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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005
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: 1-16027
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LANTRONIX, INC.
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(Exact name of registrant as specified in its charter)
DELAWARE 33-0362767
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
15353 BARRANCA PARKWAY, IRVINE, CALIFORNIA
(Address of principal executive offices)
92618
(Zip Code)
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(949) 453-3990
(Registrant's telephone number, including area code)
Former name, former address and former fiscal year, if changed since
last report: N/A
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(D) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark whether the registrant is an accelerated filer
(as defined by Rule 12b-2 of the Exchange Act). Yes |_| No |X|.
As of May 4, 2005 58,775,571 shares of the Registrant's common stock
were outstanding.
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LANTRONIX, INC.
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2005
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION............................................. 3
Item 1. Financial Statements.............................................. 3
Unaudited Condensed Consolidated Balance Sheets at
March 31, 2005 and June 30, 2004................................ 3
Unaudited Condensed Consolidated Statements of Operations
for the Three and Nine Months Ended March 31, 2005 and 2004..... 4
Unaudited Condensed Consolidated Statements of Cash Flows
for the Nine Months Ended March 31, 2005 and 2004.............. 5
Notes to Unaudited Condensed Consolidated Financial Statements.... 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations....................................... 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk........ 33
Item 4. Controls and Procedures........................................... 33
PART II. OTHER INFORMATION................................................. 34
Item 1. Legal Proceedings................................................. 34
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds....... 34
Item 3. Defaults Upon Senior Securities................................... 34
Item 4. Submission of Matters to a Vote of Security Holders............... 34
Item 5. Other Information................................................. 34
Item 6. Exhibits ......................................................... 34
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
LANTRONIX, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS EXCEPT PER SHARE AND SHARE AMOUNTS)
MARCH 31, JUNE 30,
ASSETS 2005 2004
----- --------- ---------
Current Assets:
Cash and cash equivalents $ 6,610 $ 9,128
Marketable securities -- 3,050
Accounts receivable, net 2,650 3,242
Inventories 6,496 6,677
Contract manufacturers' receivable, net 600 999
Settlements receivable 1,300 --
Prepaid expenses and other current assets 744 1,450
--------- ---------
Total Current assets 18,400 24,546
Property and equipment, net 428 865
Goodwill 9,488 9,488
Purchased intangible assets, net 900 2,056
Officer loan 115 110
Other assets 165 185
--------- ---------
Total assets $ 29,496 $ 37,250
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current Liabilities:
Bank line of credit $ 125 $ 500
Accounts payable 3,696 4,049
Accrued payroll and related expenses 1,153 1,599
Warranty reserve 1,810 1,770
Restructuring reserve 311 752
Accrued settlements 1,300 --
Other current liabilities 2,459 2,922
Convertible note payable -- 867
--------- ---------
Total current liabilities 10,854 12,459
Commitments and contingencies
Stockholders' equity:
Preferred stock, $.0001 par value; 5,000,000 shares authorized;
none issued and outstanding -- --
Common stock, $0.0001 par value; 200,000,000 shares authorized;
58,733,619 and 58,154,747 shares issued and outstanding at
March 31, 2005 and June 30,2004, respectively 6 6
Additional paid-in capital 181,376 180,712
Deferred compensation (23) (103)
Accumulated deficit (163,020) (156,078)
Accumulated other comprehensive income 303 254
--------- ---------
Total stockholders' equity 18,642 24,791
--------- ---------
Total liabilities and stockholders' equity $ 29,496 $ 37,250
========= =========
See accompanying notes
3
LANTRONIX, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
Three Months Ended Nine Months Ended
March 31, March 31,
2005 2004 2005 2004
-------- -------- -------- --------
Net revenues (A) $ 12,303 $ 12,310 $ 36,256 $ 37,009
Cost of revenues (B) 6,614 5,393 18,754 18,292
-------- -------- -------- --------
Gross profit 5,689 6,917 17,502 18,717
-------- -------- -------- --------
Operating expenses:
Selling, general and adminstrative (C) 5,593 6,572 19,229 18,027
Research and development 1,293 2,042 5,013 5,587
Stock-based compensation (B) (C) 36 89 323 307
Amortization of purchased intangible assets 15 29 63 118
Restructuring recovery -- (2,098) -- (2,098)
-------- -------- -------- --------
Total operating expenses 6,937 6,634 24,628 21,941
-------- -------- -------- --------
(Loss) income from operations (1,248) 283 (7,126) (3,224)
Interest income, net 3 8 19 43
Other income (expenses), net (193) (103) 349 (283)
-------- -------- -------- --------
(Loss) income before income taxes (1,438) 188 (6,758) (3,464)
Provision for income taxes 70 72 240 208
-------- -------- -------- --------
(Loss) income from continuing operations (1,508) 116 (6,998) (3,672)
(Loss) income from discontinued operations -- (669) 56 (5,185)
-------- -------- -------- --------
Net loss $ (1,508) $ (553) $ (6,942) $ (8,857)
======== ======== ======== ========
Basic (Loss) income per share:
(Loss) income from continuing operations $ (0.03) $ 0.00 $ (0.12) $ (0.07)
(Loss) income from discontinued operations -- (0.01) -- (0.09)
-------- -------- -------- --------
Basic net (Loss) per share $ (0.03) $ (0.01) $ (0.12) $ (0.16)
======== ======== ======== ========
Diluted (Loss) income per share:
(Loss) income from continuing operations $ (0.03) $ 0.00 $ (0.12) $ (0.07)
(Loss) income from discontinued operations -- (0.01) -- (0.09)
-------- -------- -------- --------
Diluted net (Loss) per share $ (0.03) $ (0.01) $ (0.12) $ (0.16)
======== ======== ======== ========
Weighted average shares (basic) 58,642 57,295 58,381 56,236
======== ======== ======== ========
Weighted average shares (diluted) 58,642 58,087 58,381 56,236
======== ======== ======== ========
(A) Includes net revenues from related parties $ 280 $ 352 $ 896 $ 1,154
======== ======== ======== ========
(B) Cost of revenues includes the following:
Amortization of purchased intangible assets $ 363 $ 532 $ 1,092 $ 1,596
Stock based compensation -- 11 -- 37
-------- -------- -------- --------
$ 363 $ 543 $ 1,092 $ 1,633
======== ======== ======== ========
(C) Stock-based compensation is excluded from the following:
Selling, general and administrative expenses $ 6 $ 83 $ 154 $ 271
Research and development expenses 30 6 169 36
-------- -------- -------- --------
$ 36 $ 89 $ 323 $ 307
======== ======== ======== ========
See accompanying notes
4
LANTRONIX, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
NINE MONTHS ENDED
MARCH 31,
2005 2004
------- -------
Cash flows from operating activities:
Net loss $(6,942) $(8,857)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation 504 1,406
Amortization of purchased intangible assets 1,155 1,714
Stock based compensation 323 344
Provision for doubtful accounts 59 (161)
Inventory reserve 206 140
Loss on sale of fixed assets 23 25
Equity losses from unconsolidated business -- 413
Loss on sale of long-term investment -- 31
Restructuring recovery (56) (1,428)
Foreign currency transaction gain (191) --
Changes in operating assets and liabilities:
Accounts receivable 534 88
Inventories (25) (408)
Contract manufacturers receivable 399 1,171
Prepaid expenses and other current assets 698 1,222
Other assets 16 (21)
Accounts payable (360) (632)
Due to Gordian -- (1,000)
Warranty reserve 40 144
Restructuring reserve (385) (791)
Other current liabilities (936) 1,119
Net assets of discontinued operations -- 3,351
------- -------
Net cash used in operating activities (4,938) (2,130)
------- -------
Cash flows from investing activities:
Purchase of property and equipment (87) (182)
Payment of convertible note (867) --
Purchases of marketable securities (1,000) (552)
Proceeds from sale of long-term investment -- 7
Proceeds from sale of marketable securities 4,050 4,252
------- -------
Net cash provided by investing activities 2,096 3,525
------- -------
Cash flows from financing activities
Net proceeds from issuances of common stock 422 505
(Payment) borrowing of line of credit (375) 500
------- -------
Net cash provided by financing activities 47 1,005
------- -------
Effect of foreign exchange rates on cash 277 85
------- -------
Increase (decrease) in cash and cash equivalents (2,518) 2,485
Cash and cash equivalents at beginning of period 9,128 7,328
------- -------
Cash and cash equivalents at end of period $ 6,610 $ 9,813
======= =======
See accompanying notes.
5
LANTRONIX, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005
1. BASIS OF PRESENTATION
The condensed consolidated financial statements included herein are
unaudited. They contain all normal recurring accruals and adjustments which, in
the opinion of management, are necessary to present fairly the consolidated
financial position of Lantronix, Inc. and its subsidiaries (collectively, the
"Company") at March 31, 2005, the consolidated results of its operations for the
three and nine months ended March 31, 2005 and 2004, and its cash flows for the
nine months ended March 31, 2005 and 2004. All intercompany accounts and
transactions have been eliminated. It should be understood that accounting
measurements at interim dates inherently involve greater reliance on estimates
than at year-end. The results of operations for the three and nine months ended
March 31, 2005 are not necessarily indicative of the results to be expected for
the full year or any future interim periods.
These financial statements do not include certain footnotes and
financial presentations normally required under generally accepted accounting
principles. Therefore, they should be read in conjunction with the audited
consolidated financial statements and notes thereto for the year ended June 30,
2004, included in the Company's Annual Report on Form 10-K/A filed with the
Securities and Exchange Commission ("SEC") on October 12, 2004.
In March 2004, the Company completed the sale of substantially all of
the net assets of Premise Systems, Inc. ("Premise") (Note 8). The Company's
condensed consolidated financial statements have been presented to reflect
Premise as a discontinued operation for all periods presented.
STOCK-BASED COMPENSATION
The Company has in effect several stock-based plans under which
non-qualified and incentive stock options have been granted to employees,
non-employee board members and other non-employees. The Company also has an
employee stock purchase plan for all eligible employees. The Company accounts
for stock-based awards to employees in accordance with APB Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations, and has
adopted the disclosure-only alternative of SFAS No. 123, and SFAS No. 148,
"Accounting for Stock-Based Compensation-Transition and Disclosure." Options
granted to non-employees, as defined, have been accounted for at fair market
value in accordance with SFAS No. 123.
In accordance with the disclosure requirements of SFAS No. 123, set
forth below are the assumptions used and pro forma statement of operations data
of the Company giving effect to valuing stock-based awards to employees using
the Black-Scholes option pricing model instead of the guidelines provided by APB
No. 25. Among other factors, the Black-Scholes model considers the expected life
of the option and the expected volatility of the Company's stock price in
arriving at an option valuation.
The results of applying the requirements of the disclosure-only
alternative of SFAS No. 123 to the Company's stock-based awards to employees
would approximate the following (in thousands, except per share data):
6
THREE MONTHS ENDED NINE MONTHS ENDED
March 31, March 31,
2005 2004 2005 2004
-------- -------- -------- --------
Net loss as reported $ (1,508) $ (553) $ (6,942) $ (8,857)
Add: Stock-based employee compensation expense included
in net loss - as reported, net of related tax effects 36 100 323 344
Deduct: Stock-based employee compensation expense determined
under fair value method, net of related tax effects (150) (775) (966) (2,558)
-------- -------- -------- --------
Net loss - pro forma $ (1,622) $ (1,228) $ (7,585) $(11,071)
======== ======== ======== ========
Net loss per share (basic and diluted) - as reported $ (0.03) $ (0.01) $ (0.12) $ (0.16)
======== ======== ======== ========
Net loss per share (basic and diluted) - pro forma $ (0.03) $ (0.02) $ (0.13) $ (0.20)
======== ======== ======== ========
2. RECENT ACCOUNTING PRONOUNCEMENTS
In November 2004, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 151, "Inventory
Costs - An Amendment of ARB No. 43, Chapter 4." This new standard is the result
of a broader effort by the FASB to improve financial reporting by eliminating
differences between Generally Accepted Accounting Principles ("GAAP") in the
United States and accounting principles developed by the International
Accounting Standards Board ("IASB"). As part of this effort, the FASB and the
IASB identified opportunities to improve financial reporting by eliminating
certain narrow differences between their existing accounting standards. SFAS No.
151 clarifies that abnormal amounts of idle facility expense, freight handling
costs and spoilage costs should be expensed as incurred and not included in
overhead. Further, SFAS No. 151 requires that allocation of fixed production
overheads to conversion costs should be based on normal capacity of the
production facilities. The provisions in SFAS No. 151 are effective for
inventory costs incurred during fiscal years beginning after June 15, 2005.
Companies must apply the standard prospectively. Management does not expect the
adoption of SFAS No. 151 to have a material impact on the Company's financial
position, results of operations or cash flows.
In December 2004, the FASB issued SFAS No. 123R, "Share Based Payment,"
a revision to SFAS 123, "Accounting for Stock-Based Compensation," and
supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees," and
its related implementation guidance. SFAS No. 123R establishes standards for the
accounting for transactions in which an entity exchanges instruments for goods
or services. It also addresses transactions in which an entity incurs
liabilities in exchange for goods or services that are based on the fair value
of the entity's equity instruments or that may be settled by the issuance of
those equity instruments. SFAS 123R established the accounting treatment for
transactions in which an entity obtains employee services in share-based payment
transactions. SFAS 123R requires companies to recognize in the statement of
operations the grant-date fair value of stock options and other equity-based
compensation issued to employees. SFAS 123R requires the Company to value the
share-based compensation based on the classification of the share-based award.
If the share-based award is to be classified as a liability, the Company must
re-measure the award at each balance sheet date until the award is settled. If
the share-based award is to be classified as equity, the Company will measure
the value of the share-based award on the date of grant but the award will not
be re-measured at each balance sheet date. SFAS 123R does not change the
accounting guidance for share-based payment transactions with parties other than
employees provided in SFAS 123 as originally issued and EITF Issue No. 96-18,
"Accounting for Equity Instruments that are Issued to Other than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services." SFAS 123R is
effective for public companies that do not file as small business issuers no
later than the beginning of the first fiscal year beginning after June 15, 2005.
(the effective date for small business issuers is no later than the beginning of
the first fiscal year beginning after December 15, 2005). All public companies
must use either the modified prospective or modified retrospective transition
method. Under the modified prospective method, awards that are granted,
modified, or settled after the date of adoption should be measured and accounted
for in accordance with SFAS 123R. Unvested equity classified awards that were
granted prior to the effective date should continue to be accounted for in
accordance to SFAS 123 except that the amounts must be recognized in the
statement of operations. Under the modified retrospective method, the previously
reported amounts are restated (either to the beginning of the year of adoption
or for all periods presented) to reflect SFAS 123 amounts in the statement of
operations. Management is in the process of determining the effect SFAS 123R
will have upon the Company's financial position and statement of operations and
the method of transition adoption.
7
Other recent accounting pronouncements issued by the FASB (including
its Emerging Issues Task Force), the American Institute of Certified Public
Accountants and the Securities and Exchange Commission did not or are not
believed by management to have a material impact on the Company's present or
future consolidated financial statements.
3. NET LOSS PER SHARE
Basic net loss per share is calculated by dividing net loss from
continuing operations, net income (loss) from discontinued operations, and net
loss by the weighted average number of common shares outstanding during the
period. Diluted net loss per share is calculated by adjusting outstanding shares
assuming any dilutive effects of options. However, for periods in which the
Company incurred a net loss, these incremental shares are excluded because their
effect would be to reduce recorded net loss per share.
4. MARKETABLE SECURITIES
The Company classifies its marketable securities as available for sale.
Marketable securities consist of obligations of municipal bonds which can
readily be converted to cash.
5. INVENTORIES
Inventories are stated at the lower of cost (first-in, first-out) or
market and consist of the following (in thousands):
MARCH 31, JUNE 30,
2005 2004
-------- --------
Raw Materials $ 4,355 $ 4,047
Finished Goods 6,734 7,368
Inventory at distributors 1,165 1,291
-------- --------
12,254 12,706
Reserve for excess and obsolete inventory (5,758) (6,029)
-------- --------
$ 6,496 $ 6,677
======== ========
6. GOODWILL AND PURCHASED INTANGIBLE ASSETS
The composition of purchased intangible assets is as follows (in
thousands):
MARCH 31, 2005 JUNE 30, 2004
-------------- -------------
USEFUL ACCUMULATED ACCUMULATED
LIVES GROSS AMORTIZATION NET GROSS AMORTIZATION NET
----- ----- ------------ --- ----- ------------ ---
Existing technology 1 - 5 years $ 7,090 $ (6,193) $ 897 $7,090 $ (5,101) $ 1,989
Patent/core technology 5 405 (405) - 405 (365) 40
Tradename/trademark 5 32 (29) 3 32 (24) 8
Non-compete agreements 2 - 3 140 (140) - 140 (121) 19
----------- -------------- ---------- --------- -------------- -----------
Total $ 7,667 $ (6,767) $ 900 $7,667 $ (5,611) $ 2,056
=========== ============== ========== ========= ============== ===========
The amortization expense for purchased intangible assets for the three
months ended March 31, 2005 was approximately $378,000, of which approximately
$363,000 was amortized to cost of revenues and approximately $15,000 was
amortized to operating expenses. The amortization expense for purchased
intangible assets for the three months ended March 31, 2004, was approximately
$561,000 of which approximately $532,000 was amortized to cost of revenues and
approximately $29,000 was amortized to operating expenses. The amortization
expense for purchased intangible assets for the nine months ended March 31, 2005
was approximately $1.2 million, of which approximately $1.1 million was
amortized to cost of revenues and approximately $63,000 was amortized to
operating expenses. The amortization expense for purchased intangible assets for
the nine months ended March 31, 2004 was approximately $1.7 million of which
approximately $1.6 million was amortized to cost of revenues and approximately
$118,000 was amortized to operating expenses. The estimated amortization expense
for the remainder of fiscal 2005 and the next year is as follows (in thousands):
8
COST OF OPERATING
Fiscal year ending June 30: REVENUES EXPENSES TOTAL
-------- -------- --------
2005 (Remainder of fiscal year) $ 339 $ 2 $ 341
2006 557 2 $ 559
-------- -------- --------
Total $ 896 $ 4 $ 900
======== ======== ========
The goodwill balance as of both March 31, 2005 and June 30, 2004 was
$9.5 million. Goodwill was recorded as a result of acquisitions over the years.
The current carrying value of goodwill is related to the acquisitions of
Lightwave and Stallion businesses. The Company performs an annual impairment
test of Goodwill under the guidelines of SFAS No. 142 in April.
7. RESTRUCTURING RESERVE
A summary of the activity in the restructuring reserve account is as
follows (in thousands):
CASH RESTRUCTURING
RESTRUCTURING CHARGES RESERVE AT
RESERVE AT AGAINST RESTRUCTURING MARCH 31,
JUNE 30, 2004 RESERVE RECOVERY 2005
------------- ------------- ------------- -------------
Consolidation of excess facilities $ 752 $ (385) $ (56) $ 311
============= ============= ============= ==============
On September 12, 2002 and March 14, 2003, the Company announced a
restructuring plan to prioritize its initiatives around the growth areas of its
business, focus on profit contribution, reduce expenses, and improve operating
efficiency. These restructuring plans included a worldwide workforce reduction,
consolidation of excess facilities and other charges. The Company recorded
restructuring costs totaling $5.6 million, which were classified as operating
expenses in the Company's consolidated statement of operations for the year
ended June 30, 2003. These restructuring plans resulted in the termination of
approximately 58 regular employees worldwide. The Company recorded workforce
reduction charges of approximately $1.2 million related to severance and fringe
benefits for the terminated employees. The Company recorded charges of
approximately $4.4 million related to consolidation of excess facilities,
relating primarily to lease terminations, non-cancelable lease costs, write-off
of leasehold improvements and termination of a contractual obligation.
During the quarter ended March 31, 2004, restructuring charges were
adjusted, including an increase of lease obligations of $409,000 related to the
consolidation of excess facilities from the September 12, 2002 and March 14,
2003 restructuring plans, which were previously accrued for in fiscal year 2003.
The remaining restructuring reserve is related to facility closures in
Naperville, Illinois; Hillsboro, Oregon; and Ames, Iowa. Payments under the
lease obligations will end in fiscal 2007.
8. DISCONTINUED OPERATIONS
Under SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," a component of a business is held for sale and is reported
in discontinued operations if (i) the operations and cash flows will be, or have
been, eliminated from the ongoing operations of the company, and (ii) the
company will not have any significant continuing involvement in such operations.
In March 2004, the Company completed the sale of substantially all of
the net assets of its Premise business unit for $1.0 million. Additionally, the
Company incurred $383,000 of disposal costs. As a result of the sale of the
Premise business unit, the net goodwill and purchased intangibles of Premise
have been included as part of discontinued operations.
9
The net revenues and loss from discontinued operations are as follows (in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
2005 2004 2005 2004
------- ------- ------- -------
Net revenues $ -- $ 23 $ -- $ 86
======= ======= ======= =======
Income (loss) from discontinued operations, net of income taxes of $0 $ -- $ (669) $ 56 $(5,185)
======= ======= ======= =======
Basic and diluted net income (loss) per share from discontinued
operations $ -- $ (0.01) $ -- $ (0.09)
======= ======= ======= =======
9. WARRANTY
Upon shipment to its customers, the Company provides for the estimated
cost to repair or replace products to be returned under warranty. The Company's
current warranty periods generally range from ninety days to two years from the
date of shipment. In addition, the Company also sells extended warranty services
which extend the warranty period for an additional one to three years. The
following table is a reconciliation of the changes to the product warranty
liability for the period presented:
NINE MONTHS ENDED
MARCH 31,
2005
Balance beginning of period $ 1,770
Charged to cost of revenues 385
Deductions (345)
---------------
Balance end of period $ 1,810
===============
10. PROVISION FOR INCOME TAXES AND EFFECTIVE TAX RATE
The Company utilizes the liability method of accounting for income
taxes as set forth in SFAS No. 109, "Accounting for Income Taxes." The Company's
effective tax rates were 4% and 6% for the nine month periods ended March 31,
2005 and 2004, respectively. The federal statutory rate was 34% for both
periods. The Company's condensed consolidated financial statements have been
presented to reflect Premise as a discontinued operation for all periods
presented. The effective tax rate associated with the income tax expense for the
nine month periods ended March 31, 2005 and 2004 was lower than the federal
statutory rate primarily due to an increase in the valuation allowance, due to
our inability to estimate future taxable income, and foreign taxes. In 2003, the
Internal Revenue Service completed its audit of the Company's federal income tax
returns for the years ended June 30, 1999, 2000 and 2001. As a result, the
Company paid tax and interest to the IRS and the California Franchise Tax Board
of approximately $222,000, $441,000, and $113,000 in quarters ended March 31,
2004, June 30, 2004, and September 30, 2004 respectively.
The Company had recent discussions with the Swiss Federal Tax
Authorities ("SFTA") regarding the inability of the Company's Swiss subsidiary,
Lantronix International AG, to meet certain guidelines as set within a tax
ruling that was obtained in May 2001. The ruling provided for reduced Swiss tax
rates. The subsidiary was unable to meet the guidelines set forth in the ruling
due to slower than planned growth in this subsidiary, consistent with the
overall Company, and has since converted to a holding company. The SFTA has
ruled on this matter, resulting in a tax liability to the SFTA of approximately
$50,000 plus interest. This tax liability was accrued for in the quarter ended
March 31, 2005 financial statements and will be paid in the quarter ending June
30, 2005.
10
11. BANK LINE OF CREDIT AND DEBT
In January 2002, the Company entered into a two-year line of credit
with a bank in an amount not to exceed $20.0 million. Borrowings under the line
of credit bear interest at either, (i) the prime rate or (ii) the LIBOR rate
plus 2.0%. The Company was required to pay a $100,000 facility fee which was
reduced to $62,500 and was paid. The Company was also required to pay a
quarterly unused line fee of .125% of the unused line of credit balance. Since
establishing the line of credit, the Company has twice reduced the amount of the
line, modified customary financial covenants, and adjusted the interest rate to
be charged on borrowings to the prime rate plus .50% and eliminated the LIBOR
option. Effective July 25, 2003, the Company further modified this line of
credit, reducing the revolving line to $5.0 million, and adjusting the customary
affirmative and negative covenants. The Company is also required to maintain
certain financial ratios as defined in the agreement. The agreement has an
annual revolving maturity date that renews on the effective date. The agreement
was renewed on July 24, 2004, with an amendment to a financial ratio, and again
on February 15, 2005 with an amendment to a covenant. The Company paid $12,500
and $1,000 in facility fees, respectively, for the renewals. The Company's total
available cash under the credit line at March 31, 2005 was $2.7 million. As of
March 31, 2005, the Company had borrowed $125,000 against this line of credit.
Additionally, the Company has used letters of credit available under its line of
credit totaling approximately $442,000 in place of cash to fund deposits on
leases, tax account deposits and security deposits. As a result, the Company's
available line of credit at March 31, 2005 was $2.2 million. Pursuant to the
line of credit, the Company is restricted from paying any dividends.
The Company issued a two-year note in the principal amount of $867,000
as a result of its acquisition of Stallion, accruing interest at a rate of 2.5%
per annum. Interest expense related to the note totaled approximately $3,000 and
$16,000 for the nine months ended March 31, 2005 and 2004, respectively. The
notes were convertible into the Company's common stock at any time, at the
election of the holders, at a $5.00 conversion price. The notes were due and
paid in August 2004 as the holders elected not to convert the notes into the
Company's common stock.
12. COMPREHENSIVE LOSS
SFAS No. 130, "Reporting Comprehensive Income (Loss)," establishes
standards for reporting and displaying comprehensive income (loss) and its
components in the condensed consolidated financial statements.
The components of comprehensive loss are as follows (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
2005 2004 2005 2004
------- ------- ------- -------
Net Loss $(1,508) $ (553) $(6,942) $(8,857)
Other comprehensive loss:
Change in accumulated translation adjustments, net of taxes of $0 (85) (23) 49 85
------- ------- ------- -------
Total comprehensive loss $(1,593) $ (576) $(6,893) $(8,772)
======= ======= ======= =======
13. LITIGATION
GOVERNMENT INVESTIGATION
The Securities and Exchange Commission is conducting a formal
investigation of the events leading up to the Company's restatement of its
financial statements on June 25, 2002. The Department of Justice is also
conducting an investigation concerning events related to the restatement.
CLASS ACTION LAWSUITS
Beginning on May 15, 2002, a number of securities class actions were
filed against the Company and certain of its current and former directors and
former officers alleging violations of the federal securities laws. These
actions were consolidated into a single action pending in the United States
District Court for the Central District of California and entitled: In re
Lantronix, Inc. Securities Litigation, Case No. CV 02-3899 GPS (JTLx). After the
Court appointed a lead plaintiff, amended complaints were filed by the
plaintiff, and the defendants filed various motions to dismiss directed at
particular allegations. Through that process, certain of the allegations were
dismissed by the Court.
On October 18, 2004, the plaintiff filed the third amended complaint,
which is now the operative complaint in the action. The Complaint alleges
violations of Sections 11 and 15 of the Securities Act of 1933 and violations of
Sections 10(b) and 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934.
The 1933 Act claims are brought on behalf of all persons who purchased common
stock of Lantronix pursuant or traceable to the Company's August 4, 2000 initial
public offering ("IPO"). The 1934 Act claims are based on alleged misstatements
related to the Company's financial results that were contained in the
Registration Statement and Prospectus for the IPO. The claims brought under the
11
1934 Act are brought on behalf of all persons and entities that purchased or
acquired Lantronix securities from November 1, 2000 through May 30, 2002 (the
"Class Period"). The Complaint alleges that defendants issued false and
misleading statements concerning the business and financial condition in order
to allegedly inflate the value of the Company's securities during the Class
Period. The complaint alleges that during the Class Period, Lantronix overstated
financial results through improper revenue recognition and failure to comply
with Generally Accepted Accounting Principles ("GAAP"). Defendants have filed an
answer to the complaint and the case is now in discovery. The Court has set a
trial date in September 2006. While the complaint does not specify the damages
plaintiff may seek on behalf of the purported classes of shareholders, a
recovery by the plaintiff and the plaintiff classes could have a material
adverse impact on the Company.
DERIVATIVE LAWSUIT
On July 26, 2002, Samuel Ivy filed a shareholder derivative complaint
entitled: IVY V. BERNHARD BRUSCHA, ET AL., No. 02CC00209, in the Superior Court
of the State of California, County of Orange, against certain of the Company's
current and former directors and former officers. On January 7, 2003, the
plaintiff filed an amended complaint. The amended complaint alleges causes of
action for breach of fiduciary duty, abuse of control, gross mismanagement,
unjust enrichment, and improper insider stock sales. The complaint seeks
unspecified damages against the individual defendants on the Company's behalf,
equitable relief, and attorneys' fees. All defendants have answered the
complaint and generally denied the allegations. Discovery has commenced, but no
trial date has been established. On April 21, 2005, the Court approved a motion
by a proposed new shareholder plaintiff Russell J. Drake for leave to file an
amendment to the current complaint, and to be added as a plaintiff in the action
or to be substituted in place of the current plaintiff Samuel Ivy. The action
was renamed DRAKE V. BERNHARD BRUSCHA, ET AL.
Prior to the ruling on Mr. Drake's motion, all of the defendants except
for Steve Cotton, the Company's former CFO and COO, have agreed in principle to
settle the action with Mr. Ivy's counsel. Specifically, the Company's Board had
recently approved a tentative settlement proposal which involved the adoption of
certain corporate governance measures and payment of attorneys' fees and
expenses to the derivative plaintiff's counsel in the amount of $1.2 million.
After Mr. Drake filed his amendment to the complaint and was substituted as
named plaintiff for Mr. Ivy, the parties continued with their settlement
discussions. The parties except for Mr. Cotton currently expect that a new
settlement agreement will be presented to the Court by may 12, 2005. A hearing
is scheduled for June 9, 2005 in which the Court will consider any proposed
settlement submitted by the parties for final approval. If Mr. Cotton does not
agree to join the settlement, the Company expects that as part of the final
settlement, Mr. Cotton will be dismissed along with all of the other defendants.
Any settlement is subject to a number of conditions, including court approval of
the proposed settlement. We have recorded a liability in our financial
statements for the proposed current amount of the settlement. In addition,
because the insurance carrier involved in this suit agreed to pay the entire
$1.2 million proposed settlement amount and, therefore, recovery from the
insurance carrier is probable, a receivable was also recorded for the same
amount. Accordingly, there is no impact to the statement of operations because
the amounts of the settlement and the insurance recovery fully offset each
other.
EMPLOYMENT SUIT BROUGHT BY FORMER CHIEF FINANCIAL OFFICER AND CHIEF OPERATING
OFFICER STEVE COTTON
On September 6, 2002, Steve Cotton, the Company's former CFO and COO,
filed a complaint entitled Cotton v. Lantronix, Inc., et al., No. 02CC14308, in
the Superior Court of the State of California, County of Orange. The complaint
alleges claims for breach of contract, breach of the covenant of good faith and
fair dealing, wrongful termination, misrepresentation, and defamation. The
complaint seeks unspecified damages, declaratory relief, attorneys' fees and
costs.
The Company filed a motion to dismiss on October 16, 2002, on the
grounds that Mr. Cotton's complaints are subject to the binding arbitration
provisions in Mr. Cotton's employment agreement. On January 13, 2003, the Court
ruled that five of the six counts in Mr. Cotton's complaint are subject to
binding arbitration. The court is staying the sixth count, for declaratory
relief, until the underlying facts are resolved in arbitration. No arbitration
date has been set.
SECURITIES CLAIMS BROUGHT BY FORMER SHAREHOLDERS OF SYNERGETIC MICRO SYSTEMS,
INC. ("SYNERGETIC")
On October 17, 2002, Richard Goldstein and several other former
shareholders of Synergetic filed a complaint entitled Goldstein, et al. v.
Lantronix, Inc., et al. in the Superior Court of the State of California, County
of Orange, against the Company and certain of its former officers and directors.
Plaintiffs filed an amended complaint on January 7, 2003. The amended complaint
alleges fraud, negligent misrepresentation, breach of warranties and covenants,
breach of contract and negligence, all stemming from its acquisition of
Synergetic. The complaint seeks an unspecified amount of damages, interest,
attorneys' fees, costs, expenses, and an unspecified amount of punitive damages.
On May 5, 2003, the Company answered the complaint and generally denied the
allegations in the complaint. Discovery has commenced and the court has set a
trial date in March 2006.
12
PATENT INFRINGEMENT LITIGATION
On April 13, 2004, Digi International Inc. ("Digi") filed a complaint
against the Company in the U.S. District Court in Minnesota. The complaint
alleges that certain of the Company's products infringe Digi's U.S. Patent No.
6,446,192. The complaint seeks both monetary and non-monetary relief. The
Company has filed an answer and counterclaim alleging invalidity of the patent.
The counterclaim seeks both monetary and non-monetary relief. Discovery has
commenced in the case, and the court has set a trial date in July 2006. The
Company has filed motions for summary judgment in the case that are scheduled to
be heard on May 20, 2005.
On May 3, 2004, the Company filed a complaint against Digi in the U.S.
District Court for the Central District of California. The complaint alleges
that certain of Digi's products infringe the Company's U.S. Patent No.
6,571,305. The Complaint seeks both monetary and non-monetary relief. Digi has
filed an answer and counterclaim alleging invalidity of the patent. The
counterclaim seeks both monetary and non-monetary relief. Discovery has
commenced in the case, and the court has set a trial date in October 2005.
On February 7, 2005, the Company filed a complaint against Digi in the
U.S. District Court for the Eastern District of Texas. The complaint alleges
that certain of Digi's products infringe U.S. Patent No. 4,972,470, under which
the Company is an exclusive licensee with respect to the field of use
encompassing Digi's accused products. The Complaint seeks both monetary and
non-monetary relief. Digi has filed an answer alleging invalidity of the patent.
The answer seeks both monetary and non-monetary relief.
OTHER
From time to time, the Company is subject to other legal proceedings
and claims in the ordinary course of business. The Company is currently not
aware of any such legal proceedings or claims that it believes will have,
individually or in the aggregate, a material adverse effect on its business,
prospects, financial position, operating results or cash flows.
The pending lawsuits involve complex questions of fact and law and
likely will continue to require the expenditure of significant funds and the
diversion of other resources to defend. Management is unable to determine the
outcome of its outstanding legal proceedings, claims and litigation involving
the Company, its subsidiaries, directors and officers and cannot determine the
extent to which these results may have a material adverse effect on the
Company's business, results of operations and financial condition taken as a
whole. The results of litigation are inherently uncertain, and adverse outcomes
are possible. The Company is unable to estimate the range of possible loss from
outstanding litigation, and no amounts have been provided for such matters,
except as disclosed above.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
You should read the following discussion and analysis in conjunction
with the Unaudited Condensed Consolidated Financial Statements and related Notes
thereto contained elsewhere in this Report. The information in this Quarterly
Report on Form 10-Q is not a complete description of our business or the risks
associated with an investment in our common stock. We urge you to carefully
review and consider the various disclosures made by us in this Report and in
other reports filed with the Securities and Exchange Commission, including our
Annual Report on Form 10-K/A for the fiscal year ended June 30, 2004 and our
subsequent reports on Form 8-K that discuss our business in greater detail.
The section entitled "Risk Factors" set forth below, and similar
discussions in our other SEC filings, discuss some of the important factors that
may affect our business, results of operations and financial condition. You
should carefully consider those factors, in addition to the other information in
this Report and in our other filings with the SEC, before deciding to invest in
our company or to maintain or increase your investment.
This report contains forward-looking statements which include, but are
not limited to, statements concerning projected net revenues, expenses, gross
profit and income (loss), the need for additional capital, market acceptance of
our products, our ability to consummate acquisitions and integrate their
operations successfully, our ability to achieve further product integration, the
status of evolving technologies and their growth potential and our production
capacity. These forward-looking statements are based on our current
expectations, estimates and projections about our industry, our beliefs and
certain assumptions made by us. Words such as "anticipates," "expects,"
"intends," "plans," "believes," "seeks," "estimates," "may," "will" and
variations of these words or similar expressions are intended to identify
forward-looking statements. In addition, any statements that refer to
expectations, projections or other characterizations of future events or
circumstances, including any underlying assumptions, are forward-looking
statements. These statements are not guarantees of future performance and are
subject to certain risks, uncertainties and assumptions that are difficult to
predict. Therefore, our actual results could differ materially and adversely
from those expressed in any forward-looking statements as a result of various
factors. We undertake no obligation to revise or update publicly any
forward-looking statements for any reason.
13
OVERVIEW
Lantronix designs, develops and markets products and software solutions
that make it possible to access, manage, control and configure almost any
electronic device over the Internet or other networks. We are a leader in
providing innovative networking solutions. We were initially formed as
"Lantronix," a California corporation, in June 1989. We reincorporated as
"Lantronix, Inc.," a Delaware corporation in May 2000.
We have a history of providing devices that enable information
technology ("IT") equipment to network using standard protocols for
connectivity, including fiber optic, Ethernet and wireless. Our first device was
a terminal server that allowed "dumb" terminals to connect to a network.
Building on the success of our terminal servers, we introduced a complete line
of print servers in 1991 that enabled users to inexpensively share printers over
a network. Over the years, we have continually refined our core technology and
have developed additional innovative networking solutions that expand upon the
business of providing our customers network connectivity. With the expansion of
networking and the Internet, our technology focus is increasingly broader, so
that our device solutions provide a product manufacturer with the ability to
network their products within the industrial, service and consumer markets.
We provide three broad categories of products: (i) "device networking
solutions" that enable almost any electronic product to be connected to a
network; (ii) "IT management solutions" that enable multiple pieces of hardware,
usually IT-related network hardware such as servers, routers, switches, and
similar pieces of equipment to be managed over a network; and (iii) "non-core"
products and services that include visualization solutions, legacy print
servers, software revenues, and other miscellaneous products. The expansion of
our business in the future is directed at the first two of these categories,
device networking and IT management solutions. In various discussions and
presentations of our business, we refer to device networking and IT management
solutions as our "core" business from the standpoint they represent our focus on
product and business now, and for the immediate future.
Today, our solutions include fully integrated hardware and software
devices, as well as software tools to develop related customer applications.
Because we deal with network connectivity, we provide hardware solutions to
extremely broad market segments, including industrial, medical, commercial,
financial, governmental, retail, building automation, and many more. Our
technology is used to provide networking capabilities to products such as
medical instruments, manufacturing equipment, bar code scanners, building HVAC
systems, process control equipment, thermostats, security panels, temperature
sensors, point of sale terminals, time clocks, and many products that have some
form of standard data control capability. Our current product offerings include
a wide range of hardware devices of varying size, packaging and, where
appropriate, software solutions that allow our customers to network-enable
virtually any electronic product.
THE NATURE OF OUR BUSINESS
Currently, we develop our products through engineering and product
development activities of our research and development group. In prior years,
most engineering and product development were outsourced with independent
contractors. In fiscal 2003, this practice was discontinued; however, some
product development activities such as specialized technical investigations or
qualification testing of new products is still subcontracted from time to time.
We engage outside contract manufacturers to make our products, which are then
taken to market by our marketing and sales group.
We sell our devices through distribution partners to a global network
of distributors, value-added resellers ("VARs"), manufacturers' representatives,
system integrators, and original equipment manufacturers ("OEMs"). In addition,
we sell directly to selected accounts. One distribution customer, Ingram Micro,
accounted for approximately 16% and 14.2% of our net revenues for the nine
months ended March 31, 2005 and 2004, respectively. Another distribution
customer, Tech Data, accounted for approximately 11.2% and 8.4% of our net
revenues for the nine months ended March 31, 2005 and 2004, respectively.
Accounts receivable attributable to these domestic customers accounted for
approximately 7.6% and 13% of total accounts receivable at March 31, 2005 and
June 30, 2004, respectively.
One international customer, transtec AG, which is a related party due
to common ownership by our largest stockholder and former Chairman of our Board
of Directors, Bernhard Bruscha, accounted for approximately 2.5% and 3.1% of our
net revenues for the nine months ended March 31, 2005 and 2004, respectively.
DISCONTINUED OPERATIONS
Under SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," a component of a business that is held for sale is reported
in discontinued operations if (i) the operations and cash flows will be, or have
been, eliminated from the ongoing operations of the company, and (ii) the
company will not have any significant continuing involvement in such operations.
14
In March 2004, we completed the sale of substantially all of the net
assets of our Premise business unit for $1.0 million. Additionally, we incurred
$383,000 of disposal costs. As a result of the sale of the Premise business
unit, the net goodwill and purchased intangibles of Premise have been included
as part of discontinued operations.
SUMMARY OVERVIEW OF THE THIRD FISCAL QUARTER ENDED MARCH 31, 2005
The following discussion of results of operations includes discussion of
continuing operations only.
SUMMARY OVERVIEW OF THE THIRD FISCAL QUARTER ENDED MARCH 31, 2005
As described in more detail elsewhere in this document, our business
has continued to operate in a manner consistent with the fiscal year ended June
30, 2004, and the first two fiscal quarters ended December 31, 2004. Revenues of
$12.3 million for the quarter ended March 31, 2005 were flat as compared to
revenues of $12.3 million for the same quarter a year earlier. Within our
product lines, our core businesses of device networking and IT management
solutions increased by approximately $800,000 from a year earlier, offset by an
equivalent decrease in our non-core and legacy product lines.
Net revenues decreased from $12.9 million for the quarter ended
December 31, 2004 to $12.3 million this quarter. The decrease of $600,000 from
the prior quarter is primarily due to decreased shipments of our IT Management
product lines and, to a lesser extent, a decrease in device networking
shipments.
Our cash, cash equivalents and marketable securities balances decreased
by $1.6 million, from $8.2 million at December 31, 2004 to $6.6 million at March
31, 2005. We refer to the sum of these components as "cash" for the purpose of
discussing our cash usage and liquidity. Cash usage for the quarter included
anticipated extra costs related to reductions in staff implemented in January
and other expenses. During the fiscal year ended June 30, 2004, cash usage
totaled $1.9 million. Cash usage for fiscal 2005 year-to-date through March 31,
2005 was $5.6 million. This included payments for increased marketing and sales
expenses for new product programs, repayment of a note of $867,000 related to
the Stallion acquisition, costs related to reduction in staff and other costs.
Our gross margin was 46.2% for the quarter ended March 31, 2005,
compared to a gross margin of 56.2% for the same quarter a year earlier and a
gross margin of 48.5% for the quarter ended December 31, 2004. The decrease in
gross margin for the quarter ended March 31, 2005, compared to a year earlier is
primarily due to an increase in our excess and obsolete inventory reserve in the
current quarter compared to a reduction in our reserve in the prior year, and,
to a lesser extent, an increase in overhead expense in cost of sales for the
quarter as a result of less overhead costs capitalized during the current
quarter as compared to the same quarter last year due to inventory levels. The
standard cost of goods sold increased slightly for the quarter ended March 31,
2005, compared to the year-earlier period, due to the mix of products sold.
For the quarter ended March 31, 2005, we had a loss from continuing
operations of $1.5 million, compared to a profit of $116,000 for the same
quarter a year earlier. Operating expenses were $6.9 million for the quarter
ended March 31, 2005, from $6.6 million for the same quarter a year earlier.
Selling, general and administrative decreased from $6.6 million for the quarter
ended March 31, 2004 to $5.6 million for the quarter ended March 31, 2005.
Research and development expenses decreased from $2.0 for the quarter ended
March 31, 2004 to $1.3 million for the quarter ended March 31, 2005. The
decrease in selling, general and administrative is primarily attributable to a
reduction in depreciation, headcount, IT services and tax payments. The decrease
in research and development expenses is primarily attributable to a reduction in
headcount, outside services and materials. For the three months ended March 31,
2005 and 2004, we have been reimbursed approximately $338,000 and $250,000 of
our legal expenses, respectively. The liability for legal expenses is booked as
incurred and is reduced from time to time by the reimbursement of expenses
related to shareholder lawsuit matters by our insurance carrier. For the three
months ended March 31, 2004, we booked a reduction in restructuring costs of
$2.1 million which contributed to our operating income from continuing
operations for the quarter. We did not have a similar reduction in the current
quarter.
15
OUTLOOK
Revenues for the third fiscal quarter ended March 31, 2005 were $12.3
million. Revenues for the prior quarter ended December 31, 2004 were $12.9
million. In the prior fiscal year, fiscal 2004, our revenues decreased
quarter-to-quarter, from $12.5 million in the second quarter ended December 31,
2003, to $12.3 million in the third fiscal quarter ended March 31, 2004,
indicating a possible seasonal decrease for the first calendar quarter of the
year. We believe the December quarter is seasonally our highest quarter and, in
addition, there appeared to have been a slow-down in sales of IT equipment
purchases in the March quarter that affected our IT Management business as well
as several of our competitors. Revenues for our core product lines of device
networking and IT Management for the third fiscal quarter ended March 31, 2005
were $10.8 million, an increase of 8.4% from the same period one year ago of
$10.0 million.
During the quarter ended March 31, 2005, we continued to reduce our
operating expenses through additional staff reductions and by closing a small
sales and research and development office in Milford, Connecticut in January. In
addition, we realigned our international sales operations and have reduced our
fixed costs in Japan and Europe. We anticipate that our cost reduction
initiatives implemented between October 2004 and March 2005 have lowered our
estimated cash breakeven financial model from $14.0 to $15.0 million in
quarterly revenue to approximately $13.0 million. Achieving cash breakeven in
any particular quarter is subject to many factors, including the cost of
on-going litigation, the timing of annual operating expenses such as insurance
or professional fees, increases or decreases in balance sheet accounts which may
impact cash, such as inventory levels, accounts receivable, accounts payable and
actual product margins. Nevertheless, we have constructed a financial model
assuming achievable gross margins, and are planning and operating to target cash
operating expenses that achieve cash breakeven at revenues of approximately
$13.0 million in a typical quarter.
We are continuing to invest in the development of new and innovative
products, and to support expanded sales and marketing activities to promote our
recently introduced products. During the past year, we introduced several new
products we believe will contribute to growth in revenues. These products
include WiPort, a wireless version of our Xport device server; WiBox, a wireless
external device networking solution; Secure Box, AES-encryption device
networking products; a NEBS-compliant secure console server for
telecommunications applications; a SecureLinx Remote KVM product line designed
to remotely connect IT administrators to their Windows-based equipment and an
SLC line of console servers. There can be an extended delay from the time we
introduce a new product until the time we receive significant revenues. This is
due primarily to the nature of our products and customers, which involve the
customers' design cycles, our customers' own new product introduction processes,
or qualification and other testing programs they may implement as part of their
businesses.
Our device networking business fundamentally targets the market of
products that can be networked together and/or connected to the Internet. We see
as inevitable, a world where myriads of devices are interconnected to enhance
their operation, maintenance, or to provide new functionality. Independent
researchers have made varying estimates as to the size and rate of this
expansion. However, we believe that device networking growth as evidenced by our
net revenue growth or that of our peers is still in the early adoption phase. We
believe in the next several years, the market adoption of our networking
solution devices will be strongest in the commercial and industrial markets such
as security, medical, factory automation, and similar markets, rather than in
consumer electronics. We continue to invest in building our proprietary
technology base.
Our IT management business provides remote management solutions to our
customers' IT infrastructure of servers, routers, switches, power supplies, and
other devices that comprise their networks. This business was severely impacted
by the recession of the past several years, and we are just beginning to emerge
from that recession. While we have not yet achieved significant net revenue
growth, we have confidence in our position in this market, and we have
introduced several new products over the past year that are showing success at
the early design-in stage of the sales cycle.
We have had a target cash usage of approximately $1.0 million per
quarter, while we are operating at the revenue range of $11.0 to $13.0 million.
Our actual cash usage over the previous seven quarters has varied due to a
variety of factors, including factors not related to our business revenues for
those quarters. For example, we incur legal expenses that vary each quarter. We
have benefited from other cash management activities to improve cash flow by
improving balance sheet accounts over these same periods such as reducing our
inventories. During that same period we have received cash from specific
transactions, such as our sale of Premise and our recovery of legal expenses
through insurance reimbursements. We have also exchanged deposits in the form of
cash with letters of credit. Our goal is to continue to manage expenses and
drive revenue increases to achieve cash breakeven, and then profitability. As of
March 31, 2005, we had a balance of cash and cash equivalents of $6.6 million.
Our goal is to achieve cash breakeven for the quarter ending June 30, 2005. With
the reduction in our financial model to achieve cash breakeven in the $13
million revenue range, we believe this goal is achievable, barring unexpected
events or expenses.
16
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States requires us to make estimates
and assumptions that affect the reported amounts of assets and liabilities at
the date of the financial statements and the reported amounts of net revenues
and expenses during the reporting period. We regularly evaluate our estimates
and assumptions related to net revenues, allowances for doubtful accounts, sales
returns and allowances, inventory reserves, goodwill and purchased intangible
asset valuations, warranty reserves, restructuring costs, litigation and other
contingencies. We base our estimates and assumptions on historical experience
and on various other factors that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. To the extent there are material differences between our
estimates and the actual results, our future results of operations will be
affected.
We believe the following critical accounting policies require us to
make significant judgments and estimates in the preparation of our condensed
consolidated financial statements:
REVENUE RECOGNITION
We do not recognize revenue until all of the following criteria are
met: persuasive evidence of an arrangement exists; delivery has occurred or
services have been rendered; our price to the buyer is fixed or determinable;
and collectibility is reasonably assured. Our accounting policy for revenue
recognition is to defer revenue and related gross profit from sales to
distributors until the distributor resells the product. Net revenue from certain
smaller distributors, for which point-of-sale information is not available, is
recognized one month after the shipment date. This estimate approximates the
timing of the sale of the product by the distributor to the end-user. When
product sales revenue is recognized, we establish an estimated allowance for
future product returns based on historical returns experience; when price
reductions are approved, we establish an estimated liability for price
protection payable on inventories owned by product resellers. Should actual
product returns or pricing adjustments exceed our estimates, additional
reductions to revenues would result. Revenue from the licensing of software is
recognized at the time of shipment (or at the time of resale in the case of
software products sold through distributors), provided we have vendor-specific
objective evidence of the fair value of each element of the software offering
and collectibility is probable. Revenue from post-contract customer support and
any other future deliverables is deferred and recognized over the support period
or as contract elements are delivered. Our products typically carry a ninety-day
to two-year warranty. Although we engage in extensive product quality programs
and processes, our warranty obligation is affected by product failure rates, use
of materials or service delivery costs that differ from our estimates. As a
result, additional warranty reserves could be required, which could reduce gross
margins. Additionally, we sell extended warranty services which extend the
warranty period for an additional one to three years. Warranty revenue is
recognized evenly over the warranty service period.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. Our
allowance for doubtful accounts is based on our assessment of the collectibility
of specific customer accounts, the aging of accounts receivable, our history of
bad debts and the general condition of the industry. If a major customer's
credit worthiness deteriorates, or our customers' actual defaults exceed our
historical experience, our estimates could change and impact our reported
results. We also maintain a reserve for uncertainties relative to the collection
of officer notes receivable. Factors considered in determining the level of this
reserve include the value of the collateral securing the notes, our ability to
effectively enforce collection rights and the ability of the former officers to
honor their obligations.
INVENTORY VALUATION
Our policy is to value inventories at the lower of cost or market on a
part-by-part basis. This policy requires us to make estimates regarding the
market value of our inventories, including an assessment of excess and obsolete
inventories. We determine excess and obsolete inventories based on an estimate
of the future sales demand for our products within a specified time horizon,
generally three to twelve months. The estimates we use for demand are also used
for near-term capacity planning and inventory purchasing and are consistent with
our revenue forecasts. In addition, specific reserves are recorded to cover
risks in the area of end of life products, inventory located at our contract
manufacturers, deferred inventory in our sales channel and warranty replacement
stock.
If our sales forecast is less than the inventory we have on hand at the
end of an accounting period, we may be required to take excess and obsolete
inventory charges which will decrease gross margin and net operating results for
that period.
VALUATION OF DEFERRED INCOME TAXES
We have recorded a valuation allowance to reduce our net deferred tax
assets to zero, primarily due to our inability to estimate future taxable
income. We consider estimated future taxable income and ongoing prudent and
feasible tax planning strategies in assessing the need for a valuation
allowance. If we determine that it is more likely than not that we will realize
a deferred tax asset, which currently has a valuation allowance, we would be
required to reverse the valuation allowance which would be reflected as an
income tax benefit at that time.
17
GOODWILL AND PURCHASED INTANGIBLE ASSETS
The purchase method of accounting for acquisitions requires extensive
use of accounting estimates and judgments to allocate the purchase price to the
fair value of the net tangible and intangible assets acquired, including IPR&D.
Goodwill and intangible assets deemed to have indefinite lives are no longer
amortized but are subject to annual impairment tests. The amounts and useful
lives assigned to intangible assets impact future amortization and the amount
assigned to IPR&D is expensed immediately. If the assumptions and estimates used
to allocate the purchase price are not correct, purchase price adjustments or
future asset impairment charges could be required. The value of our intangible
assets, including goodwill, could be impacted by future adverse changes such as:
(i) any future declines in our operating results, (ii) a decline in the
valuation of technology company stocks, including the valuation of our common
stock, (iii) another significant slowdown in the worldwide economy or capital
purchases of IT infrastructure equipment or (iv) any failure to meet the
performance projections included in our forecasts of future operating results.
We adopted Statement of Financial Accounting Standards ("SFAS") No. 142,
"Goodwill and Other Intangible Assets." As a result of adopting this standard,
we will continue to amortize finite-lived intangibles, but no longer amortize
certain other intangible assets, most notably goodwill. In lieu of amortization,
SFAS No. 142 requires a two-step approach to testing goodwill for impairment.
The first step tests for impairment by applying fair value-based tests. The
second step (if necessary) measures the amount of impairment by applying fair
value-based tests to individual assets and liabilities. We completed the first
step of goodwill impairment testing during the fourth quarter of fiscal 2004 and
found no indicators of impairment of our recorded goodwill. As a result, we
recognized no annual impairment loss in fiscal 2004 in connection with SFAS No.
142. Future impairment tests may result in a charge to earnings and there is a
potential for a write down of goodwill in connection with the annual impairment
test. We continue to evaluate whether any event has occurred which might
indicate that the carrying value of an intangible asset is not recoverable.
During the current year, we have observed our markets, products and technologies
related to our business and have determined that at this time there is no
significant charge that would call into question the assessments made in fiscal
2004 and accelerate our annual review. We evaluate these assets, deemed to have
indefinite lives, on an annual basis in the fourth quarter, or more frequently
if we believe indicators of impairment exist.
IMPAIRMENT OF LONG-LIVED ASSETS
We evaluate long-lived assets used in operations when indicators of
impairment, such as reductions in demand or significant economic slowdowns, are
present. Reviews are performed to determine whether the carrying values of
assets are impaired based on a comparison to the undiscounted expected future
cash flows. If the comparison indicates that there is impairment, the expected
future cash flows, using a discount rate based upon our weighted average cost of
capital, is used to estimate the fair value of the assets. Impairment is based
on the excess of the carrying amount over the fair value of those assets.
Significant management judgment is required in the forecast of future operating
results that is used in the preparation of expected discounted cash flows. It is
reasonably possible that the estimates of anticipated future net revenue, the
remaining estimated economic lives of the products and technologies, or both,
could differ from those used to assess the recoverability of these assets. In
the event they are lower, additional impairment charges or shortened useful
lives of certain long-lived assets could be required.
RESTRUCTURING CHARGE
Over the last several quarters we have undertaken, and we may continue
to undertake, significant restructuring initiatives, which have required us to
develop formalized plans for exiting certain business activities. We have had to
record estimated expenses for lease cancellations, contract terminations,
long-term asset write-downs, severance and outplacement costs and other
restructuring costs. Given the significance and timing of the execution of such
activities, this process is complex and involves periodic reassessments of
estimates made at the time the original decisions were made. Through December
31, 2002, the accounting rules for restructuring costs and asset impairments
required us to record provisions and charges when we had a formal and committed
plan. Beginning January 1, 2003, the accounting rules now require us to record
any future provisions and changes at fair value in the period in which they are
incurred. In calculating the cost to dispose of our excess facilities, we had to
estimate for each location our future space requirements, the timing of exiting
excess facilities, the future lease and operating costs to be paid until the
lease is terminated and the amount, if any, of sublease income. To form our
estimates for these costs, we performed an assessment of the affected facilities
and considered the current market conditions for each site. Our assumptions on
future space requirements, the operating costs until termination or the
offsetting sublease revenues may turn out to be incorrect, and our actual costs
may be materially different from our estimates, which could result in the need
to record additional costs or to reverse previously recorded liabilities. Our
policies require us to periodically evaluate the adequacy of the remaining
liabilities under our restructuring initiatives. As management continues to
evaluate the business, there may be additional charges for new restructuring
activities as well as changes in estimates to amounts previously recorded.
18
SETTLEMENT COSTS
From time to time, we are involved in legal actions arising in the
ordinary course of business. We cannot assure you that these actions or other
third party assertions against us will be resolved without costly litigation, in
a manner that is not adverse to our financial position, results of operations or
cash flows. As facts concerning contingencies become known, we reassess our
position and make appropriate adjustments to the financial statements. There are
many uncertainties associated with any litigation. If our initial assessments
regarding the merits of a claim prove to be wrong, our results of operations and
financial condition could be materially and adversely affected. In addition, if
further information becomes available that causes us to determine a loss in any
of our pending litigation is probable and we can reasonably estimate a range of
loss associated with such litigation, then we would record at least the minimum
estimated liability. However, the actual liability in any such litigation may be
materially different from our estimates, which could result in the need to
record additional costs. We record our legal expenses as incurred; reimbursement
of legal expenses from insurance or other sources are recorded upon receipt.
RECENT ACCOUNTING PRONOUNCEMENTS
In November 2004, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 151 "Inventory
Costs - An Amendment of ARB No. 43, Chapter 4." This new standard is the result
of a broader effort by the FASB to improve financial reporting by eliminating
differences between Generally Accepted Accounting Principles ("GAAP") in the
United States and Accounting Principles developed by the International
Accounting Standards Board ("IASB"). As part of this effort, the FASB and the
IASB identified opportunities to improve financial reporting by eliminating
certain narrow differences between their existing accounting standards. SFAS No.
151 clarifies that abnormal amounts of idle facility expense, freight handling
costs and spoilage costs should be expensed as incurred and not included in
overhead. Further, SFAS No. 151 requires that allocation of fixed production
overheads to conversion costs should be based on normal capacity of the
production facilities. The provisions in SFAS No. 151 are effective for
inventory costs incurred during fiscal years beginning after June 15, 2005.
Companies must apply the standard prospectively. Management does not expect the
adoption of SFAS No. 151 to have a material impact on the Company's financial
position, results of operations or cash flows.
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment,"
a revision to SFAS No. 123 "Accounting for Stock-Based Compensation," and
supersedes APB Opinion No. 25 "Accounting for Stock Issued to Employees" and its
related implementation guidance. SFAS No. 123R establishes standards for the
accounting for transactions in which an entity exchanges instruments for goods
or services. It also addresses transactions in which an entity incurs
liabilities in exchange for goods or services that are based on the fair value
of the entity's equity instruments or that may be settled by the issuance of
those equity instruments. SFAS No. 123R established the accounting treatment for
transactions in which an entity obtains employee services in share-based payment
transactions. SFAS No. 123R requires companies to recognize in the statement of
operations the grant-date fair value of stock options and other equity-based
compensation issued to employees. SFAS No. 123R requires the Company to value
the share-based compensation based on the classification of the share-based
award. If the share-based award is to be classified as a liability, the Company
must re-measure the award at each balance sheet date until the award is settled.
If the share-based award is to be classified as equity, the Company will measure
the value of the share-based award on the date of grant, but the award will not
be re-measured at each balance sheet date. SFAS No. 123R does not change the
accounting guidance for share-based payment transactions with parties other than
employees provided in SFAS No. 123 as originally issued and EITF Issue No.
96-18, "Accounting for Equity Instruments that are Issued to Other than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services."
SFAS No. 123R is effective for public companies that do not file as small
business issuers no later than the beginning of the first fiscal year beginning
after June 15, 2005 (the effective date for small business issuers is no later
than the beginning of the first fiscal year beginning after December 15, 2005).
All public companies must use either the modified prospective or modified
retrospective transition method. Under the modified prospective method, awards
that are granted, modified, or settled after the date of adoption should be
measured and accounted for in accordance with SFAS No. 123R. Unvested equity
classified awards that were granted prior to the effective date should continue
to be accounted for in accordance to SFAS No. 123 except that the amounts must
be recognized in the statement of operations. Under the modified retrospective
method, the previously reported amounts are restated (either to the beginning of
the year of adoption or for all periods presented) to reflect SFAS No. 123
amounts in the statement of operations. Management is in the process of
determining the effect SFAS No. 123R will have upon the Company's financial
position and statement of operations and the method of transition adoption.
Other recent accounting pronouncements issued by the FASB (including
its Emerging Issues Task Force), the American Institute of Certified Public
Accountants, and the Securities and Exchange Commission did not or are not
believed by management to have a material impact on the Company's present or
future consolidated financial statements.
19
CONSOLIDATED RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the
percentage of net revenues represented by each item in our condensed
consolidated statement of operations:
THREE MONTHS ENDED NINE MONTHS ENDED
MARCH 31, MARCH 31,
2005 2004 2005 2004
----------- ------------- ------------- -------------
Net revenues 100.0% 100.0% 100.0% 100.0%
Cost of revenues 53.8% 43.8% 51.7% 49.4%
----------- ------------- ------------- -------------
Gross Profit 46.2% 56.2% 48.3% 50.6%
----------- ------------- ------------- -------------
Operating Expenses:
Selling, general and administrative 45.5% 53.4% 53.0% 48.7%
Research and development 10.5% 16.6% 13.8% 15.1%
Stock based compensation 0.3% 0.7% 0.9% 0.8%
Amortization of purchased intangible assets 0.1% 0.2% 0.2% 0.3%
Restructuring charges 0.0% (17.0%) 0.0% (5.7%)
----------- ------------- ------------- -------------
Total operating expenses 56.4% 53.9% 67.9% 59.2%
----------- ------------- ------------- -------------
(Loss) income from operations (10.2%) 2.3% (19.6%) (8.7%)
Interest income, net 0.0% 0.1% 0.1% 0.1%
Other income (expense), net (1.6%) (0.8%) 1.0% (0.8%)
----------- ------------- ------------- -------------
(Loss) income before income taxes (11.8%) 1.6% (18.5%) (9.4%)
Provision for income taxes 0.6% 0.6% 0.7% 0.6%
----------- ------------- ------------- -------------
(Loss) income from continuing operations (12.4%) 1.0% (19.2%) (10.0%)
----------- ------------- ------------- -------------
Income (loss) from discontinued operations 0.0% (5.5%) 0.2% (13.9%)
----------- ------------- ------------- -------------
Net loss (12.4%) (4.5%) (19.0%) (23.9%)
=========== ============= ============= =============
COMPARISON OF THE THREE AND NINE MONTHS ENDED MARCH 31, 2005 AND 2004
The following discussion of results of operations includes discussion
of continuing operations only.
NET REVENUES BY PRODUCT CATEGORY (in thousands)
THREE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
------------ ------------ ------------- ------------ ------------- ------------
Device networking $ 7,814 63.5% $ 6,776 55.0% $ 1,038 15.3%
IT management 2,964 24.1% 3,184 25.9% (220) (6.9%)
Non-core 1,525 12.4% 2,350 19.1% (825) (35.1%)
------------ ------------ ------------- ------------ ------------- ------------
Total $ 12,303 100.0% $ 12,310 100.0% $ (7) (0.1%)
============ ============ ============= ============ ============= ============
NINE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
------------ ------------ ------------- ------------ ------------- ------------
Device networking $ 22,119 61.0% $ 20,269 54.8% $ 1,850 9.1%
IT management 9,385 25.9% 9,532 25.8% (147) (1.5%)
Non-core 4,752 13.1% 7,208 19.5% (2,456) (34.1%)
------------ ------------ ------------- ------------ ------------- ------------
Total $ 36,256 100.0% $ 37,009 100.0% $ (753) (2.0%)
============ ============ ============= ============ ============= ============
20
The net revenues for the three months ended March 31, 2005 were flat
compared to the same period one year ago as a result of an increase in net
revenues from our device networking products due to volume increase, offset by a
decrease in our non-core products, and to a lesser extent, our IT management
products. The decrease in our non-core product net revenues is primarily due to
a decrease in our print server, visualization, and other products. We are no
longer investing in the development of these product lines and expect net
revenues related to these products to continue to decline in the future as we
focus our investment in device networking and IT management products. The
reduction in our IT management net revenues is due to a slowdown in the IT
market.
The decrease for the nine months ended March 31, 2005 is primarily
attributable to a decrease in net revenue from our non-core products offset by
an increase in our device networking products. The decrease in our non-core
product net revenues is primarily due to a decrease in our print server,
visualization and other products. We are no longer investing in the development
of these product lines and expect net revenues related to these products to
continue to decline in the future as we focus our investment in device
networking and IT management products. Prior year results have been adjusted to
conform with current year reporting for comparison purposes.
NET REVENUES BY REGION (in thousands)
THREE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
------------ ------------ ------------- ------------ ------------- ------------
Americas $ 7,597 61.7% $ 7,957 64.5% $ (360) (4.5%)
Europe 3,600 29.3% 3,075 25.0% 525 17.1%
Other 1,106 9.0% 1,278 10.4% (172) (13.5%)
------------ ------------ ------------- ------------ ------------- ------------
Total $ 12,303 100.0% $ 12,310 100.0% $ (7) (0.1%)
============ ============ ============= ============ ============= ============
NINE MONTHS ENDED
MARCH 31,
Americas $ 23,141 63.8% $ 24,942 67.5% $ (1,801) (7.2%)
Europe 9,805 27.0% 8,491 22.9% 1,314 15.5%
Other 3,310 9.1% 3,576 9.7% (266) (7.4%)
------------ ------------ ------------- ------------ ------------- ------------
Total $ 36,256 100.0% $ 37,009 100.0% $ (753) (2.0%)
============ ============ ============= ============ ============= ============
The small change in net revenues for the three months ended March 31,
2005 is primarily due to an increase in the Europe region, offset by a decrease
in the Americas and other regions. The overall decrease in net revenues for the
nine months ended March 31, 2005 is primarily due to a decrease in the Americas
region, and to a lesser extent other regions, offset by an increase in Europe.
The decrease in net revenues in the Americas region is primarily attributable to
lower sales of non-core products. We are no longer investing in the development
of these non-core product lines and expect net revenues related to these product
lines, primarily our print server, visualization and other product lines, to
continue to decline in the future as we focus our investment on device
networking and IT management products. The increase in the European region is
primarily due to growth in our device networking business. Prior year results
have been adjusted to conform with current year reporting for comparison
purposes.
21
GROSS PROFIT (in thousands)
THREE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Gross profit $ 5,689 46.2% $ 6,917 56.2% $ (1,228) (17.8%)
=========== =========== =========== =========== =========== ============
NINE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Gross profit $ 17,502 48.3% $ 18,717 50.6% $ (1,215) (6.5%)
=========== =========== =========== =========== =========== ============
Gross profit represents net revenues less cost of revenues. Cost of
revenues consists primarily of the cost of raw material components, subcontract
labor assembly from outside manufacturers, amortization of purchased intangible
assets, impairment of purchased intangible assets, establishing or relieving
inventory reserves for excess and obsolete products or raw materials, overhead
and warranty costs. Cost of revenues for the three months ended March 31, 2005
and 2004 includes $363,000 and $532,000 of amortization of purchased intangible
assets, respectively. Cost of revenues for the nine months ended March 31, 2005
and 2004 includes $1.1 million and $1.6 million of amortization of purchased
intangible assets, respectively. At March 31, 2005, the unamortized balance of
purchased intangible assets that will be amortized to cost of revenues is
approximately $896,000, of which approximately $339,000 will be amortized in the
remainder of fiscal 2005, and approximately $557,000 in fiscal 2006. The
decrease in gross profit is primarily due to an increase of $281,000 in our
excess and obsolete inventory and other reserves in the quarter ended March 31,
2005, compared to a reduction in the same reserves of $492,000 in the prior
year. Our overhead expenses increased as a result of less overhead costs
capitalized during the current quarter as compared to the same quarter last year
due to inventory levels. Product margins decreased primarily due to product mix
in the current quarter, partially offset by a reduction in amortization expense
of purchased intangible assets. For the year-to-date ending March 31, 2005, our
excess and obsolete inventory and other reserves increased by 226,000, compared
to a decrease in reserves of $713,000 in the prior year-to-date periods ending
March 31, 2004. Our product margin decreased due to both volume and product mix,
offset by a reduction in warranty costs and amortization of purchased intangible
assets.
SELLING, GENERAL AND ADMINISTRATIVE (in thousands)
THREE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Selling, general and administrative $ 5,593 45.5% $ 6,572 53.4% $ (979) (14.9%)
=========== =========== =========== =========== =========== ===========
NINE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Selling, general and administrative $ 19,229 53.0% $ 18,027 48.7% $ 1,202 6.7%
=========== =========== =========== =========== =========== ===========
Selling, general and administrative expenses consist primarily of
personnel-related expenses including salaries and commissions, facility
expenses, information technology, trade show expenses, advertising, insurance
proceeds, purchased patents and professional legal and accounting fees. The
decrease in selling, general and administrative expense for the three months
ended March 31, 2005 is primarily due to a reduction in headcount, professional
fees, and depreciation expense, partially offset by an increase in marketing
expenses for new product introductions and existing products. The legal fees
decreased due to the timing of reimbursements from the insurance company. The
increase in selling, general and administrative expense for the nine months
ended March 31, 2005 is primarily due to increased marketing expenses for new
product introductions and existing products and an increase in channel marketing
programs, increased severance, increases in selling expense in channel sales
and, increased legal fees, offset by decreased depreciation. The legal fees
increased due to the timing of reimbursements from the insurance company. Legal
fees incurred in defense of the shareholder suits are reimbursable to the extent
provided in our directors and officers liability insurance policies, and subject
to the coverage limitations and exclusions contained in such policies. For the
three months ended March 31, 2005 and 2004, we have been reimbursed
approximately $338,000 and $250,000 of these expenses, respectively. For the
nine months ended March 31, 2005 and 2004, we have been reimbursed approximately
$518,000 and $1.7 million, respectively.
22
Because reimbursement of legal expenses, where covered by insurance,
does not typically occur within the month they are incurred, the net amount of
legal expense incurred in any one quarter may vary significantly from another.
Legal expenses are included in the selling, general and administrative expenses
category. Management expects to receive additional reimbursements from insurance
sources for legal fees in the future.
RESEARCH AND DEVELOPMENT (in thousands)
THREE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Research and development $ 1,293 10.5% $ 2,042 16.6% $ (749) (36.7%)
=========== =========== =========== =========== =========== ===========
NINE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Research and development $ 5,013 13.8% $ 5,587 15.1% $ (574) (10.3%)
=========== =========== =========== =========== =========== ===========
Research and development expenses consist primarily of
personnel-related costs of employees, as well as expenditures to third-party
vendors for research and development activities. The decrease in research and
development expenses for both the three months and the nine months ended March
31, 2005 is primarily due to a reduction in headcount, outside services and
material expenses.
STOCK-BASED COMPENSATION INCLUDED IN OPERATING EXPENSES (in thousands)
THREE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Stock-based compensation $ 36 0.3% $ 89 0.7% $ (53) (59.6%)
=========== =========== =========== =========== =========== ===========
NINE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Stock-based compensation $ 323 0.9% $ 307 0.8% $ 16 5.2%
=========== =========== =========== ============ =========== ===========
Stock-based compensation generally represents the amortization of
deferred compensation. We recorded no deferred compensation or deferred
compensation forfeitures for the nine months ended March 31, 2005. Deferred
compensation represents the difference between the fair value of the underlying
common stock for accounting purposes and the exercise price of the stock options
at the date of grant, as well as the fair market value of the vested portion of
non-employee stock options utilizing the Black-Scholes option pricing model.
Deferred compensation also includes the value of employee stock options assumed
in connection with our acquisitions calculated in accordance with current
accounting guidelines. Deferred compensation is presented as a reduction of
stockholders' equity and is amortized ratably over the respective vesting
periods of the applicable options, which is generally four years.
The increase in stock-based compensation for the nine months ended
March 31, 2005 is primarily attributable to charges for the valuation of vested
options for two terminated executives, one occurring in the quarter ended
September 30, 2004, and the second in the quarter ended December 31, 2004. At
March 31, 2005, a balance of approximately $23,000 remains. Of the remaining
$23,000, approximately $6,000 will be amortized over the balance of fiscal 2005,
and approximately $17,000 will be amortized in fiscal 2006.
In addition, included in cost of revenues is stock-based compensation
of $0 and $11,000 for the three months ended March 31, 2005 and 2004,
respectively, and $0 and $37,000 for the nine months ended March 31, 2005 and
2004, respectively.
23
AMORTIZATION OF PURCHASED INTANGIBLE ASSETS INCLUDED IN OPERATING EXPENSES
(in thousands)
THREE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Amortization of
purchased intangible assets $ 15 0.1% $ 29 0.2% $ (14) (48.3%)
=========== =========== =========== =========== =========== ============
NINE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Amortization of
purchased intangible assets $ 63 0.2% $ 118 0.3% $ (55) 46.6%
=========== =========== =========== =========== =========== ===========
Purchased intangible assets primarily include existing technology,
patents and non-compete agreements which are amortized on a straight-line basis
over the estimated useful lives of the respective assets, ranging from one to
five years. We obtained independent appraisals of the fair value of tangible and
intangible assets acquired in order to assist us in allocating the purchase
price. The decrease in amortization of purchased intangible assets is primarily
due to assets becoming fully amortized. At March 31, 2005, the unamortized
balance of purchased intangible assets that will be amortized to future
operating expense was approximately $4,000, which will be amortized in the
remainder of fiscal 2005 and 2006. In addition, approximately $363,000 and
$532,000 of amortization of purchased intangible assets has been classified as
cost of revenues for the three months ended March 31, 2005 and 2004,
respectively, and $1.1 million and $1.6 million for the nine months ended March
31, 2005 and 2004, respectively.
RESTRUCTURING CHARGES
During the nine months ended March 31, 2005, approximately $56,000 of
restructuring charges were recovered for a facility lease settlement related to
a discontinued operation.
INTEREST INCOME, NET (in thousands)
THREE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Interest income, net $ 3 0.0% $ 8 0.1% $ (5) 62.5%
=========== =========== =========== =========== =========== ===========
NINE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Interest income, net $ 19 0.1% $ 43 0.1% $ (24) (55.8%)
=========== =========== =========== =========== =========== ===========
Interest income, net consists primarily of interest earned on cash,
cash equivalents and marketable securities. The decrease is primarily due to
lower average investment balances and interest rates.
24
OTHER INCOME (EXPENSE), NET (in thousands)
THREE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Other income (expense), net $ (193) -1.6% $ (103) (0.8%) $ (90) (87.4%)
=========== =========== =========== =========== =========== ===========
NINE MONTHS ENDED
MARCH 31,
% OF NET % OF NET $ %
2005 REVENUE 2004 REVENUE VARIANCE VARIANCE
----------- ----------- ----------- ----------- ----------- -----------
Other income (expense), net $ 349 1.0% $ (283) (0.8%) $ 632 223.3%
=========== =========== =========== =========== =========== ===========
The increased expense in the quarter ended March 31, 2005 over the
quarter in the prior year is primarily due to higher foreign exchange losses in
the current quarter compared to the year earlier quarter. For the nine months
ended March 31, 2005, other income (expense), net improved over the prior year,
primarily due to the write-off of our Xanboo investment in June 2004, thereby
eliminating our equity share of losses in this investment in fiscal 2005.
Additionally, we had greater foreign currency gains in the nine months ended
March 31, 2005, than we had in the nine months ended March 31, 2004.
PROVISION FOR INCOME TAXES - EFFECTIVE TAX RATE
We utilize the liability method of accounting for income taxes as set
forth in SFAS No. 109, "Accounting for Income Taxes." Our effective tax rate was
4% and 6% for the nine months ended March 31, 2005 and 2004, respectively. The
federal statutory rate was 34% for both periods. Our effective tax rate
associated with the income tax expense for the nine month periods ended March
31, 2005 and 2004 was lower than the federal statutory rate primarily due to an
increase in the valuation allowance, primarily due to our inability to estimate
future taxable income, and foreign taxes. In 2003, the Internal Revenue Service
completed its audit of our federal income tax returns for the years ended June
30, 1999, 2000 and 2001. As a result, we paid tax and interest to the IRS and
the California Franchise Tax Board of approximately $222,000, $441,000 and
$113,000 in quarters ended March 31, 2004, June 30, 2004 and September 30, 2004,
respectively.
We recently had discussions with the Swiss Federal Tax Authorities
("SFTA") regarding the inability of our Swiss subsidiary, Lantronix
International AG, to meet certain guidelines as set within a tax ruling that was
obtained in May 2001. The ruling provided for reduced Swiss tax rates. The
subsidiary was unable to meet the guidelines set forth in the ruling due to
slower than planned growth in this subsidiary, consistent with our overall
Company, and has since converted to a holding company. The SFTA has ruled on
this matter, resulting in a tax liability to the SFTA of approximately $50,000
plus interest. This tax liability was accrued in the quarter ended March 31,
2005 financial statements and will be paid in the quarter ending June 30, 2005.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, we have financed our operations through the issuance
of common stock and through net cash generated from operations. We consider all
highly liquid investments purchased with original maturities of 90 days or less
to be cash equivalents. Cash and cash equivalents consisting of money-market
funds and commercial paper totaled approximately $6.6 million at March 31, 2005.
Our operating activities in the statement of cash flows used cash of
$4.9 million for the nine months ended March 31, 2005. We incurred a net loss of
$6.9 million, which includes the following adjustments: depreciation of
$504,000, amortization of purchased intangible assets of $1.2 million,
amortization of stock-based compensation of $323,000, provision for doubtful
accounts of $59,000, provision for inventory reserve of $206,000, loss on sale
of fixed assets of $23,000, offset by a recovery in the restructuring reserve of
$56,000 and a foreign exchange gain of $191,000. The changes in our operating
assets consist of an increase in inventory of $25,000, decrease in contract
manufacturer receivables of $399,000, decrease in prepaid expenses and other
assets of $698,000, a decrease in accounts payable of $360,000, a decrease in
other liabilities of $936,000, a decrease in accounts receivable of $534,000 and
a decrease in restructuring reserve of $385,000. The decrease in prepaid
expenses and other current assets is primarily due to the amortization of
prepaid expense during the period. The decrease in the restructuring reserve is
due to payments on lease obligations. The decrease in accounts receivable is due
to a reduction of receivables from our customers. The decrease in other current
liabilities is due to a reduction in payroll related accruals and other
accruals. The decrease in accounts payable is due to the timing of payments to
our suppliers.
25
Cash provided by investing activities in the statement of cash flows
was $2.1 million for the nine months ended March 31, 2005. We received $4.1
million in proceeds from the sale of marketable securities. We used $1.0 million
to purchase marketable securities and $867,000 to pay the convertible note from
the Stallion acquisition. We also used $87,000 to purchase property and
equipment.
Financing activities in the statement of cash flows provided $47,000 in
the nine months ended March 31, 2005. We received $422,000 related to the
purchase of common shares through option exercises and purchases through the
employee stock purchase plan. We used $375,000 to pay down our bank loan.
In January 2002, we entered into a two-year line of credit with a bank
in an amount not to exceed $20.0 million. Borrowings under the line of credit
bear interest at either (i) the prime rate or (ii) the LIBOR rate plus 2.0%. We
were required to pay a $100,000 facility fee which was reduced to $62,500 and
was paid. We are also required to pay a quarterly unused line fee of .125% of
the unused line of credit balance. Since establishing the line of credit, we
have twice reduced the amount of the line, modified customary financial
covenants and adjusted the interest rate to be charged on borrowings to the
prime rate plus .50% and eliminated the LIBOR option. Effective July 25, 2003,
we further modified this line of credit, reducing the revolving line to $5.0
million and adjusting the customary affirmative and negative covenants. We are
also required to maintain certain financial ratios as defined in the agreement.
The agreement has an annual revolving maturity date that renews on the effective
date. The agreement was renewed on July 24, 2004, with an amendment to a
financial ratio, and again on February 15, 2005 with an amendment to a covenant.
We paid $12,500 and $1,000 in facility fees, respectively, for the renewals. Our
total available cash under the credit line at March 31, 2005 was $2.7 million.
In March 2004, we borrowed $500,000 against this line of credit. In October and
December 2004 and March 2005, we made three $125,000 payments leaving an
outstanding balance of $125,000 for the period ended March 31, 2005.
Additionally, we have used letters of credit available under our line of credit
totaling approximately $442,000 in place of cash to fund tax account deposits
and security deposits. As a result, our available line of credit at March 31,
2005 was $2.2 million. Pursuant to the line of credit, we are restricted from
paying any dividends.
The following table summarizes our contractual payment obligations and
commitments (in thousands):
REMAINDER
OF FISCAL YEAR FISCAL YEARS
2005 2006 2007 2008 2009 TOTAL
---------- ---------- ---------- ---------- ---------- ----------
Bank line of credit $ 125 $ -- $ -- $ -- $ -- $ 125
Operating leases 272 1,099 724 577 605 3,277
---------- ---------- ---------- ---------- ---------- ----------
Total $ 397 $ 1,099 $ 724 $ 577 $ 605 $ 3,402
========== ========== ========== ========== ========== ==========
As of March 31, 2005, approximately $2.6 million of our tangible assets
(primarily cash held in foreign subsidiary bank accounts) were held by
subsidiaries outside the United States. Such assets are unrestricted with regard
to foreign liquidity needs, however, our ability to utilize a portion of such
assets to satisfy liquidity needs outside of such foreign locations are subject
to approval by the foreign location board of directors. With the simplification
of our foreign sales structure and closing of several offices and reduction of
operations in Europe, our business has become simpler. We have significantly
lower-cost operations and no longer perform many administrative functions in
Europe, having transferred those activities to our Irvine, California, offices.
As a result, the balances held in foreign accounts as of December 31, 2004 are
greater than our needs, and we will begin to transfer portions of those cash
balances to U.S. accounts during the fourth quarter of fiscal 2005.
Our cash, cash equivalents and marketable securities balances decreased
by $1.6 million, from $8.2 million at December 31, 2004, to $6.6 million at
March 31, 2005. We refer to the sum of these components as "cash" for the
purposes of discussing our cash usage and liquidity. During the fiscal year
ended June 30, 2004, cash usage totaled $1.9 million. Cash usage increased to
$3.0 million in the first fiscal quarter, which included payments for increased
marketing and sales expenses to launch new product programs, repayment of a note
of $867,000 related to the Stallion acquisition, audit payments and other costs.
Cash usage decreased to $1.0 million in the second fiscal quarter.
26
Throughout the quarter ended December 31, 2004, we reduced expenses
from the levels of the first fiscal quarter, as part of a planned program. These
activities have been ongoing, and in January 2005, we further cut back our staff
to reduce operating costs. In the process, we realigned our international sales
operations and have reduced our fixed costs in Japan and Europe. We also closed
a small sales office in Milford, Connecticut. The cumulative effect of the
reductions initiated in October 2004 through January 2005 is that we are
lowering our operating costs to streamline operations and lower our cash
breakeven point from the earlier revenue range of $14-15 million in quarterly
revenues as an operating model, to approximately $13 million per quarter. This
target is based upon a financial model, and we expect that actual expenses may
vary in any quarter and thus, so would financial results impacting cash usage or
profitability. Also, uses of cash to fund inventories, receivables and payables,
will cause results to vary from the financial model.
We believe that our existing cash, cash equivalents and marketable
securities and any available borrowings under our line of credit facility will
be adequate to meet our anticipated cash needs through at least the next twelve
months. Our future capital requirements will depend on many factors, including
the timing and amount of our net revenues, research and development and
infrastructure investments, and expenses related to ongoing government
investigations and pending litigation, which will affect our ability to generate
additional cash. If cash generated from operations and financing activities is
insufficient to satisfy our working capital requirements, we may need to borrow
funds through bank loans, sales of securities or other means. There can be no
assurance that we will be able to raise any such capital on terms acceptable to
us, if at all. If we are unable to secure additional financing, we may not be
able to develop or enhance our products, take advantage of future opportunities,
respond to competition or continue to operate our business.
RISK FACTORS
You should carefully consider the risks described below before making
an investment decision. The risks and uncertainties described below are not the
only ones facing our company. Our business operations may be impaired by
additional risks and uncertainties of which we are unaware or that we currently
consider immaterial.
Our business, results of operations or cash flows may be adversely
affected if any of the following risks actually occur. In such case, the trading
price of our common stock could decline, and you may lose all or part of your
investment.
VARIATIONS IN QUARTERLY OPERATING RESULTS, DUE TO FACTORS INCLUDING
CHANGES IN DEMAND FOR OUR PRODUCTS AND CHANGES IN OUR MIX OF NET REVENUES, COULD
CAUSE OUR STOCK PRICE TO DECLINE.
Our quarterly net revenues, expenses and operating results have varied
in the past and might vary significantly from quarter to quarter in the future.
We, therefore, believe that quarter-to-quarter comparisons of our operating
results are not a good indication of our future performance, and you should not
rely on them to predict our future performance or the future performance of our
stock price. Our short-term expense levels are relatively fixed and are based on
our expectations of future net revenues. If we were to experience a reduction in
net revenues in a quarter, we would likely be unable to adjust our short-term
expenditures. If this were to occur, our operating results for that quarter
would be harmed. If our operating results in future quarters fall below the
expectations of market analysts and investors, the price of our common stock
would likely fall. Other factors that might cause our operating results to
fluctuate on a quarterly basis include:
o changes in the mix of net revenues attributable to higher-margin
and lower-margin products;
o customers' decisions to defer or accelerate orders;
o variations in the size or timing of orders for our products;
o changes in demand for our products;
o defects and other product quality problems;
o loss or gain of significant customers;
o short-term fluctuations in the cost or availability of our
critical components;
o announcements or introductions of new products by our competitors;
o changes in demand for devices that incorporate our products.
WE ARE CURRENTLY ENGAGED IN MULTIPLE SECURITIES CLASS ACTION LAWSUITS,
A STATE DERIVATIVE SUIT, A LAWSUIT BY OUR FORMER CFO AND COO STEVEN V. COTTON, A
LAWSUIT BY FORMER SHAREHOLDERS OF OUR SYNERGETIC SUBSIDIARY, AND PATENT
INFRINGEMENT LITIGATION, ANY OF WHICH, IF IT RESULTS IN AN UNFAVORABLE
RESOLUTION, COULD ADVERSELY AFFECT OUR BUSINESS, RESULTS OF OPERATIONS OR
FINANCIAL CONDITION.
From time to time, we are subject to other legal proceedings and claims
in the ordinary course of business.
27
We are currently involved in significant litigation, including multiple
security class action lawsuits, a state derivative lawsuit, litigation with a
former executive officer and patent infringement litigation. The pending
lawsuits involve complex questions of fact and law and will likely continue to
require the expenditure of significant funds and the diversion of other
resources to defend. We do not know what the outcome of outstanding legal
proceedings will be and cannot determine the extent to which these resolutions
might have a material adverse effect on our business, results of operations and
financial condition taken as a whole. The results of litigation are inherently
uncertain, and adverse outcomes are possible. For a more detailed description of
pending litigation, see Note 14 of Part I of this Form 10-Q.
WE MIGHT BECOME INVOLVED IN LITIGATION OVER PROPRIETARY RIGHTS, WHICH
COULD BE COSTLY AND TIME CONSUMING.
Substantial litigation regarding intellectual property rights exists in
our industry. There is a risk that third parties, including current and
potential competitors, current developers of our intellectual property, our
manufacturing partners, or parties with which we have contemplated a business
combination, will claim that our products, or our customers' products, infringe
on their intellectual property rights or that we have misappropriated their
intellectual property. In addition, software, business processes and other
property rights in our industry might be increasingly subject to third-party
infringement claims as the number of competitors grows and the functionality of
products in different industry segments overlaps. Other parties might currently
have, or might eventually be issued, patents that infringe on the proprietary
rights we use. Any of these third parties might make a claim of infringement
against us. For example, Digi International, ("Digi") has just filed a lawsuit
alleging that we infringe their `192 patent. We have filed suit alleging that
Digi infringes our `305 patent. Please refer to Note 14 of Part I of this Form
10-Q for more information.
From time to time in the future we could encounter other disputes over
rights and obligations concerning intellectual property. We cannot assume that
we will prevail in intellectual property disputes regarding infringement,
misappropriation or other disputes. Litigation in which we are accused of
infringement or misappropriation might cause a delay in the introduction of new
products, require us to develop non-infringing technology, require us to enter
into royalty or license agreements, which might not be available on acceptable
terms, or at all, or require us to pay substantial damages, including treble
damages if we are held to have willfully infringed. In addition, we have
obligations to indemnify certain of our customers under some circumstances for
infringement of third-party intellectual property rights. If any claims from
third-parties were to require us to indemnify customers under our agreements,
the costs could be substantial, and our business could be harmed. If a
successful claim of infringement was made against us and we could not develop
non-infringing technology or license the infringed or similar technology on a
timely and cost-effective basis, our business could be significantly harmed.
WE HAVE ELECTED TO USE A CONTRACT MANUFACTURER IN CHINA, WHICH INVOLVES
SIGNIFICANT RISKS.
One of our contract manufacturers is based in China. There are
significant risks of doing business in China, including:
o China does not afford the same level of protection to intellectual
property as domestic or many foreign countries. If our products
were reverse-engineered or our intellectual property was otherwise
pirated (reproduced and duplicated without our knowledge or
approval), our revenues would be reduced.
o Delivery times are extended due to the distances involved,
requiring more lead-time in ordering and increasing the risk of
excess inventories.
o We could incur ocean freight delays because of labor problems,
weather delays or expediting and customs problems.
o China and U.S. foreign relations have, historically, been subject
to change. Political considerations and actions could interrupt
our expected supply of products from China.
INABILITY, DELAYS IN DELIVERIES OR QUALITY PROBLEMS FROM OUR COMPONENT
SUPPLIERS COULD DAMAGE OUR REPUTATION AND COULD CAUSE OUR NET REVENUES TO
DECLINE AND HARM OUR RESULTS OF OPERATIONS.
We and our contract manufacturers are responsible for procuring raw
materials for our products. Our products incorporate components or technologies
that are only available from single or limited sources of supply. In particular,
some of our integrated circuits are available from a single source. From time to
time in the past, integrated circuits we use in our products have been phased
out of production. When this happens, we attempt to purchase sufficient
inventory to meet our needs until a substitute component can be incorporated
28
into our products. Nonetheless, we might be unable to purchase sufficient
components to meet our demands, or we might incorrectly forecast our demands,
and purchase too many or too few components. In addition, our products use
components that have in the past been subject to market shortages and
substantial price fluctuations. From time to time, we have been unable to meet
our orders because we were unable to purchase necessary components for our
products. We rely on a number of different component suppliers. Because we do
not have long-term supply arrangements with any vendor to obtain necessary
components or technology for our products, if we are unable to purchase
components from these suppliers, product shipments could be prevented or
delayed, which could result in a loss of sales. If we are unable to meet
existing orders or to enter into new orders because of a shortage in components,
we will likely lose net revenues and risk losing customers and harming our
reputation in the marketplace.
IF A MAJOR CUSTOMER CANCELS, REDUCES, OR DELAYS PURCHASES, OUR NET
REVENUES MIGHT DECLINE AND OUR BUSINESS COULD BE ADVERSELY AFFECTED.
Our top five customers accounted for approximately 42.9% and 37.8% of
our net revenues for the nine months ended March 31, 2005 and 2004,
respectively. One customer, Ingram Micro, Inc., accounted for approximately
16.0% and 14.2% of our net revenues for the nine months ended March 31, 2005 and
2004, respectively. Another customer, Tech Data, accounted for approximately
11.2% and 8.4% of our net revenues for the nine months ended March 31, 2005 and
2004, respectively. Accounts receivable attributable to these two domestic
customers accounted for approximately 7.6% and 12.9% of total accounts
receivable at March 31, 2005 and June 30, 2004, respectively. The number and
timing of sales to our distributors have been difficult for us to predict. While
our distributors are customers in the sense they buy our products, they are also
part of our product distribution system. To some extent, the business lost for
some reason to a distributor would likely be replaced by sales to other
customer/distributors in a reasonable period, rather than a total loss of that
business such as from a customer who used our products in their business.
The loss or deferral of one or more significant sales in a quarter
could harm our operating results. We have in the past, and might in the future,
lose one or more major customers. If we fail to continue to sell to our major
customers in the quantities we anticipate, or if any of these customers
terminate our relationship, our reputation, the perception of our products and
technology in the marketplace, the growth of our business could be harmed. The
demand for our products from our OEM, VAR and systems integrator customers
depends primarily on their ability to successfully sell their products that
incorporate our device networking solutions technology. Our sales are usually
completed on a purchase order basis and we have no long-term purchase
commitments from our customers.
Our future success also depends on our ability to attract new
customers, which often involves an extended process. The sale of our products
often involves a significant technical evaluation, and we often face delays
because of our customers' internal procedures for evaluating and deploying new
technologies. For these and other reasons, the sales cycle associated with our
products is typically lengthy, often lasting six to nine months and sometimes
longer. Therefore, if we were to lose a major customer, we might not be able to
replace the customer on a timely basis or at all. This would cause our net
revenues to decrease and could cause the price of our stock to decline.
THE MARKET FOR OUR PRODUCTS IS NEW AND RAPIDLY EVOLVING. IF WE ARE NOT
ABLE TO DEVELOP OR ENHANCE OUR PRODUCTS TO RESPOND TO CHANGING MARKET
CONDITIONS, OUR NET REVENUES WILL SUFFER.
Our future success depends in large part on our ability to continue to
enhance existing products, lower product cost and develop new products that
maintain technological competitiveness. The demand for network-enabled products
is relatively new and can change as a result of innovations or changes. For
example, industry segments might adopt new or different standards, giving rise
to new customer requirements. Any failure by us to develop and introduce new
products or enhancements directed at new industry standards could harm our
business, financial condition and results of operations. These customer
requirements might or might not be compatible with our current or future product
offerings. We might not be successful in modifying our products and services to
address these requirements and standards. For example, our competitors might
develop competing technologies based on Internet Protocols, Ethernet Protocols
or other protocols that might have advantages over our products. If this were to
happen, our net revenue might not grow at the rate we anticipate, or could
decline.
IF OUR RESEARCH AND DEVELOPMENT EFFORTS ARE NOT SUCCESSFUL, OUR NET
REVENUES COULD DECLINE AND OUR BUSINESS COULD BE HARMED.
For the nine months ended March 31, 2005, we incurred $5.0 million in
research and development expenses, which comprised 13.8% of our net revenues. If
we are unable to develop new products as a result of this effort, or if the
products we develop are not successful, our business could be harmed. Even if we
do develop new products that are accepted by our target markets, we do not know
whether the net revenue from these products will be sufficient to justify our
investment in research and development.
29
THE AVERAGE SELLING PRICES OF OUR PRODUCTS MIGHT DECREASE, WHICH COULD
REDUCE OUR GROSS MARGINS.
In the past, we have experienced some reduction in the average selling
prices and gross margins of products and we expect that this will continue for
our products as they mature. In the future, we expect competition to increase,
and we anticipate this could result in additional pressure on our pricing. Our
average selling prices for our products might decline as a result of other
reasons, including promotional programs and customers who negotiate price
reductions in exchange for longer-term purchase commitments. We also may not be
able to increase the price of our products in the event that the prices of
components or our overhead costs increase. Changes in exchange rates between
currencies might change in such a way or over a period such that we cannot
adjust prices to maintain gross margins. If these were to occur, our gross
margins would decline. In addition, we may not be able to reduce the cost to
manufacture our products to keep up with the decline in prices.
THERE IS A RISK THAT THE SEC COULD LEVY FINES AGAINST US, OR DECLARE US
TO BE OUT OF COMPLIANCE WITH THE RULES REGARDING OFFERING SECURITIES TO THE
PUBLIC.
The SEC is investigating the events surrounding the restatement of our
financial statements filed on June 25, 2002 for the year ended June 30, 2001 and
for the six months ended December 31, 2002. The SEC could conclude that we
violated the rules of the Securities Act of 1933 or the Securities and Exchange
Act of 1934. In either event, the SEC might levy civil fines against us, or
might conclude that we lack sufficient internal controls to warrant our being
allowed to continue offering our shares to the public. This investigation
involves substantial cost and could significantly divert the attention of
management. These costs, and the cost of any fines imposed by the SEC, are not
covered by insurance. In addition to sanctions imposed by the SEC, an adverse
determination could significantly damage our reputation with customers and
vendors, and harm our employees' morale.
WE INCORPORATE SOFTWARE LICENSED FROM THIRD PARTIES INTO SOME OF OUR
PRODUCTS AND ANY SIGNIFICANT INTERRUPTION IN THE AVAILABILITY OF THESE
THIRD-PARTY SOFTWARE PRODUCTS OR DEFECTS IN THESE PRODUCTS COULD REDUCE THE
DEMAND FOR, OR PREVENT THE SALE OR USE OF, OUR PRODUCTS.
Certain of our products contain components developed and maintained by
third-party software vendors or are available through the "open source" software
community. We also expect that we may incorporate software from third-party
vendors and open source software in our future products. Our business would be
disrupted if this software, or functional equivalents of this software, were
either no longer available to us or no longer offered to us on commercially
reasonable terms. In either case, we would be required to either redesign our
products to function with alternate third-party software or open source
software, or develop these components ourselves, which would result in increased
costs and could result in delays in our product shipments. Furthermore, we might
be forced to limit the features available in our current or future product
offerings. We presently are developing products for use on the Linux platform.
The SCO Group (SCO) has filed and threatened to file lawsuits against companies
that operate Linux for commercial purposes, alleging that such use of Linux
infringes SCO's rights. These allegations may adversely affect the demand for
the Linux platform and, consequently, the sales of our Linux-based products.
UNDETECTED PRODUCT ERRORS OR DEFECTS COULD RESULT IN LOSS OF NET
REVENUES, DELAYED MARKET ACCEPTANCE AND CLAIMS AGAINST US.
We currently offer warranties ranging from ninety days to two years on
each of our products. Our products could contain undetected errors or defects.
If there is a product failure, we might have to replace all affected products
without being able to book revenue for replacement units, or we may have to
refund the purchase price for the units. Because of our recent introduction of
our line of device servers, we do not have a long history with which to assess
the risks of unexpected product failures or defects for this product line.
Regardless of the amount of testing we undertake some errors might be discovered
only after a product has been installed and used by customers. Any errors
discovered after commercial release could result in loss of net revenues and
claims against us. Significant product warranty claims against us could harm our
business, reputation and financial results and cause the price of our stock to
decline.
WE PRIMARILY DEPEND ON FIVE THIRD-PARTY MANUFACTURERS TO MANUFACTURE
SUBSTANTIALLY ALL OF OUR PRODUCTS, WHICH REDUCES OUR CONTROL OVER THE
MANUFACTURING PROCESS. IF THESE MANUFACTURERS ARE UNABLE OR UNWILLING TO
MANUFACTURE OUR PRODUCTS AT THE QUALITY AND QUANTITY WE REQUEST, OUR BUSINESS
COULD BE HARMED AND OUR STOCK PRICE COULD DECLINE.
We outsource substantially all of our manufacturing to five third-party
manufacturers, Venture Electronics Services, Varian, Inc. (which was recently
acquired by Jabil Circuit, Inc.), Irvine Electronics, Inc., Uni Precision
Industrial Ltd., and Universal Scientific Industrial Company, LTD. Our reliance
on these third-party manufacturers exposes us to a number of significant risks,
including:
30
o reduced control over delivery schedules, quality assurance,
manufacturing yields and production costs;
o lack of guaranteed production capacity or product supply; and
o reliance on third-party manufacturers to maintain competitive
manufacturing technologies.
Our agreements with these manufacturers provide for services on a
purchase order basis. If our manufacturers were to become unable or unwilling to
continue to manufacture our products in required volumes, at acceptable quality,
quantity, yields and costs, or in a timely manner, our business would be
seriously harmed. As a result, we would have to attempt to identify and qualify
substitute manufacturers, which could be time consuming and difficult, and might
result in unforeseen manufacturing and operations problems. For example, Jabil
Circuit, Inc. acquired Varian, Inc. in March 2005 and have made a decision to
close the facility that currently manufactures our product. We are in the
process of transferring this production to another contract manufacturer.
Moreover, as we shift products among third-party manufacturers, we may incur
substantial expenses, risk material delays, or encounter other unexpected
issues. For example, in the third quarter of fiscal 2003 we encountered product
shortages related to the transition to a third-party manufacturer. This product
shortage contributed to our net revenues falling below our publicly announced
estimates.
In addition, a natural disaster could disrupt our manufacturers'
facilities and could inhibit our manufacturers' ability to provide us with
manufacturing capacity on a timely basis, or at all. If this were to occur, we
likely would be unable to fill customers' existing orders or accept new orders
for our products. The resulting decline in net revenues would harm our business.
We also are responsible for forecasting the demand for our individual products.
These forecasts are used by our contract manufacturers to procure raw materials
and manufacture our finished goods. If we forecast demand too high, we may
invest too much cash in inventory and we may be forced to take a write-down of
our inventory balance, which would reduce our earnings. If our forecast is too
low for one or more products, we may be required to pay expedite charges which
would increase our cost of revenues or we may be unable to fulfill customer
orders, thus reducing net revenues and therefore earnings.
BECAUSE WE ARE DEPENDENT ON INTERNATIONAL SALES FOR A SUBSTANTIAL
AMOUNT OF OUR NET REVENUES, WE FACE THE RISKS OF INTERNATIONAL BUSINESS AND
ASSOCIATED CURRENCY FLUCTUATIONS, WHICH MIGHT ADVERSELY AFFECT OUR OPERATING
RESULTS.
Net revenues from international sales represented 36.2% and 32.6% of
net revenues for the nine months ended March 31, 2005 and 2004, respectively.
Net revenues from Europe represented 27.0% and 22.9% of our net revenues for the
nine months ended March 31, 2005 and 2004, respectively.
We expect that international revenues will continue to represent a
significant portion of our net revenues in the foreseeable future. Doing
business internationally involves greater expense and many additional risks. For
example, because the products we sell abroad and the products and services we
buy abroad are priced in foreign currencies, we are affected by fluctuating
exchange rates. In the past, we have from time to time lost money because of
these fluctuations. We might not successfully protect ourselves against currency
rate fluctuations, and our financial performance could be harmed as a result. In
addition, we face other risks of doing business internationally, including:
o unexpected changes in regulatory requirements, taxes, trade laws
and tariffs;
o reduced protection for intellectual property rights in some
countries;
o differing labor regulations;
o compliance with a wide variety of complex regulatory requirements;
o changes in a country's or region's political or economic
conditions;
o greater difficulty in staffing and managing foreign operations;
and
o increased financial accounting and reporting burdens and
complexities.
Our international operations require significant attention from our
management and substantial financial resources. We do not know whether our
investments in other countries will produce desired levels of net revenues or
profitability.
31
THERE IS A RISK WE MAY BE UNABLE TO DISPOSE OF OUR INVENTORY.
Our products and therefore our inventories are subject to technological
risk. At any time, either new products may enter the market or prices of
competitive products may be introduced with more attractive features or at lower
prices than ours. There is a risk that we may be unable to sell our inventory in
a timely manner to avoid it becoming obsolete. As of March 31, 2005, our
inventories, including raw materials, finished goods and inventory at
distributors, were valued at $12.3 million and we had excess and obsolete
inventory reserves of $5.8 million against these inventories. As of June 30,
2004, our inventories, including raw materials, finished goods and inventory at
distributors were valued at $12.7 million and we had excess and obsolete
inventory reserves of $6.0 million against these inventories. In the event we
are required to substantially discount our inventory or are unable to sell our
inventory in a timely manner, we would be required to increase our reserves and
our operating results could be substantially harmed.
OUR EXECUTIVE OFFICERS AND TECHNICAL PERSONNEL ARE CRITICAL TO OUR
BUSINESS, AND WITHOUT THEM WE MIGHT NOT BE ABLE TO EXECUTE OUR BUSINESS
STRATEGY.
Our financial performance depends substantially on the performance of
our executive officers and key employees. We are dependent in particular on Marc
Nussbaum, who serves as our President and Chief Executive Officer, and James
Kerrigan, who serves as our Chief Financial Officer. We have no employment
contracts with those executives who are at-will employees. We are also dependent
upon our technical personnel, due to the specialized technical nature of our
business. If we lose the services of Mr. Nussbaum, Mr. Kerrigan or any of our
key personnel and are not able to find replacements in a timely manner, our
business could be disrupted, other key personnel might decide to leave, and we
might incur increased operating expenses associated with finding and
compensating replacements.
THERE IS A RISK THAT OUR OEM CUSTOMERS WILL DEVELOP THEIR OWN INTERNAL
EXPERTISE IN NETWORK-ENABLING PRODUCTS, WHICH COULD RESULT IN REDUCED SALES OF
OUR PRODUCTS.
For most of our existence, we primarily sold our products to
distributors, VARs and system integrators. Although we intend to continue to use
all of these sales channels, we have begun to focus more heavily on selling our
products to OEMs. Selling products to OEMs involves unique risks, including the
risk that OEMs will develop internal expertise in network-enabling products or
will otherwise provide network functionality to their products without using our
device networking solutions. If this were to occur, our stock price could
decline in value and you could lose part or all of your investment.
NEW PRODUCT INTRODUCTIONS AND PRICING STRATEGIES BY OUR COMPETITORS
COULD ADVERSELY AFFECT OUR ABILITY TO SELL OUR PRODUCTS AND COULD REDUCE OUR
MARKET SHARE OR RESULT IN PRESSURE TO REDUCE THE PRICE OF OUR PRODUCTS.
The market for our products is intensely competitive, subject to rapid
change and is significantly affected by new product introductions and pricing
strategies of our competitors. We face competition primarily from companies that
network-enable devices, semiconductor companies, companies in the automation
industry and companies with significant networking expertise and research and
development resources. Our competitors might offer new products with features or
functionality that are equal to or better than our products. In addition, since
we work with open standards, our customers could develop products based on our
technology that compete with our offerings. We might not have sufficient
engineering staff or other required resources to modify our products to match
our competitors. Similarly, competitive pressure could force us to reduce the
price of our products. In each case, we could lose new and existing customers to
our competition. If this were to occur, our net revenues could decline and our
business could be harmed.
OUR INTELLECTUAL PROPERTY PROTECTION MIGHT BE LIMITED.
We have not historically relied on patents to protect our proprietary
rights, although we are now building a patent portfolio. We rely primarily on a
combination of laws, such as copyright, trademark and trade secret laws, and
contractual restrictions, such as confidentiality agreements and licenses, to
establish and protect our proprietary rights. Despite any precautions that we
have taken:
o laws and contractual restrictions might not be sufficient to
prevent misappropriation of our technology or deter others from
developing similar technologies;
o other companies might claim common law trademark rights based upon
use that precedes the registration of our marks;
o other companies might assert other rights to market products using
our trademarks;
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o policing unauthorized use of our products and trademarks is
difficult, expensive and time-consuming, and we might be unable to
determine the extent of this unauthorized use;
o courts may determine that our software programs use open source
software in such a way that deprives the entire programs of
intellectual property protection; and
o current federal laws that prohibit software copying provide only
limited protection from software pirates.
Also, the laws of other countries in which we market and manufacture
our products might offer little or no effective protection of our proprietary
technology. Reverse engineering, unauthorized copying or other misappropriation
of our proprietary technology could enable third-parties to benefit from our
technology without paying us for it, which could significantly harm our
business.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk for changes in interest rates relates
primarily to our investment portfolio. We do not use derivative financial
instruments for speculative or trading purposes. We place our investments in
instruments that meet high credit quality standards, as specified in our
investment policy. Information relating to quantitative and qualitative
disclosure about market risk is set forth below and in "Management's Discussion
and Analysis of Financial Condition and Results of Operations-Liquidity and
Capital Resources."
INTEREST RATE RISK
Our exposure to interest rate risk is limited to the exposure related
to our cash, cash equivalents, marketable securities and our credit facilities,
which is tied to market interest rates. As of March 31, 2005 and June 30, 2004,
we had cash and cash equivalents of approximately $6.6 million and $9.1 million,
respectively, which consisted of cash and short-term investments with original
maturities of ninety days or less, both domestically and internationally. As of
March 31, 2005 and June 30, 2004, we had marketable securities of approximately
$0.0 and $3.1 million, respectively, consisting of obligations of municipal
bonds. We believe our marketable securities will decline in value by an
insignificant amount if interest rates increase, and therefore would not have a
material effect on our financial condition or results of operations.
FOREIGN CURRENCY RISK
Fluctuations in the Euro and other currencies could impact us as the
operating results of our foreign subsidiaries are translated into U.S. dollars
for our consolidation. We have not implemented a hedging strategy to reduce
foreign currency risk. Our, financial results could be harmed by factors such as
changes in foreign currency exchange rates or weak economic conditions in
foreign markets. For the three months ended March 31, 2005 and 2004 we had
foreign exchange losses of $172,000 and $46,000. Effective April 1, 2005, we
changed our pricing to U.S. dollars for those customers that previously had Euro
pricing in effect.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures
We carried out an evaluation, under the supervision and with the
participation of our management, including our Chief Executive Officer and our
Chief Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934 (the "Exchange Act")) as of the end of
our third fiscal quarter. Based upon that evaluation, our Chief Executive
Officer and our Chief Financial Officer concluded that our disclosure controls
and procedures are effective in ensuring that information required to be
disclosed by us in reports that we file or submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in Securities and Exchange Commission's rules and forms.
(b) Changes in internal controls
During the period covered by this report, there have been no changes in
our internal control over financial reporting that have materially affected, or
are reasonably likely to materially affect, our internal control over financial
reporting.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information set forth in Note 14 of Part I, Item 1 of this Form
10-Q is hereby incorporated by reference.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ------ -----------------------
31.1 Certification of Principal Executive Officer pursuant to Securities
Exchange Act Rules 13a-15(e) and 15d-15(e), as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Principal Financial Officer pursuant to Securities
Exchange Act Rules 13a-15(e) and 15d-15(e), as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer and Chief Financial
Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.*
* Furnished, not filed.
34
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: May 12, 2005 LANTRONIX, INC.
(Registrant)
By: /s/ Marc H. Nussbaum
-----------------------------
MARC H. NUSSBAUM
CHIEF EXECUTIVE OFFICER
(PRINCIPAL EXECUTIVE OFFICER)
By: /s/ James W. Kerrigan
-----------------------------
JAMES W. KERRIGAN
CHIEF FINANCIAL OFFICER
(PRINCIPAL FINANCIAL OFFICER)
35