PEERLESS SYSTEMS CORP - 10-Q Quarterly Report

Indicate by check mark whether the registrant (1) has filed all reports required by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

The number of shares of Common Stock outstanding as of December 8, 2004 was 15,997,142.

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. Statements prompted by, qualified by or made in connection with such words as “may,” “will be,” “continue,” “anticipates,” “estimates,” “expects,” “continuing,” “plans,” “exploring,” “intends,” and “believes” and words of similar substance signal forward-looking statements. Likewise, the use of such words in connection with or related to any discussion of or reference to the Company’s future business operations, opportunities or financial performance sets apart forward-looking statements.

In particular, statements regarding the Company’s outlook for future business, financial performance and growth, including projected revenue, both quarterly and from specific sources, profit, spending, including spending on research and development efforts, costs, margins and the Company’s cash position, as well as statements regarding expectations for the digital imaging market, new product development and offerings, customer demand for the Company’s products and services, market demand for products incorporating the Company’s technology, future prospects of the Company, and the impact on future performance of organizational and operational changes; all constitute forward-looking statements.

These forward-looking statements are projections and estimations based upon the information available to the Company at this time. Thus they involve known and unknown factors and trends affecting Peerless and its business such that actual results could differ materially from those projected in the forward-looking statements made in this Quarterly Report on Form 10-Q. Factors and trends affecting Peerless and its business include, but are not limited to, the following factors and trends as well as other factors and trends described from time to time in our reports filed with the Securities and Exchange Commission: (a) the Company’s near term revenue may drop as a result of the timing of licensing revenues and the reduced demand for its existing monochrome technologies; (b) if the Company is unable to introduce its Peerless Sierra Technologies on a timely basis, the Company’s future revenue and operating results may be harmed; (c) if the marketplace does not accept our new Peerless Sierra Technologies, the Company’s future revenue and operating results may be harmed; (d) the Company’s forecasts for our Peerless Sierra Technologies may not be realized, and losses for the disposition of excess inventories may result; (e) the Company’s existing capital resources may not be sufficient, and if the Company is unable to raise additional capital its business may suffer; (f) the Company’s near term revenue from engineering services may drop as it may change its strategies in how it offers its products in the marketplace; (g) Peerless has a history of losses and anticipates continued losses; (h) the future demand for the Company’s current products is uncertain; (i) Peerless relies on relationships with certain customers and any adverse change in those relationships will harm the Company’s business; (j) Peerless relies on relationships with Adobe Systems Incorporated and Novell Inc., and any adverse change in those relationships will harm the Company’s business; (k) the Company, as a sublicensor of third party intellectual property, is subject to audits of the Company’s licensing fee costs; (l) the Company has negotiated with Adobe Systems Incorporated and Canon Inc. to remedy a contract dispute, which, if not remedied, could result in the loss of the Adobe agreement and harm to the Company’s business; (m) Peerless may be unable to develop additional new and enhanced products that achieve market acceptance; (n) if Peerless is not in compliance with the Company’s licensing agreements, Peerless may lose the Company’s rights to sublicense technology, and the Company’s competitors are aggressively pursuing the sale of licensed third party technology; (o) the industry for imaging systems for digital products involves intense competition and rapid technological changes, and the Company’s business may suffer if its competitors develop superior technology; (p) the Company’s reserves for accounts receivable may not be adequate; (q) if Peerless fails to adequately protect the Company’s intellectual property or faces a claim of intellectual property infringement by a third party, Peerless could lose the Company’s intellectual property rights or be liable for damages; (r) the Company’s international activities may expose it to risks associated with international business; (s) demand from Pacific Rim customers has continued to and may continue to decline; (t) the Company’s stock price may experience extreme price and volume fluctuations; (u) the Company’s common stock was moved to the Nasdaq SmallCap Market and may not provide adequate liquidity; (v) the Company’s business may suffer if the Company’s third party distributors are unable to distribute the Company’s products and address customer needs effectively; (w) Peerless relies on certain third party providers for applications to develop the

Company’s ASICs, and as a result the Company is vulnerable to any problems experienced by these providers, which may delay product shipments to the Company’s customers; (x) Peerless’ licensing revenue is subject to significant fluctuations; (y) the Company’s revenue from engineering services is subject to significant fluctuations; (z) Peerless may be unable to deploy the Company’s employees effectively in connection with changing demands from the Company’s original equipment manufacturer customers; and (aa) Peerless may be unable to implement its business plan effectively. Please see pages 20 through 28 of this Quarterly Report on Form 10-Q for a more in depth discussion of these factors and trends affecting Peerless and its business.

Current and prospective stockholders are urged not to place undue reliance on forward-looking statements, which speak only as of the date hereof. The Company is under no obligation, and expressly disclaims any obligation, to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. All forward-looking statements contained herein are qualified in their entirety by the foregoing cautionary statements.

Peerless®, Memory Reduction Technology® (MRT), PeerlessPowered®, WinExpress®, PeerlessPrint®, AccelePrint®, SyntheSys®, QuickPrint®, PerfecTone® and VersaPage® are registered trademarks of Peerless Systems Corporation. MagicPrint^TM and Everest^TM are trademarks of Peerless Systems Corporation and are the subjects of applications pending for registration with the United States Patent and Trademark Office. PeerlessPage^TM, ImageWorks^TM, PeerlessDriver^TM, redipS^TM, and WebWorks^TM are trademarks of Peerless Systems Corporation. Peerless Systems, P logo, and Peerless logo are trademarks and service marks of Peerless Systems Corporation registered in Japan. Peerless is a trademark of Peerless Systems Corporation that is registered in France, Spain, Taiwan, and the United Kingdom, and is the subject of applications for registration pending in Australia, China, the European Union, Hong Kong, Italy, and Korea. RedipS is a trademark of Peerless Systems Corporation registered in Canada and in the European Union. PeerlessPrint is a trademark of Peerless Systems Corporation that is the subject of an application for registration pending in Japan. PeerlessPrint (in Katakana) is a trademark of Peerless Systems Corporation that is the subject of an application for registration pending in Japan. Everest is a trademark of Peerless Systems Corporation that is the subject of an application for registration pending in the People’s Republic of China, Japan, Korea and the European Union.

The accompanying unaudited condensed consolidated financial statements of Peerless Systems Corporation (the “Company” or “Peerless”) have been prepared pursuant to the rules of the Securities and Exchange Commission (the “SEC”) for Quarterly Reports on Form 10-Q and do not include all of the information and note disclosures required by generally accepted accounting principles. The financial statements and notes herein are unaudited, but in the opinion of management, include all the adjustments (consisting only of normal, recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows of the Company. These statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on April 30, 2004. The results of operations for the interim periods shown herein are not necessarily indicative of the results to be expected for any future interim period or for the entire year.

Business: The Company has incurred losses from operations and has reported negative operating cash flows. As of October 31, 2004, the Company had an accumulated deficit of $44.4 million and cash and short-term investments of $4.4 million. The Company has no material financial commitments other than those under operating lease agreements and inventory purchase orders. The Company believes that its existing cash and short-term investments, and any cash generated from operations will be sufficient to fund its working capital requirements, capital expenditures and other obligations through the next twelve months. Long term, the Company may face significant risks associated with the successful execution of its business strategy and may need to raise additional capital in order to fund more rapid expansion, to expand its marketing activities, to develop new or enhance existing services or products, and to respond to competitive pressures or to acquire complementary services, businesses, or technologies. If the Company is not successful in generating sufficient cash flow from operations, it may need to raise additional capital through public or private financing, strategic relationships, or other arrangements. The Company has established a credit facility with its bank, Silicon Valley Bank, which allows for short-term borrowing against outstanding receivables from certain of the Company’s customers. The credit facility will only provide coverage for short-term working capital needs and the Company may require additional long-term capital to finance working capital requirements.

Revenue Recognition: The Company recognizes revenues in accordance with Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9. In December 2003, the Company adopted Staff Accounting Bulletin No. 104 “Revenue Recognition in Financial Statements.” The adoption did not impact the Company’s revenue recognition policy.

Development license revenues from the licensing of source code or software development kits (“SDKs”) for the Company’s standard products are recognized upon delivery and acceptance by the customer of the software if no significant modification or customization of the software is required and collection of the resulting receivable is probable. If modification or customization is essential to the functionality of the software, the development license revenues are recognized over the course of the modification work.

The Company also enters into engineering services contracts with certain of its original equipment manufacturers (“OEMs”) to provide turnkey solutions, adapting the Company’s software and supporting electronics to specific OEM requirements. Revenues on such contracts are recognized over the course of the engineering work on a percentage-of-completion basis. Progress-to-completion under percentage-of-completion is determined based on direct costs, consisting primarily of labor and materials, expended on the arrangement. The Company provides for any anticipated losses on such contracts in the period in which such losses are first determinable. At October 31, 2004 and January 31, 2004, the Company had no engineering contracts on which it required any loss provisions. The Company also provides engineering support on a

time-and-material basis. Revenues from this support are recognized as the services are performed. Maintenance revenues are recognized ratably over the term of the maintenance contract.

Recurring licensing revenues are derived from per unit fees paid by the Company’s customers upon manufacturing and subsequent commercial shipment of products incorporating Peerless technology and certain third party technology, of which the Company is a sub-licensor. These recurring licensing revenues are recognized on aper unit basis as products are shipped commercially. In certain cases, the Company may sell a block license, that is, a specific quantity of licensed units that may be shipped in the future, or the Company may require the customer to pay minimum royalty commitments. Associated payments are typically made in one lump sum or extend over a period of four or more quarters. The Company generally recognizes revenues associated with block licenses and minimum royalty commitments on delivery and acceptance of software, when collection of the resulting receivable is probable, when the fee is fixed or determinable, and when the Company has no future obligations. In cases where block licenses or minimum royalty commitments have extended payment terms and the fees are not fixed or determinable, revenue is recognized as payments become due. Further, when earned royalties exceed minimum royalty commitments, revenues are recognized on a per unit basis as products are shipped commercially.

For fees on multiple element arrangements, values are allocated among the elements based on vendor specific objective evidence of fair value (“VSOE”). If VSOE does not exist, all revenue for the arrangement is deferred until the earlier of the point at which such VSOE does exist or all elements of the arrangement have been delivered. If an arrangement includes software and service elements, a determination is made as to whether the service element can be accounted for separately as services are performed.

Deferred revenue consists of prepayments of licensing fees and payments billed to customers in advance of revenue recognized on engineering services contracts. Unbilled receivables arise when the revenue recognized on a contract exceeds billings due to timing differences related to billing milestones as specified in the contract.

The Company recognizes revenue from sales of its application specific integrated circuits (“ASIC”) when the earnings process is completed, as evidenced by an agreement with the customer, transfer of title, as well as fixed pricing and probable collectibility.

Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

The Company provides an accrual for estimated product licensing costs owed to third party vendors whose technology is included in the products sold by the Company. The accrual is impacted by estimates of the mix of products shipped under certain of the Company’s block license agreements. The estimates are based on historical data and available information as provided by the Company’s customers concerning projected shipments. Should actual shipments under these agreements vary from these estimates, adjustments to the estimated accruals for product licensing costs may be required.

The Company grants credit terms in the normal course of business to its customers. The Company continuously monitors collections and payments from its customers and maintains allowances for doubtful accounts for estimated losses resulting from the inability of any customers to make required payments. Estimated losses are based primarily on specifically identified customer collection issues. If the financial condition of any of the Company’s customers, or the economy as a whole, were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

The Company’s recurring product licensing revenues are dependent, in part, on the timing and accuracy of product sales reports received from the Company’s OEM customers. These reports are provided only on a calendar quarter basis and, in any event, are subject to delay and potential revision by the OEM. Therefore, the Company is required to estimate all of the recurring product licensing revenues for the last month of each fiscal quarter and to further estimate all of its quarterly revenues from an OEM when the report from such OEM is not received in a timely manner. In the event the Company is unable to estimate such revenues accurately prior to reporting financial results, the Company may be required to adjust revenues in subsequent periods.

Employee Stock-Based Compensation: The Company accounts for its stock option plans and employee stock purchase plan under the recognition and measurement principles of Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees,” and related Interpretations. Under APB No. 25, no stock-based compensation is generally reflected in net income (loss), as options granted under the plans generally had an exercise price equal to the market value of the underlying common stock on the date of grant and the related number of shares granted is fixed at that point in time. The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure:”

In determining the fair value, the Company used the Black-Scholes model, assumed no dividends per year, used expected lives ranging from 2 to 10 years, expected volatility of 74.5% and 74.7% for the three months and nine months ended October 31, 2004 and 2003, respectively, and risk free interest rates of 3.43% and 2.89% for the three and nine months ended October 31, 2004 and 2003, respectively. The weighted average per share fair values of options granted during the periods presented with exercise prices equal to market price on the date of grant were $0.82 and $2.03 for the three months ended October 31, 2004 and 2003, respectively, and $0.79 and $1.48 for the nine months ended October 31, 2004 and 2003, respectively.

Investments with contractual maturities greater than one year are classified on the condensed consolidated balance sheets as current investments, based on the Company’s intention to use these investments to fund current operations, if necessary.

The fair value of available-for-sale securities at October 31, 2004 and January 31, 2004 approximated their carrying value (amortized cost). Unrealized gains or losses on securities were immaterial for all periods presented.

In the first quarter of fiscal year 2004, the Company recorded a $121,000 loss for a correction to fiscal year 2002 reported accrued interest.

During the three months ended October 31, 2004, four customers each generated greater than 10% of the revenues of the Company and collectively contributed 83% of such revenues. Block license revenues for the same time period were 63% of the revenues of the Company. During the three months ended October 31,

2003, four customers generated greater than 10% of the revenues of the Company, and collectively contributed 77% of revenues of the Company. Block license revenues for the same time period were 59% of the revenues of the Company.

During the nine months ended October 31, 2004, six customers each generated greater than 10% of the revenues of the Company and collectively contributed 80% of such revenues. Block license revenues for the same time period were 50% of the revenues of the Company. During the nine months ended October 31, 2003, four customers generated greater than 10% of the revenues of the Company, and collectively contributed 66% of revenues of the Company. Block license revenues for the same time period were 59% of the revenues of the Company.

On July 1, 2004, a new tax treaty between Japan and the United States went into effect. The new treaty generally eliminates the requirement of the Company’s Japanese customers to withhold income taxes on royalty payments due to Peerless. The impact was to nearly eliminate the Company’s provision for income taxes in the three months ended October 31, 2004.

The provision for income taxes in the three and nine months ended October 31, 2004 and the three and nine months ended October 31, 2003 consisted primarily of foreign income taxes paid. In the three and nine months ended October 31, 2003, the Company benefited by approximately $245,000 and $735,000, respectively, for the elimination of certain income tax matters and related liabilities. At October 31, 2004 and January 31, 2004, the Company had no remaining liabilities related to these matters.

The Company has provided a full valuation allowance on its net deferred tax assets because of the uncertainty with respect to its ability to generate future taxable income to realize its deferred tax assets.

On February 20, 2003, the Company announced the sale of its remaining interest in Netreon. As a result of the sale, the Company recorded in other income a gain of $971,000, net of expenses, associated with this transaction in the nine months ended October 31, 2003.

On February 28, 2003, a sublesee terminated a sublease that involved approximately 9,000 square feet of the Company’s El Segundo, California headquarters. As a result of the termination, the Company received $639,000 in cash and a forfeited deposit, which is included in other income in the nine months ended October 31, 2003. In addition, the Company received $299,000 in net fixed assets returned to the Company, which was classified as a reduction to operating expenses, the same classification used in a prior period when a loss was recognized for the disposal of these same assets. The assets were recorded at fair market value.

On August 26, 2003, the Company’s Board of Directors approved the conversion of a royalty bearing perpetual license to a fully paid up perpetual license to use certain third party color technology that is being incorporated into the Company’s high performance color architecture and products. The licensed technology is presently being applied in several of the Company’s research and development projects and will be incorporated into the Company’s new products. The total cost of $1.1 million for this license has been capitalized and is being amortized into research and development expenses over a two-year period during its use on such projects and products. Accumulated amortization from the acquired prepaid licenses totaled $550,000 at October 31, 2004.

The Company has commitments under purchase orders for the production of its Everest controller from Cal Quality Electronics, Inc. As of October 31, 2004, the outstanding amount on these purchase orders was $535,000.

On October 27, 2004, the Company entered into a credit facility with Silicon Valley Bank. The facility allows the Company to borrow up to a maximum of $4.0 million against qualified accounts receivable. Any borrowings against this facility would be made at prime plus 2.75% and are repaid with the collection of the individual receivable financed. The Company is required to maintain a quarterly tangible net worth in excess of $2.5 million. The Company issued 30,535 warrants with an exercise price of $1.31 to the bank in connection with this facility. The warrants expire on October 27, 2009. The cost of the facility, including the fair value of warrants issued of $23,900, was $68,600, which has been capitalized and will be amortized over the term of the agreement, which is one year.

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

This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements contained in this Quarterly Report on Form 10-Q that are not purely historical are 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, including without limitation, statements regarding the Company’s expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Quarterly Report on Form 10-Q are based on current expectations, estimates, forecasts and projections about the industry in which Peerless operates, management’s beliefs and assumptions made by management. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

The Company, together with its wholly-owned subsidiary, Peerless Systems Imaging Products, Inc. (“PSIP”), is a provider of software-based imaging and networking technology to original equipment manufacturers (“OEMs”) of digital document products. The Peerless imaging solution is based on a combination of software and imaging application specific integrated circuits (“ASIC”), which together form a cost-effective imaging system that addresses virtually all sectors of the printing market, from low-end small office/home office (“SOHO”) inkjets to high-end laser digital color copiers and printers. The low-cost, high performance printers and multifunction products (“MFPs”) that incorporate the Company’s imaging solutions are increasingly replacing expensive standalone copiers and printers in corporate offices. Additionally, the Company’s embedded directory agent technology enables networked devices to use directory services. These directory services can authenticate users and administer their access rights. They also allow a device to list its configuration parameters in a central directory on the network, and to configure itself automatically without the need for user intervention.

The Company has developed and continues to develop controller products and applications for sale to OEMs and distribution channels. Digital document products include monochrome (black and white) and color printers, copiers, fax machines and scanners, as well as MFPs that perform a combination of these imaging functions. In order to process digital text and graphics, digital document products rely on a core set of imaging software and supporting electronics, collectively known as a digital imaging system. Network interfaces supply the core technologies to digital document products that enable them to communicate over local and wide area networks and the Internet. The Peerless family of products and engineering services provide fully integrated advanced and proprietary imaging and networking technologies that enable the Company’s OEM customers and third party developers for OEMs to develop stand-alone and networked digital printers, copiers, and MFPs quickly and cost effectively. The Company markets its solutions directly to OEM customers including Canon, Konica Minolta, Kyocera/ Mita, Lenovo (formerly Legend), Oki Data, Panasonic, Ricoh, and Seiko Epson. The Company has expanded its solution offerings by incorporating related imaging and networking technologies developed internally or licensed from third parties. The Company has developed more diverse distribution channels for its products and is expanding its target market to include distributors, value added resellers, system integrators, and OEM sales operations. The Company is also expanding its target market geographically to include the People’s Republic of China and Taiwan.

The Company generates revenue from its OEM customers through the sale of imaging solutions in either turnkey or software development kit (“SDK”) form. The Company’s product licensing revenues are comprised of both recurring per unit and block licensing revenues and development licensing fees for source code or SDKs. Licensing revenues are derived from per unit fees paid periodically by the Company’s OEM customers upon manufacturing and subsequent commercial shipment of products incorporating the Company’s technology. Licensing revenues are also derived from arrangements in which the Company enables

Block licenses are per-unit licenses made in large volume quantities to an OEM for products either in or about to enter into distribution into the marketplace. Payment schedules for block licenses are negotiable and payment terms are often dependent on the size of the block and other terms and conditions of the block license being acquired. Typically, payments are made in either one lump sum or over a period of four or more quarters.

Revenue received for block licenses is recognized in accordance with Statement of Position 97-2, which requires that revenue be recognized after acceptance by the OEM and if fees are fixed or determinable and the collection of fees is probable. For block licenses that have a significant portion of the payments due within twelve months, revenue is recognized at the time the block license becomes effective. When more than 10% of the payments of fees extend beyond a twelve-month period, they are recognized as revenues when they are due for payment.

The Company also has engineering services revenues that are derived primarily from adapting Company and third party software and supporting electronics to specific OEM requirements. The Company provides its engineering services to OEMs seeking a turnkey imaging solution for their digital document products. The Company’s maintenance revenues are derived from software maintenance agreements. Maintenance revenues currently constitute a small portion of total revenue.

As part of the total solution offered to its OEMs, the Company developed a direct distribution channel for its ASIC chips. Under this “fabless” model, Peerless supplies ASIC chips from the foundry directly to the OEMs through third party distributors, which include Arrow Electronics and Marubun Corporation. The Company is responsible for marketing and sales administration, including the billings and collections to and from its OEMs and distributors, and the third party is responsible for the coordination of production with the foundry, maintenance of necessary inventories, and providing just-in-time delivery to OEMs and distributors.

In response to the Company’s belief that the demand for the Company’s core monochrome offerings may grow at lower rates than in past years and that the Company may continue to meet sales resistance from its customers for its monochrome offerings, Peerless has recently developed and commercialized high performance color imaging and printing technologies and a new open architecture called “Peerless Sierra Technologies.” Peerless believes that products based on its Peerless Sierra Technologies address key growth areas in the imaging market including: increased demand for color imaging, the emergence of MFPs, and continued demand for faster low cost monochrome printing solutions, to which many of the Peerless Sierra Technologies attributes are applicable.

Subsequent to October 31, 2004, the Company began shipping its Peerless Sierra Technologies Everest controllers to distributors of Konica Minolta Corporation MFPs for evaluation. As of December 14, 2004, the Company had shipped units for evaluation to 28 dealers.

In addition, the Company is continuing to explore opportunities to enhance the value of the Company, including new market opportunities, mergers, acquisitions, spin-offs, and/or the sale of all or a portion of the Company’s assets.

Compared to January 31, 2004, total assets at October 31, 2004 decreased 43% to $11.0 million and stockholders’ equity decreased 55% to $5.3 million, primarily the result of the net loss during the nine months ended October 31, 2004. The Company’s cash and investment portfolio at October 31, 2004 was $4.4 million, down from $9.4 million as of January 31, 2004, and the ratio of current assets to current liabilities was 1.6:1, which is lower than the 2.3:1 ratio as of January 31, 2004. The decrease was primarily the result of the operating losses incurred during the nine months ended October 31, 2004. The Company’s operations used $4.8 million in cash during the nine months ended October 31, 2004, compared to $6.8 million in cash used by operations during the nines months ended October 31, 2003.

During the nine months ended October 31, 2004, $1.4 million in cash was provided by the Company’s investing activities. It is the Company’s policy to invest the majority of its unused cash in low risk government and commercial debt securities. The Company has not historically purchased, nor does it expect to purchase in the future, derivative instruments or enter into hedging transactions. During both the nine months ended October 31, 2004 and 2003, the Company invested $0.2 million in property, equipment and leasehold improvements.

At October 31, 2004, the Company’s principal source of liquidity, cash, cash equivalents and investments, was $4.4 million, a decrease of $5.0 million from January 31, 2004, compared to a decrease of $5.6 million in the comparable period in fiscal year 2004.

At the end of the third quarter the Company entered into a new credit facility with Silicon Valley Bank. The facility allows the Company to borrow up to a maximum of $4.0 million against qualified accounts receivable. Any borrowings against this facility would be made at prime plus 2.75% and are repaid with the collection of the individual receivable financed. The Company is required to maintain a quarterly tangible net worth in excess of $2.5 million. The Company issued 30,535 warrants with an exercise price of $1.31 to the bank in connection with this facility. The warrants expire on October 27, 2009. The cost of the facility, including the fair value of warrants issued of $23,900, was $68,600, which has been capitalized and will be amortized over the term of the agreement, which is one year.

During the quarter ended July 31, 2004, the Company, nearing the completion of its current Peerless Sierra Technologies development efforts, reduced its staffing level through a reduction-in-force. As a result of this action, the Company incurred a liability for severance payments of approximately $263,000. As of October 31, 2004, approximately $18,000 remained unpaid.

The Company believes that the net cash provided by operating activities, supplemented as necessary with borrowings available under its existing credit facility and existing cash and equivalents, will provide the Company with sufficient resources to meet working capital requirements and other cash needs over the next year. If the Company does not generate anticipated cash flow from sales, or if expenditures are greater than expected, the Company most likely will reduce discretionary spending, which would require the Company to delay, scale back or eliminate some or all of its development efforts, any of which could have a material adverse effect on the Company’s business, results of operations and prospects. Further, if the Company continues to experience negative cash flows, as is anticipated, and is unable to increase revenues or cut costs so that revenues generated from operating activities are sufficient to meet the Company’s obligations, the Company will exhaust its current capital resources, and will be required to obtain additional capital from other sources. Such sources might include issuance of debt or equity securities, bank financing or other means that might be available to the Company to increase its working capital. Under such circumstances, there is substantial doubt as to whether the Company would be able to obtain additional capital on commercially acceptable terms or at all. The inability to obtain such resources on commercially acceptable terms would have a material adverse effect on the Company, its operations, liquidity and financial condition, its prospects and the scope of strategic alternatives and initiatives available to the Company.

The Company’s net loss in the three months ended October 31, 2004 was $(1.3) million, or $(0.08) per share, compared to a net loss of $(2.5) million, or $(0.16) per share, in the comparable three month period ended October 31, 2003.

Consolidated revenues in the three months ended October 31, 2004 were $5.0 million, compared to $5.8 million in the comparable three month period ended October 31, 2003. ASIC sales were $75,000 in the three months ended October 31, 2004, compared to $522,000 in the comparable three month period ended October 31, 2003. The decline in revenues was due primarily to a delay in a shipment from the Company’s manufacturer to its distributor, delaying the recognition of $0.5 million in revenues until the fourth quarter.

Total cost of revenues in the three months ended October 31, 2004 was $2.1 million, compared to $2.8 million in the comparable three month period ended October 31, 2003. Product licensing costs were 17% lower in the current fiscal year period than in the comparable prior year period, due to a lower proportion of third-party technology included in certain of the Company’s licensing revenues. In addition, lower levels of revenues in engineering services and maintenance and ASICs sales resulted in decreased cost of revenues.

The Company’s gross margin in the three months ended October 31, 2004 was 58%, compared to 52% in the comparable three month period ended October 31, 2003. The increase was due primarily to the lower level of product licensing costs for third party technology associated with certain of the Company’s licensing revenues.

Total operating expenses during the three months ended October 31, 2004 were $4.2 million, compared to $5.7 million in the comparable three month period ended October 31, 2003.


	•	Research and development expenses decreased 19% to $2.6 million in the third quarter of fiscal year 2005 from $3.2 million in the comparable quarter in fiscal year 2004. The decrease was due to management cost controls and the reduced level of effort associated with the development of Peerless Sierra Technologies. The Company believes such expenses will decrease in future periods, as the development of Peerless Sierra Technologies nears completion.

	•	Sales and marketing expenses decreased 44% to $0.7 million in the third quarter of fiscal year 2005 from $1.2 million in the comparable quarter of fiscal year 2004. The decrease was the result of a reduction in staffing levels. The Company continued to focus on the launch of Peerless Sierra Technologies and on developing new OEM customers, attending industry trade shows, and evaluating other opportunities to promote the Company’s core and new imaging and network solutions. The Company believes such expenses will remain relatively flat in future periods.

	•	General and administrative expenses decreased 26% to $0.9 million in the second quarter of fiscal year 2005 from $1.3 million in the comparable quarter in fiscal year 2004. The decrease is primarily related to reduced staffing levels and legal expenses. The Company believes such expenses will remain relatively flat in future periods.

On July 1, 2004, a new tax treaty between Japan and the United States became effective, resulting in the elimination of Peerless’ Japanese customers’ requirements to withhold taxes on royalty payments to the Company. Provision for income taxes was $31,000 in the three months ended October 31, 2004, compared to a benefit for income taxes of $100,000 in the three months ended October 31, 2003. In the three months ended October 31, 2003, the tax benefit was the result of foreign income taxes paid, offset by the release of certain long-term tax liabilities.

The Company’s net loss in the nine months ended October 31, 2004 was $(6.9) million, or $(0.44) per share, compared to a net loss of $(5.5) million, or $(0.35) per share, in the comparable nine month period ended October 31, 2003.

Consolidated revenues in the nine months ended October 31, 2004 were $14.8 million, compared to $17.6 million in the comparable nine month period ended October 31, 2003. The decrease was due to lower product licensing, engineering services and maintenance revenues, and ASICs revenues.

Total cost of revenues in the nine months ended October 31, 2004 was $6.2 million, compared to $8.4 million in the comparable nine month period ended October 31, 2003. Product licensing costs were $3.1 million in the first nine months of the current fiscal year, compared to $5.4 million in the first nine months of the last fiscal year; this decrease was the primary reason for the lower level of cost of revenues. The decrease in product licensing costs was due to lower levels of product licensing revenues, and proportionately lower levels of third-party technology in certain of the Company’s product licensing revenues of the current fiscal year as compared to the prior fiscal year.

The Company’s gross margin in the nine months ended October 31, 2004 was 58%, compared to 52% in the comparable nine month period ended October 31, 2003. The improvement in the gross margin was primarily the result of lower product licensing costs, as discussed above.

Total operating expenses in the nine months ended October 31, 2004 were $15.4 million, compared to $15.8 million in the comparable nine month period ended October 31, 2003.


	•	Research and development expenses increased 5% to $9.0 million in the first nine months of fiscal year 2005 from $8.6 million in the comparable period in fiscal year 2004. The increase was primarily the result of higher staffing and consulting costs associated with the continued development of the Company’s Peerless Sierra Technologies. The majority of the increase occurred in the first quarter of this fiscal year; research and development expenses increased only 4% in the second quarter, and, as previously discussed, decreased 19% in the third quarter of fiscal year 2005 as compared to the second and third quarters of fiscal year 2004, reflecting cost reductions as the Company neared the completion of the development of its Peerless Sierra Technologies.

	•	Sales and marketing expenses decreased 18% to $2.9 million for the first nine months of fiscal year 2005, as compared to $3.6 million in the first nine months of fiscal year 2004. The decrease was due to a reduction in staffing levels. The Company continued to focus on the future launch of Peerless Sierra Technologies and on developing new OEM customers, attending industry trade shows, and evaluating other opportunities to promote the Company’s core and new imaging and network solutions.

	•	General and administrative expenses decreased 5% to $3.4 million in the first nine months of fiscal year 2005 from $3.6 million in the comparable period in fiscal year 2004. Costs in the first nine months of fiscal year 2004 were lower due largely to the receipt of a $0.2 million insurance refund for costs associated with completed legal proceedings.

Other income in the nine months ended October 31, 2003 included a gain of $1.0 million, net of expenses, associated with the Company’s sale of its remaining interest in Netreon, Inc., which was announced on February 20, 2003. In the same period, the Company recorded a gain of $0.6 million associated with the termination of a sublease of a portion of its leased office space in its headquarters in El Segundo, California, and recorded a $121,000 loss for a correction to fiscal year 2002 reported accrued interest.

The provision for income taxes for the nine months ended October 31, 2004 was $150,000, compared to $492,000 for the nine months ended October 31, 2003. The decrease was primarily the result of the new tax treaty between Japan and the United States, as discussed above, and lower levels of licensing revenues in the first quarter of fiscal year 2005. This was partially offset by the release of certain long-term tax liabilities in the first quarter of fiscal year 2004.

The Company is exposed to a variety of risks in its investments, mainly a lowering of interest rates. The primary objective of the Company’s investment activities is to preserve the principal of its investments, while at the same time maximizing yields without significantly increasing risk. To achieve this objective, the Company from time to time maintains its portfolio of cash equivalents, fixed rate debt instruments of the U.S. Government and high-quality corporate issuers and short-term investments in money market funds. Although the Company is subject to interest rate risks, the Company believes an effective increase or decrease of 10% in interest rate percentages would not have a material adverse effect on its results of operations.

The Company has not entered into any derivative financial instruments. Currently all of the Company’s contracts, including those involving foreign entities, are denominated in U.S. dollars. The Company has experienced no foreign exchange gains or losses to date. The Company has not engaged in foreign currency hedging activities to date and has no intention of doing so. The Company’s international business is subject to risks typical of an international business including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and to a lesser extent foreign exchange rate volatility. Accordingly, the Company’s future results could be materially and adversely affected by changes in these or other factors.

The Company has traditionally generated its revenue from the licensing and sale of monochrome solutions to OEMs. While the Company is continuing to provide monochrome solutions to OEM customers and continuing to seek out additional distribution channels and customers for its monochrome solutions, the Company is increasing the focus of its research and development and marketing efforts on its Peerless Sierra Technologies product line of high speed, color imaging solutions. Until the Company’s Peerless Sierra Technologies becomes accepted in the marketplace — if such technology does become accepted in the marketplace — the Company’s overall revenue may stagnate or even decrease. If the Company’s revenue stagnates or decreases, the value of the Company’s securities may be adversely affected.

The Company’s future operating results will depend to a significant extent on the Company’s success on its new Peerless Sierra Technologies. The Company has spent a significant amount of time and capital developing its new Peerless Sierra Technologies. Any significant problems associated with the launch of channel sales or a delay in licensing its Sierra Technologies in the future could harm the Company’s financial results.

Peerless Sierra Technologies may not be accepted by the marketplace for many reasons including, among others, incompatibility with existing or forthcoming systems, lack of perceived need by customers, uncertainty whether the products’ benefits exceed their cost, the availability of alternatives, and unwillingness to use new or unproven products. If the marketplace does not accept the Company’s Peerless Sierra Technologies or if the marketplace takes additional time to accept the Peerless Sierra Technologies than Peerless is expecting, the Company’s future revenues and operating results may be harmed.

The Company plans to maintain inventories to fill orders for its Peerless Sierra Technologies products on a timely basis. If the forecasts of expected orders are overstated, inventory levels may be too high, and if inventories cannot be liquidated through product orders, the Company may be required to write down the value of any excess unrealizable inventories, which would negatively impact our gross margin.

The Company’s cash and short-term investment portfolio was $4.4 million and the current ratio of current assets to current liabilities was 1.6:1 at October 31, 2004. For the nine months ended October 31, 2004, Peerless’ operations used $4.8 million in cash.

The Company’s principal source of liquidity is its cash and cash equivalents and investments, which, as of October 31, 2004 were approximately $4.4 million in the aggregate. If Peerless does not generate anticipated cash flow from licensing and services, or if expenditures are greater than expected, Peerless most likely will reduce further discretionary spending, which could require a delay, scaling back or elimination of some or all of the Company’s development efforts, any of which could have a material adverse effect on the Company’s business, results of operations and prospects. Furthermore, if Peerless experiences negative cash flows greater than anticipated, and Peerless is unable to increase revenues or cut costs so that revenues generated from operating activities are sufficient to meet the Company’s obligations, Peerless will be required to obtain additional capital from other sources. Such sources might include issuances of debt or equity securities, bank financing or other means that might be available to increase the Company’s working capital. Under such circumstances, there is substantial doubt as to whether Peerless would be able to obtain additional capital on commercially acceptable terms or at all. The inability to obtain such resources on commercially acceptable terms could have a material adverse effect on the Company’s operations, liquidity and financial condition, the Company’s prospects and the scope of strategic alternatives and initiatives available to the Company. Peerless recently established a credit facility with its bank that allows for borrowing against outstanding receivables. The credit facility generally only provides coverage for short-term working capital needs and the Company may require additional long-term capital to finance working capital requirements.

Traditionally, the Company has generated its revenue from engineering services through engineering turnkey solutions for OEMs or licensing the Company’s SDKs to OEMs. In order to gain market acceptance for its new Peerless Sierra Technologies, as well as to make its current technologies more attractive, the Company may enter into contracts with OEMs wherein the Company may agree to provide initial customization and maintenance services without charge in order to obtain increased license revenues in the future. Under these contracts, the Company would normally recover development expenses through recurring license fees. The contracting OEM would normally be asked to guarantee minimum licensing fees. However, the Company may elect to take certain risks with the contracting OEM by not requiring minimums and the Company would have no guarantee or assurance that the contracting OEMs would sell the products that contain the Company’s technology. If the OEMs under these contracts do not sell sufficient numbers of the product containing the Company’s technology, the Company may be unable to make up for the engineering services revenue lost. If the Company is unable to make up for the lost engineering services revenue, the Company’s overall revenue may decrease — which may adversely affect the price of the Company’s securities.

Peerless was unprofitable in the first three fiscal quarters of fiscal year 2005. There is no assurance that the Company will be profitable at any time in the future.

Future losses will deplete the Company’s capital resources. The factors noted in this section, “Certain Factors and Trends Affecting Peerless and Its Business,” have had and may continue to have a material adverse effect on the Company’s future revenues and/or results of operations.

Peerless’ monochrome technology and products have been in the marketplace for an average of 27 months as of October 31, 2004. This is an 8% decrease from the average of 25 months that the Company’s products had been in the marketplace as of October 31, 2003. Although Peerless continues to license the Company’s current technology and products to certain OEMs, there can be no assurance that the OEMs will continue to need or utilize the current technology and products the Company offers.

A limited number of OEM customers continue to provide a substantial portion of Peerless’ revenues. Presently, there are only a small number of OEM customers in the digital document product market to which the Company can market its technology and services. Therefore, the Company’s ability to offset a significant decrease in the revenues from a particular customer or to replace a lost customer is severely constrained.

During the third quarter of fiscal year 2005, four customers, Konica Minolta Corporation, Kyocera Mita Corporation, Novell Inc., and Seiko Epson Corporation, each generated greater than 10% of the Company’s revenues and collectively contributed 83% of such revenues. Block license revenues for the same time period totaled $3.2 million, or 63% of the Company’s revenues. During the third quarter of fiscal year 2004, four customers, Oki Data Corporation, Konica Minolta Corporation, Seiko Epson Corporation, and Novell Inc., each generated greater than 10% of the Company’s revenues, and collectively contributed 77% of such revenues. Block license revenues during the same period were $3.4 million, or 59% of the Company’s revenues.

The Company has licensing agreements with Adobe Systems Incorporated and Novell Inc. to bundle and sublicense their licensed products with the Company’s licensed software. These relationships accounted for $3.5 million in revenues and an associated $1.4 million in cost of revenues during the third quarter of fiscal year 2005. Should the Company’s agreements with any of these vendors be terminated or canceled, there is no assurance that the Company could replace the affected source of revenue in a timely manner, if at all. Such an event would have a material adverse effect on the Company’s operating results.

The Company’s licensing agreements that include third party intellectual property result in royalties contractually due and payable to the third parties. The rates are subject to interpretation of contract language and intent of the contracting parties, and may result in disputes as to the correct rates. Peerless is subject to audits of the Company’s data serving as the basis for the royalties due. Such audits may result in adjustments to the royalty amounts due, which could have a material adverse effect on the Company’s operating results.

Peerless has negotiated with Canon Inc. regarding the PostScript sublicense agreement between Peerless and Canon executed as of April 1, 2001. The sublicense did not include several terms required to be included in all OEM sublicenses by Peerless’ license with Adobe. Although Adobe has indicated to Peerless that it has no current intention to pursue claims for alleged breach of the Adobe Peerless PostScript Sublicensing Agreement, Adobe has not agreed to waive the requirement that the missing terms be included in the Canon

sublicense. To date, Peerless has been unable to amend the Canon sublicense in a manner acceptable to both Canon and Adobe. Furthermore, there is no assurance that Peerless will be able to resolve the issues in manner acceptable to both Adobe and Canon. Thus, Adobe may exercise its right to terminate its license agreement with Peerless and take other legal action against Peerless, if it so chooses. Termination of the Adobe agreement would have a material adverse effect on Peerless’ future operating results. Approximately 60% of Peerless’ revenue for the nine months ended October 31, 2004 and approximately 57% of Peerless’ revenue for the nine months ended October 31, 2003 were derived from its licensing arrangement with Adobe Systems Incorporated. See “Peerless relies on relationships with Adobe Systems Incorporated and Novell Inc., and any adverse change in those relationships will harm the Company’s business.”

Peerless currently derives substantially all of its revenues from licensing and sale of the Company’s monochrome imaging software and products and the sublicensing of third party technologies. Peerless expects that revenue from imaging products will continue to account for a substantial portion of revenues during fiscal year 2005 and beyond. The Company’s future success also depends in part on the Company’s ability to address the rapidly changing needs of potential customers in the marketplace, to introduce high-quality, cost-effective products, product enhancements and services on a timely basis, and to keep pace with technological developments and emerging industry standards. The Company’s failure to achieve its business plan to develop and to successfully introduce new products and product enhancements in the Company’s prime markets is likely to materially and adversely affect the Company’s business and financial results.

Peerless currently sublicenses third party technologies to the Company’s OEM customers; such sublicenses account for a significant amount of the Company’s gross revenues. Such sublicense agreements are non-exclusive. If Peerless is determined not to be in compliance with the Company’s agreements with its licensors, Peerless may forfeit the Company’s right to sublicense these technologies. Likewise, if such sublicense agreements were canceled, Peerless would lose the Company’s right to sublicense the affected technologies. Additionally, the licensing of these technologies has become very competitive with competitors possessing substantially greater financial and technical resources and market penetration than Peerless. As competitors are pursuing aggressive strategies to obtain similar rights as held by Peerless to sublicense these third party technologies, there is no assurance that Peerless can remain competitive in the marketplace if one or more competitors are successful. See “The Company has negotiated with Adobe Systems Incorporated and Canon, Inc. to remedy a contract dispute, which, if not remedied, could result in the loss of the Adobe agreement and harm to the Company’s business.”

The market for imaging systems for digital document products is highly competitive and characterized by continuous pressure to enhance performance, to introduce new features and to accelerate the release of new products. Peerless competes on the basis of technology expertise, product functionality, development time and price. Peerless’ technology and services primarily compete with solutions developed internally by OEMs. Virtually all of the Company’s OEM customers have significant investments in their existing solutions and have the substantial resources necessary to enhance existing products and to develop future products. These OEMs possess or may develop competing imaging systems technologies and may implement these systems into their products, thereby replacing the Company’s current or proposed technologies, eliminating a need for the Company’s services and products and limiting the Company’s future opportunities. Therefore, Peerless must persuade these OEMs to outsource the development of their imaging systems to the Company and to provide products and solutions to these OEMs that cost-effectively compete with their internally developed

As the digital document printing industry continues to develop, competition and pricing pressures will increase from OEMs, existing competitors and other companies that may enter the Company’s existing or future markets with similar or substitute solutions that may be less costly or provide better performance or functionality. Peerless anticipates increasing competition for the Company’s color products under development, particularly as new competitors develop and enter products in this marketplace. Some of the Company’s existing competitors, many of the Company’s potential competitors, and virtually all of the Company’s OEM customers have substantially greater financial, technical, marketing and sales resources than Peerless. If price competition increases, competitive pressures could require the Company to reduce the amount of royalties received on new licenses and to reduce the cost of the Company’s engineering services in order to maintain existing business and generate additional product licensing revenues. This could reduce profit margins and result in losses and a decrease in market share. No assurance can be given as to the Company’s ability to compete favorably with the internal development capabilities of the Company’s current and prospective OEM customers or with other third party digital imaging system suppliers and the inability to do so would have a material adverse effect on the Company’s operating results.

The Company’s net trade accounts receivable was $1.7 million as of October 31, 2004, a decrease from $6.1 million as of January 31, 2004. The decrease is primarily due to the lower level of revenues in the third quarter of fiscal year 2005 as compared to the fourth quarter of fiscal year 2004, and to the timing of collections of the amounts due from those contracts. Although Peerless believes that the Company’s reserves for accounts receivable are adequate for the remainder of fiscal year 2005, there can be no assurance this is the case. If the Company’s reserves for accounts receivable are inadequate, it could have a material adverse effect on the Company’s results of operations.

The Company’s success is heavily dependent upon the Company’s proprietary technology. To protect the Company’s proprietary rights, Peerless relies on a combination of patent, copyright, trade secret and trademark laws, as well as the early implementation and enforcement of nondisclosure and other contractual restrictions. As part of the Company’s confidentiality procedures, Peerless’ policies are to enter into written nondisclosure agreements with the Company’s employees, consultants, prospective customers, OEMs and strategic partners and to take affirmative steps to limit access to and distribution of the Company’s software, intellectual property and other proprietary information.

Despite these efforts, Peerless may be unable to effectively protect the Company’s proprietary rights and the enforcement of the Company’s proprietary rights may be cost prohibitive. Unauthorized parties may attempt to copy or otherwise obtain, distribute, or use the Company’s products or technology. Monitoring unauthorized use of the Company’s products is difficult. Peerless cannot be certain that the steps it takes to prevent unauthorized use of its technology, particularly in countries where laws may not protect proprietary rights as fully as in the United States, will be effective.

The Company’s source code also is protected as a trade secret. However, from time to time Peerless licenses the Company’s source code to OEMs, which subjects the Company to the risk of unauthorized use or misappropriation despite the contractual terms restricting disclosure, distribution, copying, and use. In addition, it may be possible for unauthorized third parties to copy the Company’s products or to reverse engineer the Company’s products in order to obtain and subsequently use and distribute the Company’s proprietary information.

The Company holds patents issued in the United States, France, Germany, Great Britain, Japan, Taiwan and Hong Kong. The issued patents relate to techniques developed by the Company for generating output for

continuous synchronous raster output devices, such as laser printers, compressing data for use with output devices, filtering techniques for use with output devices and communicating with peripheral devices over a network.

The Company also has patent applications pending in the United States, the European Patent Office, Japan, Hong Kong, Taiwan, China, Australia, Korea, and India.

There can be no assurance that patents Peerless holds will not be challenged or invalidated, that patents will issue from any of the Company’s pending applications or that any claims allowed from existing or pending patents will be of sufficient scope or strength (or issue in the countries where products incorporating the Company’s technology may be sold) to provide meaningful protection or any commercial advantage to the Company. In any event, effective protection of intellectual property rights may be unavailable or limited in certain countries. The status of United States patent protection in the software industry will evolve as the United States Patent and Trademark Office grants additional patents. Patents have been granted to fundamental technologies in software after the development of an industry around such technologies and patents may be issued to third parties that relate to fundamental technologies related to the Company’s technology.

As the number of patents, copyrights, trademarks and other intellectual property rights in the Company’s industry increases, products based on the Company’s technologies may become the subjects of infringement claims. There can be no assurance that third parties will not assert infringement claims against the Company in the future. Any such claims, regardless of merit, could be time consuming, divert the efforts of the Company’s technical and management personnel from productive tasks, result in costly litigation, cause product shipment delays or require the Company to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to the Company, or at all, which could have a material adverse effect on the Company’s operating results. In addition, Peerless may initiate claims or litigation against third parties for infringement of the Company’s proprietary rights or to establish the validity of the Company’s proprietary rights. Litigation to determine the validity of any claims, whether or not such litigation is determined in the Company’s favor, could result in significant expenses and divert the efforts of the Company’s technical and management personnel from productive tasks. In addition, Peerless may lack sufficient resources to initiate a meritorious claim. In the event of an adverse ruling in any litigation regarding intellectual property, Peerless may be required to pay substantial damages, discontinue the use and sale of infringing products, and expend significant resources to develop non-infringing technology or obtain licenses to infringing or substituted technology. The Company’s failure to develop, or license on acceptable terms, a substitute technology if required could have a material adverse effect on the Company’s operating results.

The Company is substantially dependent on its international business activities. Risks inherent in the Company’s international business activities include:


	•	disruptions, including by terrorists, of normal channels of distribution;

	•	disruptions, including by terrorists, of normal communications lines;

	•	major currency rate fluctuations;

	•	changes in the economic condition of foreign countries;

	•	the imposition of government controls;

	•	tailoring of products to local requirements;

	•	trade restrictions;

	•	changes in tariffs and taxes; and

	•	the burdens of complying with a wide variety of foreign laws and regulations, any of which could have a material adverse effect on the Company’s operating results.

If the Company is unable to adapt to international conditions, its business may be adversely affected.

During the past several years, and continuing into fiscal year 2005, the economies of Pacific Rim countries have been financially depressed. As a result, companies in the imaging industry have reported negative financial impacts attributable to a decrease in demand from Pacific Rim customers. The Company’s Pacific Rim customers are comprised primarily of companies headquartered in Japan. These Japanese OEMs sell products containing the Company’s technology primarily in the North American, European, and Asian marketplaces. These revenues have declined and there can be no assurance that revenues from Japanese OEMs will not continue to decline in future quarters.

The Company’s common stock has experienced price volatility. In the 60-day period ending December 8, 2004, the closing price of the Company’s common stock ranged from $1.19 per share to $1.57 per share. During the same period, daily volume for the Company’s common stock has ranged from 1,100 shares traded to 392,700 shares traded. Such price and volume volatility may occur in the future. Factors that could affect the trading price and volume of the Company’s common stock include:


	•	macroeconomic conditions;

	•	actual or anticipated fluctuations in quarterly results of operations;

	•	announcements of new products or significant technological innovations by the Company or its competitors;

	•	developments or disputes with respect to proprietary rights;

	•	losses of major OEM customers;

	•	general trends in the industry; and

	•	overall market conditions and other factors.

In addition, the stock market historically has experienced extreme price and volume fluctuations, which have particularly affected the market price of securities of many related high technology companies and which at times have been unrelated or disproportionate to the operating performance of such companies.

On July 30, 2004, the Company announced that its common stock had been transferred from the Nasdaq National Market to the Nasdaq SmallCap Market. There can be no assurance, however, that the Company will be able to maintain compliance with the continued listing standards of the Nasdaq SmallCap Market. For example, if the minimum bid price of the Company’s common stock falls below $1.00, and remains below $1.00 for thirty consecutive business days, the Company will not be in compliance with the Nasdaq SmallCap Market minimum bid requirements under Marketplace Rule 4310(c)(4).

If Peerless is not able to maintain compliance, the Company’s common stock may be subject to removal from listing on the Nasdaq SmallCap Market. Trading in the Company’s common stock after a delisting, if any, would likely be conducted in the over-the-counter markets in the so-called “pink sheets” or the National Association of Securities Dealers’ Electronic Bulletin Board and could also be subject to additional restrictions. As a consequence of a delisting, the Company’s stockholders would find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, the Company’s common stock. In addition, a delisting would make the Company’s common stock substantially less attractive as collateral for margin and purpose loans, for investment by financial institutions under their internal policies or state legal investment laws or as consideration in future capital raising transactions.

Peerless has developed a “fabless” distribution model for the sale of ASICs. Peerless has no direct distribution experience and places reliance on third party distributors to maintain inventories to address OEM needs, manage manufacturing logistics, and distribute the Company’s products in a timely manner. There can be no assurance that these distribution agreements will be maintained or will prove adequate to meet the Company’s needs and contractual requirements.

Currently, Peerless relies on two independent parties, IBM Microelectronics and NEC Microelectronics, each of which provides unique ASICs incorporating the Company’s imaging technology for use by the Company’s OEMs. These sole source providers are subject to materials shortages, excess demand, reduction in capacity and/or other factors that may disrupt the flow of goods to the Company’s customers thereby adversely affecting the Company’s customer relationships. Any such disruption could limit or delay production or shipment of the products incorporating the Company’s technologies, which could have a material adverse effect on the Company’s operating results.

The Company’s recurring licensing revenue model has shifted from per-unit royalties paid upon OEM shipment of its products and guaranteed quarterly minimum royalties to a model that results in revenues associated with the sale of SDKs and block licenses. The reliance on block licenses has occurred due to aging OEM products in the marketplace, OEM demands in negotiating licensing agreements, reductions in the number of OEM products shipping and a design win mix that changed from object code licensing arrangements to SDKs. Revenues may continue to fluctuate significantly from quarter to quarter as the number and value of design wins vary, or if the signing of block licenses are delayed or the licensing opportunities are lost to competitors. Any of these factors could have a material adverse effect on the Company’s operating results.

Peerless has experienced a significant reduction in the financial performance of its engineering services that has been caused by many factors, including:


	•	product development delays;

	•	potential non-recurring engineering reduction for product customization (see “The Company’s near term revenue from engineering services may drop as the Company may change its strategies in how it offers its products in the marketplace”);

	•	third party delays; and

	•	losses of new engineering services contracts.

There can be no assurance that these and similar factors will not continue to impact future engineering services results adversely.

The industry in which Peerless operates has experienced significant downturns, both in the United States and abroad, often in connection with, or in anticipation of, maturing product cycles and declines in general economic conditions. Over the past two years, Peerless has experienced a shift in OEM demand from the historically prevailing requirement for turnkey solutions toward SDKs. Because Peerless has experienced a

general decrease in demand for engineering services, engineering services resources have been re-deployed to research and development. Should this trend abruptly change, Peerless may be unable to re-deploy its employees effectively and in a timely manner, which inability could have a material adverse effect on the Company’s operational results.

The Company’s ability to implement the Company’s business plan, develop and offer products and manage expansion in rapidly developing and disparate marketplaces requires comprehensive and effective planning and management. The growth in the complexity of business relationships with current and potential customers and third parties has placed, and will continue to place, a significant strain on management systems and resources. The Company’s failure to continue to improve upon the operational, managerial and financial controls, reporting systems and procedures in its imaging business or the Company’s failure to expand and manage its workforce could have a material adverse effect on the Company’s business and financial results.

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rule 13a-15(b) under the Securities Exchange Act of 1934, the Company carried out an evaluation, under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the disclosure controls and procedures. Based on the foregoing, the Chief Executive Officer and Chief Financial Officer concluded that, as of end of the period covered by this report, the Company’s disclosure controls and procedures were effective at ensuring that the information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized, and reported as required in applicable SEC rules and forms.

There have been no changes in the Company’s internal controls over financial reporting during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

On October 27, 2004, the Company entered into a new credit facility with Silicon Valley Bank. The facility will allow the Company to borrow up to a maximum of $4.0 million against qualified accounts receivable. Any borrowings against this facility would be made at prime plus 2.75% and are repaid with the collection of the individual receivable financed. The Company is required to maintain a quarterly tangible net worth in excess of $2.5 million. The cost of the facility was $68,600, which has been capitalized and will be amortized over the term of the agreement, which is one year. The Company issued 30,535 warrants to the bank with an exercise price of $1.31 in connection with this facility. The warrants expire on October 27, 2009.

Effective October 15, 2004, the Company entered into Amendment No. 17 to the Postscript Software Development License and Supplement Agreement with Adobe Systems Incorporated. The amendment gives to the Company permission to develop and distribute Adobe software under Peerless’ own brands and amends testing and certification processes for Peerless-branded licensed systems.

On October 1, 2004, the Company entered into an amendment to its lease agreement with BIT Holdings Forty-Eight, Inc., its landlord for the Company’s office space in Kent, Washington. The amendment extends the lease on the facility through May 31, 2010 and includes a monthly rent schedule through this date.

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:


	By:	/s/ HOWARD J. NELLOR



	Howard J. Nellor
	President and Chief Executive Officer
	(Principal Executive Officer)


	By:	/s/ WILLIAM R. NEIL



	William R. Neil
	Vice President of Finance and
	Chief Financial Officer
	(Principal Financial and Accounting Officer)


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

		For the quarterly period ended October 31, 2004

or

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

		For the transition period from to


Delaware		95-3732595
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

2381 Rosecrans Avenue, El Segundo, CA		90245
(Address of Principal Executive Offices)		(Zip Code)


		Page No.

PART I — FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets at October 31, 2004 and January 31, 2004		5
	Condensed Consolidated Statements of Operations for the Three and Nine Month Periods Ended October 31, 2004 and 2003		6
	Condensed Consolidated Statements of Cash Flows for the Nine Month Periods Ended October 31, 2004 and 2003		7
	Notes to Condensed Consolidated Financial Statements		8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		21
Item 4.	Controls and Procedures		29

PART II — OTHER INFORMATION
Item 1.	Legal Proceedings		30
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		30
Item 3.	Defaults Upon Senior Securities		30
Item 4.	Submission of Matters to a Vote of Security Holders		30
Item 5.	Other Information		30
Item 6.	Exhibits		30
Signatures			31
Exhibit 10.83
Exhibit 10.84
Exhibit 10.85
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1


			October 31,			January 31,
			2004			2004

			(Unaudited)
ASSETS
Current assets:
	Cash and cash equivalents		$	2,039		$	5,069
	Short-term investments			2,404			4,341
	Trade accounts receivable, net			1,719			6,146
	Unbilled receivables			1,271			—
	Inventory			312			2
	Prepaid expenses and other current assets			831			620

		Total current assets		8,576			16,178
Property and equipment, net				1,565			1,981
Other assets				856			1,148

		Total assets	$	10,997		$	19,307


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	605		$	897
	Accrued wages			442			384
	Accrued compensated absences			805			805
	Accrued product licensing costs			2,618			2,834
	Income taxes payable			7			469
	Other current liabilities			287			428
	Deferred revenue			571			1,323

		Total current liabilities		5,335			7,140
Other liabilities				336			366

		Total liabilities		5,671			7,506

Stockholders’ equity:
	Common stock			15			15
	Additional paid-in capital			49,748			49,295
	Accumulated deficit			(44,359	)		(37,434	)
	Accumulated other comprehensive income			35			38
	Treasury stock			(113	)		(113	)

		Total stockholders’ equity		5,326			11,801

		Total liabilities and stockholders’ equity	$	10,997		$	19,307



			Three Months Ended						Nine Months Ended
			October 31,						October 31,

			2004			2003			2004			2003

Revenues:
	Product licensing		$	4,574		$	4,456		$	11,373		$	13,320
	Engineering services and maintenance			352			784			1,831			2,496
	Other			75			522			1,593			1,785

		Total revenues		5,001			5,762			14,797			17,601

Cost of revenues:
	Product licensing			1,488			1,796			3,126			5,403
	Engineering services and maintenance			593			729			2,468			2,245
	Other			39			233			648			786

		Total cost of revenues		2,120			2,758			6,242			8,434

		Gross margin		2,881			3,004			8,555			9,167

Operating expenses:
	Research and development			2,628			3,228			9,031			8,580
	Sales and marketing			660			1,173			2,908			3,561
	General and administrative			923			1,251			3,424			3,619

		Total operating expenses		4,211			5,652			15,363			15,760

Loss from operations				(1,330	)		(2,648	)		(6,808	)		(6,593	)

Interest income, net				15			21			33			91
Other income				—			—			—			1,490

		Total other income		15			21			33			1,581

Loss before income taxes				(1,315	)		(2,627	)		(6,775	)		(5,012	)
Provision for income taxes				31			(100	)		150			492

		Net loss	$	(1,346	)	$	(2,527	)	$	(6,925	)	$	(5,504	)

Basic and diluted loss per share			$	(0.08	)	$	(0.16	)	$	(0.44	)	$	(0.35	)

Weighted average common shares outstanding — basic and diluted				15,941			15,643			15,854			15,532

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	*Comparison of Quarters Ended October 31, 2004 and 2003*



					Percentage of
					Total Revenues						Percentage
					Three Months						Change
					Ended						Three Months
					October 31,						Ended
											October 31,
					2004			2003			2004 vs. 2003

Statements of Operations Data:
	Revenues:
		Product licensing				92	%		77	%		3	%
		Engineering services and maintenance				7			14			(55	)
		Other				1			9			(86	)

			Total revenues			100			100			(13	)

	Cost of revenues:
		Product licensing				29			31			(17	)
		Engineering services and maintenance				12			13			(19	)
		Other				1			4			(83	)

			Total cost of revenues			42			48			(23	)

				Gross margin		58			52			(4	)

	Operating expenses:
		Research and development				53			56			(19	)
		Sales and marketing				13			20			(44	)
		General and administrative				18			22			(26	)

			Total operating expenses			84			98			(26	)

		Loss from operations				(26	)		(46	)		(50	)
	Interest income, net					—			—			(29	)

	Loss before income taxes					(26	)		(46	)		(50	)

	Provision for income taxes					1			(2	)		(131	)

			Net loss			(27	)%		(44	)%		(47	)%



					Percentage of
					Total
					Revenues						Percentage
					Nine Months						Change
					Ended						Nine Months
					October 31,						Ended
											October 31,
					2004			2003			2004 vs. 2003

Statements of Operations Data:
	Revenues:
		Product licensing				77	%		76	%		(15	)%
		Engineering services and maintenance				12			14			(27	)
		Other				11			10			(11	)

			Total revenues			100			100			(16	)

	Cost of revenues:
		Product licensing				21			31			(42	)
		Engineering services and maintenance				17			13			10
		Other				4			4			(18	)

			Total cost of revenues			42			48			(26	)

				Gross margin		58			52			(7	)

	Operating expenses:
		Research and development				61			49			5
		Sales and marketing				20			20			(18	)
		General and administrative				23			20			(5	)

			Total operating expenses			104			89			(3	)

		Loss from operations				(46	)		(37	)		3

	Interest income, net					—			—			(64	)
	Other income					—			9			*

			Total other income			—			9			(98	)

	Loss before income taxes					(46	)		(28	)		35

	Provision for income taxes					1			3			(70	)

			Net loss			(47	)%		(31	)%		26	%


Item 3 —	*Quantitative and Qualitative Disclosures About Market Risk.*


	*The Company’s near term revenue may drop as a result of the timing of licensing revenues and the reduced demand for its existing monochrome technologies.*


	*If the Company is unable to achieve its expected level of sales of Peerless Sierra Technologies on a timely basis, the Company’s future revenue and operating results may be harmed.*


	*If the marketplace does not accept our new Peerless Sierra Technologies, the Company’s future revenue and operating results may be harmed.*


	*The Company’s forecasts for our Peerless Sierra Technologies may not be realized, and losses for the disposition of excess inventories may result.*


	*The Company’s existing capital resources may not be sufficient and if Peerless is unable to raise additional capital, the Company’s business may suffer.*


	*The Company’s near term revenue from engineering services may drop as the Company may change its strategies in how it offers its products in the marketplace.*


Item 1 —	*Financial Statements.*


1.	Basis of Presentation:


3.	Short-term Investments:


4.	Inventory:


	*Peerless has a history of losses and anticipates continued losses.*


	*The future demand for the Company’s current products is uncertain.*


	*Peerless relies on relationships with certain customers and any adverse change in those relationships will harm the Company’s business.*


	*The Company, as a sublicensor of third party intellectual property, is subject to audits of the Company’s licensing fee costs.*


	The Company has negotiated with Adobe Systems Incorporated and Canon Inc. to remedy a contract dispute, which, if not remedied, could result in the loss of the Adobe agreement and harm to the Company’s business.


	*Peerless may be unable to develop additional new and enhanced products that achieve market acceptance.*


	If Peerless is not in compliance with the Company’s licensing agreements, Peerless may lose the Company’s rights to sublicense technology; the Company’s competitors are aggressively pursuing the sale of licensed third party technology.


	The industry for imaging systems for digital document products involves intense competition and rapid technological changes, and the Company’s business may suffer if its competitors develop superior technology.


	*The Company’s reserves for accounts receivable may not be adequate.*


	If Peerless fails to adequately protect the Company’s intellectual property or face a claim of intellectual property infringement by a third party, Peerless could lose the Company’s intellectual property rights or be liable for damages.


	*The Company’s international activities may expose it to risks associated with international business.*


	*Demand from Pacific Rim customers has continued to and may continue to decline.*


	*The Company’s stock price may experience extreme price and volume fluctuations.*


	*The Company’s common stock was moved to the Nasdaq SmallCap Market and may not provide adequate liquidity.*


	*The Company’s business may suffer if the Company’s third party distributors are unable to distribute the Company’s products and address customer needs effectively.*


	Peerless relies on certain third party providers for applications to develop the Company’s ASICs. As a result, Peerless is vulnerable to any problems experienced by these providers, which may delay product shipments to the Company’s customers.


	*Peerless’ licensing revenue is subject to significant fluctuations.*


	*The Company’s revenue from engineering services is subject to significant fluctuations.*


	*Peerless may be unable to deploy the Company’s employees effectively in connection with changing demands from the Company’s OEM customers.*


	*Peerless may be unable to implement its business plan effectively.*