan (filed as Exhibit 99.(d)(2) to the Registrant's
Schedule TO/I (SEC File No. 5-57603) and incorporated herein
by reference)
10.8* Rights Agreement, dated as of August 21, 2002, by and between
Registrant and American Stock Transfer & Trust Company, which
includes the form of Certificate of Designation for the Series
A junior participating preferred stock as Exhibit A, the form
of Rights Certificate as Exhibit B and the Summary of Rights
to Purchase Series A Preferred Stock as Exhibit C (field as
Exhibit 4 to the Registrant's Current Report on Form 8-K dated
August 21, 2002 and incorporated herein by reference)
10.9* Employment Agreement, dated as of January 6, 2003 by and
between Registrant and Andrea Wenholz
EXHIBIT
NUMBER DESCRIPTION
10.10* Fiscal Year 2003 Stock Bonus Incentive Program Letter
Agreement, dated November 4, 2002 from Registrant to Rob Sims
10.11* Fiscal Year 2003 Stock Bonus Incentive Program Letter
Agreement, dated January 6, 2003, from Registrant to Andrea
Wenholz
10.12 Employment Agreement dated as of October 13, 2003 between
Registrant and Rob Sims
10.13 Letter Agreement dated as of October 30, 2003 between
Registrant and Brian R. Smith regarding Termination, Severance
Offer and General Release
21.1 Subsidiaries of the Registrant
23.1 Consent of KPMG LLP
23.2 Consent of PricewaterhouseCoopers LLP
24.1 Power of Attorney, pursuant to which amendments to this Form
10-K may be filed, is included on the signature page contained
on Part IV of this Form 10-K
31.1 Certification of Rob Sims, President and Chief Executive
Officer of the Company, as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
31.2 Certification of Andrea Wenholz, Vice President and Chief
Financial Officer of the Company, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of Rob Sims, President and Chief Executive
Officer of the Company, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
32.2 Certification of Andrea Wenholz, Vice President and Chief
Financial Officer of the Company, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
* Incorporated herein by reference to the indicated filing
+ Confidential treatment previously granted