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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended September 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________ to ___________.
Commission file number: 1-16027
__________
LANTRONIX, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 33-0362767
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
15353 Barranca Parkway Irvine, California 92618
(Address of principal executive offices and zip code)
__________
(949) 453-3990
(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(D) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
As of October 31, 2003, 57,430,096 shares of the Registrant's common stock
were outstanding.
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LANTRONIX, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2003
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION 3
Item 1. Financial Statements. 3
Condensed Consolidated Balance Sheets at September 30, 2003 and June 30, 2002 3
Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended
September 30, 2003 and 2002 4
Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2003 and 2002 5
Notes to Unaudited Condensed Consolidated Financial Statements. 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk. 28
Item 4. Controls and Procedures. 28
PART II. OTHER INFORMATION 30
Item 1. Legal Proceedings 30
Item 2. Changes in Securities and Use of Proceeds. 31
Item 3. Defaults Upon Senior Securities 32
Item 4. Submission of Matters to a Vote of Security Holders 32
Item 5. Other Information 32
Item 6. Exhibits and Reports on Form 8-K. 32
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
LANTRONIX, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
SEPTEMBER 30, JUNE 30,
2003 2003
----------- ----------
ASSETS
- ------------------------------------------
Current assets:
Cash and cash equivalents $ 8,867 $ 7,328
Marketable securities 4,600 6,750
Accounts receivable, net 3,721 3,858
Inventories 6,112 6,011
Deferred income taxes 7,909 7,909
Contract manufacturers receivable, net 1,065 1,744
Prepaid expenses and other current assets 2,501 3,861
---------- ----------
Total current assets 34,775 37,461
Property and equipment, net 2,090 2,541
Goodwill 11,726 11,726
Purchased intangible assets, net 4,653 5,394
Long-term investments 5,249 5,458
Officer loans. 104 104
Other assets 176 172
---------- ----------
Total assets $ 58,773 $ 62,856
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------------
Current liabilities:
Accounts payable $ 3,741 $ 4,801
Accrued payroll and related expenses 1,633 1,367
Due to Gordian - 1,000
Accrued litigation settlement - 1,533
Warranty reserve 1,301 1,193
Restructuring reserve 3,168 3,235
Other current liabilities 3,008 2,634
Convertible note payable 867 -
---------- ----------
Total current liabilities 13,718 15,763
Deferred income taxes 8,509 8,509
Convertible note payable - 867
Stockholders' equity:
Common stock 6 6
Additional paid-in capital. 180,246 178,628
Deferred compensation (446) (695)
Accumulated deficit (143,473) (140,424)
Accumulated other comprehensive loss 213 202
---------- ----------
Total stockholders' equity 36,546 37,717
---------- ----------
Total liabilities and stockholders' equity $ 58,773 $ 62,856
========== ==========
See accompanying notes.
3
LANTRONIX, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------
2003 2002
-------- ---------
Net revenues (A) $12,230 $ 12,681
Cost of revenues (B) 6,112 8,196
-------- ---------
Gross profit 6,118 4,485
-------- ---------
Operating expenses:
Selling, general and administrative (C) 6,705 7,871
Research and development (C) 1,984 2,430
Stock-based compensation (B) (C) 155 445
Amortization of purchased intangible assets 144 228
Restructuring charges - 4,929
-------- ---------
Total operating expenses 8,988 15,903
-------- ---------
Loss from operations (2,870) (11,418)
Interest income (expense), net 24 192
Other income (expense), net (170) (90)
-------- ---------
Loss before income taxes (3,016) (11,316)
Provision for income taxes 33 86
-------- ---------
Net loss $(3,049) $(11,402)
======== =========
Basic and diluted net loss per share $ (0.05) $ (0.21)
======== =========
Weighted average shares (basic and diluted) 55,484 53,935
======== =========
(A) Includes net revenues from related parties. . . . . . . . $ 311 $ 467
======== =========
(B) Cost of revenues includes the following:
Amortization of purchased intangible assets $ 597 $ 1,028
Stock-based compensation 16 19
-------- ---------
$ 613 $ 1,047
======== =========
(C) Stock-based compensation is excluded from the following:
Selling, general and administrative expenses $ 113 $ 363
Research and development expenses 42 82
-------- ---------
$ 155 $ 445
======== =========
See accompanying notes.
4
LANTRONIX, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
THREE MONTHS ENDED
SEPTEMBER 30,
------------------
2003 2002
-------- ---------
Cash flows from operating activities:
Net loss $(3,049) $(11,402)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation 504 616
Amortization of purchased intangible assets 741 1,256
Stock-based compensation. 171 464
Provision for inventory reserves (914) 654
Provision for doubtful accounts 142 231
Loss on sale of fixed assets 31 -
Equity losses from unconsolidated businesses 209 329
Restructuring charges - 4,474
Changes in operating assets and liabilities, net of effect from acquisition:
Accounts receivable (5) 623
Inventories 813 (1,062)
Contract manufacturers receivable 679 942
Prepaid expenses and other current assets 1,360 476
Other assets (4) (82)
Accounts payable. (1,060) (111)
Due to related party - (246)
Due to Gordian (1,000) (2,000)
Accrued Lightwave settlement - (2,004)
Warranty reserve 108 277
Restructuring reserve (67) -
Other current liabilities 640 (257)
-------- ---------
Net cash used in operating activities (701) (6,822)
-------- ---------
Cash flows from investing activities:
Purchase of property and equipment, net (84) (216)
Purchases of marketable securities - (9,250)
Acquisition of business, net of cash acquired - (2,114)
Proceeds from sale of marketable securities 2,150 3,000
-------- ---------
Net cash provided by (used in) investing activities 2,066 (8,580)
-------- ---------
Cash flows from financing activities:
Net proceeds from other issuances of common stock 163 9
-------- ---------
Net cash provided by financing activities 163 9
Effect of foreign exchange rates on cash. 11 23
-------- ---------
Increase (decrease) in cash and cash equivalents 1,539 (15,370)
Cash and cash equivalents at beginning of period. 7,328 26,491
-------- ---------
Cash and cash equivalents at end of period. $ 8,867 $ 11,121
======== =========
See accompanying notes.
5
LANTRONIX, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
1. BASIS OF PRESENTATION
The condensed consolidated financial statements included herein are
unaudited. They contain all normal recurring accruals and adjustments which, in
the opinion of management, are necessary to present fairly the consolidated
financial position of Lantronix, Inc. and its subsidiaries (collectively, the
"Company") at September 30, 2003, and the consolidated results of its operations
and its cash flows for the three months ended September 30, 2003 and 2002. All
intercompany accounts and transactions have been eliminated. It should be
understood that accounting measurements at interim dates inherently involve
greater reliance on estimates than at year-end. The results of operations for
the three months ended September 30, 2003 are not necessarily indicative of the
results to be expected for the full year or any future interim periods.
These financial statements do not include certain footnotes and financial
presentations normally required under generally accepted accounting principles.
Therefore, they should be read in conjunction with the audited consolidated
financial statements and notes thereto for the year ended June 30, 2003,
included in the Company's Annual Report on Form 10-K filed with the Securities
and Exchange Commission ("SEC") on September 29, 2003.
2. RECENT ACCOUNTING PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46").
FIN 46 requires the primary beneficiary of a variable interest entity ("VIE") to
consolidate the entity and also requires majority and significant variable
interest investors to provide certain disclosures. A VIE is an entity in which
the equity investors do not have a controlling interest, equity investors
participate in losses or residual interests of the entity on a basis that
differs from its ownership interest, or the equity investment at risk is
insufficient to finance the entity's activities without receiving additional
subordinated financial support from the other parties. For arrangements entered
into with VIEs created prior to January 31, 2003, the provisions of FIN 46 are
required to be adopted at the beginning of the first interim or annual period
beginning after December 15, 2003. The Company is currently reviewing its
investments and other arrangements to determine whether any of its investee
companies are VIEs. The Company does not expect to identify any significant VIEs
that would be consolidated, but may be required to make additional disclosures.
3. NET LOSS PER SHARE
Basic net loss per share is calculated by dividing net loss by the weighted
average number of common shares outstanding during the period. Diluted net loss
per share is calculated by adjusting outstanding shares assuming any dilutive
effects of options. However, for periods in which the Company incurred a net
loss, these shares are excluded because their effect would be to reduce recorded
net loss per share. The following table sets forth the computation of net loss
per share (in thousands, except per share amounts):
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------
2003 2002
-------- ---------
Numerator: Net loss $(3,049) $(11,402)
======== =========
Denominator:
Weighted-average shares outstanding 55,816 54,267
Less: non-vested common shares outstanding (332) (332)
-------- ---------
Denominator for basic and diluted loss per share 55,484 53,935
======== =========
Basic and diluted net loss per share $ (0.05) $ (0.21)
======== =========
4. MARKETABLE SECURITIES
The Company defines marketable securities as income yielding securities,
which can be readily converted to cash. Marketable securities consist of
obligations of U.S. Government agencies, state, municipal and county
governments' notes and bonds.
6
5. INVENTORIES
Inventories are stated at the lower of cost (first-in, first-out) or market
and consist of the following (in thousands):
SEPTEMBER 30, JUNE 30,
2003 2003
--------------- ----------
Raw materials . . . . . . . . . . . . . . $ 4,711 $ 5,109
Finished goods. . . . . . . . . . . . . . 6,211 7,940
Inventory at distributors . . . . . . . . 874 959
--------------- ----------
11,796 14,008
Reserve for excess and obsolete inventory (5,684) (7,997)
--------------- ----------
$ 6,112 $ 6,011
=============== ==========
6. PURCHASED INTANGIBLE ASSETS
The composition of purchased intangible assets is as follows (in
thousands):
SEPTEMBER 30, 2003 JUNE 30, 2003
------------------ -------------
USEFUL ACCUMULATED ACCUMULATED
LIVES GROSS AMORTIZATION NET GROSS AMORTIZATION NET
---------- ------------- -------------- ------ -------- -------------- ------
Existing technology. . 1-5 years $ 8,060 $ (3,691) $4,369 $ 8,060 $ (3,094) $4,966
Patent/core technology 5 405 (311) 94 405 (283) 122
Tradename/trademark. . 5 32 (19) 13 32 (18) 14
Non-compete agreements 2-3 940 (763) 177 940 (648) 292
---------- ------------- -------------- ------ -------- -------------- ------
Total . . . . . . . . $ 9,437 $ (4,784) $4,653 $ 9,437 $ (4,043) $5,394
============ ============== ====== ======== ============== ======
The amortization expense for purchased intangible assets for the three
months ended September 30, 2003 was $741,000, of which $597,000 was amortized to
cost of revenues and $144,000 was amortized to operating expenses. The
amortization expense for purchased intangible assets for the three months ended
September 30, 2002 was $1.3 million, of which $1.0 million was amortized to cost
of revenues and $228,000 was amortized to operating expenses. The estimated
amortization expense for the remainder of fiscal 2004 and the next three years
are as follows:
COST OF OPERATING
Fiscal year ending June 30: REVENUES EXPENSES TOTAL
--------- --------- ------
2004 (Remainder of fiscal year) $ 1,734 $ 217 $1,951
2005. . . . . . . . . . . . . . 1,690 65 1,755
2006. . . . . . . . . . . . . . 816 2 818
2007. . . . . . . . . . . . . . 129 - 129
--------- --------- ------
Total . . . . . . . . . . . . . $ 4,369 $ 284 $4,653
========= ========= ======
7. LONG-TERM INVESTMENTS
Long-term investments consist of a 15.3% ownership interest in Xanboo at
September 30, 2003 and June 30, 2003. The Company is accounting for this
long-term investment under the equity method based upon the Company's ability
through representation on Xanboo's board of directors to exercise significant
influence over its operations. The Company's interest in the losses of Xanboo
aggregating $209,000 and $329,000 for the three months ended September 30, 2003
and 2002, respectively, have been recognized as other expense in the condensed
consolidated statements of operations.
8. RESTRUCTURING CHARGES
On September 12, 2002 and March 14, 2003, the Company announced a
restructuring plan to prioritize its initiatives around the growth areas of its
business, focus on profit contribution, reduce expenses, and improve operating
efficiency. These restructuring plans include a worldwide workforce reduction,
consolidation of excess facilities and other charges. The Company recorded
restructuring costs totaling $5.7 million, which were classified as operating
expenses in the consolidated statement of operations for the year ended June 30,
7
2003. These restructuring plans resulted in the reduction of approximately 58
regular employees worldwide. The Company recorded workforce reduction charges of
approximately $1.3 million related to severance and fringe benefits for the
terminated employees. The Company recorded charges of approximately $4.4 million
related to the consolidation of excess facilities, relating primarily to lease
terminations, non-cancelable lease costs, write-off of leasehold improvements
and termination of a contractual obligation. The restructuring costs will be
substantially paid in cash over the next five years. The remaining restructuring
reserve is related to facility lease terminations and a contractual settlement.
A summary of the activity in the restructuring reserve account is as
follows (in thousands):
CHARGES AGAINST
---------------
RESERVE
---------
RESTRUCTURING RESTRUCTURING
RESERVE AT RESERVE AT
JUNE 30, SEPTEMBER 30,
2003 NON-CASH CASH 2003
-------------- --------- ------ --------------
Workforce reductions . . . . . . . $ 260 $ - $ - $ 260
Contractual obligations. . . . . . 2,000 - - 2,000
Consolidation of excess facilities 975 - (67) 908
-------------- --------- ------ --------------
Total. . . . . . . . . . . . . . . $ 3,235 $ - $ (67) $ 3,168
============== ========= ====== ==============
9. WARRANTY
Upon shipment to its customers, the Company provides for the estimated cost
to repair or replace products to be returned under warranty. The Company's
current warranty periods generally range from ninety days to two years from the
date of shipment. The following table is a reconciliation of the changes to the
product warranty liability for the periods presented:
THREE MONTHS
ENDED YEAR ENDED
SEPTEMBER 30, JUNE 30,
2003 2003
--------------- ------------
Balance beginning of period . $ 1,193 $ 479
Charged to costs and expenses 414 878
Charged to other expenses . . (306) (153)
Deductions. . . . . . . . . . - (11)
--------------- ------------
Balance end of period . . . . $ 1,301 $ 1,193
=============== ============
10. PROVISION FOR INCOME TAXES AND EFFECTIVE TAX RATE
The Company utilizes the liability method of accounting for income taxes as
set forth in Statement of Financial Accounting Standards ("SFAS") No. 109,
"Accounting for Income Taxes." The Company's effective tax rate was (1)% for
both the three month periods ended September 30, 2003 and September 30, 2002.
The federal statutory rate was 34% for both periods. The effective tax rate
associated with the income tax expense for both the three month periods ended
September 30, 2003 and 2002, was lower than the federal statutory rate primarily
due to the increase in valuation allowance, as well as the amortization of
stock-based compensation for which no current year tax benefit was provided. In
October 2003, the Internal Revenue Service completed its audit of the Company's
federal income tax returns for the years ended June 30, 1999, 2000 and 2001. As
a result, the Company will be required to pay approximately $500,000 in tax and
interest to the Internal Revenue Service and the California Franchise Tax Board,
in fiscal 2004. The Company had accrued for this liability in prior fiscal
periods.
11. BANK LINE OF CREDIT AND DEBT
In January 2002, the Company entered into a two-year line of credit with a
bank in an amount not to exceed $20.0 million. Borrowings under the line of
credit bear interest at either (i) the prime rate or (ii) the LIBOR rate plus
2.0%. The Company was required to pay a $100,000 facility fee of which $50,000
was paid upon the closing and $50,000 was to be paid. The Company was also
8
required to pay a quarterly unused line fee of .125% of the unused line of
credit balance. Since establishing the line of credit, the Company has twice
reduced the amount of the line, modified customary financial covenants, and
adjusted the interest rate to be charged on borrowings to the prime rate plus
..50%, and eliminated the LIBOR option. Effective July 25, 2003, the Company
further modified this line of credit, reducing the revolving line to $5.0
million, and adjusting the customary affirmative and negative covenants. The
Company is also required to maintain certain financial ratios as defined in the
agreement. The agreement has an annual revolving maturity date that renews on
the effective date. The $50,000 facility fee was reduced to $12,500 and was
paid. Prior to any advances being made under the line of credit, the bank is
required to complete an initial field examination to determine its borrowing
base. To date, the Company has not borrowed against this line of credit. The
Company is currently in compliance with the revised financial covenants of the
July 25, 2003 amended line of credit. Pursuant to the line of credit, the
Company is restricted from paying any dividends. The Company has secured two
deposits totaling approximately $365,000 under its line of credit.
The Company issued a two-year note in the principal amount of $867,000 as a
result of its acquisition of Stallion, accruing interest at a rate of 2.5% per
annum. Interest expense related to the note totaled approximately $5,400 and
$3,600 for the three months ended September 30, 2003 and 2002, respectively. The
note is convertible into the Company's common stock at any time, at the election
of the holders, at a $5.00 conversion price. The note is due in August 2004.
12. COMPREHENSIVE LOSS
SFAS No. 130, "Reporting Comprehensive Income (Loss)," establishes
standards for reporting and displaying comprehensive income (loss) and its
components in the condensed consolidated financial statements. The components of
comprehensive loss are as follows (in thousands):
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------
2003 2002
-------- ---------
Net loss $(3,049) $(11,402)
Other comprehensive loss:
Change in accumulated translation adjustments 11 23
-------- ---------
Total comprehensive loss $(3,038) $(11,379)
======== =========
13. STOCK-BASED COMPENSATION
The Company has in effect several stock-based plans under which
non-qualified and incentive stock options have been granted to employees,
non-employee board members and other non-employees. The Company also has an
employee stock purchase plan for all eligible employees. The Company accounts
for stock-based awards to employees in accordance with Accounting Principles
Board ("APB") No. 25, "Accounting for Stock Issues to Employees" ("APB 25"), and
related interpretations, and has adopted the disclosure-only alternative of SFAS
No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123") and SFAS No.
148, "Accounting for Stock-Based Compensation Transition and Disclosure."
Options granted to non-employees, as defined, have been accounted for at fair
market value in accordance with SFAS No. 123.
In accordance with the disclosure requirements of SFAS No. 123, set forth
below are the assumptions used and pro forma statement of operations data of the
Company giving effect to valuing stock-based awards to employees using the
Black-Scholes option pricing model instead of the guidelines provided by APB No.
25. Among other factors, the Black-Scholes model considers the expected life of
the option and the expected volatility of the Company's stock price in arriving
at an option valuation.
9
The results of applying the requirements of the disclosure-only alternative
of SFAS No. 123 to the Company's stock-based awards to employees would
approximate the following:
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------
2003 2002
-------- ---------
Net loss - as reported $(3,049) $(11,402)
Add: Stock-based compensation expense included in net loss - as
reported 171 464
Deduct: Stock-based compensation expense determined under fair value
method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (953) (1,902)
-------- ---------
Net loss - pro forma $(3,831) $(12,480)
======== =========
Net loss per share (basic and diluted) - as reported $ (0.05) $ (0.21)
======== =========
Net loss per share (basic and diluted) - pro forma $ (0.07) $ (0.24)
======== =========
14. LITIGATION SETTLEMENT
On August 23, 2002, a complaint entitled Dunstan v. Lantronix, Inc., et
al., was filed in the Circuit Court of the State of Oregon, County of Multnomah,
against the Company and certain of its current and former officers and directors
by the cofounders of United States Software Corporation ("USSC"). The complaint
and subsequently filed arbitration demand alleged Oregon state law claims for
securities violations, fraud, and negligence, as well as other claims related to
the Company's acquisition of USSC. Plaintiffs sought more than $14.0 million in
damages, interest, attorneys' fees, costs, expenses, and an unspecified amount
of punitive damages. The parties participated in a mediation on June 30, 2003,
and subsequently reached an agreement to settle the dispute. Pursuant to the
parties' settlement agreement, the Company released to the plaintiffs
approximately $400,000 in cash and 49,038 shares of the Company's common stock
that had been held in an escrow since December 2000 as part of the acquisition
of USSC. On September 15, 2003, the Company also issued to the plaintiffs
1,726,703 additional shares of its common stock worth approximately $1.5
million, which was recorded in the Company's results of operations as litigation
settlement costs for the year ended June 30, 2003. In exchange, the plaintiffs
released all claims against all defendants.
15. LITIGATION
Government Investigation
The SEC is conducting a formal investigation of the events leading up to
the Company's restatement of its financial statements on June 25, 2002. The
Department of Justice is also conducting an investigation concerning events
related to the restatement.
Class Action Lawsuits
On May 15, 2002, Stephen Bachman filed a class action complaint entitled
Bachman v. Lantronix, Inc., et al., No. 02-3899, in the U.S. District Court for
the Central District of California against the Company and certain of its
current and former officers and directors alleging violations of the Securities
Exchange Act of 1934 and seeking unspecified damages. Subsequently, six similar
actions were filed in the same court. Each of the complaints purports to be a
class action lawsuit brought on behalf of persons who purchased or otherwise
acquired the Company's common stock during the period of April 25, 2001 through
May 30, 2002, inclusive. The complaints allege that the defendants caused the
Company to improperly recognize revenue and make false and misleading statements
about its business. Plaintiffs further allege that the defendants materially
overstated the Company's reported financial results, thereby inflating its stock
price during its securities offering in July 2001, as well as facilitating the
use of its common stock as consideration in acquisitions. The complaints have
subsequently been consolidated into a single action and the court has appointed
a lead plaintiff. The lead plaintiff filed a consolidated amended complaint on
January 17, 2003. The amended complaint now purports to be a class action
brought on behalf of persons who purchased or otherwise acquired the Company's
common stock during the period of August 4, 2000 through May 30, 2002,
inclusive. The amended complaint continues to assert that the Company and the
individual officer and director defendants violated the 1934 Act, and also
includes alleged claims that the Company and its officers and directors violated
the Securities Act of 1933 arising from the Company's Initial Public Offering in
August 2000. The Company has filed a motion to dismiss the additional
allegations on March 3, 2003. The Court has taken the motion under submission.
10
The Company has not yet answered the complaint, discovery has not commenced, and
no trial date has been established.
Derivative Lawsuit
On July 26, 2002, Samuel Ivy filed a shareholder derivative complaint
entitled Ivy v. Bernhard Bruscha, et al., No. 02CC00209, in the Superior Court
of the State of California, County of Orange, against certain of the Company's
current and former officers and directors. On January 7, 2003, the plaintiff
filed an amended complaint. The amended complaint alleges causes of action for
breach of fiduciary duty, abuse of control, gross mismanagement, unjust
enrichment, and improper insider stock sales. The complaint seeks unspecified
damages against the individual defendants on the Company's behalf, equitable
relief, and attorneys' fees.
The Company filed a demurrer/motion to dismiss the amended complaint on
February 13, 2003. The basis of the demurrer is that the plaintiff does not have
standing to bring this lawsuit since plaintiff has never served a demand on the
Company's Board that the Board take certain actions on behalf of the Company. On
April 17, 2003, the Court overruled the Company's demurrer. All defendants have
answered the complaint and generally denied the allegations. Discovery has
commenced, but no trial date has been established.
Employment Suit Brought by Former Chief Financial Officer and Chief Operating
Officer Steven Cotton
On September 6, 2002, Steven Cotton, the Company's former CFO and COO,
filed a complaint entitled Cotton v. Lantronix, Inc., et al., No. 02CC14308, in
the Superior Court of the State of California, County of Orange. The complaint
alleges claims for breach of contract, breach of the covenant of good faith and
fair dealing, wrongful termination, misrepresentation, and defamation. The
complaint seeks unspecified damages, declaratory relief, attorneys' fees and
costs. Discovery has not commenced and no trial date has been established.
The Company filed a motion to dismiss on October 16, 2002, on the grounds
that Mr. Cotton's complaints are subject to the binding arbitration provisions
in Mr. Cotton's employment agreement. On January 13, 2003, the Court ruled that
five of the six counts in Mr. Cotton's complaint are subject to binding
arbitration. The court is staying the sixth count, for declaratory relief, until
the underlying facts are resolved in arbitration. No arbitration date has been
set.
Securities Claims Brought by Former Shareholders of Synergetic Micro Systems,
Inc. ("Synergetic")
On October 17, 2002, Richard Goldstein and several other former
shareholders of Synergetic filed a complaint entitled Goldstein, et al v.
Lantronix, Inc., et al in the Superior Court of the State of California, County
of Orange, against the Company and certain of its former officers and directors.
Plaintiffs filed an amended complaint on January 7, 2003. The amended complaint
alleges fraud, negligent misrepresentation, breach of warranties and covenants,
breach of contract and negligence, all stemming from its acquisition of
Synergetic. The complaint seeks an unspecified amount of damages, interest,
attorneys' fees, costs, expenses, and an unspecified amount of punitive damages.
On May 5, 2003, the Company answered the complaint and generally denied the
allegations in the complaint. Discovery has commenced but no trial date has been
established.
Suit filed by Lantronix Against Logical Solutions, Inc. ("Logical")
On March 25, 2003, the Company filed in Connecticut state court (Judicial
District of New Haven) a complaint entitled Lantronix, Inc. and Lightwave
Communications, Inc. v. Logical Solutions, Inc., et. al. This is an action for
unfair and deceptive trade practices, unfair competition, unjust enrichment,
conversion, misappropriation of trade secrets and tortuous interference with
contractual rights and business expectancies. The Company seeks preliminary and
permanent injunctive relief and damages. The individual defendants are all
former employees of Lightwave Communications, a company that the Company
acquired in June 2001. The Court held a non-jury trial October 10-17, 2003;
closing arguments are set for November 14, 2003.
Other
From time to time, the Company is subject to other legal proceedings and
claims in the ordinary course of business. The Company is currently not aware of
any such legal proceedings or claims that it believes will have, individually or
in the aggregate, a material adverse effect on its business, prospects,
financial position, operating results or cash flows.
The pending lawsuits involve complex questions of fact and law and likely
will continue to require the expenditure of significant funds and the diversion
of other resources to defend. Management is unable to determine the outcome of
its outstanding legal proceedings, claims and litigation involving the Company,
its subsidiaries, directors and officers and cannot determine the extent to
which these results may have a material adverse effect on the Company's
business, results of operations and financial condition taken as a whole. The
results of litigation are inherently uncertain, and adverse outcomes are
possible. The Company is unable to estimate the range of possible loss from
outstanding litigation, and no amounts have been provided for such matters in
the condensed consolidated financial statements.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
You should read the following discussion and analysis in conjunction with
the Unaudited Condensed Consolidated Financial Statements and related Notes
thereto contained elsewhere in this Report. The information in this Quarterly
Report on Form 10-Q is not a complete description of our business or the risks
associated with an investment in our common stock. We urge you to carefully
review and consider the various disclosures made by us in this Report and in
other reports filed with the Securities and Exchange Commission ("SEC"),
including our Annual Report on Form 10-K for the fiscal year ended June 30, 2003
and our subsequent reports on Form 8-K that discuss our business in greater
detail.
The section entitled "Risk Factors" set forth below, and similar
discussions in our other SEC filings, discuss some of the important factors that
may affect our business, results of operations and financial condition. You
should carefully consider those factors, in addition to the other information in
this Report and in our other filings with the SEC, before deciding to invest in
our company or to maintain or increase your investment.
This report contains forward-looking statements which include, but are not
limited to, statements concerning projected net revenues, expenses, gross profit
and income (loss), the need for additional capital, market acceptance of our
products, our ability to consummate acquisitions and integrate their operations
successfully, our ability to achieve further product integration, the status of
evolving technologies and their growth potential and our production capacity.
These forward-looking statements are based on our current expectations,
estimates and projections about our industry, our beliefs, and certain
assumptions made by us. Words such as "anticipates," "expects," "intends,"
"plans," "believes," "seeks," "estimates," "may," "will" and variations of these
words or similar expressions are intended to identify forward-looking
statements. In addition, any statements that refer to expectations, projections
or other characterizations of future events or circumstances, including any
underlying assumptions, are forward-looking statements. These statements are not
guarantees of future performance and are subject to certain risks, uncertainties
and assumptions that are difficult to predict. Therefore, our actual results
could differ materially and adversely from those expressed in any
forward-looking statements as a result of various factors. We undertake no
obligation to revise or update publicly any forward-looking statements for any
reason.
OVERVIEW
Lantronix designs, develops and markets devices and software solutions that
make it possible to access, manage, control and configure almost any electronic
product over the Internet or other networks. We are a leader in providing
innovative networking solutions. We were initially formed as "Lantronix," a
California corporation, in June 1989. We reincorporated as "Lantronix, Inc.," a
Delaware corporation in May 2000.
We have a history of providing devices that enable information technology
("IT") equipment to network using standard protocols for connectivity, including
fiber optic, Ethernet and wireless. Our first device was a terminal server that
allowed "dumb" terminals to connect to a network. Building on the success of our
terminal servers, we introduced a complete line of print servers in 1991 that
enabled users to inexpensively share printers over a network. Over the years, we
have continually refined our core technology and have developed additional
innovative networking solutions that expand upon the business of providing our
customers network connectivity. With the expansion of networking and the
Internet, our technology focus is increasingly broader, so that our device
solutions provide a product manufacturer with the ability to network their
products within the industrial, sevice and consumer markets.
We provide three broad categories of products: "device networking
solutions," that enable almost any electronic product to be connected to a
network; "IT management solutions," that enable multiple pieces of hardware,
usually IT-related network hardware such as servers, routers, switches, and
similar pieces of equipment to be managed over a network; and software that is
either embedded in the hardware devices that are mentioned above, or stand-alone
application software.
Today, our solutions include fully integrated hardware and software
devices, as well as software tools to develop related customer applications.
Because we deal with network connectivity, we provide hardware solutions to
extremely broad market segments, including industrial, medical, commercial,
financial, governmental, retail, building and home automation, and many more.
Our technology is used with products such as networking routers, medical
instruments, manufacturing equipment, bar code scanners, building HVAC systems,
elevators, process control equipment, vending machines, thermostats, security
cameras, temperature sensors, card readers, point of sale terminals, time
clocks, and virtually any product that has some form of standard data control
capability. Our current offerings include a wide range of hardware devices of
varying size, packaging and, where appropriate, software solutions that allow
our customers to network-enable virtually any electronic product.
12
We sell our devices through a global network of distributors, system
integrators, value added resellers (VARs), manufacturers' representatives and
original equipment manufacturers (OEM's). In addition, we sell directly to
selected accounts. One customer, Ingram Micro, accounted for approximately 13.4%
and 10.5% of our net revenues for the three months ended September 30, 2003 and
2002, respectively. Another customer, Tech Data, accounted for approximately
10.3% and 9.7% of our net revenues for the three months ended September 30, 2003
and 2002, respectively. Accounts receivable attributable to these domestic
customers accounted for approximately 12.2% and 16.0% of total accounts
receivable at September 30, 2003 and June 30, 2003, respectively.
One international customer, transtec AG, which is a related party due to
common ownership by our largest stockholder and former Chairman of our Board of
Directors, Bernhard Bruscha, accounted for approximately 2.5% and 3.7% of our
net revenues for the three months ended September 30, 2003 and 2002,
respectively. Accounts receivable attributable to this international customer
totaled $84,000 at September 30, 2003. No amounts were receivable on June 30,
2003.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States requires us to make estimates
and assumptions that affect the reported amounts of assets and liabilities at
the date of the financial statements and the reported amounts of net revenues
and expenses during the reporting period. We regularly evaluate our estimates
and assumptions related to net revenues, allowances for doubtful accounts, sales
returns and allowances, inventory reserves, goodwill and purchased intangible
asset valuations, warranty reserves, restructuring costs, litigation and other
contingencies. We base our estimates and assumptions on historical experience
and on various other factors that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. To the extent there are material differences between our
estimates and the actual results, our future results of operations will be
affected.
We believe the following critical accounting policies require us to make
significant judgments and estimates in the preparation of our condensed
consolidated financial statements:
Revenue Recognition
We do not recognize revenue until all of the following criteria are met:
persuasive evidence of an arrangement exists; delivery has occurred or services
have been rendered; our price to the buyer is fixed or determinable; and
collectibility is reasonably assured. Commencing July 1, 2000, we adopted a new
accounting policy for revenue recognition such that recognition of revenue and
related gross profit from sales to distributors are deferred until the
distributor resells the product. Net revenue from certain smaller distributors
for which point-of-sale information is not available, is recognized one month
after the shipment date. This estimate approximates the timing of the sale of
the product by the distributor to the end user. When product sales revenue is
recognized, we establish an estimated allowance for future product returns based
on historical returns experience; when price reductions are approved, we
establish an estimated liability for price protection payable on inventories
owned by product resellers. Should actual product returns or pricing adjustments
exceed our estimates, additional reductions to revenues would result. Revenue
from the licensing of software is recognized at the time of shipment (or at the
time of resale in the case of software products sold through distributors),
provided we have vendor-specific objective evidence of the fair value of each
element of the software offering and collectibility is probable. Revenue from
post-contract customer support and any other future deliverables is deferred and
recognized over the support period or as contract elements are delivered. Our
products typically carry a ninety day to two year warranty. Although we engage
in extensive product quality programs and processes, our warranty obligation is
affected by product failure rates, use of materials or service delivery costs
that differ from our estimates. As a result, additional warranty reserves could
be required, which could reduce gross margins.
Allowance for Doubtful Accounts
We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. Our
allowance for doubtful accounts is based on our assessment of the collectibility
of specific customer accounts, the aging of accounts receivable, our history of
bad debts and the general condition of the industry. If a major customer's
credit worthiness deteriorates, or our customers' actual defaults exceed our
historical experience, our estimates could change and impact our reported
results. We also maintain a reserve for uncertainties relative to the collection
of officer notes receivable. Factors considered in determining the level of this
reserve include the value of the collateral securing the notes, our ability to
effectively enforce collection rights and the ability of the former officers to
honor their obligations.
Inventory Valuation
Our policy is to value inventories at the lower of cost or market on a
part-by-part basis. This policy requires us to make estimates regarding the
market value of our inventories, including an assessment of excess and obsolete
inventories. We determine excess and obsolete inventories based on an estimate
of the future sales demand for our products within a specified time horizon,
13
generally three to twelve months. The estimates we use for demand are also used
for near-term capacity planning and inventory purchasing and are consistent with
our revenue forecasts. In addition, specific reserves are recorded to cover
risks in the area of end of life products, inventory located at our contract
manufacturers, deferred inventory in our sales channel and warranty replacement
stock.
If our sales forecast is less than the inventory we have on hand at the end
of an accounting period, we may be required to take excess and obsolete
inventory charges which will decrease gross margin and net operating results for
that period.
Valuation of Deferred Income Taxes
We have recorded a valuation allowance to reduce our net deferred tax
assets to zero, primarily due to our inability to estimate future taxable
income. We consider estimated future taxable income and ongoing prudent and
feasible tax planning strategies in assessing the need for a valuation
allowance. If we determine that it is more likely than not that we will realize
a deferred tax asset, which currently has a valuation allowance, we would be
required to reverse the valuation allowance which would be reflected as an
income tax benefit at that time.
Goodwill and Purchased Intangible Assets
The purchase method of accounting for acquisitions requires extensive use
of accounting estimates and judgments to allocate the purchase price to the fair
value of the net tangible and intangible assets acquired, including in-process
research and development ("IPR&D"). Goodwill and intangible assets deemed to
have indefinite lives are no longer amortized but are subject to annual
impairment tests. The amounts and useful lives assigned to intangible assets
impact future amortization and the amount assigned to IPR&D is expensed
immediately. If the assumptions and estimates used to allocate the purchase
price are not correct, purchase price adjustments or future asset impairment
charges could be required.
Impairment of Long-Lived Assets
We evaluate long-lived assets used in operations when indicators of
impairment, such as reductions in demand or significant economic slowdowns, are
present. Reviews are performed to determine whether the carrying values of
assets are impaired based on comparison to the undiscounted expected future cash
flows. If the comparison indicates that there is impairment, the expected future
cash flows using a discount rate based upon our weighted average cost of capital
is used to estimate the fair value of the assets. Impairment is based on the
excess of the carrying amount over the fair value of those assets. Significant
management judgment is required in the forecast of future operating results that
is used in the preparation of expected discounted cash flows. It is reasonably
possible that the estimates of anticipated future net revenue, the remaining
estimated economic lives of the products and technologies, or both, could differ
from those used to assess the recoverability of these assets. In the event they
are lower, additional impairment charges or shortened useful lives of certain
long-lived assets could be required.
Strategic Investments
We have made strategic investments in privately held companies for the
promotion of business and strategic investments. Strategic investments with less
than a 20% voting interest are generally carried at cost. We will use the equity
method to account for strategic investments in which we have a voting interest
of 20% to 50% or in which we otherwise have the ability to exercise significant
influence. Under the equity method, the investment is originally recorded at
cost and adjusted to recognize our share of net earnings or losses of the
investee, limited to the extent of our investment in, advances to and adjusted
to recognize our share of net earnings or losses of the investee. From time to
time we are required to estimate the amount of our losses of the investee. Our
estimates are based on historical experience. The value of non-publicly traded
securities is difficult to determine. We periodically review these investments
for other-than-temporary declines in fair value based on the specific
identification method and write down investments to their fair value when an
other-than-temporary decline has occurred. We generally believe an
other-than-temporary decline has occurred when the fair value of the investment
is below the carrying value for two consecutive quarters, absent evidence to the
contrary. Fair values for investments in privately held companies are estimated
based upon the values of recent rounds of financing. Although we believe our
estimates reasonably reflect the fair value of the non-publicly traded
securities held by us, had there been an active market for the equity
securities, the carrying values might have been materially different than the
amounts reported. Future adverse changes in market conditions or poor operating
results of companies in which we have such investments could result in losses or
an inability to recover the carrying value of the investments that may not be
reflected in an investment's current carrying value and which could require a
future impairment charge.
Restructuring Charges.
Over the last several quarters we have undertaken, and we may continue to
undertake, significant restructuring initiatives, which have required us to
develop formalized plans for exiting certain business activities. We have had to
14
record estimated expenses for lease cancellations, long-term asset write-downs,
severance and outplacement costs and other restructuring costs. Given the
significance of, and the timing of the execution of such activities, this
process is complex and involves periodic reassessments of estimates made at the
time the original decisions were made. Through December 31, 2002, the accounting
rules for restructuring costs and asset impairments required us to record
provisions and charges when we had a formal and committed plan. Beginning
January 1, 2003, the accounting rules now require us to record any future
provisions and changes at fair value in the period in which they are incurred.
In calculating the cost to dispose of our excess facilities, we had to estimate
our future space requirements and the timing of exiting excess facilities and
then estimate for each location the future lease and operating costs to be paid
until the lease is terminated and the amount, if any, of sublease income. This
required us to estimate the timing and costs of each lease to be terminated,
including the amount of operating costs and the rate at which we might be able
to sublease the site. To form our estimates for these costs, we performed an
assessment of the affected facilities and considered the current market
conditions for each site. Our assumptions on future space requirements, the
operating costs until termination or the offsetting sublease revenues may turn
out to be incorrect, and our actual costs may be materially different from our
estimates, which could result in the need to record additional costs or to
reverse previously recorded liabilities. Our policies require us to periodically
evaluate the adequacy of the remaining liabilities under our restructuring
initiatives. As management continues to evaluate the business, there may be
additional charges for new restructuring activities as well as changes in
estimates to amounts previously recorded.
Settlement Costs
From time to time, we are involved in legal actions arising in the ordinary
course of business. We cannot assure you that these actions or other third party
assertions against us will be resolved without costly litigation, in a manner
that is not adverse to our financial position, results of operations or cash
flows. As facts concerning contingencies become known, we reassess our position
and make appropriate adjustments to the financial statements. We are
aggressively defending these litigation matters and believe no material adverse
outcome will result. However, there are many uncertainties associated with any
litigation. If our assessments prove to be wrong, our results of operations and
financial condition could be materially and adversely affected. In addition, if
further information becomes available that causes us to determine a loss in any
of our pending litigation is probable and we can reasonably estimate a range of
loss associated with such litigation, then we would record at least the minimum
estimated liability. However, the actual liability in any such litigation may be
materially different from our estimates, which could result in the need to
record additional costs.
CONSOLIDATED RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the percentage
of net revenues represented by each item in our condensed consolidated statement
of operations:
THREE MONTHS
ENDED
SEPTEMBER 30,
----------------
2003 2002
------- -------
Net revenues 100.0% 100.0%
Cost of revenues 50.0 64.6
------- -------
Gross profit 50.0 35.4
------- -------
Operating expenses:
Selling, general and administrative. . . . 54.8 62.1
Research and development . . . . . . . . . 16.2 19.2
Stock-based compensation . . . . . . . . . 1.3 3.5
Amortization of purchased intangible assets 1.2 1.8
Restructuring charges. . . . . . . . . . . - 38.9
------- -------
Total operating expenses 73.5 125.4
------- -------
Loss from operations (23.5) (90.0)
Interest income (expense), net 0.2 1.5
Other income (expense), net (1.4) (0.7)
------- -------
Loss before income taxes (24.7) (89.2)
Provision for income taxes 0.3 0.7
------- -------
Net loss (24.9)% (89.9)%
======= =======
15
NET REVENUES
Net revenues decreased $451,000, or 3.6%, to $12.2 million for the three
months ended September 30, 2003 from $12.7 million for the three months ended
September 30, 2002. The decrease for the three months ended September 30, 2003
was primarily attributable to a decrease in net revenues of our other products.
IT management solutions net revenues were flat at $3.1 million, or 25.1% of net
revenues, for the three months ended September 30, 2003 and $3.1 million, or
24.2% of net revenues, for the three months ended September 30, 2002. Device
networking solutions net revenues were flat at $6.6 million, or 53.9% of net
revenues, for the three months ended September 30, 2003 and $6.6 million, or
52.1% of net revenues, for the three months ended September 30, 2002. Other
products net revenues decreased $432,000, or 14.4%, to $2.6 million, or 21.0% of
net revenues, for the three months ended September 30, 2003 from $3.0 million,
or 23.6% of net revenues, for the three months ended September 30, 2002. The
decrease in other product net revenues is primarily due to a decrease in our
legacy Print Server product line. We are no longer investing in the development
of Print Server product lines and expect net revenues related to this product
line to continue to decline in the future as we focus our investment in device
networking and IT management products. Net revenues for the three months ended
September 30, 2003 includes $52,000 of revenues from one of our industrial
controller product lines that we exited during the quarter ended September 30,
2003. Net revenues for the three months ended September 30, 2002 included
$530,000 of revenues from this exited industrial controller product line.
Net revenues generated from sales in the Americas decreased $308,000, or
3.1%, to $9.5 million, or 77.8% of net revenues, for the three months ended
September 30, 2003 from $9.8 million, or 77.4% of net revenues, for the three
months ended September 30, 2002. Our net revenues derived from customers located
in Europe decreased $204,000, or 8.6%, to $2.2 million, or 17.8% of net
revenues, for the three months ended September 30, 2003 from $2.4 million, or
18.7% of net revenues, for the three months ended September 30, 2002. The
decrease in net revenues in the Americas and Europe is primarily attributable to
a decrease in industry technology spending. Our net revenues derived from
customers located in other geographic areas increased slightly to $549,000, or
4.5% of net revenues, for the three months ended September 30, 2003 from
$488,000, or 3.8% of net revenues, for the three months ended September 30,
2002.
We experienced a slight decline in our quarterly net revenues during fiscal
2003, although we began to show a year over year quarterly revenue improvement
in the fourth quarter of fiscal 2003. In the first quarter of fiscal 2004, we
showed a slight increase over the fourth quarter of fiscal 2003 and a slight
decrease from the same period last year.
GROSS PROFIT
Gross profit represents net revenues less cost of revenues. Cost of
revenues consists primarily of the cost of raw material components, subcontract
labor assembly from outside manufacturers, amortization of purchased intangible
assets, establishing or relieving inventory reserves for excess and obsolete
products or raw materials, overhead and warranty costs. Cost of revenues for the
three months ended September 30, 2003 and 2002 consisted of $597,000 and $1.0
million of amortization of purchased intangible assets, respectively. At
September 30, 2003 the unamortized balance of purchased intangible assets that
will be amortized to cost of revenues was $4.4 million, of which $1.7 million
will be amortized in the remainder of fiscal 2004, $1.7 million in fiscal 2005,
$816,000 in fiscal 2006 and $129,000 in fiscal 2007.
Gross profit increased by $1.6 million, or 36.4%, to $6.1 million, or 50.0%
of net revenues, for the three months ended September 30, 2003 from $4.5
million, or 35.4% of net revenues, for the three months ended September 30,
2002. The increase in gross profit in absolute dollars and as a percentage of
net revenues for the three months ended September 30, 2003 was mainly
attributable to a decrease in our inventory reserve of $914,000 and the decrease
in amortization of purchased intangible assets charged to cost of revenues of
$431,000. The decrease in the amortization of purchased intangible assets is
primarily due to the impairment write-down of $3.9 million during the fourth
quarter of fiscal 2003. The decrease in our inventory reserve is primarily due
to the sale of products during the period for which reserves were previously
recorded.
SELLING, GENERAL AND ADMINISTRATIVE
Selling, general and administrative expenses consist primarily of
personnel-related expenses including salaries and commissions, facility
expenses, information technology, trade show expenses, advertising, and
professional legal and accounting fees. Selling, general and administrative
expenses decreased $1.2 million, or 14.8%, to $6.7 million, or 54.8% of net
revenues, for the three months ended September 30, 2003 from $7.9 million, or
62.1% of net revenues, for the three months ended September 30, 2002. Selling,
general and administrative expense decreased primarily due to reductions in
headcount and facility costs as a result of our fiscal 2003 restructurings and
the decrease in legal and other professional fees. The legal fees primarily
relate to our defense of the shareholder lawsuits and the SEC investigation.
Legal fees incurred in defense of the shareholder suits are reimbursable to the
extent provided in our directors and officers liability insurance policies, and
subject to the coverage limitations and exclusions contained in such policies.
For the three months ended September 30, 2003, we have been reimbursed $325,000
of these expenses. We expect to receive additional reimbursements for legal fees
in the future.
16
RESEARCH AND DEVELOPMENT
Research and development expenses consist primarily of personnel-related
costs of employees, as well as expenditures to third-party vendors for research
and development activities. Research and development expenses decreased
$446,000, or 18.4%, to $2.0 million, or 16.2% of net revenues, for the three
months ended September 30, 2003 from $2.4 million, or 19.2% of net revenues, for
the three months ended September 30, 2002. This decrease resulted primarily from
our fiscal 2003 restructurings which resulted in the closing of the Hillsboro,
Oregon; Milford, Connecticut; and Germany offices. Generally, research and
development expenses are expected to increase during the remainder of fiscal
2004 as we increase headcount to support new product development.
STOCK-BASED COMPENSATION
Stock-based compensation generally represents the amortization of deferred
compensation. We recorded no deferred compensation for the three months ended
September 30, 2003 and recorded deferred compensation forfeitures of $78,000 for
the three months ended September 30, 2003. Deferred compensation represents the
difference between the fair value of the underlying common stock for accounting
purposes and the exercise price of the stock options at the date of grant as
well as the fair market value of the vested portion of non-employee stock
options utilizing the Black-Scholes option pricing model. Deferred compensation
also includes the value of employee stock options assumed in connection with our
acquisitions calculated in accordance with current accounting guidelines.
Deferred compensation is presented as a reduction of stockholders' equity and is
amortized ratably over the respective vesting periods of the applicable options,
which is generally four years.
Included in cost of revenues is stock-based compensation of $16,000 and
$19,000 for the three months ended September 30, 2003 and 2002, respectively.
Stock-based compensation included in operating expenses decreased $290,000, or
65.2%, to $155,000, or 1.3% of net revenues, for the three months ended
September 30, 2003 from $445,000, or 3.5% of net revenues, for the three months
ended September 30, 2002. The decrease in stock-based compensation for the three
months ended September 30, 2003 is primarily attributable to the restructuring
plans whereby options for which deferred compensation has been recorded are
forfeited for terminated employees. Additionally, the decrease is due to the
acceleration of approximately $239,000 of stock-based compensation in January
2003 as a result of our completion of an offer whereby employees holding options
to purchase our common stock were given the opportunity to cancel certain of
their existing options in exchange for the opportunity to receive new options.
At September 30, 2003, a balance of $446,000 remains and will be amortized as
follows: $343,000 for the remainder of fiscal 2004, $86,000 in fiscal 2005 and
$17,000 in fiscal 2006.
AMORTIZATION OF PURCHASED INTANGIBLE ASSETS
Purchased intangible assets primarily include existing technology, patents
and trademarks and are amortized on a straight-line basis over the estimated
useful lives of the respective assets, ranging from one to five years. We
obtained independent appraisals of the fair value of tangible and intangible
assets acquired in order to allocate the purchase price. The amortization of
purchased intangible assets decreased $84,000, or 36.8%, to $144,000, or 1.2% of
net revenues, for the three months ended September 30, 2003 from $228,000, or
1.8% of net revenues, for the three months ended September 30, 2002. In
addition, approximately $597,000 and $1.0 million of amortization of purchased
intangible assets has been classified as cost of revenues for the three months
ended September 30, 2003 and 2002, respectively. The decrease in amortization of
purchased intangible assets is primarily due to the impairment write-down of
$2.4 million during the fourth quarter of fiscal 2003. At September 30, 2003,
the unamortized balance of purchased intangible assets that will be amortized to
future operating expense was $284,000, of which $217,000 will be amortized in
the remainder of fiscal 2004, $65,000 in fiscal 2005 and $2,000 in fiscal 2006.
RESTRUCTURING CHARGES
On September 12, 2002, we announced a restructuring plan to prioritize our
initiatives around the growth areas of our business, focus on profit
contribution, reduce expenses, and improve operating efficiency. This
restructuring plan included a worldwide workforce reduction, consolidation of
excess facilities and other charges. We recorded restructuring costs totaling
$4.9 million, which were classified as operating expenses in the condensed
consolidated statement of operations for the three months ended September 30,
2002. This restructuring plan resulted in the reduction of approximately 50
regular employees worldwide. We recorded workforce reduction charges of
approximately $1.2 million related to severance and fringe benefits for the
terminated employees. We recorded charges of approximately $3.7 million related
to the consolidation of excess facilities, relating primarily to lease
terminations, non-cancelable lease costs, write-off of leasehold improvements
and termination of a contractual obligation. The restructuring costs will be
substantially paid in cash over the next five years. The remaining restructuring
reserve is related to facility lease terminations and a contractual settlement.
There was no restructuring charge recorded for the three months ended September
30, 2003.
17
INTEREST INCOME (EXPENSE), NET
Interest income (expense), net consists primarily of interest earned on
cash, cash equivalents and marketable securities. Interest income (expense), net
was $24,000 and $192,000 for the three months ended September 30, 2003 and 2002,
respectively. The decrease is primarily due to lower average investment balances
and interest rates. Additionally, the decrease in the average investment balance
is due to increased legal and other professional fees resulting from our
financial statement restatements in fiscal 2002 and defense of our lawsuits.
Also, the decrease is due to the settlement of the Milford lease obligation
included in our restructuring charge, the purchase of a joint interest in
intellectual property from Gordian, our acquisition of Stallion and to fund
current operations.
OTHER INCOME (EXPENSE), NET
Other income (expense), net was $(170,000) and $(90,000) for the three
months ended September 30, 2003 and 2002, respectively. The increase in other
expense is primarily attributable to our share of the losses from our investment
in Xanboo.
PROVISION FOR INCOME TAXES-EFFECTIVE TAX RATE
We utilize the liability method of accounting for income taxes as set forth
in FASB Statement No. 109, "Accounting for Income Taxes." Our effective tax rate
was (1)% for both the three month periods ended September 30, 2003 and 2002.
The federal statutory rate was 34% for both periods. Our effective tax rate
associated with the income tax expense for both the three month periods ended
September 30, 2003 and 2002, was lower than the federal statutory rate primarily
due to the increase in valuation allowance, as well as the amortization of
stock-based compensation for which no current year tax benefit was provided. In
October 2003, the Internal Revenue Service completed its audit of our federal
income tax returns for the years ended June 30, 1999, 2000 and 2001. As a
result, we will be required to pay approximately $500,000 in tax and interest to
the Internal Revenue Service and the California Franchise Tax Board, in fiscal
2004. We accrued for this liability in prior fiscal periods.
IMPACT OF ADOPTION OF NEW ACCOUNTING STANDARDS
In January 2003, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46").
FIN 46 requires the primary beneficiary of a variable interest entity ("VIE") to
consolidate the entity and also requires majority and significant variable
interest investors to provide certain disclosures. A VIE is an entity in which
the equity investors do not have a controlling interest, equity investors
participate in losses or residual interests of the entity on a basis that
differs from its ownership interest, or the equity investment at risk is
insufficient to finance the entity's activities without receiving additional
subordinated financial support from the other parties. For arrangements entered
into with VIEs created prior to January 31, 2003, the provisions of FIN 46 are
required to be adopted at the beginning of the first interim or annual period
beginning after December 15, 2003. We are currently reviewing our investments
and other arrangements to determine whether any of its investee companies are
VIEs. We do not expect to identify any significant VIEs that would be
consolidated, but may be required to make additional disclosures.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, we have financed our operations through the issuance of
common stock and through net cash generated from operations. We consider all
highly liquid investments purchased with original maturities of 90 days or less
to be cash equivalents. Cash and cash equivalents consisting of money-market
funds and commercial paper totaled $8.9 million at September 30, 2003.
Marketable securities are income yielding securities which can be readily
converted to cash. Marketable securities consist of obligations of U.S.
Government agencies, state, municipal and county government notes and bonds and
totaled $4.6 million at September 30, 2003. Long-term investments primarily
consist of an equity security of a privately held company, Xanboo, and totaled
$5.2 million at September 30, 2003.
Our operating activities used cash of $701,000 for the three months ended
September 30, 2003. We incurred a net loss of $3.0 million, which includes the
following adjustments: benefit from inventory reserve of $914,000, amortization
of purchased intangible assets of $741,000, depreciation of $504,000,
amortization of stock-based compensation of $171,000, equity losses from
unconsolidated businesses of $209,000 and a provision for doubtful accounts of
$142,000. The changes in our operating assets consist of a decrease in inventory
18
of $813,000, decrease in contract manufacturer receivable of $679,000, decrease
in prepaid expenses and other assets of $1.4 million and an increase in other
current liabilities of $640,000 which was reduced by a decrease in the balance
due to Gordian of $1.0 million and a decrease in accounts payable of $1.1
million. The decrease in the balance due to Gordian is due to payments in
accordance with the agreement. The decrease in prepaid expenses and other
current assets is primarily due to the Gordian payment whereby we maintained a
time deposit for $1.0 million. The decrease in inventory is primarily
attributable to a concentrated effort by management to reduce inventory levels.
The increase in other current liabilities is primarily due to the issuance of
stock in satisfaction of the $1.5 million Dunstan settlement. On September 15,
2003, 1,726,703 shares were issued following a fairness determination by the
state court in Oregon. The decrease in contract manufacturer receivables is due
to improved collections. The decrease in accounts payable is due to the timing
of payments to our suppliers.
Cash provided by investing activities was $2.1 million for the three months
ended September 30, 2003 compared with a $8.6 million use of cash for the three
months ended September 30, 2002. We received $2.2 million in proceeds from the
sales of marketable securities. We also used $84,000 to purchase property and
equipment.
Cash provided by financing activities was $163,000 for the three months
ended September 30, 2003, primarily related to the purchase by the employee
stock purchase plan. Cash provided by financing activities was $9,000 for the
three months ended September 30, 2002.
In January 2002, we entered into a two-year line of credit with a bank in
an amount not to exceed $20.0 million. Borrowings under the line of credit bear
interest at either (i) the prime rate or (ii) the LIBOR rate plus 2.0%. We were
required to pay a $100,000 facility fee of which $50,000 was paid upon the
closing and $50,000 was to be paid. We are also required to pay a quarterly
unused line fee of .125% of the unused line of credit balance. Since
establishing the line of credit, we have twice reduced the amount of the line,
modified customary financial covenants, and adjusted the interest rate to be
charged on borrowings to the prime rate plus .50%, and eliminated the LIBOR
option. Effective July 25, 2003, we further modified this line of credit,
reducing the revolving line to $5.0 million, and adjusting the customary
affirmative and negative covenants. We are also required to maintain certain
financial ratios as defined in the agreement. The agreement has an annual
revolving maturity date that renews on the effective date. The renewal $50,000
facility fee was reduced to $12,500 and was paid. Prior to any advances being
made under the line of credit, the bank is required to complete a field
examination to determine its borrowing base. To date, we have not borrowed
against this line of credit. We are currently in compliance with the revised
financial covenants of the July 25, 2003 amended line of credit. Pursuant to our
line of credit, we are restricted from paying any dividends. We have secured two
deposits totaling approximately $365,000 under our line of credit.
The following table summarizes our contractual payment obligations and
commitments:
REMAINDER OF FISCAL YEAR FISCAL YEARS
------------------------------ -----------------------------------
2004 2005 2006 2007 2008 TOTAL
------ ------ ----- ----- ----- ------
Operating leases. . . . . . . $1,302 $1,348 $ 493 $ 336 $ 202 $3,681
Convertible note payable. . . 867 - - - - 867
Other contractual obligations 205 - - - - 205
------ ------ ----- ----- ----- ------
Total . . . . . . . . . . . . $2,374 $1,348 $ 493 $ 336 $ 202 $4,753
====== ====== ===== ===== ===== ======
In October 2003, the Internal Revenue Service completed its audit of our
federal income tax returns for the years ended June 30, 1999, 2000 and 2001. As
a result, we will be required to pay approximately $500,000 in tax and interest
to the Internal Revenue Service and the California Franchise Tax Board, in
fiscal 2004. We accrued for this liability in prior fiscal periods.
We believe that our existing cash, cash equivalents and marketable
securities and any available borrowings under our line of credit facility will
be adequate to meet our anticipated cash needs through at least the next twelve
months. Our future capital requirements will depend on many factors, including
the timing and amount of our net revenues, research and development and
infrastructure investments, and expenses related to on-going government
investigations and pending litigation, which will affect our ability to generate
additional cash. If cash generated from operations and financing activities is
insufficient to satisfy our working capital requirements, we may need to borrow
funds through bank loans, sales of securities or other means. There can be no
assurance that we will be able to raise any such capital on terms acceptable to
us, if at all. If we are unable to secure additional financing, we may not be
able to develop or enhance our products, take advantage of future opportunities,
respond to competition or continue to operate our business.
19
RISK FACTORS
You should carefully consider the risks described below before making an
investment decision. The risks and uncertainties described below are not the
only ones facing our company. Our business operations may be impaired by
additional risks and uncertainties of which we are unaware or that we currently
consider immaterial.
Our business, results of operations or cash flows may be adversely affected
if any of the following risks actually occur. In such case, the trading price of
our common stock could decline, and you may lose all or part of your investment.
VARIATIONS IN QUARTERLY OPERATING RESULTS, DUE TO FACTORS INCLUDING CHANGES
IN DEMAND FOR OUR PRODUCTS AND CHANGES IN OUR MIX OF NET REVENUES, COULD CAUSE
OUR STOCK PRICE TO DECLINE.
Our quarterly net revenues, expenses and operating results have varied in
the past and might vary significantly from quarter to quarter in the future. We
therefore believe that quarter-to-quarter comparisons of our operating results
are not a good indication of our future performance, and you should not rely on
them to predict our future performance or the future performance of our stock
price. Our short-term expense levels are relatively fixed and are based on our
expectations of future net revenues. If we were to experience a reduction in net
revenues in a quarter, we would likely be unable to adjust our short-term
expenditures. If this were to occur, our operating results for that quarter
would be harmed. If our operating results in future quarters fall below the
expectations of market analysts and investors, the price of our common stock
would likely fall. Other factors that might cause our operating results to
fluctuate on a quarterly basis include:
- - changes in the mix of net revenues attributable to higher-margin and
lower-margin products;
- - customers' decisions to defer or accelerate orders;
- - variations in the size or timing of orders for our products;
- - short-term fluctuations in the cost or availability of our critical
components;
- - changes in demand for our products generally;
- - loss or gain of significant customers;
- - announcements or introductions of new products by our competitors;
- - defects and other product quality problems; and
- - changes in demand for devices that incorporate our products.
WE ARE CURRENTLY ENGAGED IN MULTIPLE SECURITIES CLASS ACTION LAWSUITS, A
STATE DERIVATIVE SUIT, A LAWSUIT BY OUR FORMER CFO AND COO STEVEN V. COTTON, A
LAWSUIT BY FORMER SHAREHOLDERS OF OUR SYNERGETIC SUBSIDIARY, AND A LAWSUIT
AGAINST THE FORMER OWNERS OF OUR LIGHTWAVE COMMUNICATIONS SUBSIDIARY, ANY OF
WHICH, IF IT RESULTS IN AN UNFAVORABLE RESOLUTION, COULD ADVERSELY AFFECT OUR
BUSINESS, RESULTS OF OPERATIONS OR FINANCIAL CONDITION.
Government Investigation
The SEC is conducting a formal investigation of the events leading up to
our restatement of our financial statements on June 25, 2002. The Department of
Justice is also conducting an investigation concerning events related to this
restatement.
Class Action Lawsuits
On May 15, 2002, Stephen Bachman filed a class action complaint entitled
Bachman v. Lantronix, Inc., et al., No. 02-3899, in the U.S. District Court for
the Central District of California against us and certain of our current and
former officers and directors alleging violations of the Securities Exchange Act
of 1934 and seeking unspecified damages. Subsequently, six similar actions were
filed in the same court. Each of the complaints purports to be a class action
lawsuit brought on behalf of persons who purchased or otherwise acquired our
common stock during the period of April 25, 2001 through May 30, 2002,
inclusive. The complaints allege that the defendants caused us to improperly
recognize revenue and make false and misleading statements about our business.
Plaintiffs further allege that the defendants materially overstated our reported
financial results, thereby inflating our stock price during our securities
offering in July 2001, as well as facilitating the use of our common stock as
consideration in acquisitions. The complaints have subsequently been
consolidated into a single action and the court has appointed a lead plaintiff.
The lead plaintiff filed a consolidated amended complaint on January 17, 2003.
The amended complaint now purports to be a class action brought on behalf of
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persons who purchased or otherwise acquired our common stock during the period
of August 4, 2000 through May 30, 2002, inclusive. The amended complaint
continues to assert that we and the individual officer and director defendants
violated the 1934 Act, and also includes alleged claims that we and these
officers and directors violated the Securities Act of 1933 arising from our
Initial Public Offering in August 2000. We filed a motion to dismiss the
additional allegations on March 3, 2003. The Court has taken the motion under
submission. We have not yet answered the complaint, discovery has not commenced,
and no trial date has been established.
Derivative Lawsuit
On July 26, 2002, Samuel Ivy filed a shareholder derivative complaint
entitled Ivy v. Bernhard Bruscha, et al., No. 02CC00209, in the Superior Court
of the State of California, County of Orange, against certain of our current and
former officers and directors. On January 7, 2003, the plaintiff filed an
amended complaint. The amended complaint alleges causes of action for breach of
fiduciary duty, abuse of control, gross mismanagement, unjust enrichment, and
improper insider stock sales. The complaint seeks unspecified damages against
the individual defendants on our behalf, equitable relief, and attorneys' fees.
We filed a demurrer/motion to dismiss the amended complaint on February 13,
2003. The basis of the demurrer is that the plaintiff does not have standing to
bring this lawsuit since plaintiff has never served a demand on our Board that
our Board take certain actions on our behalf. On April 17, 2003, the Court
overruled our demurrer. All defendants have answered the complaint and generally
denied the allegations. Discovery has commenced, but no trial date has been
established.
Employment Suit Brought by Former Chief Financial Officer and Chief
Operating Officer Steven Cotton
On September 6, 2002, Steven Cotton, our former CFO and COO, filed a
complaint entitled Cotton v. Lantronix, Inc., et al., No. 02CC14308, in the
Superior Court of the State of California, County of Orange. The complaint
alleges claims for breach of contract, breach of the covenant of good faith and
fair dealing, wrongful termination, misrepresentation, and defamation. The
complaint seeks unspecified damages, declaratory relief, attorneys' fees and
costs. Discovery has not commenced and no trial date has been established.
We filed a motion to dismiss on October 16, 2002, on the grounds that Mr.
Cotton's complaints are subject to the binding arbitration provisions in Mr.
Cotton's employment agreement. On January 13, 2003, the Court ruled that five of
the six counts in Mr. Cotton's complaint are subject to binding arbitration. The
court is staying the sixth count, for declaratory relief, until the underlying
facts are resolved in arbitration. No arbitration date has been set.
Securities Claims Brought by Former Shareholders of Synergetic Micro
Systems, Inc.
On October 17, 2002, Richard Goldstein and several other former
shareholders of Synergetic filed a complaint entitled Goldstein, et al v.
Lantronix, Inc., et al in the Superior Court of the State of California, County
of Orange, against us and certain of our former officers and directors.
Plaintiffs filed an amended complaint on January 7, 2003. The amended complaint
alleges fraud, negligent misrepresentation, breach of warranties and covenants,
breach of contract and negligence, all stemming from our acquisition of
Synergetic. The complaint seeks an unspecified amount of damages, interest,
attorneys' fees, costs, expenses, and an unspecified amount of punitive damages.
On May 5, 2003, we answered the complaint and generally denied the allegations
in the complaint. Discovery has commenced but no trial date has been
established.
Suit filed by Lantronix Against Logical Solutions, Inc.
On March 25, 2003, we filed in Connecticut state court (Judicial District
of New Haven) a complaint entitled Lantronix, Inc. and Lightwave Communications,
Inc. v. Logical Solutions, Inc., et. al. This is an action for unfair and
deceptive trade practices, unfair competition, unjust enrichment, conversion,
misappropriation of trade secrets and tortuous interference with contractual
rights and business expectancies. We seek preliminary and permanent injunctive
relief and damages. The individual defendants are all former employees of
Lightwave Communications, a company that we acquired in June 2001. The Court
held a non-jury trial October 10-17, 2003; closing arguments are set for
November 14, 2003.
Other
From time to time, we are subject to other legal proceedings and claims in
the ordinary course of business. We currently are not aware of any such legal
proceedings or claims that we believe will have, individually or in the
aggregate, a material adverse effect on our business, prospects, financial
position, operating results or cash flows.
The pending lawsuits involve complex questions of fact and law and likely
will continue to require the expenditure of significant funds and the diversion
of other resources to defend. We are unable to determine the outcome of its
outstanding legal proceedings, claims and litigation involving us, our
21
subsidiaries, directors and officers and cannot determine the extent to which
these results may have a material adverse effect on our business, results of
operations and financial condition taken as a whole. The results of litigation
are inherently uncertain, and adverse outcomes are possible. We are unable to
estimate the range of possible loss from outstanding litigation, and no amounts
have been provided for such matters in the consolidated financial statements.
THERE IS A RISK THAT THE SEC COULD LEVY FINES AGAINST US, OR DECLARE US TO
BE OUT OF COMPLIANCE WITH THE RULES REGARDING OFFERING SECURITIES TO THE PUBLIC.
The SEC is investigating the events surrounding our recent restatement of
our financial statements. The SEC could conclude that we violated the rules of
the Securities Act of 1933 or the Securities and Exchange Act of 1934. In either
event, the SEC might levy civil fines against us, or might conclude that we lack
sufficient internal controls to warrant our being allowed to continue offering
our shares to the public. This investigation involves substantial cost and could
significantly divert the attention of management. These costs, and the cost of
any fines imposed by the SEC, are not covered by insurance. In addition to
sanctions imposed by the SEC, an adverse determination could significantly
damage our reputation with customers and vendors, and harm our employees'
morale.
WE MIGHT BECOME INVOLVED IN LITIGATION OVER PROPRIETARY RIGHTS, WHICH COULD
BE COSTLY AND TIME CONSUMING.
Substantial litigation regarding intellectual property rights exists in our
industry. There is a risk that third-parties, including current and potential
competitors, current developers of our intellectual property, our manufacturing
partners, or parties with which we have contemplated a business combination will
claim that our products, or our customers' products, infringe on their
intellectual property rights or that we have misappropriated their intellectual
property. In addition, software, business processes and other property rights in
our industry might be increasingly subject to third-party infringement claims as
the number of competitors grows and the functionality of products in different
industry segments overlaps. Other parties might currently have, or might
eventually be issued, patents that infringe on the proprietary rights we use.
Any of these third parties might make a claim of infringement against us.
For example, in July 2001, Digi International, Inc., filed a complaint
alleging that we directly and/or indirectly infringed upon a Digi Patent.
Following extensive and costly pre-trial preparation, we settled the matter with
Digi in November 2002. From time to time in the future we could encounter other
disputes over rights and obligations concerning intellectual property. We cannot
assume that we will prevail in intellectual property disputes regarding
infringement, misappropriation or other disputes. Litigation in which we are
accused of infringement or misappropriation might cause a delay in the
introduction of new products, require us to develop non-infringing technology,
require us to enter into royalty or license agreements, which might not be
available on acceptable terms, or at all, or require us to pay substantial
damages, including treble damages if we are held to have willfully infringed. In
addition, we have obligations to indemnify certain of our customers under some
circumstances for infringement of third-party intellectual property rights. If
any claims from third-parties were to require us to indemnify customers under
our agreements, the costs could be substantial, and our business could be
harmed. If a successful claim of infringement were made against us and we could
not develop non-infringing technology or license the infringed or similar
technology on a timely and cost-effective basis, our business could be
significantly harmed.
WE INCORPORATE SOFTWARE LICENSED FROM THIRD PARTIES INTO SOME OF OUR
PRODUCTS AND ANY SIGNIFICANT INTERRUPTION IN THE AVAILABILITY OF THESE
THIRD-PARTY SOFTWARE PRODUCTS OR DEFECTS IN THESE PRODUCTS COULD REDUCE THE
DEMAND FOR, OR PREVENT THE SALE OR USE OF, OUR PRODUCTS
Certain of our products contain components developed and maintained by
third-party software vendors or available through the "open source" software
community. We also expect that we may incorporate software from third-party
vendors and open source software in our future products. Our business would be
disrupted if this software, or functional equivalents of this software, were
either no longer available to us or no longer offered to us on commercially
reasonable terms. In either case, we would be required to either redesign our
products to function with alternate third-party software or open source
software, or develop these components ourselves, which would result in increased
costs and could result in delays in our product shipments. Furthermore, we might
be forced to limit the features available in our current of future product
offerings. We presently are developing products for use on the Linux platform.
The SCO Group (SCO) has filed and threatened to file lawsuits against companies
that operate Linux for commercial purposes, alleging that such use of Linux
infringes SCO's rights. These allegations may adversely affect the demand for
the Linux platform and, consequently, the sales of our Linux-based products.
22
FOUR OF THE FORMER STOCKHOLDERS OF LIGHTWAVE COMMUNICATIONS ARE OPERATING A
BUSINESS THAT COMPETES WITH US. IF WE ARE UNSUCCESSFUL IN OUR PENDING LITIGATION
AGAINST THIS COMPANY, AND THESE FORMER LIGHTWAVE STOCKHOLDERS, OUR BUSINESS MAY
BE HARMED
In June 2001, we acquired Lightwave Communications. Since that time, four
of the founding stockholders and executive officers of Lightwave, as well as
several other former employees of Lightwave, have begun operating a business
that competes with us. Because these individuals held senior positions at
Lightwave, and were exposed to confidential information about Lightwave, as well
as Lantronix, if we are unsuccessful in our litigation against them, we may
suffer substantial harm.
We filed this suit to protect the value of the assets we bought in the
Lightwave acquisition. If the court refuses to enjoin their use of our
confidential information, the former employees will be able to compete against
us in our markets for console servers, KVM and video display extenders.
STOCK-BASED COMPENSATION WILL NEGATIVELY AFFECT OUR OPERATING RESULTS.
We have recorded deferred compensation in connection with the grant of
stock options to employees where the option exercise price is less than the
estimated fair value of the underlying shares of common stock as determined for
financial reporting purposes. We recorded deferred compensation forfeitures of
$78,000 for the three months ended September 30, 2003. At September 30, 2003, a
balance of $446,000 remains and will be amortized as follows: $343,000 for the
remainder of fiscal 2004, $86,000 in fiscal 2005 and $17,000 in fiscal 2006.
The amount of stock-based compensation in future periods will increase if
we grant stock options where the exercise price is less than the quoted market
price of the underlying shares. The amount of stock-based compensation
amortization in future periods could decrease if options for which accrued, but
unvested deferred compensation has been recorded, are forfeited.
WE HAVE EXCESS INVENTORIES AND THERE IS A RISK WE MAY BE UNABLE TO DISPOSE
OF THEM.
Our products and therefore our inventories are subject to technological
risk at any time either new products may enter the market or prices of
competitive products may be introduced with more attractive features or at lower
prices than ours. There is a risk that we may be unable to sell our inventory in
a timely manner to avoid their becoming obsolete. As of September 30, 2003, our
inventories including raw materials, finished goods and inventory at
distributors were valued at $11.8 million and we had reserved $5.7 million
against these inventories. As of June 30, 2003, our inventories, including raw
materials, finished goods and inventory at distributors were valued at $14.0
million and we had reserved $8.0 million against these inventories. In the event
we are required to substantially discount our inventory or are unable to sell
our inventory in a timely manner, our operating results could be substantially
harmed.
WE PRIMARILY DEPEND ON FOUR THIRD-PARTY MANUFACTURERS TO MANUFACTURE
SUBSTANTIALLY ALL OF OUR PRODUCTS, WHICH REDUCES OUR CONTROL OVER THE
MANUFACTURING PROCESS. IF THESE MANUFACTURERS ARE UNABLE OR UNWILLING TO
MANUFACTURE OUR PRODUCTS AT THE QUALITY AND QUANTITY WE REQUEST, OUR BUSINESS
COULD BE HARMED AND OUR STOCK PRICE COULD DECLINE.
We outsource substantially all of our manufacturing to four third-party
manufacturers, Varian, Inc., Irvine Electronics, Technical Manufacturing Corp.
and Uni Precision Industrial Ltd. Our reliance on these third-party
manufacturers exposes us to a number of significant risks, including:
- - reduced control over delivery schedules, quality assurance, manufacturing
yields and production costs;
- - lack of guaranteed production capacity or product supply; and
- - reliance on third-party manufacturers to maintain competitive
manufacturing technologies.
Our agreements with these manufacturers provide for services on a purchase
order basis. If our manufacturers were to become unable or unwilling to continue
to manufacture our products in required volumes, at acceptable quality,
quantity, yields and costs, or in a timely manner, our business would be
seriously harmed. As a result, we would have to attempt to identify and qualify
substitute manufacturers, which could be time consuming and difficult, and might
result in unforeseen manufacturing and operations problems. Moreover, if we
shift products among third-party manufacturers, we may incur substantial
expenses, risk material delays, or encounter other unexpected issues. For
example, in the third quarter of fiscal 2003 we encountered product shortages
related to the transition to a third-party manufacturer. This product shortage
contributed to our net revenues falling below our publicly announced estimates.
23
In addition, a natural disaster could disrupt our manufacturers' facilities
and could inhibit our manufacturers' ability to provide us with manufacturing
capacity on a timely basis, or at all. If this were to occur, we likely would be
unable to fill customers' existing orders or accept new orders for our products.
The resulting decline in net revenues would harm our business. In addition, we
are responsible for forecasting the demand for our individual products. These
forecasts are used by our contract manufacturers to procure raw materials and
manufacture our finished goods. If we forecast demand too high, we may invest
too much cash in inventory and we may be forced to take a write-down of our
inventory balance, which would reduce our earnings. If our forecast is too low
for one or more products, we may be required to pay expedite charges which would
increase our cost of revenues or we may be unable to fulfill customer orders,
thus reducing net revenues and therefore earnings.
WE HAVE ELECTED TO USE A CONTRACT MANUFACTURER IN CHINA, WHICH INVOLVES
SIGNIFICANT RISKS.
One of our contract manufacturers is based in China. There are significant
risks of doing business in China, including:
- - Delivery times are extended due to the distances involved, requiring more
lead-time in ordering and increasing the risk of excess inventories.
- - We could incur ocean freight delays because of labor problems, weather
delays or expediting and customs problems.
- - China does not afford the same level of protection to intellectual property
as domestic or many other foreign countries. If our products were
reverse-engineered or our intellectual property were otherwise
pirated-reproduced and duplicated without our knowledge or approval, our
revenues would be reduced.
- - China and U.S foreign relations have, historically, been subject to change.
Political considerations and actions could interrupt our expected supply of
products from China.
INABILITY, DELAYS IN DELIVERIES OR QUALITY PROBLEMS FROM OUR COMPONENT
SUPPLIERS COULD DAMAGE OUR REPUTATION AND COULD CAUSE OUR NET REVENUES TO
DECLINE AND HARM OUR RESULTS OF OPERATIONS.
Our contract manufacturers and we are responsible for procuring raw
materials for our products. Our products incorporate components or technologies
that are only available from single or limited sources of supply. In particular,
some of our integrated circuits are available from a single source. From time to
time in the past, integrated circuits we use in our products have been phased
out of production. When this happens, we attempt to purchase sufficient
inventory to meet our needs until a substitute component can be incorporated
into our products. Nonetheless, we might be unable to purchase sufficient
components to meet our demands, or we might incorrectly forecast our demands,
and purchase too many or too few components. In addition, our products use
components that have in the past been subject to market shortages and
substantial price fluctuations. From time to time, we have been unable to meet
our orders because we were unable to purchase necessary components for our
products. We rely on a number of different component suppliers. Because we do
not have long-term supply arrangements with any vendor to obtain necessary
components or technology for our products, if we are unable to purchase
components from these suppliers, product shipments could be prevented or
delayed, which could result in a loss of sales. If we are unable to meet
existing orders or to enter into new orders because of a shortage in components,
we will likely lose net revenues and risk losing customers and harming our
reputation in the marketplace.
IF WE MAKE UNPROFITABLE ACQUISITIONS OR ARE UNABLE TO SUCCESSFULLY
INTEGRATE OUR ACQUISITIONS, OUR BUSINESS COULD SUFFER.
We have in the past and may continue in the future to acquire businesses,
client lists, products or technologies that we believe complement or expand our
existing business. In December 2000, we acquired USSC, a company that provides
software solutions for use in embedded technology applications. In June 2001, we
acquired Lightwave, a company that provides console management solutions. In
October 2001, we acquired Synergetic, a provider of embedded network
communication solutions. In January 2002, we acquired Premise, a developer of
client-side software applications. In August 2002, we acquired Stallion, an
Australian based provider of solutions that enable Internet access, remote
access and serial connectivity. Acquisitions of this type involve a number of
risks, including:
- - difficulties in assimilating the operations and employees of acquired
companies;
- - diversion of our management's attention from ongoing business concerns;
24
- - our potential inability to maximize our financial and strategic position
through the successful incorporation of acquired technology and rights into
our products and services;
- - additional expense associated with amortization of acquired assets;
- - maintenance of uniform standards, controls, procedures and policies; and
- - impairment of existing relationships with employees, suppliers and
customers as a result of the integration of new management employees.
Any acquisition or investment could result in the incurrence of debt and
the loss of key employees. Moreover, we often assume specified liabilities of
the companies we acquire. Some of these liabilities, are difficult or impossible
to quantify. If we do not receive adequate indemnification for these liabilities
our business may be harmed. In addition, acquisitions are likely to result in a
dilutive issuance of equity securities. For example, we issued common stock and
assumed options to acquire our common stock in connection with our acquisitions
of USSC, Lightwave, Synergetic and Premise. We cannot assure you that any
acquisitions or acquired businesses, client lists, products or technologies
associated therewith will generate sufficient net revenues to offset the
associated costs of the acquisitions or will not result in other adverse
effects. Moreover, from time to time we may enter into negotiations for the
acquisition of businesses, client lists, products or technologies, but be unable
or unwilling to consummate the acquisition under consideration. This could cause
significant diversion of managerial attention and out of pocket expenses to us.
We could also be exposed to litigation as a result of an unconsummated
acquisition, including claims that we failed to negotiate in good faith,
misappropriated confidential information or other claims.
In addition, from time to time we may invest in businesses that we believe
present attractive investment opportunities, or provide other synergetic
benefits. In September and October 2001, we paid an aggregate of $3.0 million to
Xanboo for convertible promissory notes, which have converted, in accordance
with their terms, into Xanboo preferred stock. In addition, we purchased an
additional $4.0 million of preferred stock in Xanboo. As of September 30, 2003,
we hold a 15.3% ownership interest with a net book value of $5.2 million, in
Xanboo. This investment is speculative in nature, and there is risk that we
could lose part or all of our investment.
OUR EXECUTIVE OFFICERS AND TECHNICAL PERSONNEL ARE CRITICAL TO OUR
BUSINESS, AND WITHOUT THEM WE MIGHT NOT BE ABLE TO EXECUTE OUR BUSINESS
STRATEGY.
Our financial performance depends substantially on the performance of our
executive officers and key employees. We are dependent in particular on Marc
Nussbaum, who serves as our President and Chief Executive Officer, and James
Kerrigan, who serves as our Chief Financial Officer. We have no employment
contracts with those executives who are at-will employees. We are also dependent
upon our technical personnel, due to the specialized technical nature of our
business. If we lose the services of Mr. Nussbaum, Mr. Kerrigan or any of our
key personnel and are not able to find replacements in a timely manner, our
business could be disrupted, other key personnel might decide to leave, and we
might incur increased operating expenses associated with finding and
compensating replacements.
THERE IS A RISK THAT OUR OEM CUSTOMERS WILL DEVELOP THEIR OWN INTERNAL
EXPERTISE IN NETWORK-ENABLING PRODUCTS, WHICH COULD RESULT IN REDUCED SALES OF
OUR PRODUCTS.
For most of our existence, we primarily sold our products to distributors,
VARs and system integrators. Although we intend to continue to use all of these
sales channels, we have begun to focus more heavily on selling our products to
OEMs. Selling products to OEMs involves unique risks, including the risk that
OEMs will develop internal expertise in network-enabling products or will
otherwise provide network functionality to their products without using our
device server technology. If this were to occur, our stock price could decline
in value and you could lose part or all of your investment.
OUR ENTRY INTO, AND INVESTMENT IN, THE HOME NETWORK MARKET HAS RISKS
INHERENT IN RELYING ON ANY EMERGING MARKET FOR FUTURE GROWTH.
The success of our Premise SYS software and our investment in Xanboo are
dependent on the development of a market for home networking. It is possible
this home network market may develop slowly, or not at all, or that others could
enter this market with superior product offerings that would impair our own
success. We could lose some or all of our investment, or be unsuccessful in
achieving significant revenues and therefore profitability, in these
initiatives. If this were to occur, our operating results could be harmed, and
our stock price could decline.
25
IF OUR RESEARCH AND DEVELOPMENT EFFORTS ARE NOT SUCCESSFUL OUR NET REVENUES
COULD DECLINE AND BUSINESS COULD BE HARMED.
For the three months ended September 30, 2003, we incurred $2.0 million in
research and development expenses, which comprised 16.2% of our net revenues. If
we are unable to develop new products as a result of this effort, or if the
products we develop are not successful, our business could be harmed. Even if we
do develop new products that are accepted by our target markets, we do not know
whether the net revenue from these products will be sufficient to justify our
investment in research and development.
IF A MAJOR CUSTOMER CANCELS, REDUCES, OR DELAYS PURCHASES, OUR NET REVENUES
MIGHT DECLINE AND OUR BUSINESS COULD BE ADVERSELY AFFECTED.
Our top five customers accounted for 39.6% of our net revenues for the
three months ended September 30, 2003. One customer. Ingram Micro, Inc.,
accounted for approximately 13.4% and 10.5% of our net revenues for the three
months ended September 30, 2003 and 2002, respectively. Another customer, Tech
Data Corporation, accounted for approximately 10.3% and 9.7% of our net revenues
for the three months ended September 30, 2003 and 2002, respectively. Accounts
receivable attributable to these two domestic customers accounted for
approximately 12.2% and 16.0% of total accounts receivable at September 30, 2003
and June 30, 2003, respectively. The number and timing of sales to our
distributors have been difficult for us to predict. The loss or deferral of one
or more significant sales in a quarter could harm our operating results. We have
in the past, and might in the future, lose one or more major customers. If we
fail to continue to sell to our major customers in the quantities we anticipate,
or if any of these customers terminate our relationship, our reputation, the
perception of our products and technology in the marketplace and the growth of
our business could be harmed. The demand for our products from our OEM, VAR and
systems integrator customers depends primarily on their ability to successfully
sell their products that incorporate our device networking solutions technology.
Our sales are usually completed on a purchase order basis and we have no
long-term purchase commitments from our customers.
Our future success also depends on our ability to attract new customers,
which often involves an extended process. The sale of our products often
involves a significant technical evaluation, and we often face delays because of
our customers' internal procedures used to evaluate and deploy new technologies.
For these and other reasons, the sales cycle associated with our products is
typically lengthy, often lasting six to nine months and sometimes longer.
Therefore, if we were to lose a major customer, we might not be able to replace
the customer on a timely basis or at all. This would cause our net revenues to
decrease and could cause the price of our stock to decline.
WE HAVE ESTABLISHED CONTRACTS AND OBLIGATIONS THAT WERE IMPLEMENTED WHEN WE
ANTICIPATED HIGHER REVENUES AND ACTIVITIES.
We have several agreements that obligate us to facilities or services that
are in excess of our current requirements and are at higher rates than could be
obtained today. It may be necessary that we sublease or otherwise negotiate
settlement of our obligations rather than perform on them as we originally
expected. If we are unable to negotiate a favorable resolution to these
contracts, we may be required to pay the entire cost of our obligations under
the agreement, which could harm our business.
THE AVERAGE SELLING PRICES OF OUR PRODUCTS MIGHT DECREASE, WHICH COULD
REDUCE OUR GROSS MARGINS.
In the past, we have experienced some reduction in the average selling
prices and gross margins of products and we expect that this will continue for
our products as they mature. In the future, we expect competition to increase,
and we anticipate this could result in additional pressure on our pricing. In
addition, our average selling prices for our products might decline as a result
of other reasons, including promotional programs and customers who negotiate
price reductions in exchange for longer-term purchase commitments. In addition,
we might not be able to increase the price of our products in the event that the
prices of components or our overhead costs increase. If this were to occur, our
gross margins would decline. In addition, we may not be able to reduce the cost
to manufacture our products to keep up with the decline in prices.
NEW PRODUCT INTRODUCTIONS AND PRICING STRATEGIES BY OUR COMPETITORS COULD
ADVERSELY AFFECT OUR ABILITY TO SELL OUR PRODUCTS AND COULD REDUCE OUR MARKET
SHARE OR RESULT IN PRESSURE TO REDUCE THE PRICE OF OUR PRODUCTS.
The market for our products is intensely competitive, subject to rapid
change and is significantly affected by new product introductions and pricing
strategies of our competitors. We face competition primarily from companies that
network-enable devices, companies in the automation industry and companies with
significant networking expertise and research and development resources. Our
competitors might offer new products with features or functionality that are
equal to or better than our products. In addition, since we work with open
26
standards, our customers could develop products based on our technology that
compete with our offerings. We might not have sufficient engineering staff or
other required resources to modify our products to match our competitors.
Similarly, competitive pressure could force us to reduce the price of our
products. In each case, we could lose new and existing customers to our
competition. If this were to occur, our net revenues could decline and our
business could be harmed.
OUR INTELLECTUAL PROPERTY PROTECTION MIGHT BE LIMITED.
We have not historically relied on patents to protect our proprietary
rights, although we have recently begun to build a patent portfolio. We rely
primarily on a combination of laws, such as copyright, trademark and trade
secret laws, and contractual restrictions, such as confidentiality agreements
and licenses, to establish and protect our proprietary rights. Despite any
precautions that we have taken:
- - laws and contractual restrictions might not be sufficient to prevent
misappropriation of our technology or deter others from developing similar
technologies;
- - other companies might claim common law trademark rights based upon use that
precedes the registration of our marks;
- - policing unauthorized use of our products and trademarks is difficult,
expensive and time-consuming, and we might be unable to determine the
extent of this unauthorized use;
- - current federal laws that prohibit software copying provide only limited
protection from software pirates; and
- - the companies we acquire may not have taken similar precautions to protect
their proprietary rights.
Also, the laws of other countries in which we market and manufacture our
products might offer little or no effective protection of our proprietary
technology. Reverse engineering, unauthorized copying or other misappropriation
of our proprietary technology could enable third parties to benefit from our
technology without paying us for it, which could significantly harm our
business.
UNDETECTED PRODUCT ERRORS OR DEFECTS COULD RESULT IN LOSS OF NET REVENUES,
DELAYED MARKET ACCEPTANCE AND CLAIMS AGAINST US.
We currently offer warranties ranging from ninety days to two years on each
of our products. Our products could contain undetected errors or defects. If
there is a product failure, we might have to replace all affected products
without being able to book revenue for replacement units, or we may have to
refund the purchase price for the units. Because of our recent introduction of
our line of device servers, we do not have a long history with which to assess
the risks of unexpected product failures or defects for this product line.
Regardless of the amount of testing we undertake, some errors might be
discovered only after a product has been installed and used by customers. Any
errors discovered after commercial release could result in loss of net revenues
and claims against us. Significant product warranty claims against us could harm
our business, reputation and financial results and cause the price of our stock
to decline.
BECAUSE WE ARE DEPENDENT ON INTERNATIONAL SALES FOR A SUBSTANTIAL AMOUNT OF
OUR NET REVENUES, WE FACE THE RISKS OF INTERNATIONAL BUSINESS AND ASSOCIATED
CURRENCY FLUCTUATIONS, WHICH MIGHT ADVERSELY AFFECT OUR OPERATING RESULTS.
Net revenues from international sales represented 22.2% and 22.6% of net
revenues for the three months ended September 30, 2003 and 2002, respectively.
Net revenues from Europe represented 17.8% and 18.7% of our net revenues for the
three months ended September 30, 2003 and 2002, respectively.
We expect that international revenues will continue to represent a
significant portion of our net revenues in the foreseeable future. Doing
business internationally involves greater expense and many additional risks. For
example, because the products we sell abroad and the products and services we
buy abroad are priced in foreign currencies, we are affected by fluctuating
exchange rates. In the past, we have from time to time lost money because of
these fluctuations. We might not successfully protect ourselves against currency
rate fluctuations, and our financial performance could be harmed as a result. In
addition, we face other risks of doing business internationally, including:
- - unexpected changes in regulatory requirements, taxes, trade laws and
tariffs;
- - reduced protection for intellectual property rights in some countries;
27
- - differing labor regulations;
- - compliance with a wide variety of complex regulatory requirements;
- - changes in a country's or region's political or economic conditions;
- - greater difficulty in staffing and managing foreign operations; and
- - increased financial accounting and reporting burdens and complexities.
Our international operations require significant attention from our
management and substantial financial resources. We do not know whether our
investments in other countries will produce desired levels of net revenues or
profitability.
THE MARKET FOR OUR PRODUCTS IS NEW AND RAPIDLY EVOLVING. IF WE ARE NOT ABLE
TO DEVELOP OR ENHANCE OUR PRODUCTS TO RESPOND TO CHANGING MARKET CONDITIONS, OUR
NET REVENUES WILL SUFFER.
Our future success depends in large part on our ability to continue to
enhance existing products, lower product cost and develop new products that
maintain technological competitiveness. The demand for network-enabled products
is relatively new and can change as a result of innovations or changes. For
example, industry segments might adopt new or different standards, giving rise
to new customer requirements. Any failure by us to develop and introduce new
products or enhancements directed at new industry standards could harm our
business, financial condition and results of operations. These customer
requirements might or might not be compatible with our current or future product
offerings. We might not be successful in modifying our products and services to
address these requirements and standards. For example, our competitors might
develop competing technologies based on Internet Protocols, Ethernet Protocols
or other protocols that might have advantages over our products. If this were to
happen, our net revenue might not grow at the rate we anticipate, or could
decline.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk for changes in interest rates relates primarily
to our investment portfolio. We do not use derivative financial instruments for
speculative or trading purposes. We place our investments in instruments that
meet high credit quality standards, as specified in our investment policy.
Information relating to quantitative and qualitative disclosure about market
risk is set forth below and in "Management's Discussion and Analysis of
Financial Condition and Results of Operations-Liquidity and Capital Resources."
INTEREST RATE RISK
Our exposure to interest rate risk is limited to the exposure related to
our cash and cash equivalents, marketable securities and our credit facilities,
which is tied to market interest rates. As of September 30, 2003 and June 30,
2003, we had cash and cash equivalents of $8.9 million and $7.3 million,
respectively, which consisted of cash and short-term investments with original
maturities of ninety days or less, both domestically and internationally. As of
September 30, 2003 and June 30, 2003, we had marketable securities of $4.6
million and $6.8 million, respectively, consisting of obligations of U.S.
Government agencies, state, municipal and county government notes and bonds. We
believe our marketable securities will decline in value by an insignificant
amount if interest rates increase, and therefore would not have a material
effect on our financial condition or results of operations.
FOREIGN CURRENCY RISK
We sell products internationally. As a result, our financial results could
be harmed by factors such as changes in foreign currency exchange rates or weak
economic conditions in foreign markets.
INVESTMENT RISK
As of September 30, 2003 and June 30, 2003, we had a net investment of $5.2
million and $5.4 million, respectively, in Xanboo, a privately held company
which can still be considered in the start-up or development stages. This
investment is inherently risky as the market for the technologies or products
they have under development are typically in the early stages and may never
materialize. There is a risk that we could lose part or all of our investment.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures.
28
Our chief executive officer and our chief financial officer, after
evaluating our "disclosure controls and procedures" (as defined in Securities
Exchange Act of 1934 (the "Exchange Act") Rules 13a-14(c) and 15-d-14(c)) as of
a date (the "Evaluation Date") within 90 days before the filing date of this
Quarterly Report on Form 10-Q, have concluded that as of the Evaluation Date,
our disclosure controls and procedures are effective to ensure that information
we are required to disclose in reports that we file or submit under the Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in Securities and Exchange Commission rules and forms.
(b) Changes in internal controls.
Prior to the evaluation date, we had identified material weaknesses in our
disclosure controls and procedures and have taken corrective actions. In certain
cases, we have identified disclosure control and procedural process improvements
that have been implemented, and will continue to be implemented after the
evaluation date. For example, we have revised our process controls that will
facilitate timely Securities and Exchange Commission filings and have
implemented additional training. We continue to study, plan, and implement
process changes in anticipation of new requirements related to Sarbanes-Oxley
legislation and SEC and Nasdaq rules.
29
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Intellectual Property
From time to time we could encounter other disputes over rights and
obligations concerning intellectual property. We cannot assume that we will
prevail in intellectual property disputes regarding infringement,
misappropriation or other disputes. Litigation in which we are accused of
infringement or misappropriation might cause a delay in the introduction of new
products, require us to develop non-infringing technology, require us to enter
royalty or license agreements, which might not be available on acceptable terms,
or at all, or require us to pay substantial damages, including treble damages if
we are held to have willfully infringed. In addition, we have obligations to
indemnify certain of our customers under some circumstances for infringement of
third-party intellectual property rights. If any claims from third-parties were
to require us to indemnify customers under our agreements, the costs could be
substantial, and our business could be harmed. If a successful claim of
infringement were made against us and we could not develop non-infringing
technology or license the infringed or similar technology on a timely and
cost-effective basis, our business could be significantly harmed.
SEC Investigation
The SEC is conducting a formal investigation of the events leading up to
our restatement of our financial statements on June 25, 2002. The Department of
Justice is also conducting an investigation concerning events related to this
restatement.
Class Action Lawsuits
On May 15, 2002, Stephen Bachman filed a class action complaint entitled
Bachman v. Lantronix, Inc., et al., No. 02-3899, in the U.S. District Court for
the Central District of California against us and certain of our current and
former officers and directors alleging violations of the Securities Exchange Act
of 1934 and seeking unspecified damages. Subsequently, six similar actions were
filed in the same court. Each of the complaints purports to be a class action
lawsuit brought on behalf of persons who purchased or otherwise acquired our
common stock during the period of April 25, 2001 through May 30, 2002,
inclusive. The complaints allege that the defendants caused us to improperly
recognize revenue and make false and misleading statements about our business.
Plaintiffs further allege that the defendants materially overstated our reported
financial results, thereby inflating our stock price during our securities
offering in July 2001, as well as facilitating the use of our common stock as
consideration in acquisitions. The complaints have subsequently been
consolidated into a single action and the court has appointed a lead plaintiff.
The lead plaintiff filed a consolidated amended complaint on January 17, 2003.
The amended complaint now purports to be a class action brought on behalf of
persons who purchased or otherwise acquired our common stock during the period
of August 4, 2000 through May 30, 2002, inclusive. The amended complaint
continues to assert that we and the individual officer and director defendants
violated the 1934 Act, and also includes alleged claims that we and these
officers and directors violated the Securities Act of 1933 arising from our
Initial Public Offering in August 2000. We filed a motion to dismiss the
additional allegations on March 3, 2003. The Court has taken the motion under
submission. We have not yet answered the complaint, discovery has not commenced,
and no trial date has been established.
Derivative Lawsuit
On July 26, 2002, Samuel Ivy filed a shareholder derivative complaint
entitled Ivy v. Bernhard Bruscha, et al., No. 02CC00209, in the Superior Court
of the State of California, County of Orange, against certain of our current and
former officers and directors. On January 7, 2003, the plaintiff filed an
amended complaint. The amended complaint alleges causes of action for breach of
fiduciary duty, abuse of control, gross mismanagement, unjust enrichment, and
improper insider stock sales. The complaint seeks unspecified damages against
the individual defendants on our behalf, equitable relief, and attorneys' fees.
We filed a demurrer/motion to dismiss the amended complaint of February 13,
2003. The basis of the demurrer is that the plaintiff does not have standing to
bring this lawsuit since plaintiff has never served a demand on our Board the
our Board take certain actions on our behalf. On April 17, 2003, the Court
overruled our demurrer. All defendants have answered the complaint and generally
denied the allegations. Discovery has commenced, but no trial date has been
established.
Securities Claims and Employment Claims Brought by the Co-Founders of USSC
On August 23, 2002, a complaint entitled Dunstan v. Lantronix, Inc., et
al., was filed in the Circuit Court of the State of Oregon, County of Multnomah,
against us and certain of our current and former officers and directors by the
cofounders of USSC. The complaint and subsequently filed arbitration demand
alleged Oregon state law claims for securities violations, fraud, and
negligence, as well as other claims related to our acquisition of USSC.
Plaintiffs sought more than $14.0 million in damages, interest, attorneys' fees,
30
costs, expenses, and an unspecified amount of punitive damages. The parties
participated in a mediation on June 30, 2003, and subsequently reached an
agreement to settle the dispute. Pursuant to the parties' settlement agreement,
we released to the plaintiffs approximately $400,000 in cash and 49,038 shares
of our common stock that had been held in an escrow since December 2000 as part
of the acquisition of USSC. On September 15, 2003, we also issued to the
plaintiffs 1,726,703 additional shares of our common stock worth approximately
$1.5 million, which was recorded in our results of operations as litigation
settlement costs for the year ended June 30, 2003. In exchange, the plaintiffs
released all claims against all defendants.
Employment Suit Brought by Former CFO and COO Steven Cotton
On September 6, 2002, Steven Cotton, our former CFO and COO, filed a
complaint entitled Cotton v. Lantronix, Inc., et al., No. 02CC14308, in the
Superior Court of the State of California, County of Orange. The complaint
alleges claims for breach of contract, breach of the covenant of good faith and
fair dealing, wrongful termination, misrepresentation, and defamation. The
complaint seeks unspecified damages, declaratory relief, attorneys' fees and
costs. Discovery has not commenced and no trial date has been established.
We filed a motion to dismiss on October 16, 2002, on the grounds that Mr.
Cotton's complaints are subject to the binding arbitration provisions in Mr.
Cotton's employment agreement. On January 13, 2003, the Court ruled that five
of the six counts in Mr. Cotton's complaint are subject to binding arbitration.
The court is staying the sixth count, for declaratory relief, until the
underlying facts are resolved in arbitration. No arbitration date has been set.
Securities Claims Brought by Former Shareholders of Synergetic
On October 17, 2002, Richard Goldstein and several other former shareholders of
Synergetic filed a complaint entitled Goldstein, et al v. Lantronix, Inc., et al
in the Superior Court of the State of California, County of Orange, against
certain of our former officers and directors. Plaintiffs filed an amended
complaint on January 7, 2003. The amended complaint alleges fraud, negligent
misrepresentation, breach of warranties and covenants, breach of contract and
negligence, all stemming from our acquisition of Synergetic. The complaint
seeks an unspecified amount of damages, interest, attorneys' fees, costs,
expenses, and an unspecified amount of punitive damages. On May 5, 2003, the
Company answered the complaint and generally denied the allegations in the
complaint. Discovery has commenced but no trial date has been established.
Suit filed by Lantronix Against Logical Solutions, Inc.
On March 25, 2003, we filed in Connecticut state court (Judicial District
of New Haven) a complaint entitled Lantronix, Inc. and Lightwave Communications,
Inc. v. Logical Solutions, Inc., et. al. This is an action for unfair and
deceptive trade practices, unfair competition, unjust enrichment, conversion,
misappropriation of trade secrets and tortuous interference with contractual
rights and business expectancies. We seek preliminary and permanent injunctive
relief and damages. The individual defendants are all former employees of
Lightwave Communications, a company that we acquired in June 2001. The Court
held a non-jury trial October 10-17, 2003; closing arguments are set for
November 14, 2003.
Other
From time to time, we are subject to other legal proceedings and claims in
the ordinary course of business. We currently are not aware of any such legal
proceedings or claims that we believe will have, individually or in the
aggregate, a material adverse effect on our business, prospects, financial
position, operating results or cash flows.
Although we believe that the claims or any litigation arising therefrom
will have no material impact on our business, all of the above matters are in
either the pleading stage or the discovery stage, and we cannot predict their
outcomes with certainty.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On August 23, 2002, a complaint entitled Dunstan v. Lantronix, Inc., et
al., was filed in the Circuit Court of the State of Oregon, County of Multnomah,
against us and certain of our current and former officers and directors by the
cofounders of USSC. The complaint and subsequently filed arbitration demand
alleged Oregon state law claims for securities violations, fraud, and
negligence, as well as other claims related to our acquisition of USSC.
Plaintiffs sought more than $14.0 million in damages, interest, attorney's fees,
costs, expenses, and an unspecified amount of punitive damages. The parties
participated in a mediation on June 30, 2003, and subsequently reached an
agreement to settle the dispute. Pursuant to the parities' settlement agreement,
we released to the plaintiffs approximately $400,000 in cash and 49,038 shares
of our common stock that had been held in an escrow since December 2000 as part
of the acquisition of USSC. On September 15, 2003, we also issued to the
plaintiffs 1,726,703 additional shares of our common stock worth approximately
31
$1.5 million, which was recorded in our results of operations as litigation
settlement costs for the year ended June 30, 2003. In exchange, the plaintiffs
released all claims against all defendants.
In January 2002, we entered into a two-year line of credit with a bank in
an amount not to exceed $20.0 million. Borrowings under the line of credit bear
interest at either (i) the prime rate or (ii) the LIBOR rate plus 2.0%. We were
required to pay a $100,000 facility fee of which $50,000 was paid upon the
closing and $50,000 was to be paid. We are also required to pay a quarterly
unused line fee of .125% of the unused line of credit balance. Since
establishing the line of credit, we have twice reduced the amount of the line,
modified customary financial covenants, and adjusted the interest rate to be
charged on borrowings to the prime rate plus .50%, and eliminated the LIBOR
option. Effective July 25, 2003, we further modified this line of credit,
reducing the revolving line to $5.0 million, and adjusting the customary
affirmative and negative covenants. We are also required to maintain certain
financial ratios as defined in the agreement. The agreement has an annual
revolving maturity date that renews on the effective date. The renewal $50,000
facility fee was reduced to $12,500 and was paid. Prior to any advances being
made under the line of credit, the bank is required to complete a field
examination to determine its borrowing base. To date, we have not borrowed
against this line of credit. We are currently in compliance with the revised
financial covenants of the July 25, 2003 amended line of credit. Pursuant to our
line of credit, we are restricted from paying any dividends. We have secured two
deposits totaling approximately $365,000 under our line of credit.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
In accord with Section 10A(i)(2) of the Securities Exchange Act of 1934, as
added by Section 202 of the Sarbanes-Oxley Act of 2002, the company is
responsible for listing the non-audit services approved in the three months
ended September 30, 2003, by the company's Audit Committee to be performed by
the company's external auditor. Non-audit services are defined in the law as
services other than those provided in connection with an audit or a review of
the financial statements of the company. The Audit Committee did not engage the
outside auditors in any non-audit related services in the three months ended
September 30, 2003.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ------ -------------------------
99.1 Certification of CEO Pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
99.2 Certification of CFO Pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
None.
32
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, as amended,
Lantronix has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Irvine, State of
California, on the 7th day of November, 2003.
LANTRONIX, INC.
By: /s/ James W. Kerrigan
---------------------
JAMES W. KERRIGAN
-----------------
CHIEF FINANCIAL OFFICER
CERTIFICATIONS
I, Marc H. Nussbaum, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Lantronix, Inc. ;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the Company and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
33
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
November 7, 2003
/s/ Marc H. Nussbaum
- ---------------------------
Marc H. Nussbaum
Chief Executive Officer
CERTIFICATIONS
I, James W. Kerrigan, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Lantronix, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
34
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
November 7, 2003
/s/ James W. Kerrigan
- ---------------------
James W. Kerrigan
Chief Financial Officer
================================================================================
CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER
PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
I, Marc H. Nussbaum, certify, pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly
Report of Lantronix, Inc. on Form 10-Q for the fiscal quarter ended September
30, 2003, fully complies with the requirements of Section 13(a) or 15(d) of the
Securities Exchange Act of 1934 and that information contained in such Quarterly
Report on Form 10-Q fairly presents in all material respects the financial
condition and results of operations of Lantronix, Inc.
By: /s/ Marc H. Nussbaum
-------------------------
Name: Marc Nussbaum
Title: Chief Executive Officer
I, James W. Kerrigan, certify, pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly
Report of Lantronix, Inc. on Form 10-Q for the fiscal quarter ended September
30, 2003, fully complies with the requirements of Section 13(a) or 15(d) of the
Securities Exchange Act of 1934 and that information contained in such Quarterly
Report on Form 10-Q fairly presents in all material respects the financial
condition and results of operations of Lantronix, Inc.
By: /s/ James W. Kerrigan
-------------------------
Name: James W. Kerrigan
Title: Chief Financial Officer
35