UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark one)
[X] Quarterly report pursuant to section 13 or 15(d)
of the Securities Exchange Act of 1934
FOR THE QUARTERLY PERIOD ENDED JULY 31, 2004
[_] Transition report pursuant to section 13 or 15(d) of the
Securities and Exchange Act of 1934
For the transition period from _______ to ________
Commission file number 0-8419
SBE, INC.
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(Exact name of registrant as specified in its charter)
Delaware 94-1517641
------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2305 Camino Ramon, Suite 200, San Ramon, California 94583
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(Address of principal executive offices and zip code)
(925) 355-2000
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(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 Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [_] No [X]
The number of shares of Registrant's Common Stock outstanding as of July 31,
2004 was 5,082,918.
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SBE, INC.
INDEX TO JULY 31, 2004 FORM 10-Q
PART I FINANCIAL INFORMATION
ITEM 1 Financial Statements (unaudited)
Condensed Consolidated Balance Sheets as of
July 31, 2004 and October 31, 2003..............................3
Condensed Consolidated Statements of Operations for the
three and nine months ended July 31, 2004 and 2003..............4
Condensed Consolidated Statements of Cash Flows for the
nine months ended July 31, 2004 and 2003........................5
Notes to Condensed Consolidated Financial Statements...............6
ITEM 2 Management's Discussion and Analysis of Financial
Condition and Results of Operations......................11
ITEM 3 Quantitative and Qualitative Disclosures about
Market Risk..............................................26
ITEM 4 Controls and Procedures..................................26
PART II OTHER INFORMATION
ITEM 6 Exhibits and Reports on Form 8-K.........................27
SIGNATURES...........................................................30
EXHIBITS.............................................................31
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SBE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
July 31, October 31,
2004 2003
--------- ---------
(Unaudited)
Current assets:
Cash and cash equivalents $ 1,497 $ 1,378
Trade accounts receivable, net 2,682 1,818
Inventories 2,535 1,880
Other 272 240
-------- --------
Total current assets 6,986 5,316
Property, plant and equipment, net 314 389
Capitalized software costs, net 189 120
Intellectual property, net 816 1,122
Other 28 28
-------- --------
Total assets $ 8,333 $ 6,975
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 1,065 $ 696
Accrued payroll and employee benefits 144 184
Other accrued liabilities and deferred revenue 491 491
-------- --------
Total current liabilities 1,700 1,371
Other long-term liabilities 1 217
-------- --------
Total liabilities 1,701 1,588
-------- --------
Commitments
Stockholders' equity:
Common stock 15,745 15,302
Note receivable from stockholder -- (142)
Accumulated deficit (9,113) (9,773)
-------- --------
Total stockholders' equity 6,632 5,387
-------- --------
Total liabilities and stockholders' equity $ 8,333 $ 6,975
======== ========
See notes to condensed consolidated financial statements.
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SBE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
Three months ended Nine months ended
July 31, July 31,
2004 2003 2004 2003
-------- ------- -------- --------
Net sales $ 2,899 $ 1,621 $ 8,846 $ 5,249
Cost of sales 1,359 559 4,101 1,971
-------- ------- -------- --------
Gross profit 1,540 1,062 4,745 3,278
Product research and development 548 334 1,596 913
Sales and marketing 539 361 1,592 1,004
General and administrative 376 381 1,140 1,259
Restructuring costs recovery -- (154) -- (154)
Loan loss recovery -- -- (239) --
-------- ------- -------- --------
Total operating expenses 1,463 922 4,089 3,022
-------- ------- -------- --------
Operating income 77 140 656 256
Interest income 2 6 4 21
Other income (expense) -- (4) -- (10)
-------- ------- -------- --------
Income before income taxes 79 142 660 267
Income tax provision (benefit) -- 1 -- (17)
-------- ------- -------- --------
Net income $ 79 $ 141 $ 660 $ 284
======== ======= ======== ========
Basic income per share $ 0.02 $ 0.03 $ 0.13 $ 0.07
======== ======= ======== ========
Diluted income per share $ 0.01 $ 0.03 $ 0.11 $ 0.07
======== ======= ======== ========
Basic - weighted average shares
used in per share computations 5,078 4,288 5,000 4,145
======== ======= ======== ========
Diluted - weighted average shares
used in per share computations 5,866 4,614 6,009 4,276
======== ======= ======== ========
See notes to condensed consolidated financial statements.
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SBE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Nine months ended
July 31,
2004 2003
-------- --------
Cash flows from operating activities:
Net income $ 660 $ 284
Adjustments to reconcile net income to net cash
used in operating activities:
Depreciation and amortization:
Property and equipment 160 254
Software 42 26
Amortization of intellectual property 306 --
Loss on abandonment of equipment -- 13
Changes in operating assets and liabilities:
Accounts receivable (864) (117)
Inventories (655) 307
Other assets (32) (62)
Trade accounts payable 369 (183)
Other accrued liabilities (256) (573)
-------- --------
Net cash used in operating activities (270) (51)
-------- --------
Cash flows from investing activities:
Purchases of property, plant and equipment (85) (77)
Capitalized software costs (111) (10)
-------- --------
Net cash used in investing activities (196) (87)
-------- --------
Cash flows from financing activities:
Proceeds from the sale of common stock and the
exercise of warrants 202 478
Proceeds from repayment of stockholder note 142 25
Proceeds from exercise of stock options 241 43
-------- --------
Net cash provided by financing activities 585 546
-------- --------
Net increase in cash and cash equivalents 119 408
Cash and cash equivalents at beginning of period 1,378 1,582
-------- --------
Cash and cash equivalents at end of period $ 1,497 $ 1,990
======== ========
See notes to condensed consolidated financial statements.
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SBE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. INTERIM PERIOD REPORTING:
These condensed consolidated financial statements of SBE, Inc. are unaudited and
include all adjustments, consisting of normal recurring adjustments, that are,
in the opinion of management, necessary for a fair presentation of the financial
position and results of operations and cash flows for the interim periods. The
results of operations for the three and nine and months ended July 31, 2004 are
not necessarily indicative of expected results for the full 2004 fiscal year.
Certain information and footnote disclosures normally contained in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. These condensed consolidated financial
statements should be read in conjunction with the financial statements and notes
contained in our Annual Report on Form 10-K for the year ended October 31, 2003.
MANAGEMENT ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles in the U.S. requires us to make estimates and assumptions
that affect the reported amounts of assets and liabilities, as well as certain
disclosure of contingent assets and liabilities as of the date of the financial
statements and the reported amounts of net sales and expenses during the
reporting period. Actual results could differ from these estimates. Significant
estimates and judgments made by us relate to matters such as potential liability
for sales allowances, warranty obligations and indemnification obligations,
collectibility of accounts receivable, realizability of inventories and
recoverability of capitalized software and deferred tax assets.
2. INVENTORIES:
Inventories were comprised of the following (in thousands):
July 31, October 31,
2004 2003
------- -------
Finished goods $ 1,568 $ 726
Parts and materials 967 1,154
------- -------
$ 2,535 $ 1,880
======= =======
3. INTANGIBLE ASSETS:
Intangible Assets represent intellectual property that consists of the
allocation of costs associated with the purchase of current and the design of
future products from Antares Microsystems on August 7, 2003. All capitalized
intellectual property is amortized to cost of goods expense on a straight line
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basis over thirty-six months which is the expected useful life and does not
materially differ from the expected cash inflow from the sale of the acquired
Antares product line. Intangible Assets subject to amortization are as follows
(in thousands):
Accumulated
Gross Amortization Net
------ ------------ ----
Intellectual Property $1,224 $408 $816
====== ---========= ====
Amortization expense of intellectual property for the three months and nine
months ending July 31, 2004 was $102,000 and $306,000 and is included in cost of
sales.
The estimated aggregate remaining amortization expense for each of the
succeeding fiscal years is as follows (in thousands):
2004 $ 102
2005 408
2006 306
-----
Total $ 816
=====
4. RESTRUCTURING COSTS:
The following table sets forth an analysis of the components of our
restructuring reserve relating to lease terminations and the payments made
against it during the nine-month period ended July 31, 2004 (in thousands):
Restructuring accrual at October 31, 2003 $ 58
Less: Cash paid for accrued lease costs (28)
-----
Total restructuring accrual included in other
accrued liabilities and deferred revenue $ 30
=====
5. NET INCOME PER SHARE:
Basic income per common share for the three and nine months ended July 31, 2004
and 2003 was computed by dividing the net income for such period by the weighted
average number of shares of common stock outstanding for such period. Common
stock equivalents for the three and nine months ended July 31, 2004 were 788,082
and 1,008,334, respectively, and have been included in the calculation of
diluted net income per share. The common stock equivalents for the three and
nine months ended July 31, 2004 include the following items: 1) 652,316 and
848,681 vested employee stock options, respectively; 2) 66,821 and 90,708 common
stock equivalents subject to warrants, respectively; 3) 68,945 shares of common
stock to be issued related to the purchase of Antares, respectively. Common
stock equivalents for the three and nine months ended July 31, 2003, were
325,711 and 131,110, respectively, and have been included in the calculation of
diluted net income per share.
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Three months ended Nine months ended
July 31, July 31,
------------------ ------------------
2004 2003 2004 2003
-------- ------- ------- --------
BASIC
Weighted average number of
common shares outstanding 5,078 4,288 5,000 4,145
-------- ------- ------- --------
Number of shares for computation of
net income per share 5,078 4,288 5,000 4,145
======== ======= ======= ========
Net income $ 79 $ 141 $ 660 $ 284
======== ======= ======= ========
Net income per share $ 0.02 $ 0.03 $ 0.13 $ 0.07
======== ======= ======= ========
DILUTED
Weighted average number of
common shares outstanding 5,078 4,288 5,000 4,145
Shares issuable pursuant to options
granted under stock option plans
and warrants granted, less assumed
repurchase at the average fair
market value for the period 788 326 1,009 131
-------- ------- ------- --------
Number of shares for computation of
net income per share 5,866 4,614 6,009 4,276
======== ======= ======= ========
Net income $ 79 $ 141 $ 660 $ 284
======== ======= ======= ========
Net income per share $ 0.01 $ 0.03 $ 0.11 $ 0.07
======== ======= ======= ========
6. STOCK BASED COMPENSATION:
At July 31, 2004, we had two stock-based employee compensation plans and one
stock-based director compensation plan. We account for these plans under the
recognition and measurement principles of Accounting Principles Board (APB)
Opinion No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. Accordingly, no stock-based employee compensation cost has been
recognized in net income for the stock option plans. Had compensation cost for
our stock option plans been determined based on the fair value recognition
provisions of Statement of Financial Accounting Standards (SFAS) No. 123,
"Accounting for Stock-Based Compensation," our net income (loss) and income
(loss) per share would have been as follows (in thousands):
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Three Months Nine Months
Ended July 31, Ended July 31,
2004 2003 2004 2003
------- ------- ------- -------
Net income, as reported $ 79 $ 141 $ 660 $ 284
Add: Total stock-based compensation
expense (benefit) included in the net
income determined under the recognition
and measurement principles of APB
Opinion 25 -- -- -- --
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects 150 149 316 374
------- ------- ------- -------
Pro forma net income (loss) $ (71) $ (8) $ 245 $ (239)
======= ======= ======= =======
Income (loss) per share:
Basic - as reported $ 0.02 $ 0.03 $ 0.13 $ 0.07
======= ======= ======= =======
Basic - pro forma $ (0.01) $ 0.00 $ 0.05 $ (0.06)
======= ======= ======= =======
Diluted - as reported $ 0.01 $ 0.03 $ 0.11 $ 0.07
======= ======= ======= =======
Diluted - pro forma $ (0.01) $ 0.00 $ 0.04 $ (0.06)
======= ======= ======= =======
There were 13,000 stock options granted in the quarter ended July 31, 2004. The
assumptions regarding the annual vesting of stock options were 25% per year for
options granted in 2004. The fair value of each option grant is estimated on the
date of grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions used for grants in 2004: Dividend yield of 0%;
expected volatility of 111%, risk-free interest rate of 3.17%, and expected life
of four years.
7. CONCENTRATION OF RISK:
In the three and nine months ended July 31, 2004 and 2003, most of our sales
were attributable to sales of communications products and were derived from a
limited number of original equipment manufacturer ("OEM") customers. In our
third quarter of fiscal 2004, we had sales to two customers that were each
greater than 10% of our net sales for the quarter. The sales to these two
customers combined totaled 67% of net sales during the third quarter of fiscal
2004. In our third quarter of fiscal 2003, we had sales to one customer that
accounted for greater than 10% of our net sales for the quarter. The sales to
this customer totaled 50% of our net sales for that quarter. In the first nine
months of fiscal 2004, we had sales to two customers that were each greater than
10% of our sales for that period. The sales to these two customers combined
totaled 59% of net sales during the first three quarters of fiscal 2004. In the
first nine months of fiscal 2003, we had sales to one customer that accounted
for greater than 10% of our net sales for that period. The sales to this
customer totaled 52% of our net sales for the first three quarters of fiscal
2003.
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We have two customers that each accounted for more than 10% of our accounts
receivable as of July 31, 2004 compared to one customer that accounted for more
than 10% of our accounts receivable at July 31, 2003.
8. WARRANTY OBLIGATIONS AND OTHER GUARANTEES:
Warranty Reserve:
Our products are sold with warranty provisions that require us to remedy
deficiencies in quality or performance of our products over a specified period
of time, generally 12 months, at no cost to our customers. We accrue the
estimated costs to be incurred in performing warranty services at the time of
revenue recognition and shipment of our products to our customers. Our estimate
of costs to service our warranty obligations is based on historical experience
and expectation of future conditions. To the extent we experience increased
warranty claim activity or increased costs associated with servicing those
claims, the warranty accrual may increase, resulting in decreased gross margin.
The following table sets forth an analysis of our warranty reserve for the nine
month period ended July 31, 2004 (in thousands):
Warranty reserve at October 31, 2003 $53
Less: Cost to service warranty obligations 33
---
Total warranty reserve included in other accrued expenses $20
===
The following is a summary of our agreements that we have determined are within
the scope of the Financial Accounting Standards Board's ("FASB") Interpretation
No. 45 "Guarantor's Accounting and Disclosure Requirements for Guarantees" ("FIN
45").
Indemnification Agreements:
We have agreed to indemnify each of our executive officers and directors for
certain events or occurrences arising as a result of the officer or director
serving in such capacity. The term of the indemnification period is for the
officer's or director's lifetime. The maximum potential amount of future
payments we could be required to make under these indemnification agreements is
unlimited. However, we have a directors' and officers' liability insurance
policy that should enable us to recover a portion of any future amount paid. As
a result of our insurance policy coverage, we believe the estimated fair value
of these indemnification agreements is minimal and have no liabilities recorded
for these agreements as of July 31, 2004 and October 31, 2003.
We enter into agreements with other companies containing indemnification
provisions in the ordinary course of business, typically with business partners,
contractors, customers and landlords. Under these provisions, we generally agree
to indemnify and hold harmless the indemnified party for losses suffered or
incurred by the indemnified party as a result of our activities or, in some
cases, as a result of the indemnified party's activities under the agreement.
These indemnification provisions often relate to representations made by us with
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regard to our intellectual property rights. These indemnification provisions
generally survive termination of the underlying agreement. The maximum potential
amount of future payments we could be required to make under these
indemnification provisions is unlimited. To date, we have not incurred material
costs to defend lawsuits or settle claims related to these indemnification
provisions. As a result, we believe the estimated fair value of these agreements
is minimal. Accordingly, we have no liabilities recorded for these agreements as
of July 31, 2004 and October 31, 2003.
Other:
We are the secondary guarantor on the lease assignment of our previous
headquarters that expires in 2006. We believe we will not have to make any
payments as a result of this guarantee and thus have not recorded a liability at
July 31, 2004.
9. LOAN TO OFFICER
On November 6, 1998, we made a loan to one of our officers and stockholders
which was used by the officer/stockholder to exercise an option to purchase
139,400 shares of our common stock and related taxes. The loan, as amended, was
collateralized by shares of our common stock, bore interest at a rate of 2.48%
per annum, with interest due annually and the entire amount of the principal was
due on December 14, 2003.
On October 31, 2002, we determined that it was probable that we would be unable
to fully recover the balance of the loan on its due date of December 14, 2003.
Accordingly, a valuation allowance of $474,000 was recorded against the loan at
October 31, 2002.
During the fourth quarter of fiscal 2003, the officer repaid $362,800 of the
loan and as a result, we recognized a benefit of $235,000 related to the
reversal of the loan impairment charge taken by us in fiscal 2002. During the
first quarter of fiscal 2004, the officer repaid the remaining loan balance in
full and as a result, we recorded a benefit of $239,000 relating to the reversal
of the remaining loan impairment charge.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD LOOKING STATEMENTS
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that involve risks and
uncertainties. Words such as "believes," "anticipates," "expects," "intends" and
similar expressions are intended to identify forward-looking statements, but are
not the exclusive means of identifying such statements. Readers are cautioned
that the forward-looking statements reflect our analysis only as of the date
hereof, and we assume no obligation to update these statements. Actual events or
results may differ materially from the results discussed in or implied by the
forward-looking statements. Factors that might cause such a difference include,
but are not limited to, those risks and uncertainties set forth under the
caption "Risk Factors" below.
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The following discussion should be read in conjunction with the Financial
Statements and the Notes thereto included in Item 1 of this Quarterly Report on
Form 10-Q and in our Form 10-K for the fiscal year ended October 31, 2003.
RISK FACTORS
In addition to the other information in this Quarterly Report on Form 10-Q,
stockholders or prospective investors should carefully consider the following
risk factors:
RISKS RELATED TO OUR BUSINESS
OUR FUTURE SUCCESS DEPENDS ON OUR ABILITY TO REPLACE NET SALES PREVIOUSLY
GENERATED BY SALES OF VME PRODUCTS TO HP.
In the first three quarters of fiscal 2004 and 2003, sales of our Versa Module
Europa ("VME") products to The Hewlett-Packard Company ("HP") accounted for 47%
and 52%, respectively, of our net sales. We shipped $1.6 million of VME products
to HP over the first three quarters of fiscal 2003 pursuant to an end-of-life
product discontinuation purchase order that is no longer in effect. In September
2003, HP notified us that they would purchase an additional $2.6 million of VME
products, with deliveries scheduled for our fourth quarter of fiscal 2003 and
the first two quarters of fiscal 2004. In our first two quarters of 2004, we
shipped $2.0 million of VME products to HP under the September 2003 purchase
order. In April 2004, we received an additional $2.9 million purchase order of
VME products from HP and shipped $1.2 million against this purchase order in the
third quarter of fiscal 2004 with deliveries for the remaining $1.7 million
scheduled for the fourth quarter of fiscal 2004 and first quarter of fiscal
2005. While we have continued to sell VME products to HP pursuant to individual
purchase orders, we believe that HP will cease purchasing our VME products in
fiscal 2005 as the HP products in which our VME products are embedded are phased
out. Our net sales derived from these individual purchase orders have been
significant and when HP ceases to purchase VME products we will need to increase
our net sales from other sources in order to be successful. We can provide no
assurance that we will succeed in obtaining new orders from existing or new
customers sufficient to replace or exceed the net sales attributable to HP.
WE SELL OUR PRODUCTS TO A SMALL NUMBER OF OEM CUSTOMERS, AND THE LOSS OF ANY OF
THEM, OR THEIR FAILURE TO SELL THEIR PRODUCTS, WOULD LIMIT OUR ABILITY TO
GENERATE NET SALES.
In fiscal 2003 and the first three quarters of fiscal 2004, most of our sales
were derived from a limited number of OEM customers, primarily HP. We expect
that we will always derive most our sales from a limited number of OEM
customers. Orders by our OEM customers are affected by factors such as new
product introductions, product life cycles, inventory levels, manufacturing
strategies, contract awards, competitive conditions and general economic
conditions. Our sales to any single OEM customer are also subject to significant
variability from quarter to quarter. Such fluctuations may have a material
adverse effect on our operating results. A significant reduction in orders from
any of our OEM customers would have a material adverse effect on our operating
results, financial condition and cash flows. None of our customers is bound by a
long-term purchase contract. Thus, we cannot provide any assurance that we will
continue to sell our products at existing levels, if at all, to our existing OEM
customers.
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BECAUSE OF OUR DEPENDENCE ON SINGLE SUPPLIERS FOR SOME COMPONENTS, WE MAY BE
UNABLE TO OBTAIN AN ADEQUATE SUPPLY OF SUCH COMPONENTS, OR WE MAY BE REQUIRED TO
PAY HIGHER PRICES OR TO PURCHASE COMPONENTS OF LESSER QUALITY.
The chipsets used in most of our products are currently available only from
Motorola. In addition, certain other components are currently available only
from single suppliers. Suppliers may discontinue or upgrade some of the
components used in our products, which could require us to redesign a product to
incorporate newer or alternative technology. The inability to obtain sufficient
key components as required, or to develop alternative sources if and as required
in the future, could result in delays or reductions in product shipments or
margins that, in turn, would have a material adverse effect on our business,
operating results and financial condition. If enough components are unavailable,
we may have to pay a premium in order to meet customer demand. Paying premiums
for parts, building inventories of scarce parts and obsolesce of existing
inventories could lower or eliminate our profit margin, harm our financial
condition and otherwise harm our business. To offset potential component
shortages, we have in the past, and may in the future, carry an inventory of
these components. As a result, our inventory of components parts may become
obsolete and may result in write-downs.
IF WE FAIL TO DEVELOP AND PRODUCE NEW PRODUCTS, WE MAY LOSE SALES AND OUR
REPUTATION MAY BE HARMED.
We focus a significant portion of our research and development, marketing and
sales efforts on our HighWire, WAN/LAN and TCP/IP Offload Engine ("TOE") Adapter
products. The success of these products is dependent on several factors,
including timely completion of new product designs, achievement of acceptable
manufacturing quality and yields, introduction of competitive products by other
companies and market acceptance of our products. If the HighWire and Adapter
products or other new products developed by us do not gain market acceptance,
our business, operating results, financial condition and cash flows would be
materially adversely affected.
THE COMMUNICATIONS AND STORAGE PRODUCTS MARKET IS INTENSELY COMPETITIVE, AND OUR
FAILURE TO COMPETE EFFECTIVELY COULD REDUCE OUR NET REVENUES AND MARGINS.
We compete directly with vendors of terminal servers, modems, remote control
software, terminal emulation software and application-specific communications
and storage solutions. We also compete with suppliers of routers, hubs, network
interface cards and other data communications and storage products. In the
future, we expect competition from companies offering client/server access
solutions based on emerging technologies such as switched digital telephone
services, iSCSI, TCP/IP Offload Engine ("TOE") and other technologies. In
addition, we may encounter increased competition from operating system and
network operating system vendors to the extent such vendors include full
communications and storage capabilities in their products. We may also encounter
future competition from telephony service providers (such as AT&T or the
regional Bell operating companies) that may offer communications services
through their telephone networks.
-13-
Increased competition with respect to any of our products could result in price
reductions and loss of market share, which would adversely affect our business,
operating results, financial condition and cash flows. Many of our current and
potential competitors have greater financial, marketing, technical and other
resources than we do. There can be no assurance that we will be able to compete
successfully with our existing competitors or will be able to compete
successfully with new competitors.
OUR SALES AND OPERATING RESULTS HAVE FLUCTUATED, AND ARE LIKELY TO CONTINUE TO
FLUCTUATE SIGNIFICANTLY IN FUTURE PERIODS CAUSING AND MAY CONTINUE TO CAUSE, OUR
STOCK PRICE TO FALL AS A RESULT OF FAILURE TO MEET THE EXPECTATIONS OF
SECURITIES ANALYSTS OR INVESTORS.
Our quarterly operating results have fluctuated significantly in the past and
are likely to fluctuate significantly in the future due to several factors, some
of which are outside our control and which we may not be able to predict,
including the existence or absence of significant orders from OEM customers,
fluctuating market demand for, and declines in the average selling prices of our
products, success in achieving design wins, delays in the introduction of our
new products, competitive product introductions, the mix of products sold,
changes in our distribution network, the failure to anticipate changing customer
product requirements, the cost and availability of components and general
economic conditions. We generally do not operate with a significant order
backlog, and a substantial portion of our net sales in any quarter is derived
from orders booked in that quarter. Accordingly, our sales expectations are
based almost entirely on our internal estimates of future demand and not on firm
customer orders.
Due to the adverse economic conditions in the telecommunications industry, our
customers now typically require a "just-in-time" ordering and delivery cycle
where they will place a purchase order with us after they receive an order from
their customer. This "just-in-time" inventory purchase cycle by our customers
has made forecasting of our future sales volumes very difficult and has required
us to build up inventory.
Based on the foregoing, we believe that quarterly operating results are likely
to vary significantly in the future and that period-to-period comparisons of our
results of operations are not necessarily meaningful and should not be relied
upon as indications of future performance. Further, it is likely that in some
future quarter our net sales or operating results will be below the expectations
of public market analysts and investors. In such event, the price of our common
stock is likely to fall.
IF WE ARE UNABLE TO KEEP UP WITH THE RAPID TECHNOLOGICAL CHANGES THAT
CHARACTERIZE OUR INDUSTRY, OUR BUSINESS WOULD SUFFER.
The markets for our products are characterized by rapidly changing technologies,
evolving industry standards and frequent new product introductions. Our future
success will depend on our ability to enhance our existing products and to
introduce new products and features to meet and adapt to changing customer
requirements and emerging technologies such as ACTA form factors with AMC
daughter cards, TCP/IP offload engines ("TOE"), Encryption, 10 Gigabit Ethernet
("10Gig"), Voice over Internet Protocol ("VoIP") and Third Generation Wireless
-14-
Services ("3G"). The development of new and enhanced technology and products is
a complex and uncertain process requiring high levels of innovation, highly
skilled engineering and development personnel, and the accurate anticipation of
technological and marketing trends. There can be no assurance that we will be
successful in identifying, developing, manufacturing, marketing or supporting
new products or enhancing our existing products on a timely basis, if at all. In
addition, there can be no assurance that services, products or technologies
developed by others will not render our products noncompetitive or obsolete.
WE DEPEND ON OUR KEY PERSONNEL. IF WE ARE UNABLE TO RETAIN OUR CURRENT PERSONNEL
AND HIRE ADDITIONAL QUALIFIED PERSONNEL AS NEEDED, OUR BUSINESS WOULD BE HARMED.
We are highly dependent on the technical, management, marketing and sales skills
of a limited number of key employees. We do not have employment agreements with,
or life insurance on the lives of, any of our key employees. The loss of the
services of any key employees could adversely affect our business and operating
results. Our future success will depend on our ability to continue to attract
and retain highly talented personnel to the extent our business grows.
Competition for qualified personnel in the networking industry, and in the San
Francisco Bay Area, is intense. There can be no assurance that we will be
successful in retaining our key employees or that we can attract or retain
additional skilled personnel as required.
OUR FUTURE CAPITAL NEEDS MAY EXCEED OUR ABILITY TO RAISE CAPITAL.
While we believe that our existing cash balances and our anticipated cash flow
from operations will satisfy our working capital needs for the next 12 months,
we cannot give assurance that this will be the case. Declines in our net sales
or a failure to keep expenses in line with net sales could require us to seek
additional financing in the future. In addition, should we experience a
significant growth in customer orders, we may be required to seek additional
capital to meet our working capital needs through the issuance of equity or debt
securities and we may not be able to sell these equity or debt securities under
then-existing market conditions or on acceptable terms, if at all. If additional
funds are raised through the issuance of equity or debt securities, these equity
securities could have rights, privileges or preferences senior to those of
common stock. If we issue debt securities, we may be forced to pay high interest
rates or agree to debt covenants that impose onerous restrictions on our
operations. The sale of equity or debt securities could result in additional
dilution to current stockholders.
WE MAY BE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, WHICH COULD REDUCE ANY
COMPETITIVE ADVANTAGE WE HAVE.
Although we believe that our future success will depend primarily on continuing
innovation, sales, marketing and technical expertise, the quality of product
support and customer relations, we must also protect the proprietary technology
contained in our products. We currently hold four technology related patents but
rely primarily on a combination of copyright, trademark, trade secret laws and
contractual provisions to establish and protect proprietary rights in our
products. There can be no assurance that steps taken by us in this regard will
be adequate to deter misappropriation or independent third-party development of
our technology. Although we believe that our products and technology do not
infringe on the proprietary rights of others, there can be no assurance that
third parties will not assert infringement claims against us.
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RISKS ASSOCIATED WITH OWNERSHIP OF OUR COMMON STOCK
OUR COMMON STOCK HAS BEEN AT RISK FOR DELISTING FROM THE NASDAQ SMALLCAP MARKET.
IF IT IS DELISTED, OUR STOCK PRICE AND YOUR LIQUIDITY MAY BE IMPACTED.
Our common stock is currently listed on the Nasdaq SmallCap Market. Nasdaq has
requirements that a company must meet in order to remain listed on the Nasdaq
SmallCap Market. These requirements include maintaining a minimum closing bid
price of $1.00 and minimum stockholders' equity of $2.5 million. The closing bid
price for our common stock was below $1.00 for more than 30 consecutive trading
days during portions of fiscal 2003. Our stockholders' equity as of July 31,
2004 was approximately $6.6 million. Although we currently meet all the minimum
continued listing requirements for the Nasdaq SmallCap Market, should our stock
price again decline, our common stock could be subject to potential delisting
from the Nasdaq SmallCap Market.
If we fail to maintain the standards necessary to be quoted on the Nasdaq
SmallCap Market and our common stock is delisted, trading in our common stock
would be conducted on the OTC Bulletin Board as long as we continue to file
reports required by the Securities and Exchange Commission. The OTC Bulletin
Board is generally considered to be a less efficient market than the Nasdaq
SmallCap Market, and our stock price, as well as the liquidity of our common
stock, may be adversely impacted as a result.
THE MARKET PRICE OF OUR COMMON STOCK IS LIKELY TO CONTINUE TO BE VOLATILE. YOU
MAY NOT BE ABLE TO RESELL YOUR SHARES AT OR ABOVE THE PRICE AT WHICH YOU
PURCHASED SUCH SHARES.
The trading price of our common stock is subject to wide fluctuations in
response to quarter-to-quarter fluctuations in operating results, the failure to
meet analyst estimates, announcements of technological innovations or new
products by us or our competitors, general conditions in the computer and
communications industries and other events or factors. In addition, stock
markets have experienced extreme price and trading volume volatility in recent
years. This volatility has had a substantial effect on the market price of the
securities of many high technology companies for reasons frequently unrelated to
the operating performance of the specific companies. These broad market
fluctuations may adversely affect the market price of our common stock. Our
common stock has historically had relatively small trading volumes. As a result,
small transactions in our common stock can have a disproportionately large
impact on the quoted price of our common stock.
OUR CERTIFICATE OF INCORPORATION AND BYLAWS AND THE DELAWARE GENERAL CORPORATION
LAW CONTAIN PROVISIONS THAT COULD DELAY OR PREVENT A CHANGE IN CONTROL.
Our board of directors has the authority to issue up to 2,000,000 shares of
preferred stock and to determine the price, rights, preferences and privileges
of those shares without any further vote or action by the stockholders. The
rights of the holders of common stock will be subject to, and may be materially
adversely affected by, the rights of the holders of any preferred stock that may
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be issued in the future. The issuance of preferred stock could have the effect
of making it more difficult for a third party to acquire a majority of our
outstanding voting stock. Furthermore, certain other provisions of our
certificate of incorporation and bylaws may have the effect of delaying or
preventing changes in control or management, which could adversely affect the
market price of our common stock. In addition, we are subject to the provisions
of Section 203 of the Delaware General Corporation Law, an anti-takeover law.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OVERVIEW
We architect and provide board-level network communications solutions for OEMs
in both the embedded and enterprise-level information technology ("IT")
computing markets. Our solutions enable both data communications and
telecommunications companies, in addition to enterprise-class high-end server
clients, to rapidly deliver advanced networking and storage products and
services. We offer a broad selection of wide area network ("WAN") such as T1/T3,
local area network ("LAN") such as Gigabit Ethernet, SCSI, Fibre Channel, and
intelligent carrier cards across both the enterprise and embedded server
markets. Our products have been integrated into a variety of applications,
including storage area networks and mission-critical data centers. Our products,
with Linux and Solaris drivers and software, include WAN and LAN interface
adapters, storage network interface cards ("NICs") products such as SCSI and
Fibre Channel, and high performance intelligent communications controllers for
high-end enterprise level servers, workstations, media gateways, routers,
internet access devices, home location registers and data messaging
applications. Our products are distributed worldwide through a direct sales
force, distributors, independent manufacturers' representatives and value-added
resellers. We continue to operate in a single business segment.
CONCENTRATIONS
Our business is characterized by a concentration of sales to a small number of
OEMs and, consequently, the timing of significant orders from major customers
and their product cycles causes fluctuations in our operating results. HP is the
largest of our customers. Sales to HP accounted for 55% and 47% of our net sales
in the three and nine months ended July 31, 2004, respectively, and 50% and 52%
for the same periods in fiscal 2003, respectively. In the third quarter of
fiscal 2004, sales to Data Connection Limited accounted for 11% of net sales, in
addition, Nortel Networks contributed 11% of our revenue for the nine month
period ended July 31, 2004. No other customer accounted for greater than 10% of
net sales in the three or nine months ended July 31, 2004 or 2003. HP accounted
for 58% and 30% of our accounts receivable as of July 31, 2004 and 2003,
respectively. At July 31, 2004, one other customer accounted for greater that
10% of our accounts receivable compared to one other customer as of July 31,
2003. No other customers accounted for more than 10% of our accounts receivable
as of July 31, 2004 or 2003, respectively. Orders by our OEM customers are
affected by factors such as new product introductions, product life cycles,
inventory levels, manufacturing strategy, contract awards, competitive
conditions and general economic conditions. If any of our major customers
reduces orders for our products, we would lose revenues and could suffer damage
to our business reputation.
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BACKLOG
On July 31, 2004, we had a sales backlog of product orders of approximately $3.9
million compared to a sales backlog of product orders of approximately $0.2
million one year ago. Of the July 31, 2004 backlog approximately $1.6 million
relates to sales of VME products for HP compared to no backlog as of July 31,
2003.
We have begun to see a slight recovery in certain segments of our markets, such
as, wireless, VoIP, voice conferencing among others and customers in those
markets have been increasing their ordering levels. As a result we have begun to
increase our headcount in our engineering and production departments. Although
we are responding to current and future customer design and support needs, we
continue to focus on cost containment and cash preservation and monitor our
expense levels very closely.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles in the U.S. requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Significant estimates and judgments made by us
include matters such as indemnifications obligations, accounts receivable,
realizability of inventories and recoverability of capitalized software and
deferred tax assets. Actual results could differ from those estimates.
Our critical accounting policies and estimates include the following:
Revenue Recognition:
Our policy is to recognize revenue for product sales when title transfers and
risk of loss has passed to the customer, which is generally upon shipment of our
products to our customers. We defer and recognize service revenue over the
contractual period or as services are rendered. We estimate expected sales
returns and record the amount as a reduction of revenue and cost of goods sold
("COGS") at the time of shipment. Our policy complies with the guidance provided
by Staff Accounting Bulletin No. 104, "Revenue Recognition in Financial
Statements," issued by the Securities and Exchange Commission. Judgments are
required in evaluating the credit worthiness of our customers. Credit is not
extended to customers and revenue is not recognized until we have determined
that collectibility is reasonably assured. Our sales transactions are
denominated in U.S. dollars. The software component of our products is
considered incidental. We, therefore do not recognize software revenue
separately from the product sale.
Our agreements with OEMs, such as HP, Nortel Networks Corp. and Lockheed Martin,
typically incorporate clauses reflecting the following understandings:
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- all prices are fixed and determinable at the time of sale;
- title and risk of loss pass at the time of shipment (FOB shipping
point);
- collectibility of the sales price is probable (the OEM is obligated
to pay and such obligation is not contingent on the ultimate sale of
the OEM's integrated solution);
- the OEM's obligation to us will not be changed in the event of theft
or physical destruction or damage of the product;
- we do not have significant obligations for future performance to
directly assist in the resale of the product by the OEMs; and
- there is no contractual right of return other than for defective
products.
Our agreements with our distributors include certain product rotation and price
protection rights. All distributors have the right to rotate slow moving
products once each fiscal quarter. The maximum dollar value of inventory
eligible for rotation is equal to 25% of our products purchased by the
distributor during the previous quarter. In order to take advantage of their
product rotation rights, the distributors must order and take delivery of
additional SBE products equal to at least the dollar value of the products that
they want to rotate.
Each distributor is also allowed certain price protection rights. If and when we
reduce or plan to reduce the price of any of our products and the distributor is
holding any of the affected products in inventory, we will credit the
distributor the difference in price when they place their next order with us. We
record an allowance for price protection, reducing our net sales and accounts
receivable. The allowance is based on the price difference of the inventory held
by our stocking distributors at the time we expect to reduce selling prices. We
believe we are able to fully evaluate potential returns and adjustments and
continue to recognize the sale based on shipment to our distributors. Reserves
for the right of return and restocking are established based on the requirements
of SFAS 48, "Revenue Recognition when Right of Return Exists."
During the quarter ended July 31, 2004, $168,000 or 6% of our sales were sold to
distributors compared to $0 in the same quarter of fiscal 2003. During the nine
months ended July 31, 2004, $706,000 or 8% of our sales were sold to
distributors compared to $0 in the same period of fiscal 2003. Our reserves for
distributor programs total approximately $40,000 as of July 31, 2004.
Allowance for Doubtful Accounts:
Our policy is to maintain allowances for estimated losses resulting from the
inability of our customers to make required payments. Credit limits are
established through a process of reviewing the financial history and stability
of each customer. Where appropriate, we obtain credit rating reports and
financial statements of the customer when determining or modifying their credit
limits. We regularly evaluate the collectibility of our trade receivable
balances based on a combination of factors. When a customer's account balance
becomes past due, we initiate dialogue with the customer to determine the cause.
If it is determined that the customer will be unable to meet its financial
obligation to us, such as in the case of a bankruptcy filing, deterioration in
the customer's operating results or financial position or other material events
impacting their business, we record a specific allowance to reduce the related
receivable to the amount we expect to recover.
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We also record an allowance for all customers based on certain other factors
including the length of time the receivables are past due and historical
collection experience with customers. We believe our reported allowances are
adequate. If the financial conditions of those customers were to deteriorate,
however, resulting in their inability to make payments, we may need to record
additional allowances which would result in additional general and
administrative expenses being recorded for the period in which such
determination was made.
Warranty Reserves
We accrue the estimated costs to be incurred in performing warranty services at
the time of revenue recognition and shipment of the products to the OEMs.
Because there is no contractual right of return other than for defective
products, we can reasonably estimate such returns and record a warranty reserve
at the point of shipment. Our estimate of costs to service our warranty
obligations is based on historical experience and expectation of future
conditions. To the extent we experience increased warranty claim activity or
increased costs associated with servicing those claims, the warranty accrual
will increase, resulting in decreased gross margin.
Inventories
We are exposed to a number of economic and industry factors that could result in
portions of our inventory becoming either obsolete or in excess of anticipated
usage, or subject to lower of cost or market issues. These factors include, but
are not limited to, technological changes in our markets, our ability to meet
changing customer requirements, competitive pressures in products and prices,
and the availability of key components from our suppliers. Our policy is to
establish inventory reserves when conditions exist that suggest that our
inventory may be in excess of anticipated demand or is obsolete based upon our
assumptions about future demand for our products and market conditions. We
regularly evaluate our ability to realize the value of our inventory based on a
combination of factors including the following: historical usage rates,
forecasted sales or usage, product end-of-life dates, estimated current and
future market values and new product introductions. Purchasing practices and
alternative usage avenues are explored within these processes to mitigate
inventory exposure. When recorded, our reserves are intended to reduce the
carrying value of our inventory to its net realizable value. If actual demand
for our products deteriorates, or market conditions are less favorable than
those that we project, additional inventory reserves may be required.
Inventories are stated at the lower of cost, using the first-in, first-out
method, or market value.
Deferred Taxes
We record a valuation allowance to reduce our deferred taxes to the amount that
is more likely than not to be realized. Based on the uncertainty of future
pre-tax income, we have fully reserved our deferred tax assets as of July 31,
2004 and October 31, 2003, respectively. In the event we were to determine that
we would be able to realize our deferred tax assets in the future, an adjustment
to the deferred tax asset would increase income in the period such determination
was made.
-20-
Intangible Assets:
We adopted the Financial Accounting Standards Board ("FASB") Statements of
Financial Accounting Standards ("SFAS") No. 141, "Business Combinations" and
SFAS No. 142, "Goodwill and Other Intangible Assets" on accounting for business
combinations and goodwill as of the beginning of fiscal year 2002. Accordingly,
we will not amortize goodwill from acquisitions, but will continue to amortize
other acquisition-related intangibles and costs. All of the intangible assets
that we currently own are intellectual property acquired in the Antares
acquisition.
As required by these rules, we will perform an impairment review annually, or
earlier if indicators of potential impairment exist. This annual impairment
review was completed during the fourth quarter of fiscal year 2003, and no
impairment was found. The impairment review is based on a discounted cash flow
approach that uses estimates of future market share and revenues and costs for
our segments as well as appropriate discount rates. The estimates used are
consistent with the plans and estimates that we use to manage the underlying
business. However, if we fail to deliver new products, if the products fail to
gain expected market acceptance, or if market conditions are unfavorable,
revenue and cost forecasts may not be achieved, and we may incur charges for
impairment of goodwill.
For identifiable intangible assets, we amortize the cost over the estimated
useful life and assess any impairment by estimating the future cash flow from
the associated asset in accordance with SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets". If the estimated undiscounted cash
flow related to these assets decreases in the future or the useful life is
shorter than originally estimated, we may incur charges for impairment of these
assets. The impairment is based on the estimated discounted cash flow associated
with the asset. An impairment could result if the underlying technology fails to
gain market acceptance, we fail to deliver new products related to these
technology assets, the products fail to gain expected market acceptance or if
market conditions are unfavorable.
Intellectual property costs consist of the allocation of costs associated with
the purchase of current and the design of future products from Antares
Microsystems on August 7, 2003. All capitalized intellectual property is
amortized to expense over thirty-six months which is the expected useful life.
The quarterly amortization expense is approximately $102,000.
RESULTS OF OPERATIONS
The following table sets forth, as a percentage of net sales, consolidated
statements of operations data for the three and nine months ended July 31, 2004
and 2003. These operating results are not necessarily indicative of our
operating results for any future period.
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THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
2004 2003 2004 2003
------- -------- -------- -------
Net sales 100% 100% 100% 100%
Cost of sales 47 34 46 38
------- -------- -------- -------
Gross profit 53 66 54 62
------- -------- -------- -------
Product research and development 19 21 18 17
Sales and marketing 19 22 18 19
General and administrative 13 24 13 24
Restructuring (benefit) -- (10) -- (3)
Loan loss recovery -- -- (3) --
------- -------- -------- -------
Total operating expenses 51 57 46 57
------- -------- -------- -------
Operating income 3 9 8 5
Interest income -- -- -- --
Income tax benefit -- -- -- --
------- -------- -------- -------
Net income 3% 9% 8% 5%
======= ======== ======== =======
NET SALES
Net sales for the third quarter of fiscal 2004 were $2.9 million, an 81%
increase from $1.6 million in the third quarter of fiscal 2003. For the first
nine months of fiscal 2004, net sales were $8.8 million, which represented a 69%
increase over net sales of $5.2 million for the same period in fiscal 2003. This
increase was primarily attributable to an increase in shipments to HP combined
with an increase in shipments in our WAN and LAN adapter products plus an
increase in our Highwire business. Sales to HP were $1.6 million and $4.2
million in the three and nine months ending July 31, 2004, respectively,
compared to $804,000 and $2.7 million for the same periods of fiscal 2003,
respectively. Sales to HP, primarily of VME products, represented 55% and 47% of
total sales for the three and nine months ending July 31, 2004 compared to 50%
and 52% of total sales during the comparable periods in fiscal 2003. We shipped
$1.2 million of VME products in the third fiscal quarter of 2004 against a $2.9
million purchase order from HP that we received in April 2004 with deliveries
for the remaining $1.7 million scheduled for the fourth quarter of fiscal 2004
and the first quarter of fiscal 2005. We can provide no assurance that we will
receive any further purchase orders for VME products from HP or succeed in
obtaining new orders from existing or new customers sufficient to replace or
exceed the net sales attributable to HP. Data Connection Limited was our only
other customer that accounted for over 10% of sales in the three-month period
ended July 31, 2004.
Sales of our products acquired in the Antares acquisition on August 7, 2007 were
$203,000 for the quarter ended July 31, 2004 compared to $517,000 in the prior
quarter and $1.0 million for the nine months ended July 31, 2004 compared to $0
in the same period in fiscal 2003. Sales of our adapter products were $1.1
million and $3.6 million for the three and nine months ending July 31, 2004,
respectively, as compared to $423,000 and $1.4 million for the same periods in
fiscal 2003, respectively. Sales of our HighWire products were $401,000 and
$876,000 for the three and nine months ending July 31, 2004, respectively, as
compared to $165,000 and $799,000 for the same periods in fiscal 2003,
respectively. Our adapter products are used primarily in edge-of-the-network
applications such as VPN and in routers, VoIP gateways and security devices,
whereas our HighWire products are primarily targeted at core-of-the-network
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applications used primarily by telecommunications central offices. The Gigabit
Ethernet and other adapter products we acquired in the Antares acquisition are
used primarily in enterprise applications such as high-end servers and storage
arrays using both Solaris and Linux software. In the future, we expect our net
sales to be generated predominantly by sales of our adapter products with Linux
and Solaris software, followed by the Antares SCSI and Fibre Channel storage
products. We have seen an upturn in the sales of our Highwire products that is
primarily related to one customer beginning to deploy VoIP systems that includes
our HW400CR intelligent carrier grade communication controller card. We expect
to continue to see strong demand for this product for the foreseeable future. We
will continue to sell and support our older VME products, but expect them to
decline significantly as the OEM products in which they are embedded are phased
out.
Our sales backlog at July 31, 2004 was $3.9 million, including an HP order of
VME products of $1.7 million to be shipped over our next two fiscal quarters,
compared to $0.2 million at July 31, 2003, with no HP backlog. While we
anticipate an increase in our sales volume over the remainder of fiscal 2004 and
into fiscal 2005 as our customers deploy new product designs and as we release
new products, there can be no assurances that such an increase will occur. Due
to the current economic uncertainty, our customers typically require a
"just-in-time" ordering and delivery cycle where they will place a purchase
order with us after they receive an order from their customer. This
"just-in-time" inventory purchase cycle by our customers has made forecasting of
our future sales volumes very difficult. Because our sales are generally
concentrated with a small group of OEM customers, we could experience
significant fluctuations in our quarterly sales volumes due to fluctuating
demand from any major customer or delay in the rollout of any significant new
product by a major customer.
GROSS MARGIN
Gross margin as a percentage of sales in the third quarter of fiscal 2004 was
53% compared to 66% for the third quarter of fiscal 2003. For the first nine
months of fiscal 2004 our gross margin was 54% compared to 62% for the same
period in fiscal 2003. Our gross margin on sales of HP products for the quarter
was 70% versus 100% in 2003 due, in part, to the sales of previously written
down inventory to HP. The decrease in the gross margin is due primarily to a
combination of the reduction in the gross margin attributable to the sale of
products to HP as previously mentioned and an increase in our cost of goods that
resulted from the addition of approximately $102,000 of non-cash quarterly
amortization of the intellectual property acquired from Antares. We will
continue to amortize this intellectual property at the rate of $102,000 per
quarter for the next 8 quarters. We have also seen some erosion in gross margin
due to slightly higher raw material and manufacturing costs. To help counteract
component delivery lead-time and price increase issues, we have decided to
purchase certain critical components ahead of our customer's orders, thereby
increasing our on-hand inventory. Although we continue to have limited
visibility into our customer's product demand, our critical inventory purchase
plan is based on our best estimate of current customer demand and their past
ordering patterns.
Including this non-cash amortization expense, we expect our gross margin to
range between 52% and 55% for the remainder of fiscal 2004.
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However, if market and economic conditions, particularly in the
telecommunications sector deteriorate and raw material pricing continues to
escalate, gross margin may be lower than projected.
PRODUCT RESEARCH AND DEVELOPMENT
Product research and development expenses for the three and nine month periods
ended July 31, 2004 were $548,000 and $1.6 million, respectively, an increase
from $334,000 and $913,000 for the same periods in fiscal 2003. The increase
resulted primarily from engineering staffing increases. When we acquired the
Antares assets in August 2003, we hired a Vice President of Engineering and
three design engineers to enhance our product development and support
activities. We expect overall spending for our product research and development
to range between 15% and 18% of net sales in fiscal 2004 as we remain committed
to the development and enhancement of new and existing products. We did not
capitalize any internal software development costs in the nine-month period
ending July 31, 2004.
SALES AND MARKETING
Sales and marketing expenses for the three and nine month periods ended July 31,
2004 were $539,000 and $1.6 million, respectively, an increase from $361,000 and
$1.0 million for the same periods in fiscal 2003. The increase is primarily due
to increased marketing program spending for products, in addition to new
marketing and sales personnel hired during the latter part of fiscal 2003. We
hired a Vice President of Marketing, a product manager and a technical support
engineer in conjunction with the acquisition of the Antares products. We expect
our sales and marketing expenses to range between 16% and 18% of net sales in
fiscal 2004 as we continue to accelerate our product marketing efforts and
attend an increasing number of industry-specific trade shows.
GENERAL AND ADMINISTRATIVE
General and administrative expenses for the three and nine months periods ended
July 31, 2004 were $376,000 and $1.1 million, respectively, a decrease from
$381,000 and $1.3 million for the same periods of fiscal 2003. This decrease was
due to the effect of a continued focus on controlling spending, primarily legal
and employee benefit expense, during the first three quarters of fiscal 2004.
The decrease in general and administrative expenses is also a result of
decreased depreciation expense as we have fully depreciated certain equipment.
General and administrative expenses are expected to range between 14% and 18% of
net sales for fiscal 2004.
LOAN LOSS RECOVERY
On November 6, 1998, we made a loan to one of our officers and stockholders
which was used by the officer/stockholder to exercise an option to purchase
139,400 shares of our common stock and related taxes. The loan, as amended, was
collateralized by shares of our common stock, bore interest at a rate of 2.48%
per annum, with interest due annually and the entire amount of the principal was
due on December 14, 2003.
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On October 31, 2002, we determined that it was probable that we would be unable
to fully recover the balance of the loan on its due date of December 14, 2003.
Accordingly, a valuation allowance of $474,000 was recorded against the loan at
October 31, 2002.
During the fourth quarter of fiscal 2003, the officer repaid $362,800 of the
loan, and as a result, we recognized a benefit of $235,000 related to the
reversal of the loan impairment charge taken by us in fiscal 2002. During the
first quarter of fiscal 2004, the officer repaid the remaining loan balance in
full, and as a result, we recorded a benefit of $239,000 resulting from the
reversal of the remaining loan impairment charge.
NET INCOME
As a result of the factors discussed above, we recorded net income of $79,000
and $660,000 in the three and nine month periods ended July 31, 2004, as
compared to net income of $141,000 and $284,000 for the same periods in fiscal
2003.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any transactions, arrangements, or other relationships with
unconsolidated entities that are reasonably likely to affect our liquidity or
capital resources. We have no special purpose or limited purpose entities that
provide off-balance sheet financing, liquidity, or market or credit risk
support. We also do not engage in leasing, hedging, research and development
services, or other relationships that could expose us to liability that is not
reflected on the face of the financial statements.
LIQUIDITY AND CAPITAL RESOURCES
Our liquidity is dependent on many factors, including sales volume, operating
profit and the efficiency of asset use and turnover. Our future liquidity will
be affected by, among other things:
- the actual versus anticipated increase in sales of our products;
- ongoing cost control actions and expenses, including for example,
research and development and capital expenditures;
- timing of product shipments which occur primarily during the last
month of the quarter;
- the gross profit margin;
- the ability to raise additional capital, if necessary; and
- the ability to secure credit facilities, if necessary.
At July 31, 2004, we had cash and cash equivalents of $1.5 million, as compared
to $1.4 million at October 31, 2003. In the first nine months of fiscal 2004,
$270,000 of cash was used in operating activities primarily as a result of
generating net income for the nine months ended July 31, 2004 of $660,000 that
was reduced by an increase in our inventory, trade accounts receivable and
liabilities that was partially offset by an increase in trade accounts payable.
The increase in inventory is reflective of the purchase of bulk raw materials to
partially offset vendor price increases and to meet "just-in-time" customer
demands. The increase in trade accounts receivable is due the shipment of
significant amounts of product to HP during the last two weeks of the quarter.
The increase in trade accounts payable was primarily due to the receipt of
finished goods from our contract manufacturers during the last two weeks of the
quarter with payment in the first month of the following quarter. Working
capital, comprised of our current assets less our current liabilities, at July
31, 2004 was $5.3 million, as compared to $3.9 million at October 31, 2003.
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In the first nine months of fiscal 2004, we purchased $85,000 of fixed assets,
consisting primarily of computer and engineering equipment and $111,000 in
software primarily for engineering and product design activities. Capital
expenditures for the remaining quarter of fiscal 2004 are expected to
approximate $100,000.
We received $241,000 in the first nine months of fiscal 2004 from payments
related to common stock purchases made by employees pursuant to our employee
stock purchase plan and the exercise of employee stock options. During the nine
month period, we also received cash proceeds of $116,000 from an investor for
the purchase of 70,000 shares of our common stock pursuant to a warrant the
investor received in conjunction with a private placement of common stock
transaction that was completed in fiscal 2003.
In November 2003, we received a loan payment from an officer of $142,000. Our
projected quarterly operational cash flow break-even point is approximately $2.4
million to $2.6 million in net sales if gross margin is 53% to 55%. Our
projected sales are to a limited number of new and existing OEM customers and
are based on internal and customer-provided estimates of future demand, not firm
customer orders. If our projected sales do not materialize, we may need to
reduce expenses and raise additional capital through customer prepayments or the
issuance of debt or equity securities. If additional funds are raised through
the issuance of preferred stock or debt, these securities could have rights,
privileges or preferences senior to those of common stock, and debt covenants
could impose restrictions on our operations. The sale of equity or debt could
result in additional dilution to current stockholders, and such financing may
not be available to us on acceptable terms, if at all.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our cash and cash equivalents are subject to interest rate risk. We invest
primarily on a short-term basis, maturity of less than three months, principally
money market instruments. We have no other investments with significant interest
rate risks. If interest rates increased by 10%, the expected effect on net
income related to our financial instruments would be immaterial. We hold no
assets or liabilities denominated in a foreign currency. Since October 31, 2003,
there has been no change in our exposure to market risk.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
An evaluation as of July 31, 2004 was carried out under the supervision of
and with the participation of the Company's management, including the Company's
Chief Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of the Company's "disclosure controls and procedures,"
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which are defined under SEC rules as controls and other procedures of a company
that are designed to ensure that information required to be disclosed by a
company in the reports that it files under the Securities Exchange Act of 1934
(the "Exchange Act") is recorded, processed, summarized and reported within
required time periods. Based upon that evaluation, the Company's Chief Executive
Officer and Chief Financial Officer concluded that the Company's disclosure
controls and procedures were effective.
(b) Changes in Internal Controls over Financial Reporting
The Company's management, including the Company's Chief Executive Officer
and Chief Financial Officer, has evaluated any changes in the company's internal
control over financial reporting that occurred during the quarter ended July 31,
2004, and has concluded that there was no change during such quarter that has
materially affected, or is reasonably likely to materially affect, the Company's
internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a)(3) List of Exhibits
Exhibit
Number Description
------ -----------
2.1 (1) Asset Purchase Agreement dated August 8, 2003, by and
between D.R. Barthol & Company and SBE, Inc.
3.1(2) Certificate of Incorporation, as amended through
December 15, 1997.
3.2(3) Bylaws, as amended through December 8, 1998.
10.1(4)* 1996 Stock Option Plan, as amended.
10.2(4)* 1991 Non-Employee Directors' Stock Option Plan, as amended.
10.3(4) 1992 Employee Stock Purchase Plan, as amended.
10.4(4) 1998 Non-Officer Stock Option Plan as amended.
10.5(5) Lease for 4550 Norris Canyon Road, San Ramon, California
dated November 2, 1992 between the Company and
PacTel Properties.
10.6(6) Amendment dated June 6, 1995 to lease for 4550 Norris
Canyon Road, San Ramon, California, between the Company
and CalProp L.P. (assignee of PacTel Properties).
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10.7(4)* Full Recourse Promissory Note executed by William B.
Heye, Jr. in favor of the Company dated November 6, 1998,
as amended and restated on December 14, 2001.
10.8(4)+ Letter Agreement, dated October 30, 2001, amending (i)
Amendment No. S/M018-4 dated April 3, 2001, and (ii) Purchase
Agreement dated May 6, 1991, each between SBE, Inc. and
Compaq Computer Corporation
10.9(7) Stock subscription agreement and warrant to purchase
111,111 of SBE, Inc. Common Stock dated April 30, 2002
between SBE, Inc. and Stonestreet Limited Partnership.
10.10(8) Amendment dated August 22, 2002 to stock subscription
agreement dated April 20, 2002 between SBE, Inc. and
Stonestreet LP.
10.11(9) Securities Purchase Agreement, dated July 27, 2003, between
SBE, Inc. and purchasers of SBE's common stock thereunder,
including form of warrant issued thereunder
10.12(9) Form of warrant issued to associates of Puglisi & Co. ($1.50
exercise price)
10.13(9) Form of warrant issued to associates of Puglisi & Co. ($1.75
and $2.00 exercise price)
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
* Indicates management contract or compensation plans or
arrangements filed pursuant to Item 601(b)(10) of Regulation
SK.
+ Certain confidential information has been deleted from this
exhibit pursuant to a confidential treatment order that has
been granted.
(1) Filed as an exhibit to Current Report on Form 8-K, dated April
30, 2002 and incorporated herein by reference.
(2) Filed as an exhibit to Annual Report on Form 10-K for the year
ended October 31, 1997 and incorporated herein by reference.
(3) Filed as an exhibit to Annual Report on Form 10-K for the year
ended October 31, 1998 and incorporated herein by reference.
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(4) Filed as an exhibit to Annual Report on Form 10-K for the year
ended October 31, 2002 and incorporated herein by reference.
(5) Filed as an exhibit to Annual Report on Form 10-K for the year
ended October 31, 1993 and incorporated herein by reference.
(6) Filed as an exhibit to Annual Report on Form 10-K for the year
ended October 31, 1995 and incorporated herein by reference.
(7) Filed as an exhibit to Registration Statement on Form S-3
dated May 23, 2002 and incorporated herein by reference.
(8) Filed as an exhibit to Quarterly Report on Form 10-Q for the
quarter ended July 31, 2002 and incorporated herein by
reference.
(9) Filed as an exhibit to Registration Statement on Form S-3
dated July 11, 2003 and incorporated herein by reference.
(b) REPORTS ON FORM 8-K
A report on Form 8-K was filed with the Securities and Exchange Commission
on May 19, 2004. The report furnished our press release announcing our financial
results for the quarter ended April 30, 2004.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized, on September 7, 2004.
SBE, INC.
---------
Registrant
Date: September 7, 2004 By: /s/ William B. Heye, Jr.
------------------------------
William B. Heye, Jr.
Chief Executive Officer and
President
(Principal Executive Officer)
Date: September 7, 2004 By: /s/ David W. Brunton
------------------------------
David W. Brunton
Chief Financial Officer,
Vice President, Finance
and Secretary
(Principal Financial and
Accounting Officer)
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