PEERLESS SYSTEMS CORP - 10-K Annual Report

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

FORM 10-K

(Mark One)

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

For the Fiscal Year Ended January 31, 2002

Commission File Number: 000-21287

PEERLESS SYSTEMS CORPORATION
(Exact name of registrant as specified in its charter)

Delaware 95-3732595
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)

2381 Rosecrans Avenue, El Segundo, CA 90245
(Address of principal executive offices, including zip code)

(310) 536-0908
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.001 Par Value Per Share

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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [_]

The approximate aggregate market value of the Common Stock held by
non-affiliates of the Registrant, based upon the last sale price of the Common
Stock reported on the Nasdaq National Market on April 24, 2002 was approximately
$26,208,662.

The number of shares of Common Stock outstanding as of April 24, 2002 was
15,416,860.

DOCUMENTS INCORPORATED BY REFERENCE

Certain parts of the Peerless Systems Corporation Proxy Statement relating
to the annual meeting of stockholders to be held on or around June 20, 2002 (the
"Proxy Statement") are incorporated by reference into Part III of this Annual
Report on Form 10-K.

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SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS

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

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

These forward-looking statements are just projections and estimations based upon
the information available to the Company at this time. Thus they involve known
and unknown risks and uncertainties such that actual results could differ
materially from those projected in the forward-looking statements made in this
Annual Report on Form 10-K. Risks and uncertainties include, but are not limited
to: a) changes in the marketplaces in which the Company offers its products; b)
the failure of Peerless' business to produce the projected financial results; c)
the failure of Peerless to maintain its margins due to changes in its business
model in reaction to competitive pressures; d) the delay in or the
non-acceptance by the market of new product and technology offerings; e) the
inability of the Company to retain and attract the technical talent to compete
effectively in the marketplace for imaging; f) the failure of Peerless' markets
to achieve anticipated growth rates; g) unfavorable economic conditions
resulting in decreased demand for original equipment manufacturers' ("OEMs")
products using Peerless' technology, making it difficult for the Company to
obtain new licensing agreements; h) OEM's determinations not to proceed with
development of products using Peerless' technology due to, among other things,
changes in the demand for anticipated OEM products, age of Peerless' technology,
concerns about Peerless' financial position and Peerless' competitors offering
alternative solutions; i) the lack of acceptance of Peerless' Internet printing
technology by users in the hospitality markets; j) Peerless' competitors coming
to market with new products or alternative solutions that are superior or
available at a lower cost or earlier than anticipated or believed to be
possible; k) the markets in imaging and networking may not grow to anticipated
levels; l) the costs associated with the development and marketing of products
for imaging and networking may be higher than currently forecasted; m) an
unfavorable outcome to the class action lawsuit presently being litigated; n)
changes in demand for the Company's products and services based on market
conditions and the competitiveness of Peerless' products from both technological
and pricing perspectives; o) the Company's inability to maintain or further
improve operating efficiencies or to further streamline operations; p) the
impact on the Company's financials of any future need to expand the organization
to meet customer or market demands; q) continuing unfavorable world-wide
economic conditions exacerbated by the terrorist attacks on the worldwide
financial infrastructure; and r) other factors affecting Peerless' business and
the forward-looking statements set forth herein. Those risks and uncertainties
include those set forth in pages 26 through 34 of this Annual Report on Form
10-K.

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

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PEERLESS SYSTEMS CORPORATION

2002 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

Page
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PART I

Item 1. Business 4

Item 2. Properties 16

Item 3. Legal Proceedings 16

Item 4. Submission Of Matters To A Vote Of Security Holders 16

PART II

Item 5. Market For The Registrant's Common Equity Related Stockholder Matters 17

Item 6. Selected Financial Data 17

Item 7. Management's Discussion And Analysis Of Financial Condition And Results Of Operations 18

Item 7A. Quantitative and Qualitative Disclosures About Market Risk 26

Item 8. Consolidated Financial Statements And Supplementary Data 35

Item 9. Changes In And Disagreements With Accountants On Accounting And Financial Disclosure 35

PART III

Item 10. Directors And Executive Officers 36

Item 11. Executive Compensation 36

Item 12. Security Ownership Of Certain Beneficial Owners And Management 36

Item 13. Certain Relationships And Related Transactions 36

PART IV

Item 14. Exhibits, Financial Statement Schedules And Reports On Form 8-K 37

TRADEMARKS

Memory Reduction Technology(R) (MRT), PeerlessPowered(R), WinExpress(R),
PeerlessPrint(R), RedipS(R), AccelePrint(R), SyntheSys(R) and QuickPrint(R) are
registered trademarks of Peerless Systems Corporation. MagicPrint(TM),
VersaPage(TM) and PerfecTone(TM) are trademarks of Peerless Systems Corporation
and are the subjects of applications pending for registration with the United
States Patent and Trademark Office. PeerlessPage(TM), ImageWorks(TM) and
WebWorks(TM) are trademarks of Peerless Systems Corporation. Peerless Systems, P
logo, and Peerless logo are trademarks and service marks trademarks of Peerless
Systems Corporation registered in Japan. RedipS is a trademark of Peerless
Systems Corporation registered in Canada and in the European Community.
PeerlessPrint is a trademark of Peerless Systems Corporation which is the
subject of applications for registration pending in Japan and the European
Community. PeerlessPrint (in Katakana) is a trademark of Peerless Systems
Corporation which is the subject of an application for registration pending in
Japan. This Annual Report on Form 10-K also refers to various products and
companies by their trademark names. In most, if not in all cases, their
respective companies claim these designations as trademarks or registered
trademarks.

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PART I

Item 1-Business.

Peerless Systems Corporation ("Peerless" or the "Company") provides
software-based imaging and networking technology for digital document products
and integrates proprietary software into enterprise networks of original
equipment manufacturers ("OEMs").

Digital document products include monochrome and color printers, copiers,
fax machines and scanners, as well as multifunction products ("MFPs") that
perform a combination of these imaging functions. In order to process digital
text and graphics, digital document products rely on a core set of imaging
software and supporting electronics, collectively known as a digital imaging
system. Network interfaces supply the core technologies to digital document
products that enable them to communicate over local and wide area networks and
the Internet. The Peerless family of products and engineering services provide
fully integrated advanced and proprietary imaging and networking technologies
that enable the Company's OEM customers and third party developers for OEM's to
develop stand-alone and networked digital printers, copiers, and MFPs quickly
and cost effectively. The Company markets its solutions directly to OEM
customers including Canon, Konica, Kyocera, Ricoh, Oki Data, Seiko Epson,
Minolta, and Matsushita Electric Industries. The Company is currently exploring
alternative methods for distributing its technology into new markets, including
packaged configurations suitable for direct sale to distribution channels and
regional sales organizations.

The Company's traditional embedded development focus has historically been
to offer high performing systems at a lower cost compared to competitive
offerings. Peerless controllers achieve their performance objectives by
interpreting printer description languages such as Adobe PostScript,
PeerlessPrint 5C or PeerlessPrint 5E, and PeerlessPrint 6 while simultaneously
executing raster image processing commands on Peerless' proprietary
co-processor. Lower component costs result from reducing the amount of random
access memory ("RAM") required to process raster images through the use of
Peerless' proprietary application specific integrated circuit ("ASIC")
compression technology. Integrating network components further reduces the cost
of Peerless' solutions and software typically supplied by third party technology
vendors in separately mounted network interface cards. Peerless software has a
modular architecture allowing for fast replacement of the key components
required to support new printer and copier engine interfaces. This architecture
helps OEMs meet the fast time to market requirements in today's hardcopy imaging
business. These three core areas of higher performance, lower cost, and fast
time to market describe the competitive advantages of Peerless technologies in
the printer controller markets.

In June 1999, Peerless acquired Auco, Inc., which became a wholly-owned
subsidiary of the Company named Netreon, Inc. ("Netreon"). On January 29, 2002,
Peerless divested itself of the Netreon storage management operations while
retaining the networking technology obtained from the 1999 acquisition of
Netreon for the continuing integration into Peerless' core imaging product
development. As part of this divesture, the Company and Netreon negotiated the
termination of the Company's obligations under the lease agreement for the
Mountain View facility then occupied by Netreon that obligated the Company for a
total of approximately $5.1 million over the remaining 65 months of the lease.
In consideration of the termination of the Company's obligations, the Company
paid the landlord of such property approximately $0.9 million. The Company
continues to hold a minority interest in the newly independent storage
management software company arising from the divestiture.

In December 1999, the Company acquired HDE, Inc. ("HDE"), a developer of digital
imaging and Internet printing products. HDE's name was changed to Peerless
Systems Imaging Products, Inc. ("PSIP") and PSIP is a wholly-owned subsidiary of
Peerless. This acquisition expanded Peerless' presence in the digital imaging
and Internet printing solutions markets, and added new customers to the
Company's portfolio. In conjunction with PSIP's strategic relationship with
Adobe Systems Incorporated, Peerless now ranks among the leading embedded Adobe
PostScript suppliers to the imaging market. PSIP has engaged in the development
of Internet printing solutions, such as enabling users to print without the need
to load drivers on their computing device.

The Company believes that the combination of its established network
software solutions and expertise in Microsoft Windows and Internet technologies
have put Peerless in the vanguard of networking, Internet printing, and
directory integration for networked imaging devices.

Peerless was incorporated in California in 1982 and reincorporated in
Delaware in September 1996.

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Digital Document Products

Industry Background

Today's office environment is increasingly dependent on a variety of
electronic imaging products such as printers, copiers, fax machines, scanners,
and MFP devices, collectively known as digital document products. These imaging
products also have become common in the home environment. Historically, most
electronic imaging products in the office environment have been stand-alone,
monochrome (black-and-white) machines, which are dedicated to a single print,
copy, fax or scan function. However, with the proliferation of personal
computers, desktop publishing software, network computing, and color, documents
increasingly are being created, stored and transmitted digitally, thereby
creating the need for digital document reproduction.

Digital documents have become increasingly complex and may include digital
text, line art or photographic images. In order to process and render these
documents, digital document products rely upon a core set of imaging software
and supporting electronics collectively known as a digital imaging system. A
digital imaging system may be integrated with a digital document product in a
variety of configurations: embedded, where it resides completely inside the
imaging device, attached, where it resides outside the imaging device but is
physically attached to it, and stand-alone, where it resides completely outside
the imaging device. To date, the majority of embedded imaging systems have been
developed and produced internally by digital document product manufacturers such
as Hewlett-Packard ("HP"), Xerox, and Canon, whereas attached and stand-alone
imaging systems have, for the most part, been developed by third party
suppliers.

Based primarily on data and projections provided by International Data
Corporation ("IDC"), the Company estimates that the worldwide digital document
market was approximately $51 billion in 2001. The Company estimates that the
total color and monochrome printer and MFP controller market will grow by
approximately 8% per year during the next five years. The Company estimates that
the monochrome and color printer and MFP controller licensing market will grow
by approximately 12% per year during the next five years.

Developments in the Digital Document Products Market

Rapid changes in technology and end-user requirements have created
challenges for digital document product manufacturers, particularly in the area
of digital imaging systems. These changes include increased technical
complexity, the demand for color imaging, the emergence of MFPs, the increased
role of networking, and the emergence of Internet printing standards.

Ever Increasing Technical Complexity. Like other high technology markets,
the digital document products market is under constant pressure to offer higher
performance, higher quality solutions at prices that are equivalent to or lower
than previous levels. The imaging devices themselves operate at speeds,
resolutions, and levels of color quality that require the imaging system to
process and deliver data at very high rates.

Digital imaging systems use a variety of software and hardware techniques
to process large volumes of data in a cost effective way. As end users demand
higher levels of print performance and quality, digital imaging systems must
increase in sophistication without becoming prohibitively expensive.

Demand for Color Imaging. The processing requirements that color printing
imposes on a digital imaging system is one of the key reasons why monochrome
printing continues to prevail in the office environment. Nevertheless, the
Company's market research indicates that the desire for cost effective color
printing in the office environment is increasing to the point where end users
are demanding color printing at monochrome speeds and prices. Digital document
product manufacturers are addressing the performance issue with more
sophisticated imaging devices that are capable of printing multiple colors
concurrently (so called "tandem" print engines), which in turn require more
sophisticated digital imaging systems to supply them with print data.

Emergence of Multifunction Products. The advent of MFPs has eroded the
boundaries between the previously distinct printer, copier, fax and scanner
market sectors. MFPs range from small home products to large high-speed office
devices. They offer several of these functions for significantly less cost than
would otherwise be incurred by purchasing these functions separately. In the
copier market, the transition from analog to digital technologies has
accelerated demand for mid-range and high-speed MFP devices. Most of the
dominant vendors in the printer, copier and fax markets have now introduced MFPs
that have required each vendor to broaden its imaging expertise. At the

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same time, the need for concurrent processing of multiple digital document
product functions has created the need for real-time, multitasking operating
system support.

Increased Role of Networking. Within the office environment, digital
document products increasingly are deployed in a networked configuration. The
network connectivity rate of MFPs in the enterprise is estimated to be in the
range of 50-60% by IDC. Because multiple local area network protocols and
network operating systems are deployed in the corporate network environment,
networked digital document products must support a broad array of networking
technologies to maximize accessibility by various user groups. The network
environment is also changing rapidly and becoming increasingly complex, with a
growing requirement for remote network management that extends across local area
networks, wide area networks, the enterprise information technology ("IT")
environment and the Internet. A key indicator of the growing network management
requirements is the rise in the deployment of Directory based management systems
which consolidate information about all network resources and users in a
centrally managed directory such as Microsoft Active Directory (R) or Novell's
eDirectory (TM).

In addition, because the majority of office digital document products are
networked, the image processing intelligence may be partitioned and located
anywhere within the network: at the site of document or image origination, at a
server, or, as is typically the case today, inside the digital document product
itself. In some instances, such as when printing to a remote location, it can be
advantageous to perform image pre-processing and compression at the document
origination site prior to transmission over usage-sensitive or congested
facilities. In other instances, such as when printing from a graphics
workstation, it can be advantageous to perform most of the image processing at
the printer in order to offload a host computer that is under a heavy workload.
In order to accommodate the emerging needs of the networked office environment,
an optimal digital imaging system must employ a modular architecture capable of
serving and managing distributed corporate resources.

Growing need for device and document management. Shared imaging devices on
a network require greater levels of administrative control than stand-alone
devices. Users and administrators must be able to discover printing services on
a network, and a well designed imaging device should be able to "advertise" its
capabilities. Systems that are capable of processing a high volume of print jobs
originating from a variety of clients are expected to report back considerable
detail about those jobs for accounting purposes and to alert remote users about
error conditions that require human intervention. Such systems often are capable
of holding documents for printing at a later time or routing documents to other
parts of the network for additional processing. Document security is a paramount
concern in the corporate market, and secure access to an imaging device helps
prevent unauthorized abuse. In such an environment, the digital imaging system
becomes part of the entire document management work flow, not just an end point
that simply outputs sheets of paper.

Emergence of Internet Printing Standards. The requirements of a global
economy managed by a mobile work force that travels frequently to worldwide
business locations include the need to print to devices both across the Internet
and within remote Intranets using temporary connections. The Printer Working
Group ("PWG"), an international standards body comprised of the leaders in the
enterprise printing industry, has developed a communications protocol for the
transmission and management of print jobs over TCP/IP connected networks. The
Internet Printing Protocol ("IPP") standard has been adopted by many leading
printer OEMs and is available in increasing numbers of commercially available
products. A further major application of the IPP standard is IPP-Fax, which is
envisioned as a real-time Internet fax-like service for document image sending
and receiving. Peerless has been a leader in the development of the emerging
IPP-Fax standard. The PWG is also expected to consider how to leverage IPP
across wireless network interfaces. These wireless communications options can
enable more devices to use Internet printing services.

Change in patterns of OEM Demand. There has been a general decline in the
rates of growth for the work group printer and copier market segments in which
Peerless is primarily engaged. While the markets for these products have
continued to grow in absolute numbers, the rates of growth have declined. With
the decline in the rates of growth, the OEMs that produce products in these
markets have reacted by engaging in internal controller development and
consolidating through mergers and acquisitions. In addition, the OEMs are now
introducing new product platforms at a slower rate than they had in the past.

Technology

The Company develops proprietary technologies for the digital imaging and
digital document marketplace that are designed to provide meaningful
improvements in performance, cost and time-to-market for Peerless' OEM
customers. The Company's proprietary object-based imaging system reduces the
size of digital document imaging files with virtually no loss of visual quality.
This proprietary technology enables the Company's OEM customers to reduce

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memory cost and increase print quality and speed, while eliminating or reducing
the need for incremental compression technology. When optimized, this component
of the digital imaging system can provide significant cost savings and
performance differentiation to digital document product manufacturers. The
Company incorporates complementary technologies, or makes its technologies
compatible with third party technologies, in order to provide its customers with
a more comprehensive imaging solution.

Object-Based Image Processing. Peerless has developed a proprietary
approach to the embedded imaging task. Peerless' object-based image processing
technology recognizes basic imaging elements in the document, differentiating
between text, line art and photographs much as the human eye does. Peerless'
approach is distinguished from that of many other imaging systems which utilize
a different method for processing documents selected for printing. These systems
convert a file that represents a document page into a bitmap and then process
all page elements as a collection of pixels. Because bitmaps generate large
files, the image-processing task can become time-consuming, requiring subsequent
document pages to be stored in memory while previous pages are being processed.
To accommodate memory limitations, file compression techniques are often
utilized. These compression techniques frequently result in a loss of clarity
and detail in the printed document, and require significant processing power.

Peerless' software creates a compact command stream known as a display list
that assembles all the printable objects on the page in an intermediate
representation of the document to be printed. This display list is a more
concise means of representing the imaging information of the document, enabling
complex imaging data to be processed more quickly and with less memory,
typically without resorting to compression techniques that degrade the image.
For high performance applications, the display list can be processed in real
time with assistance from a Peerless-designed graphics co-processor embedded in
the digital document product. Because Peerless' technology enables the page
image to be rendered and delivered to the print engine in real time, concurrent
with the transmission of the document print file from the host computer, memory
requirements can be reduced and performance can be enhanced. Furthermore, the
image quality or resolution can be modified to accommodate limitations in the
digital document product's memory, or progressively enhanced by installation of
additional memory. The Company's object-based image processing technology
provides more significant benefits as the image processing workload increases,
which occurs with increased resolution or a transition from monochrome to color.

Systems Architecture. The Company's Systems Architecture, which it has
branded as "ImageWorks(TM)", takes advantage of hardware and software design
methodologies which have allowed the company to establish a modular approach to
its architecture. This modular approach has enabled the Company to have
standardized interfaces for its family of products and further allows for
its imaging solutions to be ported to a variety of platforms, languages and
applications. For example, the standardized PeerlessPage interface provides the
ability to support multiple printer languages. The PeerlessPage object-based
imaging modules are both platform and device-independent, and are able to
accommodate a variety of print engines and controller architectures. This
architecture is capable of supporting monochrome and color digital documents
products and is being modified to support higher performance color solutions.

The Company has also developed a set of application programming interfaces
("APIs") that enable the support of features and functions such as spooling,
stored macros, stored forms, electronic collation, and stapling.

The Company has recently begun developing system architectures and
technologies to support driverless printing for the mobile and hospitality
printing marketplace.

Technology Partners. The Company has established relationships that permit
it to offer its customers complementary technologies developed by various
technology partners. Adobe has been a development partner with Peerless since
1992 and the relationship has grown with each new application of Peerless and
Adobe technologies. In 1999, Adobe and Peerless entered into a PostScript
Software Development License and Sublicense Agreement that expanded the
application and integration of the respective technologies. The Company's
relationship with Adobe permits the Company to offer a convenient and optimized
Adobe PostScript-enabled solution, as well as directly license PostScript to its
OEM customers.

Peerless has invested in the development of PSIP's VersaPage API technology
which is designed to better enable OEMs to integrate Adobe PostScript into their
products. In addition, the Company incorporates font rasterizers into its
imaging solution to enable its OEM customers to license font technology from
providers such as Agfa Corporation and Bitstream, Inc. The Company has also
established semiconductor agreements with some of the leading developers and
manufacturers of RISC (reduced instruction set computer) microprocessors in
order to offer

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integrated processor and co-processor solutions. The integrated processors
combine the Company's basic imaging rendering functionality with an
industry-standard microprocessor.

Peerless has a strategic partnership with Novell. The partnership covers
networking and device management software licenses for imaging devices across
the Novell NDS (Novell Directory Services) server environment, which includes
NEST ('Novell Embedded Systems Technology') Server Software and eDirectory. The
Company's agreement with Novell enables Peerless to directly license embedded
directory and network services technology for multiple market segments, allowing
Peerless to offer greater functionality for all network devices, extending the
Company's reach from digital output systems to other devices such as set top
boxes and cable modems. Peerless also provides custom engineering to OEMs for
implementation of Novell NDPS (Novell Distributed Print Server) gateways.

Products and Solutions

The main source of Peerless revenues comes from its software-based imaging
and networking systems for the digital document product marketplace. The
Company's technology and engineering services provide advanced imaging solutions
that enable the Company's OEM customers to develop digital printers, copiers and
MFPs cost effectively. The Company delivers its products to its OEM customers in
multiple ways, including: licensing of the Company's software development kit
("SDK") that provides imaging and networking technology for the OEM's internal
product development; turnkey product development whereby the Company provides
the technology and the additional engineering services necessary to integrate
the appropriate technology into a complete imaging system solution optimized to
the OEM's specific requirements; and a co-development relationship that combines
the licensing of Peerless technology with joint Peerless and OEM engineering
resources.

Peerless' technology allows copiers and printers to be shared across work
groups, a distributed enterprise and the Internet. The Company's products
support a wide range of digital printing devices for both direct connect and
networked configurations, including: desktop color printers; digital black and
white copiers; digital black and white laser printers; digital color copiers and
language-enabled (i.e., PostScript, PeerlessPrint5C, or PeerlessPrint6), as well
as raster-based desktop inkjet printers. Peerless' raster-based solutions (often
referred to as "GDI" or "Windows" printing technology) are marketed under the
trade name AccelePrint(TM), and are capable of driving a variety of lower cost
monochrome and color devices, including both printers and copiers.

The Company has designed its imaging technology with a modular architecture
that addresses a broad spectrum of digital document product solutions tailored
to an individual OEM's requirements. The Company's technology is being shipped
in both embedded and server-based configurations which support monochrome and
color printers as well as monochrome copiers.

In addition to products currently in production, Peerless is developing new
products and solutions for targeted markets which Peerless believes will provide
opportunities for growth. These markets include the wireless and mobile document
management and the high speed color printing environments.

Strategy for Business

In response to the general industry downturn which began in 1999 and has
continued through 2001, the Company developed, and is in the process of
implementing, a strategy designed to (a) improve and broaden its core imaging
technology and product offerings and (b) leverage existing capabilities into new
marketable technologies and products.

Throughout fiscal year 2002, the Company executed a number of changes to
reduce expenses and to manage cash to enable investment in new technologies and
product improvements.

The Company expects its future revenue generators to come from the high
performance color embedded and server-based imaging controllers, the low end GDI
controller products, continuation of revenues from existing and improved core
imaging products, and from the wireless document management and printing
enterprise marketplace. To this end, the Company is developing new products and
solutions designed to address these opportunities. There is no assurance that
the Company can or will be successful in the pursuit of these new opportunities.
Failure to realize success in the development of new products and solutions and
the marketing of these opportunities could have a material adverse effect on the
Company and its results of operations.

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Products and Services

Peerless' current product and services offering includes the following:

. ImageWorks
. PeerlessPrint
. PDL printer drivers
. ASICs
. Network printer job management software
. Systems integration services
. Networking technology
. Directory services technology for Microsoft and Novell
Environments
. MagicPrint
. AccelePrint
. Engineering services
. Certification services

ImageWorks. ImageWorks includes a complete object-based imaging system as
well as a high performance real-time operating system kernel, print engine
driver, object-based image processing model, graphics library, font management,
hard disk management, print job management, user control panel interface, and a
full suite of direct and networked connectivity options. The scaleable nature of
the Company's technology enables it to serve both the low cost and high
performance sectors of both the monochrome and color markets. The multitasking
operating system enables the Company to manage concurrent processing of digital
document product tasks for the MFP marketplace. For added performance and
flexibility, the Company's imaging system may be implemented to operate in a
distributed fashion, allowing for portions of the imaging-processing task to
take place in the originating host computer, in the digital document product, or
elsewhere in the network.

When completed, architectural extensions to ImageWorks are planned to
support the unique requirements of current and new high performance color
printers, copiers, and MFPs.

PeerlessPrint. The Company offers PeerlessPrint technology, which emulates
Hewlett-Packard's PCL and which provides OEMs with support for the most widely
used and standard page description languages ("PDLs"): Adobe's PostScript (R)
Software and Hewlett-Packard's Printer Control Language ("PCL"). The complete
range of PeerlessPrint products include PeerlessPrint 5E, 5C, and 6.
PeerlessPrint5E provides compatibility with HP's PCL5E language utilized in its
LaserJet 2200, LJ4100 and LJ9000 laser printer products, as well as enhancements
to support higher resolutions and added paper handling options. PeerlessPrint 5C
is designed to provide compatibility with HP's PCL5C utilized in its Color
LaserJet 4500 and high-end inkjet products. PeerlessPrint 6 provides monochrome
and color compatibility with HP's latest PCL6 language utilized in its LaserJet
8100 and Color LaserJet 4550 printers. Peerless also offers a complete emulation
of HP's Printer Job Language ("PJL") which is capable of being extended. As a
third-party co-developer, the Company provides an optimized, high performance
integration of Adobe PostScript 3 into both the PeerlessPage imaging system and
OEM imaging systems, as well as certification services for customers desiring to
license Adobe PostScript from Peerless.

Integration of PostScript and other PDLs into OEM imaging systems can be a
very complex task. Peerless is in the process of developing a framework for
technology integration to simplify this task, and plans to market the product
under the trade name VersaPage(TM). VersaPage is intended to enable the
packaging of Adobe PostScript as a Software Development Kit (SDK), which the
Company believes will allow OEMs to achieve faster time-to-market in deploying
PostScript in their products. VersaPage is intended to simplify the integration
of PostScript into OEM products by providing standard reusable interfaces that
can be leveraged to deploy the SDK across a family of related products. The
Company currently believes that VersaPage will be completed and commercially
available during fiscal year 2003. Peerless also provides a version of the Adobe
PostScript SDK that is designed to integrate into the Company's ImageWorks based
imaging systems and which offers access to the full range of ImageWorks
value-added technologies.

PCL Family of Microsoft Windows Printer Drivers. The Company provides a
complete set of PeerlessPrint products, the Company's family of PCL language
emulations and drivers that optimize the printing process in the Windows 95, 98,
NT 4.0, and Windows 2000 environments. The Company is also currently developing
Windows XP Drivers which are planned for future release. In today's typical
networked computer environment, the printing process consists of a workstation
running an application capable of creating and/or viewing document content, a
communications link between the workstation and one or more intermediate network
servers, and the target

9

printing device capable of receiving print data in a format suitable for
interpretation. The Company's print solutions consist of substantially all the
software necessary to run the targeted print device, as well as translation
software running on the workstation computer. This software translates the
document into a format suitable for network transmission and the interpretation
at the printer. The software is known as a host-based "printer driver." The
printer driver's role is to translate Windows Graphics Device Interface ("GDI")
functions into a suitable PDL. The Company's printer drivers are able to
translate GDI functions into PCL5E, PCL5C, and PCL6 languages, as well as fully
rasterized page images suitable for de-compression and printing directly on the
target device. These languages represent the image to be printed in a compact
form that is easily transmitted across the network and subsequently interpreted
into raster images suitable for transferring to a printed page. The Company's
PDL printer drivers can be used to drive controllers supplied by the Company, as
well as controllers supplied by most third parties or developed by OEMs.

ASICs. The Company designs application specific integrated circuit ("ASIC")
solutions for the enterprise and the small office/home office ("SOHO") sectors
of the digital document product marketplace. These ASICs provide an integrated
chip implementation of key components of its imaging technology. Peerless has
licensed its proprietary ASIC designs to semiconductor manufacturers, such as
IBM Microelectronics, Motorola, and NEC Microelectronics, who, in turn, have the
right to manufacture and sell these ASICs directly to digital document product
manufacturers.

The QuickPrint ASIC is a key component of Peerless' scaleable architecture.
To provide highly competitive solutions at various price/performance points, a
QuickPrint-based system can combine a single processor with one, two, or four
QuickPrint devices to match the price/performance goals of an OEM product. When
partnered with a minimum of external read only memory ("ROM") and synchronous
dynamic random access memory ("SDRAM"), the QuickPrint ASIC provides a complete
solution with unique and powerful functionality specifically designed for page
printers, copiers, and imaging systems.

A QuickPrint ASIC contains powerful subsystems to simultaneously render and
print page images, called the graphics execution unit ("GEU"), and print engine
video controller ("PVC"). In addition, the QuickPrint core combines these logic
units with basic system elements such as a SDRAM controller, ROM controller, I/O
controller, IEEE 1284 parallel port interface with DMA, serial port with FIFO,
and serial print engine communication port. All ASIC designs contain patented
compression and raster image processing technologies.

The Company's QuickPrint line of imaging ASIC co-processors and integrated
"system on a chip" components incorporate basic components of the Company's
imaging system into a silicon solution to reduce controller costs and enhance
overall performance. For the high performance sector of the office market, the
Company offers specialized co-processors that accelerate Peerless' imaging
software and incorporate controller functionality and imaging features to
provide both cost savings and performance enhancements. The Company currently
markets the QP 1800, QP 1910, QP 1940, QP+401, and QP+405 ASICs. The QP+401 and
QP+405 ASICs are "system on a chip" solutions that integrate the processor and
co-processor on a single chip. The single chip configuration delivers the
processor power and co-processor functionality in a cost-effective package with
excellent performance characteristics. The "system on a chip" designs include
the QP+401, which integrates the PowerPC 401 with the QP 1800 co-processor, and
the QP+405, which integrates the PowerPC 405 with the QP 1910 co-processor. The
QP 1910 is targeted at very high-speed monochrome printing and single drum color
printing, while the QP 1940 ASIC is targeted at tandem color engines and higher
speed color printing. The "system on a chip" designs address the market for low
cost office, mid-range monochrome or color printers.

With the introduction of the QP 1900 ASIC family and subsequently the
QP+405, Peerless introduced a new business model in which Peerless designs and
contracts for the manufacture and distribution of an ASIC semiconductor system,
which permits Peerless to offer an integrated solution to its OEM customers.

Peerless Job Management. Peerless Job Management enables print job
management from different computer platforms through OEM, third party, Web, or
Peerless developed user interfaces. This software enables remote access to print
queues so users or administrators can track and control their print jobs. This
technology also provides the job accounting necessary in some network printing
environments. Peerless Job Management supports a wide variety of industry
standard and OEM proprietary print protocols, including IPP, using a plug-in
architecture for rapid customization.

Directory Services Technology for Microsoft and Novell Environments.
Peerless currently offers printer management capabilities through directory
services technology that integrates into both the Microsoft and Novell
environments. Peerless' technology to support Microsoft's Active Directory and
Novell's eNDPS technologies can be embedded into products to provide directory
services support for all new products. In additon, Peerless currently provides
gateway capabilities for both active directory and NDPS that allows systems
administrators to manage all the legacy products in their environments. The
active directory gateway allows for the management of legacy products in the
Microsoft Windows 2000 environment. Peerless also offers customization to the
standard Novell NDPS gateway which increases the functionality and capabilities
of managing devices in the Novell environment.

Systems Integration. The Company has assembled an experienced team of
technical personnel with backgrounds in image processing, compression, language
interpreters, networking, ASIC and hardware engineering, software engineering,
color reproduction, real-time operating systems, and systems integration.
Systems integration is the process of combining multiple technologies into one
coherent whole. The resulting system needs to conform to accepted standards,
ranging from networking protocols to language syntaxes, and color processing
methodologies. The Company's system integration skills are exemplified by
combining such disparate technologies as Adobe PostScript, networking protocols,
proprietary OEM languages, engine control drivers for different printer devices,
ASIC

10

technologies, and many types of hardware communication interfaces. System
integration skills are a critical component in providing fast time to market
print system solutions.

Networking Technology. Peerless supports a broad array of networking
protocols, allowing its OEM customers to address the majority of end-user
networking requirements. To accommodate the need for remote network management
of digital document products over local area network ("LAN") and across wide
area networks ("WAN"), including Intranets, the Company supplies management
information base tables ("MIBs") that may be utilized by open industry-standard
network management applications. Peerless' networking technology provides
integrated network solutions, thereby eliminating the need for a network
interface card ("NIC"). This technology provides low cost, high-speed integrated
networking solutions for all market segments. To address the rapid deployment of
Directory based management systems throughout enterprises, the embedded Active
Directory Agent that the Company provides as part of its networking technologies
supports seamless integration of imaging devices into an Active Directory.

To further support the deployment of printers into small LANs, Peerless
networking technology includes support for Universal Plug and Play ("UPnP"),
which allows devices to be added to certain Microsoft Windows based networks
with no administrative setup by the user.

Internet Printing Technology. PSIP's main research and development focus in
fiscal year 2002 was to expand its Internet printing technology, marketed under
the name "MagicPrint", with features specifically targeted at the hospitality
market. A patent is now pending for MagicPrint, which enables mobile users, such
as hotel guests, to print documents and Web pages through a standard browser
interface without loading any software or making any configuration changes to
their portable computing devices. The technology is based on the Print Service
concept currently being studied by the Printer Working Group whereby an office
document can be converted to a form which can then be delivered to and printed
on network connected printers. The MagicPrint product offers convenience, and
minimizes or eliminates conflicting configuration problems associated with
making temporary connections to new printers and networks. In addition to hotels
and conference centers, the MagicPrint technology is applicable to a variety of
temporary and mobile configurations such as multiple dwelling units, multiple
tenant units, airport kiosks, corporate, academic and government campuses.
MagicPrint is currently being marketed to systems integrators and Internet
service providers that service the hospitality market.

Wireless Document Access and Distribution. MagicPrint is being expanded to
solve document access and distribution problems experienced by mobile
professionals who are in need of accessing large, time-critical documents while
on-the-road and distributing these documents by email, fax, or by printing them
to a remote device. Through the use of a cellular phone or personal digital
assistant, a mobile professional can securely browse a document, select a file,
and choose to view the document in a secure fashion or distribute it to others
by any number of means. The core Print Service capability of MagicPrint provides
the capabilities to translate, format, or package office documents for
distribution. Peerless has patents pending on its wireless document access and
distribution technology and architecture. Products based on this technology are
expected to become available in late fiscal year 2003 and early fiscal year
2004.

AccelePrint. Peerless has developed the AccelePrint family of products to
deliver raster-based printing for inclusion in OEM products. AccelePrint
provides a complementary solution to ImageWorks for cost sensitive imaging
systems. With the rapid growth in the performance of personal computers,
followed by the introduction and deployment of higher speed connectivity options
such as 100Mb Ethernet, Gigabit Ethernet, USB 2.0 and IEEE 1394, a shift in the
workload of the printing process is underway. The host workstation is now
capable of completely rendering a document in the form needed by the print
engine with little noticeable performance impact upon the PC user. The rendered
format of the document, which can be quite large especially if it is rendered in
color, can be compressed and transferred efficiently to the printer over
one of the available high-speed interfaces. This architecture simplifies the
hardware and software required in the embedded imaging system resulting in a
very low cost controller capable of accurate image reproduction with excellent
quality. AccelePrint takes advantage of new Field Programmable Gate Array
("FPGA") to efficiently handle the data de-compression necessary for raster
printing.

AccelePrint technology is packaged in two different platforms. AccelePrint
LX is a low cost configuration that includes a host driver, the FPGA, memory and
basic connectivity needed for a direct connect raster only printing solution.
AccelePrint EX is an enhanced version that supports multiple connectivity
options, including on board networking, USB 2.0, and Centronics interfaces; the
EX Version also includes an optional upgrade to a PDL such as PeerlessPrint 5C,
5E, or 6. A third configuration, the EX-Lite version, combines the functionality
of both a direct connect version and a networked version into a single
architecture which simplifies the purchasing, inventory, and production
requirements for multiple products. Both the LX and EX configurations are
capable of printing to monochrome and color devices.

Engineering Services. For those OEMs that wish to outsource the development
of some or all of the imaging system for a digital document product, the Company
offers engineering services. These include controller design and

11

custom engineering for vendor-specific features that complement the Company's
standard imaging technology. These services can be adapted to the OEMs needs for
hourly time and material support and fixed price quotations. Peerless supplies a
development process including project management, the management of multiple
suppliers, design, testing, and quality assurance to enable the delivery of
quality proven products to meet customer needs.

Certification Services. To complement the licensing of PostScript that the
Company provides through its relationship with Adobe, Peerless provides
engineering support to PostScript licensees to certify the OEM's PostScript
implementation. This service includes support for all phases of the
certification process and reduces the time to achieve final certification.

The Company is leveraging its technology to provide a wide range of
scaleable solutions.

. Multifunction Solution. The Company's MFP imaging solutions
target high-speed copier-based MFP products and lower-cost color
inkjet, fax or laser-based workgroup MFP products. The higher-end
solutions combine the Company's network imaging products with
MFP-specific extensions to facilitate printing, copying, faxing
and scanning in the same digital document product.

. Color Solution. The Company's color imaging solutions target OEM
requirements for a broad range of color imaging devices. The
Company's proprietary object-based imaging system reduces the
workload of the central processing unit ("CPU") and reduces
resource requirements for printing color pages, while
simultaneously accelerating the speed of document imaging and
increasing print quality.

. Monochrome Solution. The Company's monochrome solutions target
both monochrome printers and digital copiers and are currently
deployed in copiers and printers in the office environment at
speeds ranging from a few pages per minute to over one hundred
pages per minute.

. High Performance Color Multifunction Solution. Recent
advancements in color copier engine technology have enabled the
development of higher speed color printers and MFPs at price
points low enough to make them practical for the deployment in
the office environment. Based on generally available market
research, the Company believes this represents a growing,
attractive market opportunity and intends to target the
development of solutions that provide color printing and other
functionality for these high performance copier engines. The
Company is currently undertaking research and development
activities designed to extend the performance of its patented
core imaging technology in order to address the significantly
higher data throughput required by the next generation of office
color printers and copiers.

Customers and Markets

Customers

Peerless markets its imaging and networking technology to OEMs that
manufacture digital document products for the high to medium performance sector
of the office market. In addition, the Company markets its imaging and
networking technology to technology partners, which incorporate certain
components of the Company's technology into integrated product offerings that
are ultimately marketed to digital document OEMs. With the exception of
technology partners such as Adobe and Novell, the Company has derived
substantially all of its revenues in recent years from direct sales to digital
document product OEMs.

Three of the Company's customers Konica, Oki Data, and Ricoh each generated
more than 10% of the Company's total revenues for fiscal year 2002. Revenues
from the Company's top three customers accounted for 56%, 45%, and 40% of the
Company's total revenues for fiscal years 2002, 2001, and 2000, respectively.
Although the Company has expanded and diversified its customer base through
focused sales efforts and acquisitions, the Company anticipates that its future
revenues may be similarly concentrated with a limited number of customers. The
Company's largest customers vary to some extent from year to year as product
cycles end, contractual relationships expire and new products and customers
emerge. Many of the engineering services and licensing arrangements with the
Company's customers are provided on a project-by-project basis, are terminable
with limited or no notice, and in certain instances are not governed by
long-term agreements. Because a limited number of customers generate a large
percentage of the Company's revenues, any loss of these customers would have a
material adverse impact on the Company's results of operations.

As discussed previously, there has been a general decline in the rates of
growth for the work group printer and copier market segments in which Peerless
is engaged. For those product platforms that do go forward for

12

development and customer introduction, the OEMs, in a number of instances, have
not selected the Company's solutions. This occurred in some cases because the
OEMs perceived that the Company's solutions did not meet their technical
requirements. In other cases it occurred by the OEMs developing the technology
themselves or by utilizing lower cost offshore software competitors.

Markets

Segments. The Company sells its products and services to OEMs which produce
products for the enterprise and office sector of the digital document product
market, which is characterized by digital document products ranging in price
from approximately $1,000 to in excess of $40,000 each. These products typically
offer high performance differentiated by customized features. In many cases,
digital document product manufacturers demand turnkey, customized digital
imaging solutions that include imaging software, controller design and network
interface card design. As a result of these unique requirements, Peerless
typically addresses the mid to high performance sector of the digital document
product market via direct OEM relationships with individual digital document
product manufacturers. The Company's major customers in the office market in the
fiscal year 2002 included Canon, Konica, Oki Data, Seiko Epson, Matsushita
Electric Industries, Kyocera, Minolta, and Ricoh.

Geography. Since the majority of the Company's OEM customers are comprised
primarily of companies headquartered in Japan, revenues from customers outside
the United States accounted for 87%, 81%, and 72% of the Company's total
revenues for fiscal years 2002, 2001, and 2000, respectively. Further, the
Company expects that sales to customers located outside the United States may
increase in absolute dollars in the future. These customers sell products
containing Peerless' technology primarily in the North American and European
marketplaces. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations" for further discussion on Asian markets.

All of the Company's contracts with international customers are, and the
Company expects that in the future will be, denominated in U.S. dollars. As a
result, the Company is currently not subject to foreign currency transaction and
translation gains and losses. However, see "The Company's International
Activities May Expose The Company To Risks Associated With Currency
Fluctuations" on page 30.

Growth and Expansion Objectives

The Company's overall objectives for growth in the imaging business are to
develop more diverse distribution channels for its products, to broaden the
number of supported imaging devices to include higher margin color copier and
printing devices, to reduce the time-to-market of Peerless-based products
through the increased use of standardized PC hardware and software tools, and to
increase its focus on developing applications that perform job, document, and
content management. The Company's imaging software is portable to a wide range
of technology platforms, and the Company can take advantage of that fact to move
its product line both up market and down market in relation to its traditional
market presence. The Company has devoted research and development resources on
its line of PC-based applications to support an end-to-end solution for ease of
use during the printing process. The Company intends to address this interest to
include applications supporting job management, document management, and
accounting functions for printing.

It is the Company's view that time-to-market is one of the largest factors
in vendor selection when an OEM decides whether to outsource or develop new
products internally. The Company has devoted research and development resources
on improving time-to-market for its products through the use of well-developed
APIs between functional areas of the Company's software and hardware technology.
It is the Company's goal to extend these time-to-market concepts to include
standardized PC software and hardware tools for development and deployment of
its products, thereby increasing the value provided to its customers.

Sales and Marketing

The Company markets its products to the leading OEMs that sell digital
document products to the worldwide market. The Company directs most of its sales
efforts through its headquarters in California and its subsidiary in Japan.
Sales to European digital document product manufacturers are conducted out of
the Company's California headquarters. The Company intends to extend its sales
efforts in the future to include distributors, value added resellers, system
integrators, and geographically based OEM sales operations.

The Company markets its technology directly to OEMs, as well as through
focused trade relations and branding programs. Direct OEM marketing consists of
focused public relations activities and the development of sales collateral,
mailers, trade show attendance, and sales support. The Company devotes time and
resources on increasing Peerless'

13

presence in media accessed by OEM customers. The Company directs public
relations and product branding programs toward building awareness of the
Peerless brand name.

Product Development and Engineering Services

The Company's product development activities are located at two sites, El
Segundo, California, and Kent, Washington. These activities primarily consist of
new product development, enhancement of existing products, product testing, and
technical documentation. The Company's engineering is focused on two primary
areas. They are research and development, which focuses on development and
enhancement of the Company's products and core technologies; and engineering
services, which focuses on customized customer design activities.

The Company's engineers work closely with OEMs that desire a turnkey
solution, developing customized interfaces and applications specific to
individual OEMs. The Company typically receives a fee for such engineering
services. To further support the development of technology and products for our
OEMs, Peerless has established co-development relationships with Metatechno, a
Japan based company that provides product development support for some of the
Peerless OEMs in Japan, and WeSoft, a Hong Kong based company that currently
supports development of customer projects. The Metatechno relationship provides
local technical support to Peerless OEMs and has proved valuable in addressing
the cultural and language differences. WeSoft will play a similar role as
Peerless addresses the Southeast Asia market, including China.

Intellectual Property and Proprietary Rights

The Company's success is heavily dependent upon its proprietary technology.
To protect its proprietary rights, the Company relies on the combination of
patent, copyright, trade secret and trademark laws. The Company also enters into
nondisclosure agreements and other contractual provisions and restrictions. The
Company holds nine patents issued in the United States, one of which is also
issued in France, Germany, Great Britain, Japan and Hong Kong. The issued
patents relate to techniques developed by the Company for generating output for
continuous synchronous raster output devices, such as laser printers,
compressing data for use with output devices, filtering techniques for use with
output devices and communicating with peripheral devices over a network.

The Company also has five patent applications and two provisional
applications pending in the United States, four applications pending in the
European Patent Office, four applications pending in Japan, two applications
pending in Hong Kong, one application pending in Canada and one application
pending in the Republic of China.

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

As part of its confidentiality procedures, the Company enters into
nondisclosure agreements with its employees, consultants, OEMs and strategic
partners and takes further affirmative steps to limit access to and distribution
of its software and other proprietary information. Despite these efforts and in
the event such agreements are not timely made, complied with or enforced, the
Company may be unable to protect its proprietary rights. In any event,
enforcement of the Company's proprietary rights may be very expensive. The
Company's source code also is protected as a trade secret. However, the Company
from time to time licenses its source code to OEMs pursuant to protective
agreements, which subjects the Company to the risk of unauthorized use or
misappropriation despite the contractual terms restricting disclosure, copying
and use. In addition, it may be possible for unauthorized third parties to
obtain, copy or use the Company's proprietary information, or to reverse
engineer the Company's trade secrets.

14

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

Competition

The market for outsourced imaging systems for digital document products is
highly competitive and characterized by continuous pressure to enhance
performance, add functionality, reduce costs and accelerate the release of new
products. The Company competes on the basis of technology expertise, product
functionality, development time and price. The Company's technology and services
primarily compete with solutions developed internally by OEMs. Virtually all of
the Company's OEM customers have significant investments in their existing
solutions and have the substantial resources necessary to enhance existing
products and to develop future products. These OEMs have or may develop
competing imaging system technologies and may implement these systems into their
products, thereby replacing the Company's current or proposed technologies,
eliminating the need for the Company's services and products and limiting future
opportunities for the Company. In fact, OEMs have increasingly been shifting
away from third party solutions in favor of in-house development. Therefore, the
Company is required to persuade these OEMs to outsource the development of their
imaging systems and to provide products and solutions to these OEMs that
favorably compete with their internally developed products. The Company also
competes with software and engineering services provided in the digital document
product marketplace by other systems suppliers to OEMs. In this regard, the
Company competes with, among others, Destiny Technologies Corporation,
Electronics for Imaging, and Oak Technologies.

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

Employees

As of April 26, 2002 the Company had a total of approximately 106 employees
and independent contractors. None of the Company's employees is represented by a
labor union, and the Company has never experienced any work stoppage. The
Company considers its relations with its employees to be good.

15

Item 2--Properties.

The Company leases its principal facilities in El Segundo, California. The
operating lease, as amended, expires in March 2007. The Company also leases
office space in Kent, Washington for PSIP, and in Japan. The lease on the Kent
property expires in June 2005. The Company subleases 9,000 square feet of its El
Segundo, California facility. The term of the sublease is for the balance of the
term of the underlying lease. The Company believes that its existing leased
space is more than adequate for its current operations and that suitable
replacement and additional space will be available in the future on commercially
reasonable terms.

Item 3--Legal Proceedings.

On August 28, 2000, a stockholder class action lawsuit was filed against
the Company and two of the Company's former officers in the United States
District Court for the Southern District of California. A second stockholder
class action lawsuit was filed on September 19, 2000 against the Company and the
same two former officers of the Company in the same United States District
Court. On April 17, 2001, the Company was served with an Amended and
Consolidated Complaint. These lawsuits allege a scheme to artificially inflate
the Company's stock price based on alleged misleading public announcements and
seek compensatory damages with interest and attorneys fees and expenses.
Peerless believes all of the claims to be without merit. A hearing on the motion
filed by the Company and the two former officers to dismiss the Amended and
Consolidated Complaint was held on October 9, 2001. By an order dated January
14, 2002, the Court dismissed the First Amended and Consolidated Complaint
without prejudice and granted the plaintiffs sixty days to file a Second Amended
and Consolidated Complaint. The plaintiff class filed a Second Amended and
Consolidated Complaint on March 15, 2002.

Item 4--Submission of Matters to a Vote of Security Holders.

No matters were submitted to a vote of the Company's stockholders during
the fourth quarter of fiscal year 2002.

16

PART II

Item 5--Market for Registrant's Common Equity and Related Stockholder
Matters.

The Company's common stock has been traded on the Nasdaq National Market
under the symbol "PRLS" since its initial public offering on September 26, 1996.
The table below sets forth, during the periods indicated, the high and low sales
price for the Company's common stock as reported on the Nasdaq National Market.

Fiscal Year Ended January 31,
------------------------------------
2002 2001
---------------- ----------------
Quarter High Low High Low
- ------- ------ ------ ------ ------
First $1.050 $0.500 $6.875 $2.188
Second $2.270 $0.900 $3.563 $1.750
Third $2.110 $0.780 $2.750 $1.016
Fourth $1.500 $0.870 $2.875 $0.438

As of April 24, 2002, there were approximately 144 holders of record of the
Company's common stock.

Dividend Policy

The Company has not declared or paid any cash dividends on its common stock
during any period for which financial information is provided in this Annual
Report on Form 10-K. The Company currently intends to retain future earnings, if
any, to fund the development and growth of its business and does not anticipate
paying any cash dividends on its common stock in the foreseeable future.

Item 6--Selected Financial Data.

The statement of operations data for the fiscal years ended January 31,
2002, 2001 and 2000 and the balance sheet data at January 31, 2002 and 2001, are
derived from, and should be read in conjunction with, the audited consolidated
financial statements and notes thereto included elsewhere in this Annual Report
on Form 10-K. The balance sheet data at January 31, 1998 is derived from
unaudited consolidated financial statements not included in this Annual Report
on Form 10-K. The data set forth below (in thousands, except per share data) are
qualified in their entirety by, and should be read in conjunction with,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the audited consolidated financial statements and notes thereto
included elsewhere in this Annual Report on Form 10-K.

17

Years Ended January 31,
-----------------------------------------------------
2002 2001 2000 1999 1998
-------- -------- ------- ------- -------

Statement of Operations Data:
Net sales $ 29,767 $ 27,407 $42,076 $41,077 $30,958
Income (loss) from operations (9,948) (17,228) 4,133 4,647 3,283
Net income (loss) (10,997) (17,649) 3,441 2,462 1,527
Basic earnings (loss) per share (0.73) (1.19) 0.25 0.19 0.12
Diluted earnings (loss) per share ( 0.73) (1.19) 0.22 0.16 0.11

Years Ended January 31,
------------------------------------------------
2002 2001 2000 1999 1998
------- ------- ------- ------- --------
(unaudited)
Balance Sheet Data:
Total Assets $24,934 $37,108 $52,565 $49,887 $42,829
Long-term obligations 2,181 2,357 3,165 3,703 1,367

Selected Quarterly Financial Data (Unaudited):

Year Ended January 31, 2002 Year Ended January 31, 2001
---------------------------------------- ----------------------------------------
Quarter Fourth Third Second First Fourth Third Second First
- ------- ------- ------- ------- ------- ------- ------- ------- -------

Revenues $ 8,038 $ 7,686 $ 7,339 $ 6,704 $ 3,435 $ 9,465 $10,120 $ 4,387
Gross margin 5,501 4,593 3,072 3,378 1,355 4,875 4,781 1,044
Gross margin % 68.44% 59.76% 41.86% 50.39% 39.45% 51.51% 47.24% 23.80%
Loss from operations $ (122) $(2,203) $(4,504) $(3,119) $(6,724) $(1,811) $(1,782) $(6,911)
Net loss (2,493) (2,713) (2,532) (3,259) (7,072) (2,021) (2,337) (6,219)
Basic earnings (loss) per share (0.16) (0.18) (0.17) (0.22) (0.47) (0.14) (0.16) (0.42)
Diluted earnings (loss) per share (0.16) (0.18) (0.17) (0.22) (0.47) (0.14) (0.16) (0.42)

Item 7--Management's Discussion and Analysis of Financial Condition and
Results of Operations.

This Annual Report on Form 10-K contains forward-looking statements that
involve risks and uncertainties. The statements contained in this Annual Report
on Form 10-K that are not purely historical are forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934, including without limitation, statements
regarding the Company's expectations, beliefs, intentions or strategies
regarding the future. All forward-looking statements included in this Annual
Report on Form 10-K are based on current expectations, estimates, forecasts and
projections about the industry in which Peerless operates, management's beliefs
and assumptions made by management. These statements are not guarantees of
future performance and involve certain known and unknown risks, uncertainties
and assumptions that are difficult to predict. Therefore, actual outcomes and
results may differ materially from what is expressed or forecasted in such
forward-looking statements. The Company undertakes no obligation to update
publicly any forward-looking statements, whether as a result of new information,
future events or otherwise.

Highlights

Consolidated revenues for fiscal year 2002 were $29.8 million, an 8.6%
increase over the prior fiscal year. The increase was attributable to increased
licensing and ASIC chips revenues. Product licensing revenues for fiscal year
2002 of $21.6 million, including $17.3 million of block licenses, increased
16.3% from the previous fiscal year. Fifteen block licensing agreements totaling
$24.4 million were signed during fiscal year 2002 of which approximately $17.3
million was recognized as revenue during the year. The remaining $7.1 million
will be recognized over the following seven quarters, due to extended payment
terms. Under the terms of the block licensing agreements entered into in fiscal
year 2001, no amounts were carried forward for revenue recognition in future
fiscal years.

18

Engineering services and maintenance contract backlog at January 31, 2002
approximated $1.9 million; this compares to $1.0 million as of January 31, 2001.

During fiscal year 2002, the Company reorganized its core imaging
operations to streamline engineering processes and strengthen the architectural
part of the engineering organization to more efficiently deploy engineering
staff across customer project and product development efforts. These changes
allow the Company to maintain better focus on developing a new high performance
color architecture.

Additionally, the Company expanded its strong relationship with Adobe
Systems Incorporated through the latest release of Adobe(R) Postscript(R)
printing and imaging technologies which support the Adobe Portable Document
Format (PDF) 1.4 specification.

On January 31, 2002, the Company announced the divestiture of its Netreon
storage management operations, effective January 29, 2002. Peerless retained the
networking technology obtained from the Company's 1999 acquisition of Netreon
for continuing integration into Peerless' core document imaging products. As a
result of the divestiture, the Company expects operating expenses to decrease by
approximately 30% in fiscal year 2003 from levels experienced during fiscal year
2002. Because the effective date of the divestiture so closely approximates the
Company's year end, the 2002 consolidated results of operations include
Netreon's results for the entire year, which is reflected in the comparison of
results of operations for fiscal years 2002 and 2001 in management's discussion
and analysis.

There is no assurance that the Company can or will be successful in the
pursuit of these new opportunities that are expected to result in a growth in
revenues. Failure to realize success in these opportunities could have a
material adverse effect on the Company's operational results.

General

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

The Company generates revenue from its OEMs through the sale of imaging
solutions in either turnkey or software development kit form. Historically, OEM
demand for turnkey solutions had exceeded demand for SDK solutions. However, in
the fiscal year 2000, the Company experienced a shift in demand away from
turnkey solutions towards demand for the Company's SDKs, particularly for its
mature monochrome solutions. The Company has attempted to expand its solution
offerings by incorporating related imaging and networking technologies licensed
from third parties.

The Company's product licensing revenues are comprised of both recurring
per unit and block licensing revenues and development licensing fees for source
code or SDKs. Licensing revenues are derived from per unit fees paid
periodically by the Company's OEM customers upon manufacturing and subsequent
commercial shipment of products incorporating the Company's technology.
Licensing revenues are also derived from arrangements in which the Company
enables third party technology, such as solutions from Adobe or Novell, to be
used with its products.

Block licenses are per-unit licenses made in large volume quantities to an
OEM for products either in or about to enter into distribution into the
marketplace. Payment schedules for block licenses are negotiable and payment
terms are often dependent on the size of the block and other terms and
conditions of the block license being acquired. Typically, payments are made in
either one lump sum or over a period of four or more quarters. Revenue received
for block licenses is recognized in accordance with SOP 97-2, which requires
that revenue be recognized after acceptance by the OEM and if fees are fixed and
determinable and the collection of fees is probable. For block licenses that
have a significant portion of the payments due within twelve months, revenue is
recognized at the time the block license becomes effective.

19

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

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

Historically, a limited number of customers have provided a substantial
portion of the Company's revenues. Therefore, the availability and successful
closing of new contracts, or modifications and additions to existing contracts
with these customers may materially impact the Company's financial position and
results of operations from quarter to quarter.

The current market in which the Company operates has been consolidating,
and the demand for the technology and products offered by the Company declined
throughout fiscal year 2002. Peerless' technology addresses the worldwide market
for printers (21-69 PPM) and MFP (21-110 PPM). Unit volume for these types of
printers is projected by IDC to grow at lower rates than in years past.
Available data indicate that retail prices are declining in these segments. Both
of these segments are key target markets for the Company. There has been a
decline in the number of contracts that the Company has with OEMs under which
the Company is currently performing services and granting licenses, and this
decline is likely to continue along with the demand for the technology and
products the Company presently offers. Competitors have merged into larger
business units with the resulting strength to acquire and impose a competitive
advantage in the Company's market segments.

Although sales have increased during fiscal year 2002, the Company is
continuing to meet sales resistance from its customers. In the past, these OEMs
have reduced the absolute number of new products being developed and in some
instances, the OEMs have preferred to perform in-house development projects for
the products that they are developing and/or planning to launch. Although there
have been fewer opportunities for the Company to sell its turnkey services and
SDKs, the Company continued to support its current OEM controller customers in
the digital printing devices business with its existing technology and has sized
the organization to provide the necessary support and maintenance. During the
current fiscal year, the Company has invested in research and development and
has developed and integrated new product technologies that the Company will
offer to its OEM customers in this and future quarters.

The Company has addressed the deterioration in the demand for its solutions
by sizing its organization to manage the current business requirements of
imaging for digital document products and has adapted its pricing model to
changing market conditions.

In addition, as a result of the decline in the embedded controller
business, the Company is exploring opportunities to enhance the value of the
Company, including new market opportunities, mergers, acquisitions and/or the
sale of all or a portion of Company's assets.

There is no assurance that the Company can or will be successful in the
pursuit of these new opportunities that are expected to result in a growth in
revenues. Failure to realize success in these opportunities could have a
material adverse effect on the Company's operational results.

Critical Accounting Policies

The Company accounts for its software revenues in accordance with Statement
of Position ("SOP") 97-2, "Software Revenue Recognition" as amended by SOP 98-9,
Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements"
and Emerging Issues Task Force 99-19, "Reporting Revenue Gross as a Principal
versus Net as an Agent." The Company over the past two years entered into block
license agreements that represent unit licenses for products that will be
licensed over a period of time. In accordance with SOP 97-2, revenue is
recognized when the following attributes have been met: 1) an agreement exists
between the Company and the OEM selling product utilizing the Company's
intellectual property and/or a third party's intellectual property for which
Peerless is an authorized licensor, 2) delivery and acceptance of the
intellectual property has occurred, 3) the fees associated with

20

the sale are fixed and determinable and 4) collection of the fees are probable.
Under the Company's accounting policies fees are fixed and determinable if 90%
of the fees are to be collected within a twelve-month period, in accordance with
SOP 97-2. If more than 10% of the payments of fees extend beyond a twelve-month
period, they are recognized as revenues when they are due for payment, in
accordance with SOP 97-2. If the Company had negotiated all of its block license
agreements such that agreements would have been recognized in the period in
which the agreements had been entered into, revenues for fiscal year ended
January 31, 2002 would have increased $7.1 million or 23.8% from that actually
recognized and the Company would not have $7.1 million in licensing revenues to
be recognized in fiscal years ending January 31, 2003 and 2004.

The Company recognizes revenues for certain of its engineering services
projects on a percentage-of-completion basis, in accordance with Accounting
Research Bulletin 45, "Long-Term Construction-Type Contracts" and SOP 81-1,
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts." The estimates to complete the projects are determined by the
individual project-engineering manager responsible for the oversight of the
individual projects. The estimates are made at end of each accounting period and
are subject to unforeseen circumstances that can increase or decrease the hours
necessary to complete the efforts. For example, the impact on fiscal year 2002
engineering services revenues of a 10% increase in the estimate of total hours
to complete projects under contract would be to decrease engineering services
revenues by $0.1 million or 2.3% and consolidated net income by $0.2 million, or
1.7%. The impact of a 10% decrease in the estimate of total hours to complete
projects under contract would be to increase engineering services revenues by
$0.1 million or 2.9% and consolidated net income by $0.2 million or 1.8%.

As of January 31, 2002, the Company had net operating loss carryforwards
available to reduce future federal and state income of approximately $4.0
million and $4.4 million, respectively, which expire through fiscal years 2022
for federal and 2007 for state, respectively. In addition, as of January 31,
2002, the Company had tax credit carryforwards available to reduce future income
tax liabilities of approximately $6.2 million, which expire between fiscal years
2003 and 2022. The realization of these assets is based upon management's
estimates of future taxable income. The Company has provided a valuation
allowance for all of its net deferred tax assets because of the uncertainty with
respect to the Company's ability to generate future taxable income to realize
the deferred tax assets. With a change in management's assessment of the
uncertainty, the valuation allowance will be adjusted accordingly.

21

Results of Operations

The following table sets forth, for the periods indicated, the percentage
relationship of certain items from the Company's statements of operations to
total revenues.

Percentage of Total Revenues
Years Ended January 31,
----------------------------
2002 2001 2000
---- ---- ----

Statements of Operations Data:
Revenues:
Product licensing 73% 68% 62%
Engineering services and maintenance 21 27 38
Other 6 5 --
---- ---- ----
Total revenues 100 100 100
---- ---- ----

Cost of revenues:
Product licensing 21 18 2
Engineering services and maintenance 19 35 31
Other 4 3 --
---- ---- ----
Total cost of revenues 44 56 33
---- ---- ----

Gross margin 56 44 67
---- ---- ----

Operating expenses:
Research and development 46 48 23
Sales and marketing 20 21 15
General and administrative 23 38 14
Other - non recurring expenses -- -- 5
---- ---- ----
Total operating expenses 89 107 57
---- ---- ----

Income (loss) from operations (33) (63) 10
Other income 8 -- --
Loss on divestiture of storage operations (8) -- --
Interest income, net 2 4 3
---- ---- ----
Income (loss) before income taxes (31) (59) 13
Provision for income taxes 6 6 5
---- ---- ----
Net income (loss) (37)% (65)% 8%
==== ==== ====

Comparison of Fiscal Years 2002 and 2001

The Company narrowed its net loss for the twelve month period ended January
31, 2002 to $(11.0) million or $(0.73) per basic and diluted share, compared to
a net loss of $(17.6) million, or $(1.19) per basic and diluted share, in fiscal
year 2001.

Consolidated revenues for fiscal year 2002 were $29.8 million, a 9%
increase from fiscal year 2001. The increase was attributable to increased
licensing and ASICs revenues which were partially offset by lower engineering
services and maintenance revenues.

22

Product licensing revenues for the year of $21.6 million, including $17.3
million of block license revenues, increased 16% from fiscal year 2001. Block
licensing agreements totaling $24.4 million were signed during fiscal year 2002,
of which approximately $17.3 million was recognized as revenue during the year,
with the remaining $7.1 million to be recognized over the following seven
quarters.

During the fiscal year, the Company had revenues of $14.6 million in block
licenses with Adobe technology bundled with Peerless' intellectual property,
compared with $9.0 million in fiscal year 2001. Prior to fiscal year 2001, OEMs
would license Adobe technology directly from Adobe. Adobe would pay Peerless a
portion of the revenues that Adobe derived from its products that were licensed
for use in Peerless enabled products. Commencing in fiscal year 2001, OEMs
licensed and continue to license Adobe technology from Peerless, with Peerless
assuming additional responsibilities (i.e., certification, maintenance,
collections, etc.). Peerless pays Adobe a portion of the revenues that Peerless
derives from Adobe technology.

Engineering services and maintenance fees generated by the Company
decreased approximately 18% from fiscal year 2001 to fiscal year 2002. This was
primarily the result of lower levels of turnkey bookings, an increase in the
amount of work performed in-house by OEMs, and product offerings by the Company
that did not match OEMs changing needs. Contract backlog at January 31, 2002 was
approximately $1.9 million, as compared with $1.0 million at January 31, 2001.

Cost of revenues was $13.2 million for fiscal year 2002, a 14% decrease
from fiscal year 2001. Product licensing costs increased 30% to $6.3 million,
compared with $4.9 million in fiscal year 2001. This increase was primarily due
to licensing costs of Adobe technology bundled with Peerless intellectual
property associated with the Adobe-related block license revenues discussed
above. Engineering services and maintenance costs represent a 41% decrease from
fiscal year 2001, due to lower levels of revenues and improved performance.

Gross margin as a percentage of total revenues increased to 56% in fiscal
year 2002 from 44% in fiscal year 2001. The improvement in gross margin is
attributable to approximately $2.8 million in licensing agreements of Peerless
proprietary technology without any associated third party licensing costs. The
increase was also due largely to engineering services and maintenance margins,
which improved to 7% in fiscal year 2002 from (29)% in fiscal year 2001, due to
reduced costs for engineering services as previously discussed.

Operating expenses for fiscal year 2002 were $26.5 million, a 10% decrease
from fiscal year 2001.

. Research and development expenses increased 5% from fiscal year
2001 to fiscal year 2002. Research and development expense
increased as engineering efforts were directed at NAS and SAN
storage, MagicPrint(TM), and the development of new imaging
technologies.

. Sales and marketing expenses increased 4% from fiscal year 2001
to fiscal year 2002 with activities directed at NAS and SAN
storage. The Company continues to focus on the penetration of new
OEM customers and other opportunities to promote the Company's
imaging and network solutions.

. General and administrative expenses decreased 35% from fiscal
year 2001 to fiscal year 2002. Insurance policy reimbursements
for legal expenses, the reduction of compensation expense
associated with management bonuses, and lower consulting and
advisory fees were the primary factors for the decrease.

The Company resolved a disputed claim regarding the licensing of its
intellectual property and reported non-recurring other income of $2.3 million
and collected a $1.5 million receivable during fiscal year 2002. In addition,
the Company recorded a $2.3 million loss in connection with the divestiture of
the Netreon storage management operations.

Interest income earned in both fiscal years was attributable to interest
and investment income earned on cash and cash equivalents and investment
balances. The 40% decrease from fiscal year 2001 in interest income was due to a
lower level of investments and lower interest rates.

The Company's effective tax rate for fiscal 2002 was 20% compared to 10% in
fiscal year 2001.

The provision for taxes for the fiscal year 2002 was primarily attributable
to foreign taxes paid. The Company has provided a valuation allowance on its net
deferred tax assets because of the uncertainty with respect to the Company's
ability to generate future taxable income to realize the deferred tax assets.

23

Comparison of Fiscal Years 2001 and 2000

Net loss for the twelve month period ended January 31, 2001 was $(17.6)
million or $(1.19) per diluted share, compared to net income of $3.4 million, or
$0.22 per diluted share, in fiscal year 2000. Fiscal year 2001 revenues
decreased 35% from the previous year. Product licensing revenues for the year,
which included $10.3 million of block license revenues, decreased 29% from the
previous year. Block licenses result in bringing forward revenues to the current
period if the fees are determined to be fixed and determinable and collection of
the fees is probable.

The decrease in revenues would have been larger had it not been for the
change in the Company's licensing arrangement with Adobe, whereby OEMs currently
license Adobe technology from Peerless, with Peerless paying Adobe a portion of
the revenues that Peerless derives from Adobe technology. The change in the
Adobe arrangement has resulted in higher revenues and higher cost of revenues.
During fiscal year 2001, the Company made approximately $9.0 million in block
licenses with Adobe technology bundled with Peerless' intellectual property.
This compares with block licenses in fiscal year 2000 of $1.5 million. As noted
below, these block licenses also resulted in an increase in cost of revenues.

The decrease in revenues also resulted from the lower level of engineering
services associated with turnkey efforts performed during the last 12 months.
This was primarily the result of lower levels of turnkey bookings, a higher
proportion as a percentage of total sales of SDK design wins during the prior
fiscal year, an increase in the amount of work performed in-house by OEMs, and
product offerings by the Company that did not match OEMs changing needs.
Engineering services and maintenance fees generated by the Company decreased
approximately 53% during fiscal year 2001. Furthermore, revenues are negatively
impacted, as the Company does not receive royalty revenue in respect of SDK
placements until after OEMs complete their development effort from the SDK and
market their products.

Cost of revenues was $15.4 million for fiscal year 2001, representing an
increase of 10% over the prior fiscal year. The increase was due primarily to
licensing costs of $4.5 million for fiscal year 2001 associated with the
approximately $9.0 million in licensing to OEMs of block licenses of third party
technology bundled with Peerless' intellectual property. During fiscal year
2000, block licensing costs were $0.8 million on $1.5 million of Adobe
technology sales.

A decrease of 20% from the prior fiscal year in the cost of engineering
services, maintenance and other primarily due to staff reductions during fiscal
year 2001, partially offset the increase in cost of revenues. Although costs
were down for engineering services, the Company experienced losses on its
engineering efforts as a result of cost overruns due to unanticipated
complexities in the integration of new technologies into OEM products.

The Company's gross margin as a percentage of total revenues decreased to
44% in fiscal year 2001 from 67% in fiscal year 2000. The decrease was due, in
part, to higher licensing fees as a percentage of total revenue associated with
the block sale of third party licenses. Engineering services and maintenance
margins decreased from 19% in fiscal year 2000 to (29)% in fiscal year 2001. The
decline was attributable to additional costs associated with the completion of
product deliveries for customers on fixed-fee arrangements, complexities in the
integration of new technologies into OEM products, and severance costs.

Peerless continues to invest heavily in the future by funding the research
and development of new technology solutions. Research and development expenses
increased 36% in fiscal year 2001 due primarily to increased spending on
technical solutions and continued investments in new storage technologies and
imaging development programs.

Although sales and marketing expenses decreased 9% between fiscal years
2001 and 2000 due to staffing reductions, the Company is still focused on the
penetration of new OEM customers, attendance at industry trade shows, and other
opportunities to promote the Company's imaging and network solutions.

General and administrative expenses for fiscal year 2001 increased 82% from
fiscal year 2000. The resulting increase was due to increased legal costs
associated with litigation, start up expenses associated with professional
advisory firms, the use of outside strategy consultants relating to the
Company's exploration of strategic opportunities, and non-recurring expenses
arising out of severance agreements during the year.

Interest income of $1,229 and $1,224 earned in fiscal years 2001 and 2000,
respectively, was attributable to interest and investment income earned on cash
and cash equivalents and investment balances resulting primarily from proceeds
received from operations that have been retained in the business.

24

The Company's effective tax rate for fiscal 2001 is 10% compared to 36% in
the prior year.

The provision for taxes for the fiscal year 2001 was primarily attributable
to foreign taxes paid and an increase in the valuation allowance, net of the
benefit to the Company that will be realized from the loss carry-back. The
Company has provided a valuation allowance on its net deferred tax assets
because of the uncertainty with respect to the Company's ability to generate
future taxable income to realize the deferred tax assets.

Liquidity and Capital Resources

The Company's principal source of liquidity is its cash and cash
equivalents and investments, which, as of January 31, 2002 were $14.7 million in
the aggregate. For the twelve month period ended January 31, 2002, the Company
incurred a loss and experienced substantial negative cash flow.

Compared to January 31, 2001, total assets at January 31, 2002 decreased
33% to $24.9 million and stockholders' equity decreased 40% to $16.0 million.
The Company's cash and short-term investment portfolio was $11.5 million at
January 31, 2002, a decrease of 37% from January 31, 2001. The ratio of current
assets to current liabilities was 2.6:1 compared to 3.3:1 last year. The Company
used $5.3 million in cash during the twelve month period ended January 31, 2002
to finance operations as compared to $5.8 million in cash used for operations
during the twelve month period ended January 31, 2001.

The Company's investing activities during the fiscal year ended January 31,
2002 resulted in a net source of cash of $4.2 million. It is the Company's
policy to invest the majority of its unused cash in low risk government and
commercial debt securities. The Company has not historically purchased
derivative instruments or entered into hedging transactions. For the twelve
month period ended January 31, 2002, the Company invested approximately $0.9
million in property, equipment and leasehold improvements compared to $1.2
million during the previous twelve month period.

During fiscal year 2002, $0.2 million was provided by the issuance of
common stock under the Company's employee stock purchase plan and exercise of
stock options. During the fiscal year, the Company repurchased 150,000 shares of
common stock for an aggregate cost of $0.1 million pursuant to a settlement
agreement with one of the former owners of PSIP. Those purchases occurred at the
former owner's option, which option expired on October 10, 2001. Net cash
provided by financing activities during fiscal years 2002 and 2001 was $0.1
million and $0.3 million, respectively.

During the twelve month period ended January 31, 2002, cash and investments
decreased by $6.8 million compared to a $7.4 million decrease in the prior
fiscal year. To offset the Company's decrease in cash, the Company has made a
determined effort to collect its accounts receivable. As a result, the Company
had a $1.3 million reduction in current net trade receivables. Additionally, the
Company resolved a disputed claim regarding the licensing of intellectual
property and as a result collected a $1.5 million long-term receivable during
the fiscal year.

During fiscal year 2002, $9.7 million of cash was consumed by the
operations of Netreon and the divestiture of Netreon's storage operations. The
divestiture resulted in cash payments of $1.3 million, which, among other
things, included a $0.9 million payment made to a landlord to terminate the
Company's obligations under one of Netreon's leases. This termination also
resulted in the release of $0.6 million of previously restricted cash.

The Company does not have a credit facility and the Company does not expect
to secure a line of credit.

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

25

Item 7A--Quantitative and Qualitative Disclosures About Market Risk.

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

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

Risks and Uncertainties

An investment in the Company's common stock involves a high degree of risk.

Peerless operates in a dynamic and rapidly changing industry that involves
numerous risks and uncertainties. The risks and uncertainties described below
are not the only ones the Company faces, and other risks and uncertainties,
including those that the Company does not consider material at the time of the
filing of this Annual Report on Form 10-K, may impair the Company's business or
operations. If events giving rise to any of the risks discussed below actually
occur, the Company's business, financial condition, operating results or cash
flows could be materially adversely affected.

Peerless has a history of losses and anticipates continued losses.

Peerless has been unprofitable since the fourth quarter of fiscal year
2000, which ended on January 31, 2000. Peerless expects to continue to incur
quarterly losses at least through the first half of fiscal year 2003 and perhaps
beyond. While the divestiture of the unprofitable storage operations of Netreon
is expected to improve the Company's operating results, there is no assurance
that the Company will be profitable in the future.

Continuing losses will deplete the Company's capital resources, and the
Company does not expect projected decreases in expenses to offset the lack of
revenues. The factors noted below have had and will continue to have a material
adverse effect on the Company's future revenues and/or results of operations.

The future demand for the Company's current Imaging products is uncertain.

Peerless' current technology and products in the Imaging segment have been
in the marketplace for an average of 29 months as of January 31, 2002. This
represents a 38% increase from the average of 21 months that the Company's
products had been in the marketplace as of January 31, 2001. The growth in the
average age of current technology and products in the marketplace reflects the
decline in demand for the Company's technology and products. While Peerless
continues to license its current technology and products to certain OEMs, and
has introduced new technology and products during this current fiscal year,
there can be no assurance that the OEMs will continue to need or utilize the
current technology and products that the Company offers.

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

Peerless currently derives substantially all of its revenues from licensing
and sale of the Company's embedded imaging software and products. Peerless
expects that revenue from embedded imaging products will continue to account for
a substantial portion of revenues during fiscal year 2003 and beyond. The
Company's future success also depends in part on the Company's ability to
address the rapidly changing needs of potential customers in the marketplace, to
introduce high-quality, cost-effective products, product enhancements and
services on a timely basis, and to keep pace with technological developments and
emerging industry standards. The Company's failure to

26

achieve its business plan to develop and to successfully introduce new products
and product enhancements in the Company's prime markets is likely to materially
and adversely affect the Company's business and financial results.

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

During fiscal year 2002, three customers each generated greater than 10% of
the Company's revenues and collectively contributed 55.7% of revenues. Block
license revenues for the same time period totaled $17.3 million, or 58.1%, of
revenues. During fiscal year 2001, two customers each generated greater than 10%
of the revenues, and collectively contributed 36% of revenues. There were $10.3
million of block license revenues during fiscal year 2001.

A limited number of OEM customers continue to provide a substantial portion
of Peerless' revenues. There presently are only a small number of OEM customers
in the digital document product market to which the Company can market its
technology and services. Therefore, the Company's ability to replace a lost
customer or offset a significant decrease in the revenues from a particular
customer is severely constrained. A reduction in business from just one customer
providing a significant portion of the Company's revenues can have a material
adverse effect on the Company's operating results.

International political instability may increase the cost of doing business
and disrupt the Company's business.

Increased international political instability, disruption in air
transportation and further enhanced security measures as a result of the
September 2001 terrorist attacks, the conflict in Afghanistan and the
hostilities in the Middle East, may hinder the Company's ability to do business
and may increase its costs. The increased instability may, for example,
negatively impact the reliability and cost of transportation, negatively impact
the desire of the company's employees and customers to travel, adversely affect
the ability to obtain adequate insurance at reasonable rates, or require the
company to take extra security precautions for operations. In addition, to the
extent that air and other transportation is delayed or disrupted, the operations
of Peerless' OEMs and suppliers may be disrupted, and if such political
instability or hostilities continue or increase, the business results for the
Company could be harmed.

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

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

. product development delays (see "Peerless must adapt to technology
trends and evolving industry standards or the Company will not be
competitive" below);

. third party delays; and

. loss of new engineering services contracts.

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

Peerless' licensing revenue is subject to significant fluctuations.

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

27

Peerless may be unable to accurately estimate the Company's revenues from
product licensing and as a result may be required to adjust the Company's
revenues in the future.

In addition to block licenses, Peerless' recurring product licensing
revenues are dependent on the timing and accuracy of product sales reports
received from OEM customers' non-block license agreements. These reports are
provided on a calendar quarter basis and, in any event, are subject to delay and
potential revision by the OEM. Therefore, the Company must estimate the entire
recurring product licensing revenues for the last month of each fiscal quarter.
The Company must also estimate all quarterly and annual revenues from an OEM
when the report from such OEM is not received in a timely manner. In the event
that the Company is unable to estimate such revenues accurately prior to
reporting quarterly or annual results, the Company may be required to adjust
recorded revenues in subsequent periods.

Peerless must adapt to technology trends and evolving industry standards or
the Company will not be competitive.

The marketplace for Peerless' products and services is characterized by
rapidly changing technology, evolving industry standards and needs, frequent new
product introductions, knowledgeable OEMs with financial strength and
negotiating leverage greater than the Company's own, and a high degree of
competition. Peerless' success has always depended on the achievement of new
design wins followed by OEM deployment of associated new digital document
products with attendant license fees, and the regular and continued introduction
of new and enhanced technology and services to the Company's OEMs on a timely
and cost-effective basis. The shortfall of the acceptance by OEMs of the
Company's technology has been further exacerbated by less than projected
deliveries of digital document products by the Company's OEM customers to the
marketplace due to the recent slow down in business and economic activity.

There can be no assurance that the product solutions and technology of the
Company's competitors or the OEMs themselves will not render the Company's
technology or the Company's OEMs' products technically or fiscally
noncompetitive or obsolete. If Peerless or its OEMs fail to anticipate or
respond adequately to the rapidly changing technology and evolving industry
standards and needs, or any significant delay in development or introduction of
new and enhanced products and services, it could result in a loss of
competitiveness and/or revenues. Such actions would have a material adverse
effect on the Company's operating results.

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

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

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

28

current and prospective OEM customers or with other third party digital imaging
system suppliers, and the inability to do so would have a material adverse
effect on the Company's operating results.

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

Peerless currently sublicenses third party technologies to the Company's
OEM customers. Such sublicense agreements are non-exclusive. If Peerless is
determined not to be in compliance with the Company's agreements with its
licensors, Peerless may forfeit the Company's right to sublicense these
technologies. Likewise, if such sublicense agreements were canceled, Peerless
would lose the Company's right to sublicense these technologies. Additionally,
the licensing of these technologies has become very competitive with competitors
possessing substantially greater financial and technical resources and market
penetration than Peerless. As competitors are pursuing aggressive strategies to
obtain similar rights as held by Peerless to sublicense these third party
technologies, there is no assurance that Peerless can remain competitive in the
marketplace if one or more competitors are successful.

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

The Company's net accounts receivable declined to $5.2 million as of
January 31, 2002, down from $7.9 million as of January 31, 2001, reflecting
significant collections from several major customers, including the conversion
of unbilled receivables to accounts receivable and the resolution of a disputed
claim regarding the licensing of intellectual property resulting in a collection
of a $1.5 million long-term receivable. Although Peerless believes that the
Company's reserves for accounts receivable are adequate for fiscal year 2003,
there can be no assurance this is the case. If the Company's reserves for
accounts receivable are inadequate, it could have a material adverse effect on
the Company's results of operations.

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

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

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

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

Peerless relies on relationships with Adobe Systems Incorporated and Novell
Inc. and any change in those relationships will harm the Company's business.

The Company has licensing agreements with Adobe Systems Incorporated and
Novell Inc. to bundle and sublicense their licensed products with the Company's
licensed software. These relationships accounted for $17.8 million in revenues
and an associated $6.2 million in cost of revenues during fiscal year 2002.
Should the agreement with either vendor be terminated or canceled, there is no
assurance that the Company could replace that source of revenue within a short
period of time, if at all. Such an event would have a material adverse effect on
the Company's operating results.

29

Peerless may be unable to respond quickly to changes in demand.

Most of the Company's costs and expenses are related to costs of
engineering services and maintenance, product development, other personnel
costs, marketing programs and facilities. The level of spending for such costs
and expenses is based, in significant part, on the Company's expectations of
future revenues and anticipated OEM commitments and thus cannot be adjusted
quickly. As in fiscal year 2002, if such commitments do not materialize or are
terminated or if revenues are below expectations, costs and expenses will
continue to be incurred and the Company's quarterly and annual operating results
will be materially and adversely affected.

Peerless is dependent on key personnel and on employee retention and
recruiting for the Company's future success.

Peerless is largely dependent upon the skills and efforts of the Company's
senior management and other officers and key employees. The Company's future
success will continue to depend in large part upon the Company's ability to
retain and attract highly skilled managerial, engineering, sales, marketing and
operations personnel, many of whom are in great demand. Competition for such
personnel is intense. The loss of key personnel or the inability to hire or
retain qualified personnel has had and could continue to have a material adverse
effect on the Company's operating results.

The Company's international activities may expose the Company to risks
associated with currency fluctuations.

Peerless is substantially dependent on the Company's international business
activities. The international market for products incorporating the Company's
technology is highly competitive, and Peerless faces substantial competition in
this market from technologies developed internally by the Company's OEMs.

Risks inherent in the Company's international business activities also
include:

. disruptions by terrorists of normal channels of distribution;

. disruptions by terrorists of normal communications lines;

. major currency rate fluctuations;

. changes in the economic condition of foreign countries;

. the imposition of government controls;

. tailoring of products to local requirements;

. trade restrictions;

. changes in tariffs and taxes; and

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

Although all of the Company's contracts are, and Peerless expects that the
Company's future contracts will be, denominated in U.S. dollars, there can be no
assurance that the Company's contracts with international OEMs in the future
will be denominated in U.S. dollars. If any of the Company's contracts are
denominated in foreign currencies, Peerless will be subject to major risks
associated with currency fluctuations, which could have a material adverse
effect on the Company's operating results.

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

During the past several years and continuing through fiscal year 2002, the
Pacific Rim economies have been financially depressed. As a result, companies in
the imaging industry have reported negative financial impacts attributable to a
decrease in demand from Pacific Rim customers. The Company's Pacific Rim
customers are comprised primarily of companies headquartered in Japan. These
Japanese OEMs sell products containing the Company's technology primarily in the
North American, European, and Asian marketplaces. These revenues have

30

declined and there can be no assurance that revenues from Japanese OEMs will not
continue to decline in future quarters.

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

The Company's common stock has experienced price volatility. In the 60 day
period ending April 25, 2002, the closing price of the stock ranged from $1.15
per share to $1.89 per share, and, since the beginning of fiscal year 2002, the
stock has closed as low as $0.53 per share. Such price volatility may occur in
the future. Factors that could affect the trading price of the Company's common
stock include:

. macroeconomic conditions;

. actual or anticipated fluctuations in quarterly results of operations;

. announcements of new products or significant technological innovations
by the Company or the Company's competitors;

. developments or disputes with respect to proprietary rights;

. losses of major OEM customers;

. general trends in the industry; and

. overall market conditions, and other factors.

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

Peerless is subject to securities litigation which is expensive and results
in a diversion of resources. Peerless could be subject to additional litigation
due to the volatility of the Company's stock price or for other reasons.

Securities class action litigation has become increasingly common in recent
years. Technology companies are frequently the subjects of such litigation.
Securities class action litigation is particularly common following periods of
market volatility and significant fluctuations in companies' stock prices. In
fiscal year 2000, Peerless and two of the Company's former officers were named
in two separate shareholder class action lawsuits. The first was filed on August
28, 2000; the second was filed on September 19, 2000. On April 17, 2001, the
Company was served with an Amended and Consolidated Complaint. These lawsuits
allege a scheme to artificially inflate the Company's stock price based on
alleged misleading public announcements and seek compensatory damages with
interest and attorneys fees and expenses. Peerless believes all of the claims to
be without merit. A hearing on the motion filed by the Company and the two
former officers to dismiss the Amended and Consolidated Complaint was held on
October 9, 2001. By an order dated January 14, 2002, the Court dismissed the
First Amended and Consolidated Complaint without prejudice and granted the
plaintiffs sixty days to file a Second Amended and Consolidated Complaint. The
plaintiff class filed a Second Amended and Consolidated Complaint on March 15,
2002.Litigation is often expensive and diverts management's attention and
resources, which could materially and adversely affect business, financial
conditions and results of operations.

Future sales of the Company's common stock may affect the market price of
the Company's common stock.

As of April 24, 2002, Peerless had 15,416,860 shares of common stock
outstanding, which does not include 2,795,758 shares subject to options
outstanding as of such date under stock option plans that are exercisable at
prices ranging from $0.39 to $22.375 per share. Management cannot predict the
effect, if any, that future sales of common stock or the availability of shares
of common stock for future sale will have on the market price of common stock
prevailing from time to time. Certain holders of the Company's common stock have
registration rights with respect to their shares. Sales of substantial amounts
of common stock (including shares issued upon the exercise of stock options), or
the perception that such sales could occur, may materially and adversely affect
prevailing market prices for common stock.

31

The Company's common stock may be removed from listing on the Nasdaq
National Market and thus may not provide adequate liquidity.

Nasdaq Marketplace Rule 4450(a)(5) requires companies listed on the Nasdaq
National Market to maintain a minimum bid price of $1.00 over a 30 trading day
period. If Peerless is unable to maintain compliance with these rules, the
Company's common stock may become subject to being removed from listing on the
Nasdaq National Market. Trading in the Company's common stock after a delisting,
if any, would likely be conducted in the over-the-counter markets in the
so-called "pink sheets" or the National Association of Securities Dealers'
Electronic Bulletin Board and could also be subject to additional restrictions.
As a consequence of a delisting, the Company's stockholders would find it more
difficult to dispose of, or to obtain accurate quotations as to the market value
of, the Company's common stock. In addition, a delisting would make the
Company's common stock substantially less attractive as collateral for margin
and purpose loans, for investment by financial institutions under their internal
policies or state legal investment laws or as consideration in future capital
raising transactions.

The Company's common stock may be subject to the "penny stock" regulations
which may affect the ability of the holders to sell the Company's common stock.

If the Company's common stock were to be delisted from the Nasdaq National
Market, it may become subject to regulation as a "penny stock." The Securities
and Exchange Commission has adopted regulations that generally define "penny
stock" to be any equity security that has a market price or exercise price less
than $5.00 per share, subject to certain exceptions, including listing on the
Nasdaq National Market. If the common stock is delisted from the Nasdaq National
Market and no other exception applies, the Company's common stock may become
subject to the Securities and Exchange Commission's Penny Stock Rules, Rule
15g-1 through Rule 15g-9 under the Securities Exchange Act of 1934. For
transactions covered by these rules, the broker-dealer must make a special
suitability determination for the purchase of such securities and have received
the purchaser's written consent to the transaction prior to the purchase.
Additionally, a risk disclosure document mandated by the Securities and Exchange
Commission relating to the "penny stock" market must be delivered to the
purchaser prior to the transaction, unless the transaction satisfies one of the
exemptions under the rules. The broker-dealer must also disclose the commission
payable to both the broker-dealer and the registered representative, current
quotations for the securities and, if the broker-dealer is the sole market
maker, the broker-dealer must disclose this fact and the broker-dealer's
presumed control over the market. Monthly statements must be sent disclosing
recent price information for the "penny stock." Additionally, the rules may
restrict the ability of broker-dealers to sell the Company's common stock and
may affect the ability of holders to sell the Company's common stock in the
secondary market.

The Company's future investment income may fall below expectations due to
adverse market conditions.

Market risk is the potential loss arising from adverse changes in market
rates and prices, such as interest rates. The Company's exposure to market rate
risk for changes in interest rates relates primarily to the Company's investment
portfolio. Peerless invests the Company's excess cash in fixed rate debt
instruments of the U.S. Government and high-quality corporate issuers as well as
floating rate money market funds. Interest rates on these instruments have
declined substantially. Peerless, by policy, limits the amount of credit
exposure to any one issuer. Investments in both fixed rate and floating rate
interest earning instruments carry a degree of interest rate risk. Fixed rate
securities may have their fair market value adversely impacted due to a rise in
interest rates, while floating rate securities may produce less income than
expected if interest rates fall. Due in part to these factors, the Company's
future investment income may fall short of expectations due to changes in
interest rates, or Peerless may suffer losses in principal if forced to sell
securities before maturity, if they have declined in market value due to changes
in interest rates.

Effects of anti-takeover provisions could discourage, delay or prevent the
Company's acquisition that a stockholder may consider favorable.

Some of the provisions of the Company's certificate of incorporation,
by-laws and Delaware law could, together or separately:

. discourage potential acquisition proposals;

. delay or prevent a change in control;

. limit the price that investors might be willing to pay in the future
for shares of the Company's common stock.

32

Furthermore, certain of the Company's agreements with strategic partners
and customers require that Peerless give prior notice of a change of control or
may terminate if the Company undergoes a change of control, without obtaining
the prior written consent of such strategic partners and customers.

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

The Company's cash and short-term investment portfolio was $11.5 million at
January 31, 2002 and the current ratio of assets to current liabilities was
2.6:1. For the twelve-month period ended January 31, 2002, Peerless used $5.3
million in cash to finance operations.

The Company's principal source of liquidity is the Company's cash and cash
equivalents and investments, which, as of January 31, 2002 were $14.7 million in
the aggregate. For the twelve-month period ended January 31, 2002, Peerless
incurred a loss and experienced negative cash flow from operating activities.
Peerless does not have a credit facility and Peerless does not expect to secure
a line of credit. If Peerless does not generate anticipated cash flow from
licensing, or if expenditures are greater than expected, Peerless most likely
will reduce discretionary spending, which could require a delay, scaling back or
elimination of some or all of the Company's development efforts, any of which
could have a material adverse effect on the Company's business, results of
operations and prospects. Furthermore, if Peerless continues to experience
negative cash flows, as is currently forecasted, and Peerless is unable to
increase revenues or cut costs so that revenues generated from operating
activities are sufficient to meet the Company's obligations as a result of which
Peerless exhausts current capital resources, Peerless will be required to obtain
additional capital from other sources. Such sources might include issuances of
debt or equity securities, bank financing or other means that might be available
to increase the Company's working capital. Under such circumstances, there is
substantial doubt as to whether Peerless would be able to obtain additional
capital on commercially reasonable terms or at all. The inability to obtain such
resources on commercially acceptable terms could have a material adverse effect
on the Company's operations, liquidity and financial condition, the Company's
prospects and the scope of strategic alternatives and initiatives available to
the Company.

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

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

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

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

The Company holds nine patents issued in the United States, one of which is
also issued in France, Germany, Great Britain, Japan and Hong Kong. The issued
patents relate to techniques developed by the Company for generating output for
continuous synchronous raster output devices, such as laser printers,
compressing data for use with output devices, filtering techniques for use with
output devices and communicating with peripheral devices over a network.

The Company also has five patent applications and two provisional
applications pending in the United States, four applications pending in the
European Patent Office, four applications pending in Japan, two applications
pending in Hong Kong, one application pending in Canada and one application
pending in the Republic of China.

33

The Company holds nine patents issued in the United States, one of which is
also issued in France, Germany, Great Britain, Japan and Hong Kong. The issued
patents relate to techniques developed by the Company for generating output for
continuous synchronous raster output devices, such as laser printers,
compressing data for use with output devices, filtering techniques for use with
output devices and communicating with peripheral devices over a network.

The Company also has five patent applications and two provisional
applications pending in the United States, four applications pending in the
European Patent Office, four applications pending in Japan, two applications
pending in Hong Kong, one application pending in Canada and one application
pending in the Republic of China.

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

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

Peerless may be unable to manage expansion and growth effectively.

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

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

The industry in which Peerless operates has experienced significant
downturns, both in the United States and abroad, often in connection with, or in
anticipation of, maturing product cycles and declines in general economic
conditions. Over the past two years, Peerless has experienced a shift in OEM
demand from the historically prevailing requirement for turnkey solutions toward
SDKs. Because Peerless has experienced a general decrease in demand for
engineering services, engineering services resources have been re-deployed to
research and development. Should this trend abruptly change, Peerless may be
unable to re-deploy labor effectively and in a timely manner, which inability
could have a material adverse effect on the Company's operational results.

34

Item 8--Consolidated Financial Statements and Supplementary Data.

See Index to Financial Statements on page F-1.

Item 9--Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.

None.

35

PART III

Item 10--Directors and Executive Officers.

See the information set forth in the sections entitled "Proposal No. 1 -
Election of Directors," "Executive Compensation and Other Matters" and "Section
16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy
Statement for the 2002 Annual Meeting of Stockholders to be filed with the
Securities and Exchange Commission within 120 days after the end of fiscal year
2002 (the "2002 Proxy Statement"), which is incorporated herein by reference.

Item 11--Executive Compensation.

See the information set forth in the section entitled "Executive
Compensation and Other Matters" in the 2002 Proxy Statement, which is
incorporated herein by reference.

Item 12--Security Ownership of Certain Beneficial Owners and Management.

See the information set forth in the section entitled "Securities Ownership
of Certain Beneficial Owners and Management" in the 2002 Proxy Statement, which
is incorporated herein by reference.

Item 13--Certain Relationships and Related Transactions.

See the information set forth in the sections entitled "Certain
Relationships and Related Transactions" and "Compensation Committee Interlocks
and Insider Participation" in the 2002 Proxy Statement, which is incorporated
herein by reference.

36

PART IV

Item 14--Exhibits, Financial Statement Schedules and Reports on Form 8-K.

(a)Documents filed as a part of this Annual Report on Form 10-K:

(1)Financial Statements:

Page
----
Report of Ernst & Young LLP, Independent Auditors. F-2

Consolidated Statements of Operations. F-4

Consolidated Balance Sheets. F-5

Consolidated Statements of Stockholders' Equity. F-6

Consolidated Statements of Cash Flows. F-7

Notes to Consolidated Financial Statements. F-8

(2) Financial Statement Schedules:

The following financial statement schedule of the Company is filed as part
of this Report and should be read in conjunction with the Financial Statements
of the Company.

Schedule Page
-------- ----
II Valuation and Qualifying Accounts S-1

Schedules not listed above have been omitted because they are not
applicable or are not required or the information required to be set forth
therein is included in the Financial Statements or Notes thereto.

(b) Reports on Form 8-K:

1. Form 8-K was filed on December 7, 2001 reporting other events
pursuant to Item 5 of Form 8-K and reporting Financial Schedules, Pro Forma
Financials and Exhibits pursuant to Item 7 of Form 8-K.

2. Form 8-K was filed on December 20, 2001 reporting other events
pursuant to Item 5 of Form 8-K.

(c) Exhibits: The following exhibits are filed as part of, or incorporated
by reference into, this Annual Report on Form 10-K:

Exhibit
Number
- -------

3.1(1) Certificate of Incorporation of the Company.

3.2(9) Amended and Restated Bylaws of the Company.

4.1 Instruments defining the rights of security holders. Reference is made to Exhibits 3.1 and 3.2.

4.2(4) Rights Agreement, dated October 7, 1998, between the Company and Wells Fargo Shareowner Services, a
division of Wells Fargo Bank Minnesota, N.A., formerly known as Norwest Shareowner Services, as Rights
Agent.

10.1(10)(2) 1996 Equity Incentive Plan, as amended and form of stock option agreements thereunder.

10.2(11)(2) 1996 Employee Stock Purchase Plan, as amended.

10.3(1)(3) Reference Post Appendix No. 2 to the Adobe Third Party License dated February 11, 1993.

10.4(1) Amendment No. 1 to the Adobe Third Party License dated November 29, 1993.

37

Exhibit
Number
- -------

10.5(1)(3) PCL Development and License Agreement (the "PCL License ") dated June 14, 1993, between the Registrant and
Adobe.

10.6(1)(3) Amendment No. 1 to the PCL License dated October 31, 1993.

10.7(1)(3) Letter Modification to the PCL License dated August 5, 1994.

10.81)(3) Addendum No. 1 to the PCL License dated March 31, 1995.

10.9(1)(3) Letter Modification to the PCL License dated August 30, 1995.

10.10(1) Lease Agreement between the Company and Continental Development Corporation dated February
6, 1992, and Addendum, dated February 6, 1992.

10.11(1) First Amendment to Office Lease dated December 1, 1995, between the Company and Continental Development
Corporation.

10.12(5) Second Amendment to Office Lease dated April 8, 1997, between the Company and Continental Development
Corporation.

10.13(5) Third Amendment to Office Lease dated December 16, 1997, between the Company and Continental Development
Corporation.

10.14(6) Fourth Amendment to Office Lease dated April 22, 1998, between the Company and Continental Development
Corporation.

10.15(7) Agreement and Plan of reorganization and Merger by and among Peerless Systems Corporation, Auco Merger Sub,
and Auco, Inc. dated as of April 6, 1999.

10.16(8) Marubun Supplier/Distribution Agreement dated December 14, 1999.

10.17(8) Lease PSN McKelvy Family Trust (386 Main Street) Standard Industrial/Commercial Single-Tenant Lease-Net
dated March 14, 1997.

10.18(8) Lease PSIP Kent Centennial Limited Partnership dated January 31, 1996.

10.19(2)(12) Form of Indemnification Agreement, effective as of March 12, 2001.

10.20(13) Settlement Agreement and Mutual Release dated April 11, 2001 between Peerless Systems Corporation and
Gordon L. Hanson.

10.21(9) Settlement Agreement and Mutual Release, effective as of April 27, 2001, by and among the State of
Wisconsin Investment Board, Peerless Systems Corporation and Edward A. Gavaldon.

10.22 Series A Preferred Stock Purchase Agreement dated January 29, 2002 by and among Netreon, Inc., a Delaware
corporation, Netreon, Inc., a California corporation and each of the several purchasers named therein.

10.23 Series A Preferred Stock Contribution Agreement dated January 29, 2002 by and between Netreon, Inc., a
Delaware corporation and Peerless Systems Corporation.

21 Peerless Wholly-Owned Subsidiaries.

23.1 Consent of Ernst & Young LLP, Independent Auditors.

24.1 Power of Attorney. Reference is made to the signature page to this Annual Report on Form 10-K.

(1)Previously filed in the Company's Registration Statement on Form S-1
(File No. 333-09357), as amended and incorporated herein by reference.
(2)Management contract or compensatory plan or arrangement.
(3)Subject to a Confidential Treatment Order.
(4)Previously filed in the Company's Current Report on Form 8-K, filed
October 13, 1999, and incorporated herein by reference.

38

(5)Previously filed in the Company's 1998 Annual Report filed on Form 10-K,
filed April 24, 1998, and incorporated herein by reference.
(6)Previously filed in the Company's 1999 Annual Report filed on Form 10-K,
filed April 26, 1999, and incorporated herein by reference.
(7)Previously filed in the Company's Registration Statement on Form S-4
(File No. 333-77049) as amended and incorporated herein by reference.
(8)Previously filed in the Company's 2000 Annual Report filed on Form 10-K,
filed April 28, 2000, and incorporated herein by reference.
(9)Previously filed in the Company's Current Report on Form 8-K, filed July
2, 2001, and incorporated herein by reference.
(10) Previously filed in the Company's Registration Statement on Form S-8
(File No. 333-73562), filed November 16, 2001, and incorporated herein by
reference.
(11) Previously filed in the Company's Registration Statement on Form S-8
(File No. 333-57362), filed March 21, 2001, and incorporated herein by
reference.
(12) Previously filed in the Company's Amendment No. 4 to its Registration
Statement on Form S-3 (File No. 333-60284), filed July 27, 2001, and
incorporated herein by reference.
(13) Previously filed in the Company's 2001 Annual Report filed on Form
10-K, filed May 1, 2001, and incorporated herein by reference.

39

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Registrant has duly caused this Report to
be signed on its behalf by the undersigned, thereunto duly authorized, on the
1st day of May, 2002.

Peerless Systems Corporation

By: /s/ William R. Neil
----------------------------
William R. Neil
Vice President of Finance and
Chief Financial Officer

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Howard J. Nellor and William R. Neil,
his/her attorneys-in-fact, each with the power of substitution, for him/her in
any and all capacities, to sign any amendments to this Annual Report on Form
10-K, and to file the same, with Exhibits thereto and other documents in
connection therewith with the Securities and Exchange Commission, hereby
ratifying and confirming all that each of said attorneys-in-fact, or substitute
or substitutes may do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.

Signature Title Date
- --------- ----- ----

/s/ Howard J. Nellor Chief Executive Officer, May 1, 2002
- ------------------------ President & Director
Howard J. Nellor (Principal Executive Officer)

/s/ Robert G. Barrett Director May 1, 2002
- ------------------------
Robert G. Barrett

/s/ Robert L. North Director May 1, 2002
- ------------------------
Robert L. North

/s/ Louis C. Cole Director May 1, 2002
- ------------------------
Louis C. Cole

/s/ William R. Neil Vice President of Finance and Chief May 1, 2002
- ------------------------ Financial Officer
William R. Neil (Principal Financial and Accounting
Officer)

40

PEERLESS SYSTEMS CORPORATION

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Page
----
Report of Ernst & Young LLP, Independent Auditors F-2

Consolidated Statements of Operations F-3

Consolidated Balance Sheets F-4

Consolidated Statements of Stockholders' Equity F-5

Consolidated Statements of Cash Flows F-6

Notes to Consolidated Financial Statements F-7

F-1

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders of Peerless Systems Corporation

We have audited the accompanying consolidated balance sheets of Peerless
Systems Corporation as of January 31, 2002 and 2001, and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended January 31, 2002. Our audits also
included the financial statement schedule listed in the Index at Item 14 (a) for
each of the three years in the period ended January 31, 2002. These financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatements. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Peerless
Systems Corporation at January 31, 2002 and 2001 and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended January 31, 2002 in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related financial
statement schedule for each of the three years in the period ended January 31,
2002, when considered in relation to the basic financial statements taken as a
whole, presents fairly in all material respects the information set forth
therein.

/s/ Ernst & Young LLP
-----------------------------------

Los Angeles, California
March 21, 2002

F-2

PEERLESS SYSTEMS CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)

Years Ended January 31,
-----------------------------
2002 2001 2000
-------- -------- -------

Revenues:
Product licensing $ 21,606 $ 18,571 $26,042
Engineering services and maintenance 6,132 7,481 15,989
Other 2,029 1,355 45
-------- -------- -------
Total revenues 29,767 27,407 42,076
-------- -------- -------

Cost of revenues:
Product licensing 6,309 4,867 932
Engineering services and maintenance 5,708 9,662 13,030
Other 1,206 823 11
-------- -------- -------
Total cost of revenues 13,223 15,352 13,973
-------- -------- -------
Gross margin 16,544 12,055 28,103
-------- -------- -------

Operating expenses:
Research and development 13,634 13,019 9,600
Sales and marketing 6,001 5,783 6,366
General and administrative 6,857 10,481 5,752
Other-non-recurring expenses -- -- 2,252
-------- -------- -------
Total operating expenses 26,492 29,283 23,970
-------- -------- -------
Loss from operations (9,948) (17,228) 4,133
Other income 2,320 -- --
Loss on divestiture of storage operations (2,303) -- --
Interest income, net 743 1,229 1,209
-------- -------- -------
Total other income 760 1,229 1,209
-------- -------- -------
Income (loss) before income taxes (9,188) (15,999) 5,342
Provision for income taxes 1,809 1,650 1,901
-------- -------- -------
Net income (loss) $(10,997) $(17,649) $ 3,441
======== ======== =======

Basic earnings (loss) per share $ (0.73) $ (1.19) $ 0.25
======== ======== =======

Diluted earnings (loss) per share $ (0.73) $ (1.19) $ 0.22
======== ======== =======

Weighted average common shares outstanding - basic 15,062 14,886 13,890
======== ======== =======

Weighted average common shares outstanding - diluted 15,062 14,886 15,483
======== ======== =======

The accompanying notes are an integral part of these financial statements.

F-3

PEERLESS SYSTEMS CORPORATION

CONSOLIDATED BALANCE SHEETS
(in thousands)

January 31,
-------------------
2002 2001
-------- --------

ASSETS
Current assets:
Cash and cash equivalents $ 11,030 $ 12,073
Restricted cash -- 742
Short term investments 508 6,358
Trade accounts receivable, less allowance for doubtful accounts of $100 and $755
in 2002 and 2001, respectively 5,158 6,428
Unbilled receivables 160 159
Prepaid expenses and other current assets 537 493
-------- --------
Total current assets 17,393 26,253
Investments 3,116 3,070
Long-term receivable -- 1,500
Property and equipment, net 4,038 5,710
Other assets 387 575
-------- --------
Total assets $ 24,934 $ 37,108
======== ========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 742 $ 901
Accrued wages 1,033 2,075
Accrued compensated absences 675 714
Other current liabilities 2,482 3,507
Deferred revenue 1,827 826
-------- --------
Total current liabilities 6,759 8,023
Other tax liabilities 2,060 2,260
Deferred rent 121 97
-------- --------
Total liabilities 8,940 10,380
-------- --------

Stockholders' equity:
Common stock, $.001 par value, 30,000 shares authorized, 15,377 and 14,909 shares
issued and outstanding in 2002 and 2001, respectively 15 15
Additional paid-in capital 48,789 48,471
Deferred compensation -- (58)
Accumulated deficit (32,697) (21,700)
Treasury stock, 150 shares in 2002 (113) --
-------- --------
Total stockholders' equity 15,994 26,728
-------- --------
Total liabilities and stockholders' equity $ 24,934 $ 37,108
======== ========

The accompanying notes are an integral part of these financial statements.

F-4

PEERLESS SYSTEMS CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands)

Convertible Convertible
Preferred Stock Preferred Stock
Common Stock Series A Series B
--------------- ---------------- ----------------
Shares Amount Shares Amount Shares Amount
------ ------ ------ ------- ------ -------

Balances, January 31, 1999 12,838 $13 3,228 $ 3,217 1,413 $ 3,520
Issuance of common stock 151 -- -- -- -- --
Exercise of stock options 530 1 -- -- -- --
Conversion of preferred stock
Series A and B to common stock 1,200 1 (3,228) (3,217) (1,413) (3,520)
Conversion of notes payable to common stock 5 -- -- -- -- --
Acquisition adjustment -- -- -- -- -- --
Amortization of deferred compensation -- -- -- -- -- --
Net income -- -- -- -- -- --
------ --- ------ ------- ------ -------
Balances, January 31, 2000 14,724 15 -- -- -- --
Compensation expense for stock option modifications -- -- -- -- -- --
Issuance of common stock 107 -- -- -- -- --
Exercise of stock options 78 -- -- -- -- --
Amortization of deferred compensation -- -- -- -- -- --
Net Loss -- -- -- -- -- --
------ --- ------ ------- ------ -------
Balances, January 31, 2001 14,909 15 -- -- -- --
Issuance of put options -- -- -- -- -- --
Exercise of put options -- -- -- -- -- --
Expiration of put options -- -- -- -- -- --
Issuance of common stock 406 -- -- -- -- --
Exercise of stock options 62 -- -- -- -- --
Amortization of deferred compensation -- -- -- -- -- --
Net loss -- -- -- -- -- --
------ --- ------ ------- ------ -------
Balances, January 31, 2002 15,377 $15 -- $ -- -- $ --
====== === ====== ======= ====== =======

Treasury Stock Aditional Total
--------------- Paid - In Deferred Accumulated Stockholders'
Shares Amount Capital Comp. Deficit Equity
------ ------ --------- -------- ----------- -------------

Balances, January 31, 1999 -- $ -- $39,360 $(188) $ (7,493) $ 38,429
Issuance of common stock -- -- 846 -- -- 846
Exercise of stock options -- -- 961 -- -- 962
Conversion of preferred stock
Series A and B to common stock -- -- 6,736 -- -- --
Conversion of notes payable to common stock -- -- 50 -- -- 50
Acquisition adjustment -- -- -- -- 1 1
Amortization of deferred compensation -- -- -- 65 -- 65
Net income -- -- -- -- 3,441 3,441
---- ----- ------- ----- -------- --------
Balances, January 31, 2000 -- -- 47,953 (123) (4,051) 43,794
Compensation expense for stock option modifications -- -- 241 -- -- 241
Issuance of common stock -- -- 225 -- -- 225
Exercise of stock options -- -- 52 -- -- 52
Amortization of deferred compensation -- -- -- 65 -- 65
Net Loss -- -- -- -- (17,649) (17,649)
---- ----- ------- ----- -------- --------
Balances, January 31, 2001 -- -- 48,471 (58) (21,700) 26,728
Issuance of put options -- -- (232) -- -- (232)
Exercise of put options (150) (113) 113 -- -- -
Expiration of put options -- -- 209 -- -- 209
Issuance of common stock -- -- 209 -- -- 209
Exercise of stock options -- -- 19 -- -- 19
Amortization of deferred compensation -- -- -- 58 -- 58
Net loss -- -- -- -- (10,997) (10,997)
---- ----- ------- ----- -------- --------
Balances, January 31, 2002 (150) $(113) $48,789 $ -- $(32,697) $ 15,994
==== ===== ======= ===== ======== ========

The accompanying notes are an integral part of these financial statements.

F-5

PEERLESS SYSTEMS CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

Years Ended January 31,
--------------------------------
2002 2001 2000
-------- -------- --------

Cash flows from operating activities:
Net income (loss) $(10,997) $(17,649) $ 3,441
Adjustments to reconcile net income (loss) to net cash provided (used)
by operating activities
Depreciation and amortization 2,126 2,048 1,540
Amortization of investment discounts and premiums (10) (63) (146)
Amortization of deferred compensation 58 65 65
Loss on divestiture of storage operations 2,303 -- --
Compensation expense for option modifications and
common stock issued to employees -- 241 48
Allowance for bad debt (150) 881 97
Deferred taxes -- 1,732 640
Other -- -- 2
Changes in operating assets and liabilities:
Trade accounts receivable 1,420 2,859 278
Unbilled receivables (1) 2,184 651
Prepaid expenses and other assets (60) 282 (997)
Long-term receivable 1,500 -- (1,500)
Accounts payable (150) 286 (312)
Deferred revenue 1,001 155 (2,360)
Other liabilities (2,360) 1,168 1,513
-------- -------- --------
Net cash provided (used) by operating activities (5,320) (5,811) 2,960
-------- -------- --------
Cash flows from investing activities:
Purchases of property and equipment (698) (1,084) (1,742)
Purchases of leasehold improvements (216) (73) (818)
Purchases of available-for-sale securities (7,640) (31,645) (22,892)
Maturities of held-to-maturity securities -- -- 5,500
Proceeds from sales of available-for-sale securities 13,454 37,531 23,050
Divestiture of storage operations (1,343) -- --
Purchases of software licenses (137) -- (30)
Restricted cash 742 (742) --
-------- -------- --------
Net cash provided by investing activities 4,162 3,987 3,068
-------- -------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock 209 225 798
Proceeds from exercise of common stock options 19 52 962
Repayment of outstanding notes payable -- -- (300)
Repurchase of common stock (113) -- --
-------- -------- --------
Net cash provided by financing activities 115 277 1,460
-------- -------- --------
Net increase (decrease) in cash and cash equivalents (1,043) (1,547) 7,488
Cash and cash equivalents, beginning of period 12,073 13,620 6,132
-------- -------- --------
Cash and cash equivalents, end of period $ 11,030 $ 12,073 $ 13,620
======== ======== ========

Supplemental disclosure of cash flow information:
Cash paid during the year for:
Income taxes $ 1,629 $ 736 $ 1,554
Interest $ -- $ -- $ 15
Supplemental schedule of noncash investing and financing activities:
Conversion of preferred stock Series A to common stock $ -- $ -- $ 3,217
Conversion of preferred stock Series B to common stock $ -- $ -- $ 3,520
Conversion of notes payable to common stock $ -- $ -- $ 50
Common stock issued to employees $ -- $ -- $ 48

The accompanying notes are an integral part of these financial statements.

F-6

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share amounts)

1. Organization and Summary of Significant Accounting Policies:

Organization: Peerless Systems Corporation ("Peerless" or the "Company")
was incorporated in the state of California in April 1982 and reincorporated in
the state of Delaware in September 1996. Peerless develops and licenses
software-based digital imaging and networking systems and supporting electronic
technologies and provides custom engineering services to Original Equipment
Manufacturers ("OEMs") of digital document products located primarily in the
United States and Japan. Digital document products include printers, copiers,
fax machines, scanners and color products, as well as multifunction products
that perform a combination of these imaging functions. In order to process
digital text and graphics, digital document products rely on a core set of
imaging software and supporting electronics, collectively known as a digital
imaging system. Network interfaces supply the core technologies to digital
document products that enable them to communicate over local area networks and
the Internet.

Principles of Consolidation and Basis of Presentation: The consolidated
financial statements include the accounts of the Company and its subsidiaries.
All significant intercompany accounts and transactions have been eliminated. As
a result of the Netreon exchange transaction, the Company's Netreon subsidiary
was deconsolidated effective January 29, 2002. Although the Company has retained
an equity interest in the business formed as a result of the transaction, the
Company has not recorded a related investment and has no continuing obligation
to fund this business (see Note 2).

Business Combinations: All business combinations have been accounted for
under the pooling-of-interests method of accounting under Accounting Principles
Board Opinion No. 16. In such cases, the assets, liabilities and stockholders'
equity of the acquired entities were combined with the Company's respective
accounts at recorded values. Prior period financial statements have been
restated to give effect to the mergers.

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

Investments: The Company's investments at January 31, 2002 and 2001
consisted of available-for-sale U.S. government debt, state and local government
debt and corporate debt. Available-for-sale securities are carried at fair
value. Unrealized gains and losses, if material, are reported as a separate
component of stockholders' equity. Realized gains and losses and declines in
value judged to be other than temporary are included in results of operations.
Realized gains and losses are calculated using the specific identification
method and were not material to the Company's results of operations in any
period presented.

Property and Equipment: Property and equipment are stated at cost, less
accumulated depreciation. Depreciation on property and equipment is calculated
using the straight-line method as follows:

Computers and equipment 3 to 5 years

Furniture 10 years

Leasehold improvements Shorter of useful life or lease term

Maintenance and repairs are expensed as incurred, while renewals and
betterments are capitalized. Upon the sale or retirement of property and
equipment, the accounts are relieved of the cost and the related accumulated
depreciation, and any resulting gain or loss is included in results of
operations.

Long-Lived Assets: The Company identifies and records impairment losses on
long-lived assets when events and circumstances indicate that such assets may be
impaired. To date, no such impairment has been recorded.

Capitalization of Software Development Costs: The Company follows the
working model approach to determine technological feasibility of its products.
Costs that are incurred subsequent to establishing technological feasibility are
immaterial and, therefore, the Company expenses all costs associated with the
development of its products as such costs are incurred.

F-7

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

Revenue Recognition: The Company recognizes revenues in accordance with
Statement of Position 97-2 "Software Revenue Recognition" as amended by
Statement of Position 98-9. In November 2000, the Company adopted Staff
Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements" and
Emerging Issues Task Force 99-19, "Reporting Revenue Gross as a Principal versus
Net as an Agent." The adoptions did not impact the Company's revenue recognition
policy.

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

The Company also enters into engineering services contracts with certain of
its OEMs to provide a turnkey solution, adapting the Company's software and
supporting electronics to specific OEM requirements. Revenues on such contracts
are recognized over the course of the engineering work on a
percentage-of-completion basis. Progress-to-completion under
percentage-of-completion is determined based on direct costs, consisting
primarily of labor and materials, expended on the arrangement. The Company
provides for any anticipated losses on such contracts in the period in which
such losses are first determinable. The Company accrued $91 and $176 for losses
on contracts that experienced delays in completion at January 31, 2002 and 2001,
respectively. Maintenance revenues are recognized ratably over the term of the
maintenance contract.

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

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

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

Research and Development Costs: Research and development costs are expensed
as incurred.

Advertising Costs: Advertising costs are expensed as incurred in accordance
with Statement of Position 93-7 "Reporting on Advertising Costs." Advertising
expenses are recorded in sales and marketing expense and were immaterial to the
results of operations for all periods presented.

Income Taxes: The Company accounts for income taxes in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for
Income Taxes." Under this method, deferred income taxes are recognized for the
tax consequences in future years resulting from differences between the tax
bases of assets and liabilities and their financial reporting amounts at each
year-end based on enacted tax laws and statutory rates applicable to the periods
in which the differences are expected to reverse. Valuation allowances are
established, when necessary, to reduce deferred income tax assets to the amount
expected to be realized. Income tax provision is the tax payable for the period
and the change during the period in net deferred income tax assets and
liabilities.

F-8

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

Earnings Per Share: Basic earnings per share ("basic EPS") is computed by
dividing net income available to common stockholders (the numerator) by the
weighted average number of common shares outstanding (the denominator) during
the period. The computation of diluted earnings per share ("diluted EPS") is
similar to the computation of basic EPS except that the denominator is increased
to include the number of additional common shares that would have been
outstanding if dilutive potential common shares had been issued. Potential
common shares include outstanding options under the company's employee stock
option plan (which are included under the treasury stock method) and any
outstanding convertible securities. In addition, in computing the dilutive
effect of convertible securities, the numerator is adjusted to add back the
after-tax amount of interest recognized in the period associated with any
convertible debt. A reconciliation of basic EPS to diluted EPS is presented in
Note 10 to the Company's financial statements.

Common Stock Options: During 1997, the Company implemented the disclosure
requirements of SFAS No. 123, "Accounting for Stock-Based Compensation." This
statement sets forth alternative standards of recognition of the cost of
stock-based compensation and requires that the Company's financial statements
include certain disclosures about stock-based employee compensation arrangements
regardless of the method used to account for them. As permitted by this
statement, the Company continues to apply Accounting Principles Board ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees," and related
interpretations in recording compensation related to its plans. The supplemental
disclosure requirements and further information related to the Company's stock
option plans are presented in Note 13 to the Company's financial statements.

Cash and Cash Equivalents: Cash and cash equivalents represent cash and
highly liquid investments which mature within three months from date of
purchase.

Reclassifications: Certain previously reported financial information has
been reclassified to conform to the fiscal 2002 presentation.

Future Developments: In August 2001, the Financial Accounting Standards
Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," which addresses financial accounting and reporting for the
impairment or disposal of long-lived assets and supercedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long- Lived Assets
to be Disposed Of," and the accounting and reporting provisions of APB Opinion
No. 30, "Reporting the Results of Operations," for a disposal of a segment of a
business. SFAS No. 144 is effective for fiscal years beginning after December
15, 2001, with earlier application encouraged. The Company expects to adopt SFAS
No. 144 as of February 1, 2002 and it has not determined the effect, if any, the
adoption of SFAS No. 144 will have on the Company's financial position and
results of operations.

2. Business Developments:

Acquisitions:

In June 1999, the Company completed its acquisition of Auco, Inc. ("Auco").
Auco, based in Redwood City, California, developed embedded networking
technology and was privately held prior to the acquisition. As a result of the
acquisition, Auco was renamed Peerless Systems Networking ("PSN") and became a
wholly-owned subsidiary of the Company. The Company exchanged 2,500 shares of
its common stock for all outstanding shares of Auco capital stock on a fully
diluted basis, and its convertible note payable. Each share of Auco was
exchanged for .2585 shares of Peerless common stock. In September 2000, the
Company changed the name of its PSN subsidiary to Netreon, Inc., a California
corporation ("Netreon'). This corporate re-branding reflected Netreon's mission
to integrate networked storage devices into the Windows 2000 environment.

In December 1999, the Company completed its acquisition of HDE, Inc.
("HDE"). HDE, based in Seattle, Washington, developed embedded imaging and
Internet printing solutions and was privately held prior to the acquisition. As
a result of the acquisition, HDE was renamed Peerless Systems Imaging Products,
Inc. ("PSIP") and became a wholly-owned subsidiary of the Company. The Company
exchanged 890 shares of its common stock for all of the outstanding shares of
HDE common stock.

F-9

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

Both the Auco and HDE acquisitions qualified as tax-free exchanges and were
accounted for as poolings-of-interests under Accounting Principles Board Opinion
No. 16. Accordingly, the Company's financial statements have been restated to
include the results of Auco and HDE for all periods presented.

Prior to the June 1999 merger with the Company, Auco's fiscal year ended on
December 31. Beginning in the second quarter of fiscal 2000, Auco's fiscal year
end was changed to conform to Peerless' fiscal year end of January 31.
Accordingly, Auco's results of operations for the month of April 1999 were
excluded from the Company's consolidated operating results. Revenues and net
income of Auco for April 1999 were $463 and $1, respectively, with net income
reflected as an adjustment to retained earnings effective May 1, 1999.

There were no transactions between Peerless and Auco prior to the
combination. Prior to the acquisition, HDE provided engineering services to the
Company. Transactions between the Company and HDE have been eliminated in
consolidation. Certain reclassifications were made to the Auco and HDE financial
statements to conform to Peerless' presentations.

The results of operations for the separate companies and the combined
amounts presented in the consolidated financial statements are as follows:

Nine Month Period
Ended October 31, Three Month Period
1999 Ended April 30, 1999
----------------- ----------------------
(Unaudited) (Unaudited)
Revenues:
Peerless 31,065 8,194
Auco (A) 1,666
HDE 2,787 880
------- -------
Combined $33,852 $10,740
======= =======

Net income (loss):
Peerless 4,178 1,091
Auco (A) 122
HDE 35 (1)
------- -------
Combined $ 4,213 $ 1,212
======= =======

(A) Included in Peerless consolidated amounts after merger in June 1999.

Netreon Exchange:

In January 2002, the Company exchanged all of the outstanding capital stock of
Netreon for 7,714 shares of Series A Preferred Stock of Netreon, Inc., a
Delaware corporation ("Newco"), representing a 40.8% interest in the voting
shares of Newco stock. The remaining 59.2% of the voting shares of Newco stock
is held by parties external to the Company, including a former executive officer
of Netreon, who is also a former member of the Company's board of directors. The
Company does not expect to realize the cost of the Netreon capital stock
exchanged or costs incurred which were direct and incremental to the
transaction. As a result, the Company did not record an investment in Newco and
recorded a $2.3 million charge to loss on divestiture of storage operations.
Among other things, this includes a $947 payment made to a landlord to terminate
the Company's obligations under one of Netreon's leases and a $420 accrual for
other Netreon lease obligations to be paid by the Company through fiscal year
2005. The Company has no continuing obligation to provide funding in any form to
Newco.

F-10

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

3. Investments:

Investments available-for-sale at January 31 consisted of the following:

2002 2001
------ ------
Available-for-sale securities:
Maturities within one year:
U.S. government debt securities $ 308 $ --
State and local government debt securities 200 1,417
Corporate debt securities -- 4,941
------ ------
508 6,358
------ ------
Maturities after one year through five years:
U.S. government debt securities 1,916 604
Corporate debt securities -- 308
------ ------
1,916 912
------ ------
Maturities after five years:
State and local government debt securities -- 858
Corporate debt securities 1,200 1,300
------ ------
1,200 2,158
------ ------

Total investments $3,624 $9,428
====== ======

The fair value of available-for-sale securities at January 31, 2002 and
2001 approximated their carrying value (amortized cost). Unrealized gains or
losses on available-for-sale securities were immaterial for all periods
presented.

4. Restricted Cash:

On March 16, 2000, Netreon, Inc. entered into an agreement to lease
approximately twelve thousand square feet of office space in Mountain View,
California. The term of the lease agreement was seven years. The Company
guaranteed the lease commitment of Netreon, Inc. and secured the first twelve
months of the agreement with a $742 standby letter of credit. This letter of
credit was secured by a certificate of deposit of a like amount. In March of
fiscal year 2002, the amount was decreased to $594. In January, 2002, the
Company was relieved of any further obligations under the lease agreement (see
Note 2), the letter of credit was terminated, and the securing cash was released
without restriction.

5. Property and Equipment:

Property and equipment at January 31 consisted of the following:

2002 2001
------- -------
Computers and other equipment $ 7,493 $ 8,055
Furniture 464 491
Leasehold improvements 3,102 3,062
Construction-in-progress -- 55
------- -------
11,059 11,663
Less, accumulated depreciation
and amortization (7,021) (5,953)
------- -------
$ 4,038 $ 5,710
======= =======

Depreciation and amortization for the years ended January 31, 2002, 2001,
and 2000 was $1,930, $2,012, and $1,144, respectively.

F-11

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

6. Liabilities:

Other current liabilities consisted of the following at January 31:

2002 2001
------ ------
Accrued license fees $ 884 $1,957
Accrued legal expenses 66 471
Accrued lease expenses 420 --
Accrued foreign taxes 358 435
Other current liabilities 754 644
------ ------
$2,482 $3,507
====== ======

7. Income Taxes:

The income tax provision for the years ended January 31 consisted of:

2002 2001 2000
------ ------- ------
Current:
Federal $ (200) $(1,878) $ 232
State 2 -- 92
Foreign 2,007 1,796 937
------ ------- ------
1,809 (82) 1,261
------ ------- ------

Deferred:
Federal -- 1,518 365
State -- 214 275
------ ------- ------
-- 1,732 640
------ ------- ------
$1,809 $ 1,650 $1,901
====== ======= ======

The foreign tax provision was comprised of foreign withholding taxes on license
fees and royalty payments.

F-12

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

Temporary differences that give rise to the deferred tax provision for the
years ended January 31, consisted of:

2002 2001
------- -------
Deferred tax assets:
Net operating loss carryforwards $ 1,590 $ 7,349
Accrued liabilities 339 298
Allowance for doubtful accounts 39 223
Deferred Revenue -- 221
Deferred expenses 56 132
Tax credit carryforwards 6,212 442
Other 12 1
------- -------
Total deferred tax assets 8,248 8,666
Deferred tax liabilities
Property and equipment (255) (409)
------- -------
Subtotal 7,993 8,257
Valuation allowance (7,993) (8,257)
------- -------
Net deferred income tax asset $ -- $ --
======= =======

The Company provided a valuation allowance on its net deferred tax assets
because of the uncertainty with respect to the Company's ability to generate
future taxable income to realize the deferred tax assets. As a result of the
Netreon exchange (see Note 2), the Company will no longer file a consolidated
return with Netreon. The deferred tax assets and liabilities, including net
operating losses, have been adjusted to reflect this change in ownership.

A portion of the valuation allowance related to stock option compensation
deductions incurred in the Company's net operating loss carryforwards. If and
when the Company reduces any portion of the valuation allowance related to stock
option compensation deduction, the benefit will be added to stockholders'
equity, rather than being shown as a reduction of future income tax expense.

The provision for income taxes for the years ended January 31, differed
from the amount that would result from applying the federal statutory rate as
follows:

2002 2001 2000
----- ----- -----
Statutory federal income tax rate (34.0)% (34.0)% 34.0%
Foreign provision 21.9 11.2 17.5
Nondeductible acquisiton expenses -- -- 13.8
Divestiture of Netreon 8.5 -- --
Other nondeductible expenses 0.5 0.2 9.0
State tax (1.0) (2.5) 4.7
Research and experimentation credits -- -- (20.6)
Change in valuation allowance 26.0 44.5 (31.2)
Preacquisition reserves (2.2) (9.4) --
Other -- 0.3 8.4
----- ------ ------
Provision for income taxes 19.7% 10.3% 35.6%
===== ===== =====

As of January 31, 2002, the Company had net operating loss carryfowards
available to reduce future federal and state income of approximately $4,006 and
$4,411, respectively, which expire through the periods ending in fiscal years
2022 for federal and 2007 for state. In addition, as of January 31, 2002, the
Company had tax credit carryforwards available to reduce future income tax
liabilities of approximately $6,212, which expire between fiscal years 2003 and
2022. Utilization of the net operating loss and tax carryforwards will be
subject to an annual limitation if a change in the Company's ownership should
occur as defined by Section 382 and Section 383 of the Internal Revenue Code.

F-13

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

8. Commitments:

Operating Leases: The Company leases its offices and certain operating
equipment under operating leases that expire through fiscal year 2007. The
principal operating leases covering the Company's office space contain certain
predetermined rent increases calculated at the inception of the lease based on
the lessor's estimate of expected increases in the fair market value of the
leased space. The leases do not specifically provide for renewal options.

Future minimum rental payments under long-term operating leases for the
years ending January 31 are as follows:

Operating
Leases
----------

2003 $1,353
2004 1,403
2005 1,305
2006 1,380
2007 1,359
------
$6,800
======

Total rental expense was $2,460, $1,900, and $1,403 for the years ended
January 31, 2002, 2001, and 2000, respectively.

9. Risks and Uncertainties:

Concentration of Credit Risk: The Company had cash and certificates of
deposit on deposit at banks at certain times throughout the year that was in
excess of federally insured limits.

The Company's credit risk in accounts receivable, which are generally not
collateralized, is concentrated with customers which are OEMs of laser printers
and printer peripheral technologies. The financial loss, should a customer be
unable to meet its obligation to the Company, would be equal to the recorded
accounts receivable. At January 31, 2002, three customers collectively
represented 80% of total trade accounts receivable and at January 31, 2001, two
customers collectively represented 38%. For the years ended January 31 the
following customers, not necessarily the same from year to year, represented
greater than ten percent of total revenues:

2002 2001 2000
------------- ------------- -------------
Customer A $ 7,405 25% $ 7,230 26% $ 7,888 19%
Customer B 4,856 16% 2,845 10% 4,496 11%
Customer C 4,306 15% 4,413 10%
------- ------- -------
$16,567 56% $10,075 36% $16,797 40%
======= ======= =======

Significant Estimates of Revenues: The Company's recurring product
licensing revenues are dependent, in part, on the timing and accuracy of product
sales reports received from the Company's OEM customers. These reports are
provided only on a calendar quarter basis and, in any event, are subject to
delay and potential revision by the OEM. Therefore, the Company is required to
estimate all of the recurring product licensing revenues for the last month of
each fiscal quarter and to further estimate all of its quarterly revenues from
an OEM when the report from such OEM is not received in a timely manner. In the
event the Company is unable to estimate such revenues accurately prior to
reporting financial results, the Company may be required to adjust revenues in
subsequent periods. Fiscal year 2002 revenues subject to such estimates were
minimal in amount as of January 31, 2002.

F-14

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

Legal Proceedings

The Company engaged in the following litigation matters:

On August 28, 2000, a stockholder class action lawsuit was filed against the
Company and two of the Company's former officers. A second stockholder class
action lawsuit was filed on September 19, 2000 against the Company and the same
two former officers of the Company. On April 17, 2001, the Company was served
with an Amended and Consolidated Complaint. These lawsuits allege a scheme to
artificially inflate the Company's stock price and seek compensatory damages
with interest and attorneys fees and expenses. A hearing on the motion filed by
the Company and the two former officers to dismiss the Amended and Consolidated
Complaint was held on October 9, 2001. On January 14, 2002, the Court dismissed
the First Amended and Consolidated Complaint and granted the plaintiffs sixty
days to file a Second Amended and Consolidated Complaint. The plaintiff class
filed a Second Amended and Consolidated Complaint on March 15, 2002. Peerless
believes all of the claims to be without merit and is responding accordingly.

In December 1999, the Company and the Company's former Chief Executive Officer
were sued by the State of Wisconsin Investment Board ("SWIB") in the Court of
Chancery of the State of Delaware in New Castle County. The complaint alleged
that Peerless wrongfully influenced the passage and provided misleading
information in connection with a proposal to increase the number of shares
available for issuance under the Company's 1996 Equity Incentive Plan by 1,000
options at the Company's Annual Meeting of Stockholders in June 1999. In fiscal
year 2002, the parties signed a settlement agreement that, among other things,
resulted in a payment of $375 from the Company to SWIB for a portion of its
legal fees. The lawsuit has been resolved in a manner satisfactory to the
Company.

10. Earnings (Loss) Per Share:

Earnings (loss) per share for the years ended January 31, is calculated as
follows:

2002 2001 2000
----------------------------- ----------------------------- ---------------------------
Net Per-Share Net Per-Share Net Per-Share
Loss Shares Amount Loss Shares Amount Income Shares Amount
-------- ------ --------- -------- ------ --------- ------ ------ ---------

Basic EPS
Earnings (loss) available to
common stockholders $(10,997) 15,062 $(0.73) $(17,649) 14,886 $(1.19) $3,441 13,890 $0.25
======= ====== =====
Effect of Dilutive Securities
Options -- -- -- -- -- 1,115
Convertible preferred stock
Series A -- -- -- -- -- 332
Convertible preferred stock
Series B -- -- -- -- -- 146
-------- ------ ------- -------- ------ ------ ------ ------ -----
Diluted EPS
Earnings (loss) available to
common stockholders with
assumed conversions $(10,997) 15,062 $(0.73) $(17,649) 14,886 $(1.19) $3,441 15,483 $0.22
======== ======== ======= ======== ====== ====== ====== ====== =====

The Company has certain common stock options that are not included in the
calculation of diluted earnings (loss) per share because the effects are
antidilutive. The stock options are described in Note 13.

11. Issuance and Purchase of Shares:

In April 2001, the Company entered into a settlement agreement with one of
the former owners of HDE, relating to a lawsuit filed by the Company against the
former owners of HDE in July 2000. Pursuant to the settlement, the Company
issued 429 put options with a strike price of $0.75 per share. The put options
entitled the holder to sell shares of Peerless common stock to the Company at
the strike price before the expiration of the put options in

F-15

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

October 2001. Prior to the formal settlement, at January 31,2001, the Company
accrued $90, representing the deemed fair value of the put options as determined
by the difference between the put option purchase price and the fair market
value of the Company's stock on the date of the settlement agreement. Upon
issuance of the put options in fiscal year 2002, the potential obligation under
the outstanding put options was transferred from stockholders' equity to "common
stock subject to put options." During fiscal year 2002, the Company repurchased
150 shares for $113 as the result of the exercise of put options. The remaining
obligation under the outstanding put options, which expired in October 2001, has
been transferred back to stockholders' equity.

12. Convertible Preferred Stock:

In June 1999, upon closing of the merger between Peerless and Netreon, all
outstanding shares of Netreon's Convertible Preferred Stock Series A and
Convertible Preferred Stock Series B were converted into 835 and 365 shares of
common stock, respectively.

13. Stock Option and Purchase Plans:

1992 Stock Option Plan: During 1992, the Board of Directors authorized the
1992 Stock Option Plan for the purpose of granting options to purchase the
Company's common stock to employees, directors and consultants. The Board of
Directors determines the form, term, option price and conditions under which
each option becomes exercisable. Options to purchase a total of 1,055 shares of
common stock have been authorized by the Board under this plan.

The following represents option activity for the years ended January 31
under the 1992 Stock Option Plan:

2002 2001 2000
------------------------- --------------------- ---------------------
Weighted Weighted Weighted
Average Average Average
Per Share Per Share Per Share
Number of Exercise Number of Exercise Number of Exercise
Options Price Options Price Options Price
------------- --------- --------- --------- --------- ---------

Options outstanding at beginning of year 152 $1.45 164 $1.44 444 $1.43
Options granted -- -- --
Options exercised (1) $0.53 (9) $0.68 (277) $1.42
Options forfeited (122) $1.43 (3) $2.38 (3) $1.61
------------- --- ----
Options outstanding at year-end 29 $1.29 152 $1.45 164 $1.44
============= === ====
Options exercisable at year-end 29 $1.29 151 $1.45 158 $1.40
============= === ====
Options available for future grant --
=============

Weighted average remaining contractual
life in years 3.0
=============

Range of per share exercise prices for
options outstanding at year-end $0.53 - $1.65
=============

Incentive Plan: In May 1996, the Board adopted the Company's 1996 Stock
Option Plan. The Company's 1996 Equity Incentive Plan (the "Incentive Plan") was
adopted by the Board of Directors in July 1996 as an amendment and restatement
of the Company's 1996 Plan. At that time, the Board had authorized and reserved
an aggregate of 1,267 shares of common stock for issuance under the Incentive
Plan. Additional shares of common stock were authorized and reserved for
issuance under the Incentive Plan in June 1998, June 1999, and June 2002 in the
amounts of 1,200, 750, and 750 shares, respectively.

F-16

PEERLESS SYSTEMS CORPORATION

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(in thousands, except per share amounts)

The Incentive Plan provides for the grant of incentive stock options to
employees and nonstatutory stock options, restricted stock purchase awards and
stock bonuses to employees, directors and consultants. The terms of stock
options granted under the Incentive Plan generally may not exceed 10 years. The
exercise price of options granted under the Incentive Plan is determined by the
Board of Directors, provided that the exercise price for an incentive stock
option cannot be less than 100% of the fair market value of the common stock on
the date of the option grant and the exercise price for a nonstatutory stock
option cannot be less than 85% of the fair market value of the common stock on
the date of the option grant. Options granted under the Incentive Plan vest at
the rate specified in each optionee's option agreement.

During 1994, the Auco, Inc. Board of Directors authorized the 1994 Stock
Option Plan. The terms and conditions of this plan were generally the same as
those of the Peerless Incentive Plan except options issued under the Auco plan
were exercisable immediately subject to repurchase rights held by Auco. In June
1999, upon completion of the merger between Peerless and Auco, the Auco options
were converted to options under the Company's Incentive Plan.

The following represents option activity under the Incentive Plan for the
years ended January 31:

2002 2001 2000
-------------------------- --------------------- ---------------------
Weighted Weighted Weighted
Average Average Average
Per Share Per Share Per Share
Number of Exercise Number of Exercise Number of Exercise
Options Price Options Price Options Price
-------------------------- --------------------- ---------------------

Options outstanding at beginning of year 2,457 $6.19 2,337 $8.96 1,884 $ 7.67
Options granted 1,523 $0.92 1,174 $2.70 1,180 $10.09
Options exercised (61) $0.31 (68) $0.61 (253) $ 2.33
Options forfeited (1,184) $4.49 (986) $8.94 (474) $ 9.34
-------------- ----- -----
Options outstanding at year-end 2,735 $3.68 2,457 $6.19 2,337 $ 8.96
============== ===== =====

Options exercisable at year-end 1,193 $5.70 989 $7.98 640 $ 6.87
============== ===== =====

Options available for future grant 910
==============

Weighted average remaining contractual
life in years 7.8
==============

Range of per share exercise prices for
options outstanding at year-end $0.39 - $22.38
==============

F-17

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

For various price ranges, weighted average characteristics of outstanding
stock options under the Incentive Plan at January 31, 2002 were as follows:

Outstanding Options Exercisable Options
------------------------------ -------------------

Weighted Weighted Weighted
Average Average Average
Shares Remaining Per Share Shares Per Share
Under Life Exercise Under Exercise
Range of Exercise Prices Option (Years) Price Option Price
- ------------------------ ------ --------- --------- ------ ---------

$0.00 to $2.31 1,762 8.7 $ 1.09 423 $ 1.45
$2.31 to $4.63 256 7.5 $ 3.46 244 $ 3.50
$4.63 to $6.94 148 6.6 $ 5.04 110 $ 4.98
$6.94 to $9.25 226 4.6 $ 8.56 169 $ 8.53
$9.25 to $11.56 95 5.9 $10.41 73 $10.60
$11.56 to $13.88 122 5.9 $13.16 77 $13.23
$13.88 to $16.19 89 6.0 $14.37 67 $14.40
$16.19 to $18.50 21 5.8 $17.50 16 $17.50
$18.50 to $20.81 1 6.3 $19.75 1 $19.75
$20.81 to $22.38 15 6.4 $22.15 13 $22.15
----- -----
Total 2,735 1,193
===== =====

Compensation Expense: In connection with the resignation of an executive in
April 2000, the Company accelerated the vesting of stock options held by this
executive. In addition, the Company extended the terms of the executive's stock
options to one year beyond separation date. During the year ended January 31,
2001, the Company recognized $241 as compensation expense for the modifications
which represented the difference between the exercise price and the deemed fair
market value of the Company's stock at the date of the modification.

Deferred Compensation: During the year ended January 31, 1997, the Company
recorded deferred compensation costs of $452 for the difference between the
exercise price and the deemed fair value of the Company's common stock at the
date of grant for options issued under the Incentive Plan. Of the total deferred
expense, the Company recognized $58, $65 and $65 as compensation expense during
the years ended January 31, 2002, 2001 and 2000, respectively.

Employee Stock Purchase Plan: In July 1996, the Company's Board of
Directors approved the Employee Stock Purchase Plan (the "Purchase Plan")
covering an aggregate of 300 shares of the Company's common stock. An additional
500 shares were approved by the stockholders in June 2000. Under the Purchase
Plan, the Board of Directors may authorize participation by eligible employees,
including officers, in periodic offerings following the adoption of the Purchase
Plan. The offering period for any offering will be no more than 27 months. Plan
offering periods have been six months since the inception of the plan. Employees
are eligible to participate if they are employed by the Company or an affiliate
of the Company designated by the Board of Directors and meet eligibility
standards established by the Board of Directors. Employees who participate in an
offering can have up to 15% of their earnings withheld pursuant to the Purchase
Plan and applied, on specified dates determined by the Board of Directors, to
the purchase of shares of common stock. The price of common stock purchased
under the Purchase Plan will be equal to 85% of the lower of the fair market
value of the common stock on the commencement date or the purchase date of each
offering period. Employees may end their participation in the offering at any
time during the offering period, and participation ends automatically on
termination of employment with the Company and its affiliates. The Purchase Plan
will terminate at the Board of Directors' discretion.

During the year ended January 31, 2002, 2001 and 2000, employees purchased
406, 49 and 146 shares of common stock at weighted average per share prices of
$0.51, $4.57 and $5.48, respectively.

F-18

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

SFAS No. 123: The Company applies APB Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations to account for its stock
option plans and employee stock purchase plan, and therefore does not recognize
compensation expense for grants of stock options or shares sold under the
Purchase Plan. Under SFAS No. 123, compensation cost would be recognized for the
fair value of the employee option rights and shares sold under the employee
stock purchase plan. In determining the fair value, the Company used the Black-
Scholes model, assumed no dividend per year, used expected lives ranging from 2
to 10 years, expected volatility of 130.6%, 132.1%, and 99.5% for the years
ended January 31, 2002, 2001 and 2000, respectively, and risk free interest
rates of 3.27%, 5.50%, and 5.70% for the years ended January 31, 2002, 2001, and
2000, respectively. The weighted average per share fair value of options granted
during the year with exercise prices equal to market price on the date of grant
was $0.80, $2.60, and $8.83 per share for the years ended January 31, 2002, 2001
and 2000, respectively. There were no options granted with exercise prices below
market price on the date of grant during any of the years presented. Had
compensation cost for the Company's grants under stock-based compensation plans
and shares sold under the Purchase Plan been determined consistent with SFAS No.
123, the Company's net income (loss) and earnings (loss) per share would have
been changed to the proforma amounts indicated below:

Year Ended January 31,
-------------------------------
2002 2001 2000
-------- -------- -------

Net income (loss) as reported $(10,997) $(17,649) $ 3,441
======== ======== =======
Proforma net loss $(17,104) $(23,996) $(1,881)
======== ======== =======

Net income (loss) per share as reported:
Basic $ (0.73) $ (1.19) $ 0.25
======== ======== =======
Diluted $ (0.73) $ (1.19) $ 0.22
======== ======== =======

Proforma net loss per share:
Basic $ (1.14) $ (1.61) $ (0.14)
======== ======== =======
Diluted $ (1.14) $ (1.61) $ (0.14)
======== ======== =======

14. Shareholder Rights Plan:

In October 1998, the Board of Directors of the Company adopted a
stockholder rights plan, as set forth in the Rights Agreement, dated as of
October 7, 1998, by and between the Company and Wells Fargo Shareowner Services,
a division of Wells Fargo Bank Minnesota, N.A., formerly known as Norwest
Shareowner Services, as rights agent. Pursuant to the Rights Agreement, one
right was issued for each share of the Company's 11,037 outstanding shares of
common stock as of October 15, 1998. Each of the Rights entitles the registered
holder to purchase, from the Company, one one-thousandth of a share of Series A
Junior Participating Preferred Stock at a price of $35.50 per one one-thousandth
of a share. The Rights generally will not become exercisable unless and until,
among other things, any person or group not approved by the Board of Directors
acquires beneficial ownership of 15% or more of the Company's outstanding common
stock or commences a tender offer or exchange offer which would result in a
person or group beneficially owning 15% or more of the Company's outstanding
common stock. Upon the occurrence of certain events, each holder of a Right,
other than such person or group, would thereafter have the right to purchase,
for the then exercise price of the Right, shares of common stock of the Company
or a corporation or other entity acquiring the Company, having a value equal to
two times the exercise price of the Right. The Rights are redeemable by the
Company under certain circumstances at $0.01 per Right and will expire, unless
earlier redeemed or extended, on October 15, 2008.

15. Employee Savings Plans:

Previously, the Company and Netreon had maintained employee savings plans
that qualify under Section 401(k) of the Internal Revenue Code (the "Code") for
all of the Peerless and Netreon full-time employees, respectively. The plans
allowed employees to make specified percentage pretax contributions up to the
maximum dollar limitation prescribed by the Code. The Company has the option to
contribute to both plans up to a maximum of $2,000 per

F-19

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

employee per year. Company contributions to the Peerless plan during the years
ended January 31, 2002, 2001, and 2000 were $219, $373, and $245, respectively.
The Company contributed $53 to the Netreon plan during the year ended January
31, 2000. No contributions were made to the Netreon plan during the year ended
January 31, 2001. In 2001, the Netreon plan was terminated and merged into the
Peerless plan.

PSIP maintains a profit sharing plan for all eligible employees. Company
contributions to the profit sharing plan were $35 for the year ended January 31,
2000. In fiscal year 2001, the PSIP plan was terminated and no contributions
were made during the year ended January 31, 2001. Commencing fiscal year 2001,
PSIP employees qualified under the Company's 401(k).

16. International Operations:

The Company's long-lived assets are located principally in the United
States. The Company's revenues for the years ended January 31, which are
transacted in U.S. dollars, are derived based on sales to customers in the
following geographic regions:

Years Ended January 31

2002 2001 2000
------- ------- -------

United States $ 3,826 $ 5,336 $11,864
Japan 25,856 21,536 28,537
Other 85 535 1,675
------- ------- -------
$29,767 $27,407 $42,076
======= ======= =======

17. Segment Reporting:

Peerless provides software-based digital imaging and networking technology
for digital document products and provides directory and management software for
networked storage devices and integrates proprietary software into enterprise
networks of original equipment manufacturers.

The Company views its operations as two segments: Imaging and Storage. The
factors that management uses to identify the separate segments include customer
base, products and technology. The factors used to measure the performance of
the two segments include revenues, operating profit and staffing.

A description of the products and services provided by each segment is as
follows:

Imaging provides to OEM customers imaging systems, page description
languages, drivers, application specific integrated circuits, engineering
services to modify products for specific applications and maintenance for
digital document products. Products can be purchased in source code form or can
be modified using the Company's engineering services to adapt for a specific
application. License fees are charged for the utilization of imaging technology.

Storage provides OEM storage customers Network Attached Storage software
development kits that allow NAS OEMs to provide NetWare or Windows 2000
compatibility for their products. Storage is currently developing comparable
products for the Storage Area Networks. Products can be purchased in source code
form or can be modified using the Storage engineering services to adapt for a
specific application. License fees are charged for the utilization of the
Storage technology.

The segment information presented below as to revenues, operating loss,
depreciation and amortization, capital expenditures are reported for the storage
segment through the period ending January 29, 2002, the effective date of the
Company's announced divestiture of its storage operations. No information as to
assets is given, as the storage operation was not part of the Company as of
January 31, 2002.

F-20

PEERLESS SYSTEMS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except per share amounts)

The accounting policies used to derive reportable segments results are
generally the same as those described in Note 1. Inter-segment transactions are
not material. The Company's selling, general and administrative expenses are not
identified by segments or accumulated in this manner due to, among other things,
shared management and cross-utilization of personnel. For fiscal year 2002, such
expenses related to the Company's Netreon, Inc. subsidiary are attributed to the
Storage segment; all other such expenses incurred by the Company are allocated
to the Imaging segment. In fiscal year 2001 and prior, these expenses are
allocated to segments based on the ratio of the segments' revenues to total
revenues.

The table below presents segment information for fiscal year ended January
31:

Total
Imaging Storage Segments
-------- ------- --------

2002
- ----
Revenues $ 29,654 $ 113 $ 29,767
Operating loss $ (742) $(9,206) $ (9,948)
Depreciation and amortization $ 1,788 $ 338 $ 2,126
Capital expenditures $ 369 $ 545 $ 914

2001
- ----
Revenues $ 27,157 $ 250 $ 27,407
Operating loss $(13,788) $(3,440) $(17,228)
Depreciation and amortization $ 1,882 $ 166 $ 2,048
Assets $ 35,879 $ 1,229 $ 37,108
Capital expenditures $ 186 $ 971 $ 1,157

2000
- ----
Revenues $ 41,826 $ 250 $ 42,076
Operating income/(loss) $ 4,582 $ (449) $ 4,133
Depreciation and amortization $ 1,445 $ 95 $ 1,540
Assets $ 49,713 $ 2,852 $ 52,565
Capital expenditures $ 2,399 $ 161 $ 2,560

18. Other Income:

The Company resolved a disputed claim regarding the licensing of its
intellectual property and reported non-recurring other income of $2.3 million
and collected a $1.5 million receivable during fiscal year 2002.

F-21

SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
(In thousands)

Additions
Balance Charged Balance
at to Costs at End
Beginning and of
of Period Expenses Deductions (a) Period
--------- --------- -------------- -------

Year Ended January 31, 2000
Reserves deducted from assets to which they apply:
Allowances for uncollectable accounts receivable $175 $(248) $ 248 $175

Year Ended January 31, 2001
Reserves deducted from assets to which they apply:
Allowances for uncollectable accounts receivable $175 $ 881 $(301) $755

Year Ended January 31, 2002
Reserves deducted from assets to which they apply:
Allowances for uncollectable accounts receivable $755 $(150) $(505) $100

- ----------
(a) Accounts written off, net of recoveries.

S-1