UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2003
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 0-220-20
CASTELLE
(Exact name of Registrant as specified in its charter)
California 77-0164056
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
855 Jarvis Drive, Suite 100, Morgan Hill, California 95037
(Address of principal executive offices, including zip code)
(408) 852-8000
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK,
NO PAR VALUE
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 __
The number of shares of Common Stock outstanding as of April 30, 2003 was
3,179,946.
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b of the Exchange Act). Yes __ No |X|
CASTELLE
FORM 10-Q
TABLE OF CONTENTS
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements:
Consolidated Balance Sheets 2
Consolidated Statements of Income 3
Consolidated Statements of Cash Flows 4
Notes to Consolidated Financial Statements 5
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS 12
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 13
Item 3 Quantitative and Qualitative Disclosures About Market Risk 23
Item 4 Controls and Procedures 23
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 24
Item 2. Changes in Securities and Use of Proceeds 24
Item 3. Defaults Upon Senior Securities 24
Item 4. Submission of Matters to a Vote of Security Holders 24
Item 5. Other Information 24
Item 6. Exhibits and Reports on Form 8-K 24
Signatures 25
Certifications pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002 26
Exhibit 99.1 - Certificate pursuant to 18 U.S.C. Section 1350,
as adopted to Section 906 of the Sarbanes-Oxley Act of
2002 E-1
Exhibit 99.2 - Certificate pursuant to 18 U.S.C. Section 1350,
as adopted to Section 906 of the Sarbanes-Oxley Act of
2002 E-2
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
CASTELLE
CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands)
March 31, 2003 December 31, 2002
---------------------- --------------------
Assets:
Current assets:
Cash and cash equivalents $ 3,356 $ 3,460
Accounts receivable,
net of allowance for doubtful accounts
of $37 and $70, respectively 660 444
Inventories, net 963 1,110
Prepaid expenses and other current assets 201 88
---------------------- --------------------
Total current assets 5,180 5,102
Property and equipment, net 458 425
Other non-current assets 108 108
---------------------- --------------------
Total assets $ 5,746 $ 5,635
====================== ====================
Liabilities and Shareholders' Equity:
Current liabilities:
Long-term debt, current portion $ 21 $ 21
Accounts payable 282 359
Accrued liabilities 2,266 2,288
---------------------- --------------------
Total current liabilities 2,569 2,668
Long term debt, net of current portion 39 44
---------------------- --------------------
Total liabilities 2,608 2,712
---------------------- --------------------
Shareholders' equity:
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 3,161 and 3,187,
respectively 27,010 27,038
Accumulated deficit (23,872) (24,115)
---------------------- --------------------
Total shareholders' equity 3,138 2,923
---------------------- --------------------
Total liabilities and shareholders' equity $ 5,746 $ 5,635
====================== ====================
See accompanying notes to consolidated financial statements.
2
CASTELLE
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)
Three months ended
......................................
March 31, 2003 March 31, 2002
----------------- ------------------
Net sales $ 2,500 $ 2,368
Cost of sales 697 777
----------------- ------------------
Gross profit 1,803 1,591
----------------- ------------------
Operating expenses:
Research and development 355 413
Sales and marketing 735 763
General and administrative 457 404
----------------- ------------------
Total operating expenses 1,547 1,580
----------------- ------------------
Income from operations 256 11
Interest income, net 4 10
Other income/(expense), net (15) 11
----------------- ------------------
Income before provision for income taxes 245 32
Provision for income taxes 2 -
----------------- ------------------
Net income $ 243 $ 32
================= ==================
Earnings per share:
Net income per common share - basic $ 0.08 $ 0.01
Net income per common share - diluted $ 0.06 $ 0.01
Shares used in per share calculation - basic 3,200 4,745
Shares used in per share calculation - diluted 3,828 4,774
See accompanying notes to consolidated financial statements..
3
CASTELLE
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Three months ended
......................................
March 31, 2003 March 31, 2002
----------------- ------------------
Cash flows from operating activities:
Net income $ 243 $ 32
Adjustment to reconcile net income to net cash provided
by/(used in) operating activities:
Depreciation and amortization 57 54
Provision for doubtful accounts and sales returns (143) 111
Provision for excess and obsolete inventory (5) (50)
Loss on disposal of fixed assets - 1
Changes in assets and liabilities:
Accounts receivable (73) (189)
Inventories 152 202
Prepaid expenses and other current assets (113) 14
Accounts payable (77) (142)
Accrued liabilities (22) (132)
----------------- ------------------
Net cash provided by/(used in) operating activities 19 (99)
----------------- ------------------
Cash flows from investing activities:
Acquisition of equipment (90) (3)
----------------- ------------------
Net cash used in investing activities (90) (3)
----------------- ------------------
Cash flows from financing activities:
Repayment of long-term debt (5) (4)
Proceeds from exercise of options 21 -
Repurchase of common stock (49) -
----------------- ------------------
Net cash used in financing activities (33) (4)
Net decrease in cash and cash equivalents (104) (106)
Cash and cash equivalents at beginning of period 3,460 4,568
----------------- ------------------
Cash and cash equivalents at end of period $ 3,356 $ 4,462
================= ==================
See accompanying notes to consolidated financial statements.
4
CASTELLE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation:
The accompanying unaudited consolidated financial statements include the
accounts of Castelle and its wholly-owned subsidiary in the United Kingdom.
These financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America. All
intercompany balances and transactions have been eliminated. In the opinion
of management, all adjustments (consisting only of normal recurring
adjustments) considered necessary for a fair presentation of the Company's
financial position, results of operations and cash flows at the dates and
for the periods indicated have been included. Because all of the
disclosures required by accounting principles generally accepted in the
United States of America are not included in the accompanying consolidated
financial statements and related notes, they should be read in conjunction
with the audited consolidated financial statements and related notes
included in the Company's Form 10-K for the year ended December 31, 2002.
The condensed balance sheet data as of December 31, 2002 was derived from
our audited financial statements and does not include all of the
disclosures required by accounting principles generally accepted in the
United States of America. The results of operations for the periods
presented are not necessarily indicative of results that we expect for any
future period, or for the entire year.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
The Company believes that its existing cash balances and anticipated cash
flows from operations will be sufficient to meet its anticipated capital
requirements for the next 12 months. However, a decline in future orders
and revenues might require the Company to seek additional capital to meet
its working capital needs during or beyond the next twelve months if the
Company is unable to reduce expenses to the degree necessary to avoid
incurring losses. If the Company has a need for additional capital
resources, it may be required to sell additional equity or debt securities,
secure additional lines of credit or obtain other third party financing.
The timing and amount of such capital requirements cannot be determined at
this time and will depend on a number of factors, including demand for the
Company's existing and new products, if any, and changes in technology in
the networking industry. There can be no assurance that such additional
financing will be available on satisfactory terms when needed, if at all.
Failure to raise such additional financing, if needed, may result in the
Company not being able to achieve its long-term business objectives. To the
extent that additional capital is raised through the sale of additional
equity or convertible debt securities, the issuance of such securities
would result in additional dilution to the Company's shareholders.
In addition, because the Company is dependent on a small number of
distributors for a significant portion of the sales of its products, the
loss of any of the Company's major distributors or their inability to
satisfy their payment obligations to the Company could have a significant
adverse effect on the Company's business, operating results and financial
condition. In the first quarter of 2003, Ingram Micro and Tech Data, the
Company's two largest distributors, collectively represented approximately
51% of the Company's net sales.
5
In the same period of 2002, the same distributors collectively represented
approximately 50% of the Company's net sales.
2. Revenue Recognition
Castelle recognizes revenue based on the provisions of Staff
Accounting Bulletin No. 101 "Revenue Recognition in Financial
Statements" and Statement of Financial Accounting Standards ("SFAS") No.
48 "Revenue Recognition When Right of Return Exists."
Product revenue is recognized upon shipment if a signed contract or
purchase order exists, the fee is fixed and determinable, collection of the
resulting receivable is probable and product returns are reasonably
estimable. Shipment generally occurs and title is transferred when product
is delivered to a common carrier.
The Company enters into agreements with some of its distributors that
permit limited stock rotation rights. These stock rotation rights allow the
distributor to return products for credit but require the purchase of
additional products of equal value. Customers who purchase products
directly from Castelle also have limited return rights, which expire 30
days from product shipment. Revenues subject to stock rotation rights are
reduced by management's estimates of anticipated exchanges. Castelle
establishes its returns allowance for distributors and direct customers
based on historic return rates.
Pursuant to the Company's agreements with distributors, the Company also
protects its distributors' exposure related to the impact of price
reductions. Price adjustments are recorded at the time price reductions are
communicated to the Company's distributors.
Revenue for transactions that include multiple elements such as hardware
and post-contract customer support is allocated to each element based on
its relative fair value and recognized for each element when the revenue
recognition criteria have been met for such element. Fair value is
generally determined based on the price charged when the element is sold
separately.
The Company recognizes revenue from support or maintenance contracts,
including extended warranty and support programs, ratably over the period
of the contract.
Castelle recognizes royalty income on the sale of LANpress products by a
Japanese distributor. Royalties are not recognized as revenue until the
products are sold by the distributor.
3. Net Income Per Share:
Basic net income per share is computed by dividing net income available to
common shareholders by the weighted average number of common shares
outstanding for that period. Diluted net income per share reflects the
potential dilution from the exercise or conversion of other securities into
common stock that were outstanding during the period. Diluted net loss per
share excludes shares that are potentially dilutive if their effect is
anti-dilutive. Shares that are potentially dilutive consist of incremental
common shares issuable upon exercise of stock options and warrants.
Basic and diluted earnings per share are calculated as follows for first
quarters of 2003 and 2002 (unaudited, in thousands, except per share
amounts):
6
March 31, 2003 March 31, 2002
----------------------------------------
Basic:
Weighted average common shares outstanding 3,200 4,745
=========================================
Net income $ 243 $ 32
=========================================
Net income per common share - basic $ 0.08 $ 0.01
=========================================
Diluted:
Weighted average common shares outstanding 3,200 4,745
Common equivalent shares from stock options 628 29
-----------------------------------------
Shares used in per share calculation - diluted 3,828 4,774
=========================================
Net income $ 243 $ 32
=========================================
Net income per common share - diluted $ 0.06 $ 0.01
=========================================
The calculation of diluted shares outstanding excludes 1,558,000 and
1,235,000 shares of common stock issuable upon exercise of outstanding
stock options at March 31, 2003 and March 31, 2002, respectively, as their
effect was anti-dilutive in the periods.
Stock-Based Compensation
On December 31, 2002, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 148,
"Accounting for Stock Based Compensation - Transition and Disclosure,"
which amends SFAS No. 123. SFAS No. 148 requires more prominent and
frequent disclosures about the effects of stock-based compensation. The
Company accounts for its stock-based compensation plans using the intrinsic
value method prescribed in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees." Compensation cost for stock
options, if any, is measured by the excess of the quoted market price of
the Company's stock at the date of grant over the amount an employee must
pay to acquire the stock. SFAS No. 123, "Accounting for Stock-Based
Compensation," established accounting and disclosure requirements using a
fair-value based method of accounting for stock-based employee compensation
plans.
Had compensation costs been determined consistent with SFAS No. 123, the
Company's net income or loss would have been changed to the amounts
indicated below for the quarters ended March 31 (unaudited, in thousands,
except per share data):
2003 2002
---- ----
Net income - as reported $ 243 $ 32
Fair value of stock-based compensation (42) (45)
--------------- --------------
Net income - pro forma $ 201 $ (13)
=============== ==============
Net income per share - basic - as reported $ 0.08 $ 0.01
Net income per share - diluted - as reported $ 0.06 $ 0.01
Net income per share - basic - pro forma $ 0.06 $ -
Net income per share - diluted - pro forma $ 0.05 $ -
The Company accounts for stock-based compensation arrangements with
non-employees in accordance with the Emerging Issues Task Force ("EITF")
7
Abstract No. 96-18, Accounting for Equity Instruments That Are Issued to
Other Than Employees for Acquiring, or in Conjunction with Selling Goods
or Services. Accordingly, unvested options and warrants held by
non-employees are subject to revaluation at each balance sheet date based
on the then current fair market value.
4. Inventories:
Inventories are stated at the lower of standard cost (which approximates
cost on a first-in, first-out basis) or market and net of reserves for
excess and obsolete inventory. Inventory details are as follows (unaudited,
in thousands):
March 31, 2003 December 31, 2002
----------------------- -----------------------
Raw material $ 471 $ 493
Work in process 38 179
Finished goods 454 438
----------------------- -----------------------
Total inventory, net $ 963 $ 1,110
======================= =======================
5. Segment Information:
The Company has determined that it operates in one segment. Revenues by
geographic area are determined by the location of the end user and are
summarized as follows (unaudited, in thousands):
March 31, 2003 March 31, 2002
----------------------- ---------------------
North America $ 2,083 $ 1,978
Europe 175 232
Pacific Rim 242 158
----------------------- ---------------------
Total Revenue $ 2,500 $ 2,368
======================= =====================
Customers that individually accounted for greater than 10% of net sales are
as follows (unaudited, in thousands):
March 31, 2003 March 31, 2002
Customer Amount Percentage Amount Percentage
--------------------------------- ---------------- ----------------- ---------------- ---------------
A $ 664 27% $ 706 30%
B $ 605 24% $ 592 25%
6. Comprehensive Income:
Comprehensive income is the change in equity from transactions and other
events and circumstances other than those resulting from investments by
owners and distributions to owners. There are no significant components of
comprehensive income excluded from net income, therefore, no separate
statement of comprehensive income has been presented.
7. Commitments and Contingencies:
Contingencies
From time to time, the Company is involved in various legal proceedings in
the ordinary course of business. The Company is not currently involved in
any litigation, which, in management's
8
opinion, would have a material adverse effect on its business, operating
results, cash flows or financial condition; however, there can be no
assurance that any such proceeding will not escalate or otherwise become
material to the Company's business in the future.
Lease Commitments
The following represents combined aggregate maturities for all the
Company's financing and commitments as of March 31, 2003 (unaudited, in
thousands):
Capital Lease Total
Operating Leases Obligations Commitments
----------------------------------------------------
Nine months ending December 31, 2003 $ 195 $ 21 $ 216
Year ending December 31, 2004 269 20 289
Year ending December 31, 2005 263 18 281
Year ending December 31, 2006 - 15 15
----------------------------------------------------
Total Commitments $ 727 $ 74 $ 801
====================================================
The lease on the Company's headquarters facility has a term of 5 years,
expiring in December 2005 with one conditional three-year option, which if
exercised would extend the lease to December 2008 commencing with rent at
ninety-five percent of fair market value.
The Company leases certain of its equipment under various operating and
capital leases that expire at various dates through 2006. The lease
agreements frequently include renewal and escalation clauses and purchase
provisions and require the Company to pay taxes, insurance and maintenance
costs. As of March 31, 2003, the Company had loan and security agreements
for an aggregate value of $100,000, which are subject to interest rates of
12.5% to 12.8%.
Product Warranties and Guarantor Arrangements
In November 2002, the FASB issued FIN No. 45 "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others, an interpretation of FASB Statements No. 5, 57, and
107 and rescission of FASB Interpretation No. 34 ("FIN 45"). FIN 45
requires that a guarantor recognize, at the inception of a guarantee, a
liability for the fair value of the obligation undertaken by issuing the
guarantee. FIN 45 also requires additional disclosures to be made by a
guarantor in its interim and annual financial statements about its
obligations under certain guarantees it has issued.
The Company offers warranties on certain products and records a liability
for the estimated future costs associated with warranty claims, which is
based upon historical experience and our estimate of the level of future
costs. Warranty costs are reflected in the income statement as a cost of
sales. A reconciliation of the changes in the Company's warranty liability
for the quarter ending March 31, 2003 follows (unaudited, in thousands):
Warranty accrual as of December 31, 2002 $ 34
Accruals for warranties issued during the quarter 29
Settlements made in kind during the quarter (30)
---------
Warranty accrual as of March 31, 2003 $ 33
=========
As permitted under California law, the Company has agreements whereby the
Company indemnifies its officers and directors for certain events or
occurrences while the officer or director is, or was serving, at the
Company's request 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 the Company could be required to make under these
9
indemnification agreements is unlimited; however, the Company has a
director and officer insurance policy that limits the Company's exposure
and enables us to recover a portion of any future amounts paid. As a result
of the Company's insurance policy coverage, the Company believes the
estimated fair value of these indemnification agreements is minimal.
The Company enters into standard indemnification agreements in the ordinary
course of business. Pursuant to these agreements, the Company indemnifies,
holds harmless, and agrees to reimburse the indemnified party for losses
suffered or incurred by the indemnified party, generally the Company's
business partners or customers, in connection with any U.S. patent, or any
copyright or other intellectual property infringement claim by any third
party with respect to the Company's products. The term of these
indemnification agreements is generally perpetual following execution of
the agreement. The maximum potential amount of future payments the Company
could be required to make under these indemnification agreements is
unlimited; however, the Company has never incurred costs to defend lawsuits
or settle claims related to these indemnification agreements. As a result,
the Company believes the estimated fair value of these agreements is
minimal.
8. Stock Buyback:
In the fourth quarter of 2002, the Company's Board of Directors authorized
the Company, from time to time, to repurchase at market prices, up to $2.25
million of its common stock for cash in open market, negotiated or block
transactions. The timing of such transactions will depend on market
conditions, other corporate strategies and will be at the discretion of the
management of the Company. No time limit was set for the completion of this
program. At the time of the approval by the Board of Directors, the Company
had approximately 4.8 million shares of common stock outstanding. During
the fourth quarter of 2002, the Company repurchased from open market and
negotiated transactions a total of approximately 1.62 million shares for
approximately $1.8 million, at an average per share price of $1.10. During
the first quarter of 2003, the Company repurchased from open market
transactions a total of 46,500 shares for $49,000, at an average per share
price of $1.04. The Company intends to continue to execute its buyback
program in 2003 as it deems necessary.
9. Recent Accounting Pronouncements:
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 requires
companies to recognize costs associated with exit or disposal activities
when they are incurred rather than at the date of a commitment to an exit
or disposal plan. Examples of costs covered by the standard include lease
termination costs and certain employee severance costs that are associated
with a restructuring, discontinued operation, plant closing, or other exit
or disposal activity. SFAS No. 146 replaces EITF Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to
Exit an Activity (including Certain Costs Incurred in a Restructuring)".
SFAS No. 146 is to be applied prospectively to exit or disposal activities
initiated after December 31, 2002. Management does not expect this
statement to have a material impact on the Company's results of operations
or consolidated financial statements, although SFAS No. 146 may impact the
timing of recognition of costs associated with future restructuring, exit
or disposal activities.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others", ("FIN 45"). FIN 45 requires that
upon issuance of a guarantee, a guarantor must recognize a liability for
the fair value of an obligation assumed under a guarantee. FIN 45 also
requires additional disclosures by a guarantor in its interim and annual
10
financial statements about the obligations associated with guarantees
issued. The recognition provisions of FIN 45 are effective for any
guarantees issued or modified after December 31, 2002. These consolidated
financial statements comply with the recognition and disclosure
requirements of this interpretation.
In November 2002, the EITF reached a consensus on Issue No. 00-21, "Revenue
Arrangements with Multiple Deliverables" ("EITF 00-21"). EITF 00-21
provides guidance on how to account for arrangements that involve the
delivery or performance of multiple products, services and/or rights to use
assets. The provisions of EITF 00-21 will apply to revenue arrangements
entered into in fiscal periods beginning after June 15, 2003. The Company
is currently assessing the impact of the adoption of this pronouncement on
its consolidated financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure that amends SFAS No. 123,
Accounting for Stock-Based Compensation, to provide alternative methods of
transition to SFAS No. 123's fair value method of accounting for
stock-based employee compensation". SFAS No. 148 also amends the disclosure
provisions of SFAS No. 123 and APB Opinion No. 28, Interim Financial
Reporting, to require disclosure in the summary of significant accounting
policies of the effects of an entity's accounting policy with respect to
stock-based employee compensation on reported net income and earnings per
share in annual and interim financial statements. SFAS No. 148 does not
amend SFAS No. 123 to require companies to account for employee stock
options using the fair value method. SFA No. 148 is effective for years
ending after December 15, 2002. These consolidated financial statements
comply with the requirements of SFAS No. 148.
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation
of Variable Interest Entities" ("FIN 46"). FIN 46 addresses consolidation
by business enterprises of variable interest entities. Under that
interpretation, certain entities known as Variable Interest Entities
("VIEs") must be consolidated by the primary beneficiary of the entity. The
primary beneficiary is generally defined as having the majority of the
risks and rewards arising from the VIE. For VIEs in which a significant
(but not majority) variable interest is held, certain disclosures are
required. It applies immediately to variable interest entities created
after January 31, 2003, and applies in the first year or interim period
beginning after June 15, 2003 to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1,
2003. The Company does not believe the adoption of this interpretation will
have a material impact on its results of operations and consolidated
financial statements.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging
activities under SFAS No. 133. The new guidance amends SFAS No. 133 for
decisions made as part of the Derivatives Implementation Group ("DIG")
process that effectively required amendments to SFAS No. 133, and decisions
made in connection with other FASB projects dealing with financial
instruments and in connection with implementation issues raised in relation
to the application of the definition of a derivative and characteristics of
a derivative that contains financing components. In addition, it clarifies
when a derivative contains a financing component that warrants special
reporting in the statement of cash flows. SFAS No. 149 is effective for
contracts entered into or modified after June 30, 2003 and for hedging
relationships designated after June 30, 2003. The Company does not believe
the adoption of SFAS No. 149 will have a material impact on its results of
operations and consolidated financial statements.
11
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This document contains forward-looking statements that involve risks and
uncertainties. The Company's operating results may vary significantly from
quarter to quarter due to a variety of factors, including changes in the
Company's product and customer mix, constraints in the Company's manufacturing
and assembling operations, shortages or increases in the prices of raw materials
and components, changes in pricing policy by the Company or its competitors, a
slowdown in the growth of the networking market, seasonality, timing of
expenditures, and economic conditions in the United States, Europe and Asia.
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. Unless the context otherwise
requires, references in this Form 10-Q to "we," "us," or the "Company" refer to
Castelle. Readers are cautioned that the forward-looking statements reflect
management's analysis only as of the date hereof, and the Company assumes no
obligation to update these statements. Actual events or results may differ
materially from the results discussed in the forward-looking statements. Factors
that might cause such a difference include, but are not limited to the risks and
uncertainties discussed herein, as well as other risks set forth under the
caption "Risk Factors" below and in the Company's Annual Report on Form 10-K for
the year ended December 31, 2002.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and Results of
Operations contains forward-looking statements that are subject to many risks
and uncertainties that could cause actual results to differ significantly from
expectations. For more information on forward-looking statements, refer to the
"Special Note on Forward-Looking Statements" prior to this section. 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 the Company's Form 10-K for the year ended December 31, 2002.
Critical Accounting Policies
Castelle's financial statements and accompanying notes are prepared in
accordance with generally accepted accounting principles in the United States of
America. Preparing financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets, liabilities, sales
and expenses. These estimates and assumptions are affected by management's
application of accounting policies. Critical accounting policies for Castelle
include revenue recognition; distributor programs and incentives; warranty;
credit, collection and allowances for doubtful accounts; inventories and related
allowance for obsolete and excess inventory; and income taxes, which are
discussed in more detail under the caption "Critical Accounting Policies" in the
Company's 2002 Annual Report on Form 10-K.
Consolidated Statements of Income - As a Percentage of Net Sales
(unaudited)
THREE MONTHS ENDED
......................................
March 31, 2003 March 31, 2002
------------------ ------------------
Net sales 100% 100%
Cost of sales 28% 33%
------------------ ------------------
Gross profit 72% 67%
------------------ ------------------
Operating expenses:
Research and development 14% 17%
Sales and marketing 30% 32%
General and administrative 18% 17%
------------------ ------------------
Total operating expense 62% 66%
Income from operations 10% *
Interest income, net * *
Other income/(expense), net * *
------------------ ------------------
Income before provision for income taxes 10% 1%
Provision for income taxes * --
------------------ ------------------
Net income 10% 1%
================== ==================
* Less than 1%
13
Results of Operations
Net Sales
Net sales for the first quarter of 2003 increased 5.6% to $2.5
million from $2.4 million for the same period in 2002. The increase of
$135,000 was primarily attributable to an increase in shipments of our
products to domestic customers.
Domestic sales in the first quarter of 2003 were $2.1 million as
compared to $2.0 million for the same period in 2002, which represents
approximately 83% of total net sales in both periods. International sales
in the first quarter of 2003 were $417,000 as compared to $390,000 for the
same period in 2002, representing 17% of total net sales in both periods.
Cost of Sales; Gross Profit
Gross profit was $1.8 million, or 72% of net sales, for the first
quarter of 2003, as compared to $1.6 million, or 67% of net sales, for the
same period in 2002. Product cost reductions, outsourcing of our
manufacturing operations and a continuing shift in product mix, which is
resulting in a greater percentage of our sales arising from sales of our
fax server products that have higher gross profit, contributed to the
improvement in gross profit in the first quarter of 2003 as compared to the
same period in 2002.
Research & Development
Research and product development expenses were $355,000 or 14% of
net sales, for the first quarter of 2003, as compared to $413,000 or 17% of
net sales, for the same period in 2002. The decrease was primarily due to
lower compensation expenses of $36,000.
Sales & Marketing
Sales and marketing expenses were $735,000, or 29% of net sales,
for the first quarter of 2003 as compared to $763,000, or 32% of net sales,
for the same period in 2002. The decrease was mostly attributable to lower
compensation expenses of $32,000.
General & Administrative
General and administrative expenses were $457,000, or 18% of net
sales, for the first quarter of 2003, as compared to $404,000 or 17% of net
sales, for the first quarter of 2002. The increase was largely attributable
to higher compensation expenses of $48,000, audit and accounting expenses
of $21,000 and investor relation expenses of $30,000, offset partially by a
decrease in provision for doubtful accounts of $45,000.
Liquidity and Capital Resources
As of March 31, 2003, we had approximately $3.4 million of cash and
cash equivalents, a decrease of $104,000 from December 31, 2002. The decrease in
cash and cash equivalents was mostly attributable to $90,000 used to purchase
equipment and $49,000 used to repurchase shares of our common stock on the open
market in the first quarter of 2003.
We lease our corporate headquarters in Morgan Hill, California. The
lease on the Morgan Hill facility has a term of five years, expiring in December
2005, with one conditional three-year option,
14
which if exercised would extend the lease to December 2008 commencing with rent
at 95% of fair market value. As of March 31, 2003, the future minimum payments
under the lease were $727,000.
In December 2000, as a source of capital asset financing, we entered
into a loan and security agreement with a finance company for an amount of
$75,000. This loan is subject to interest of 12.8% and is repayable by December
2006. As of March 31, 2003, the aggregate value of future minimum payments was
$64,000.
In April 2001, as a source of capital asset financing, we entered into
a loan and security agreement with a finance company for an amount of $25,000.
This loan is subject to interest of 12.5% and is repayable by April 2004. As of
March 31, 2003, the aggregate value of future minimum payments was $10,000.
We have a $3.0 million collateralized revolving line of credit with a
bank, which expires in March 2004, pursuant to which we may borrow 100% against
pledges of cash at the bank's prime rate. Borrowings under this line of credit
agreement are collateralized by all of our assets. We are in compliance with the
terms of the agreement, and as of March 31, 2003, had no borrowings under the
line of credit.
As of March 31, 2003, net accounts receivable were $660,000 compared to
$444,000 as of December 31, 2002. The increase in net accounts receivable was
mainly attributable to higher sales at the end of the first quarter of 2003
compared to the fourth quarter of 2002.
Net inventories as of March 31, 2003 were $963,000 compared to $1.1
million as of December 31, 2002. The reduction in inventory was mainly due to
more components being used in production than components purchased in the same
period.
We believe that our existing cash balances and anticipated cash flows
from operations will be sufficient to meet our anticipated capital requirements
for the next 12 months. However, a decline in future orders and revenues might
require us to seek additional capital to meet our working capital needs during
or beyond the next twelve months if we are unable to reduce expenses to the
degree necessary to avoid incurring losses. If we have a need for additional
capital resources, we may be required to sell additional equity or debt
securities, secure additional lines of credit or obtain other third party
financing. The timing and amount of such capital requirements cannot be
determined at this time and will depend on a number of factors, including demand
for our existing and new products, if any, and changes in technology in the
networking industry. There can be no assurance that such additional financing
will be available on satisfactory terms when needed, if at all. Failure to raise
such additional financing, if needed, may result in our inability to achieve our
long-term business objectives. To the extent that additional capital is raised
through the sale of additional equity or convertible debt securities, the
issuance of such securities would result in additional dilution to our
shareholders.
In addition, because we are dependent on a small number of distributors
for a significant portion of the sales of our products, the loss of any of our
major distributors or their inability to satisfy their payment obligations to us
could have a significant adverse effect on our business, operating results and
financial condition.
We believe that, for the periods presented, inflation has not had a
material effect on our operations.
15
Recent Accounting Pronouncements:
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 requires companies to
recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan.
Examples of costs covered by the standard include lease termination costs and
certain employee severance costs that are associated with a restructuring,
discontinued operation, plant closing, or other exit or disposal activity. SFAS
No. 146 replaces EITF Issue No. 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring)". SFAS No. 146 is to be applied
prospectively to exit or disposal activities initiated after December 31, 2002.
Management does not expect this statement to have a material impact on our
results of operations or consolidated financial statements, although SFAS No.
146 may impact the timing of recognition of costs associated with future
restructuring, exit or disposal activities.
In November 2002, the FASB issued FASB Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others", ("FIN 45"). FIN 45 requires that
upon issuance of a guarantee, a guarantor must recognize a liability for the
fair value of an obligation assumed under a guarantee. FIN 45 also requires
additional disclosures by a guarantor in its interim and annual financial
statements about the obligations associated with guarantees issued. The
recognition provisions of FIN 45 are effective for any guarantees issued or
modified after December 31, 2002. These consolidated financial statements comply
with the recognition and disclosure requirements of this interpretation.
In November 2002, the EITF reached a consensus on Issue No. 00-21,
"Revenue Arrangements with Multiple Deliverables" ("EITF 00-21"). EITF 00-21
provides guidance on how to account for arrangements that involve the delivery
or performance of multiple products, services and/or rights to use assets. The
provisions of EITF 00-21 will apply to revenue arrangements entered into in
fiscal periods beginning after June 15, 2003. We are currently assessing the
impact of the adoption of this pronouncement on its consolidated financial
statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure that amends SFAS No. 123,
Accounting for Stock-Based Compensation, to provide alternative methods of
transition to SFAS No. 123's fair value method of accounting for stock-based
employee compensation". SFAS No. 148 also amends the disclosure provisions of
SFAS No. 123 and APB Opinion No. 28, Interim Financial Reporting, to require
disclosure in the summary of significant accounting policies of the effects of
an entity's accounting policy with respect to stock-based employee compensation
on reported net income and earnings per share in annual and interim financial
statements. SFAS No. 148 does not amend SFAS No. 123 to require companies to
account for employee stock options using the fair value method. SFA No. 148 is
effective for years ending after December 15, 2002. These consolidated financial
statements comply with the requirements of SFAS No. 148.
In January 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities" ("FIN 46"). FIN 46 addresses
consolidation by business enterprises of variable interest entities. Under that
interpretation, certain entities known as Variable Interest Entities ("VIEs")
must be consolidated by the primary beneficiary of the entity. The primary
beneficiary is generally defined as having the majority of the risks and rewards
arising from the VIE. For VIEs in which a significant (but not majority)
variable interest is held, certain disclosures are required. It applies
immediately to variable interest entities created after January 31, 2003, and
applies in the
16
first year or interim period beginning after June 15, 2003 to variable interest
entities in which an enterprise holds a variable interest that it acquired
before February 1, 2003. We do not believe the adoption of this interpretation
will have a material impact on our results of operations and consolidated
financial statements.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under SFAS
No. 133. The new guidance amends SFAS No. 133 for decisions made as part of the
Derivatives Implementation Group ("DIG") process that effectively required
amendments to SFAS No. 133, and decisions made in connection with other FASB
projects dealing with financial instruments and in connection with
implementation issues raised in relation to the application of the definition of
a derivative and characteristics of a derivative that contains financing
components. In addition, it clarifies when a derivative contains a financing
component that warrants special reporting in the statement of cash flows. SFAS
No. 149 is effective for contracts entered into or modified after June 30, 2003
and for hedging relationships designated after June 30, 2003. We do not believe
the adoption of SFAS No. 149 will have a material impact on our results of
operations and consolidated financial statements.
RISK FACTORS
Shareholders or investors considering the purchase of shares of our
common stock should carefully consider the following risk factors, in addition
to other information in this Quarterly Report on Form 10-Q and in our Annual
Report on Form 10-K for the year ended December 31, 2002. Additional risks and
uncertainties not presently known to us or that we currently deem immaterial
also may impair our business operations.
Our revenue and operating results have fluctuated in the past and are likely to
fluctuate significantly in the future, particularly on a quarterly basis.
Our operating results may vary significantly from quarter to quarter
due to many factors, some of which are outside our control. For example, the
following conditions could all affect our results:
o changes in our product sales and customer mix;
o constraints in our manufacturing and assembling operations;
o shortages or increases in the prices of raw materials and components;
o changes in pricing policy by us or our competitors;
o a slowdown in the growth of the networking market;
o seasonality;
o timing of expenditures; and
o economic conditions in the United States, Europe and Asia.
Our sales often reflect orders shipped in the same quarter in which
they are received. In addition, significant portions of our expenses are
relatively fixed in nature, and planned expenditures are based primarily on
sales forecasts. Therefore, if the Company inaccurately forecasts demand for our
products, the impact on net income may be magnified by the Company's inability
to adjust spending quickly enough to compensate for the net sales shortfall.
17
Other factors contributing to fluctuations in our quarterly operating
results include:
o changes in the demand for our products;
o customer order deferrals in anticipation of new versions of our
products;
o the introduction of new products and product enhancements by us or our
competitors;
o the effects of filling the distribution channels following
introductions of new products and product enhancements;
o potential delays in the availability of announced or anticipated
products;
o the mix of product and revenue derived from the sale of extended
warranty contracts;
o the commencement or conclusion of significant development contracts;
o changes in foreign currency exchange rates; and
o the timing of significant marketing and sales promotions.
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
viewed as indications of future performance.
We have a history of losses and a large accumulated deficit.
We have experienced significant operating losses and, as of March 31,
2003, had an accumulated deficit of $23.9 million. Our development and marketing
of current and new products will continue to require substantial expenditures.
We incurred $591,000 of losses in 2001 due to a slowdown in demand for our
products due in part to industry-wide adverse economic factors. We were able to
recover and have been profitable since the third quarter of 2001, with total net
income of $659,000 in 2002 and $243,000 in the first quarter of 2003. There can
be no assurance that growth in net sales will be achieved or profitability
sustained in future years.
Our common stock is listed on the Nasdaq SmallCap Market, and we have had
difficulty satisfying the listing criteria to avoid the delisting of our common
stock
Our common stock has been listed on the Nasdaq SmallCap Market since
April 1999. In order to maintain our listing on the Nasdaq SmallCap Market, we
must maintain total assets, capital and public float at specified levels, and
our common stock generally must maintain a minimum bid price of $1.00 per share.
If we fail to maintain the standards necessary to be quoted on the Nasdaq
SmallCap Market, our common stock could become subject to delisting. There can
be no assurance that we will be able to maintain the $1.00 minimum bid price per
share of our common stock and thus maintain our listing on the Nasdaq SmallCap
Market. We have traded below $1.00 as recently as December 2002.
If our common stock is delisted, trading in our common stock could be
conducted on the OTC Bulletin Board or in the over-the-counter market in what is
commonly referred to as the "pink sheets." If this occurs, a shareholder will
find it more difficult to dispose of our common stock or to obtain accurate
quotations as to the price of our common stock. Lack of any active trading
market would have an adverse effect on a shareholder's ability to liquidate an
investment in our common stock easily and quickly at a reasonable price. It
might also contribute to volatility in the market price of our common stock and
could adversely affect our ability to raise additional equity or debt financing
on acceptable terms or at all. Failure to obtain desired financing on acceptable
terms could adversely affect our business, financial condition and results of
operations.
The market for our products is affected by rapidly changing technology and if we
fail to predict and respond to customers' changing needs, our business,
operating results and financial condition may suffer.
18
The market for our products is affected by rapidly changing networking
technology, evolving industry standards and the emergence of the Internet and
other new communication technologies. We believe that our future success will
depend upon our ability to enhance our existing products and to identify,
develop, manufacture and introduce new products that
o conform to or support emerging network telecommunications standards;
o are compatible with a growing array of computer and peripheral
devices;
o support popular computer and network operating systems and
applications;
o meet a wide range of evolving user needs; and
o achieve market acceptance.
There can be no assurance that we will be successful in these efforts.
We have incurred, and expect to continue to incur, substantial expenses
associated with the introduction and promotion of new products. There can be no
assurance that the expenses incurred will not exceed research and development
cost estimates or that new products will achieve market acceptance and generate
sales sufficient to offset development costs. In order to develop new products
successfully, we are dependent upon timely access to information about new
technological developments and standards. There can be no assurance that we will
have such access or will be able to develop new products successfully and
respond effectively to technological change or new product announcements by
others.
We expect that printer and other peripheral manufacturers will add
features to their products that make them more network accessible, which may
reduce demand for our print servers. There can be no assurance that products or
technologies developed by others will not render our products non-competitive or
obsolete. The fax-on-demand market in general has been negatively affected by
the growth of the Internet. Although we have new Web/fax/email products in
development, there can be no assurance these products will compete successfully.
Complex products such as those offered by us may contain undetected or
unresolved hardware defects or software errors when they are first introduced or
as new versions are released. Changes in our or our suppliers' manufacturing
processes or the inadvertent use of defective components could adversely affect
our ability to achieve acceptable manufacturing yields and product reliability.
We have in the past discovered hardware defects and software errors in certain
of our new products and enhancements after their introduction. There can be no
assurance that despite testing by us and by third-party test sites, errors will
not be found in future releases of our products, which would result in adverse
product reviews and negatively affect market acceptance of these products.
The introduction of new or enhanced products requires us to manage the
transition from the older products to the new or enhanced products or versions,
both internally and for customers. We must manage new product introductions so
as to minimize disruption in customer ordering patterns, avoid excessive levels
of older product inventories and ensure that adequate supplies of new products
can be delivered to meet customer demands. We have from time to time experienced
delays in the shipment of new products. There can be no assurance that we will
successfully manage future product transitions.
Our success depends upon the continued contributions of our key management,
marketing, product development and operational personnel.
Our success will depend, to a large extent, upon our ability to retain
and continue to attract highly skilled personnel in management, marketing,
product development and operations. Competition for employees in the computer
and electronics industries is intense, and there can be
19
no assurance that we will be able to attract and retain enough qualified
employees. Volatility or lack of positive performance in our stock price may
also adversely affect our ability to retain and continue to attract key
employees, many of whom have been granted stock options. Our inability to retain
and attract key employees could have a material adverse effect on our product
development, business, operating results and financial condition. We do not
carry key person life insurance with respect to any of our personnel.
The introduction of new products may reduce the demand for our existing products
and increase returns of existing products.
From time to time, we may announce new products, product versions,
capabilities or technologies that have the potential to replace or shorten the
life cycles of existing products. The release of a new product or product
version may result in the write-down of products in inventory if this inventory
becomes obsolete. We have in the past experienced increased returns of a
particular product version following the announcement of a planned release of a
new version of that product. There can be no assurance that product returns will
not exceed our allowance for these returns in the future and will not have a
material adverse effect on our business, operating results and financial
condition.
If we fail to obtain components of our products from third-party suppliers and
subcontractors, our business could suffer.
Our products require components procured from third-party suppliers.
Some of these components are available only from a single source or from limited
sources. In addition, we subcontract a substantial portion of our manufacturing
to third parties, and there can be no assurance that these subcontractors will
be able to support our manufacturing requirements. We purchase components on a
purchase order basis, and generally have no long-term contracts for these
components. If we are unable to obtain a sufficient supply of high-quality
components from our current sources, we could experience delays or reductions in
product shipments. Furthermore, a significant increase in the price of one or
more of these components or our inability to lower component or sub-assembly
prices in response to competitive price reductions could adversely affect our
gross margin.
Government regulation could increase our costs of doing business and adversely
affect our gross margin.
Certain aspects of the networking industry in which we compete are
regulated both in the United States and in foreign countries. Imposition of
public carrier tariffs, taxation of telecommunications services and the
necessity of incurring substantial costs and expenditure of managerial resources
to obtain regulatory approvals, or the inability to obtain regulatory approvals
within a reasonable period of time, could have a material, adverse effect on our
business, operating results and financial condition. This is particularly true
in foreign countries where telecommunications standards differ from those in the
United States. Our products must comply with a variety of equipment, interface
and installation standards promulgated by communications regulatory authorities
in different countries. Changes in government policies, regulations and
interface standards could require the redesign of products and result in product
shipment delays which could have a material, adverse impact on our business,
operating results and financial condition.
We depend on proprietary technology, and inability to develop and protect this
technology or license it from third parties could adversely affect our business,
operating results and financial condition.
20
Our success depends upon our technological expertise and proprietary
software technology. We rely upon a combination of contractual rights and
copyright, trademark and trade secret laws to establish and protect our
technologies. It may be possible for unauthorized third parties to copy our
products or to reverse engineer or obtain and use information that we regard as
proprietary. In addition, the laws of some foreign countries either do not
protect our proprietary rights or offer only limited protection. Given the rapid
evolution of technology and uncertainties in intellectual property law in the
United States and internationally, there can be no assurance that our current or
future products will not be subject to third-party claims of infringement. Any
litigation to determine the validity of any third-party claims could result in
significant expense and divert the efforts our technical and management
personnel, whether or not any litigation is determined in favor of us. In the
event of an adverse result in litigation, we could be required to expend
significant resources to develop non-infringing technology or to obtain licenses
to the technology that is the subject of the litigation. There can be no
assurance that the Company would be successful in this development or that any
such licenses would be available on commercially reasonable terms. We also rely
on technology licensed from third parties. There can be no assurance that these
licenses will continue to be available upon reasonable terms, if at all. Any
impairment or termination of our relationship with third-party licensors could
have a material adverse effect on our business, operating results and financial
condition. There can be no assurance that our precautions will be adequate to
deter misappropriation or infringement of our proprietary technologies.
We have received, and may receive in the future, communications
asserting that our products infringe the proprietary rights of third parties or
seeking indemnification against the alleged infringement. There can be no
assurance that third parties will not assert infringement claims against us with
respect to current or future products or that any assertion may not require us
to enter into royalty arrangements or result in costly litigation. Any claims,
with or without merit, can be time consuming and expensive to defend. There can
be no assurance that any intellectual property litigation will not have a
material adverse effect on our business, operating results and financial
condition.
Our stock price has been volatile, and is likely to continue to be volatile in
the future.
The price of our common stock has fluctuated widely in the past. Sales
of substantial amounts of our common stock, or the perception that such sales
could occur, could adversely affect prevailing market prices for our common
stock. Our management believes past fluctuations may have been caused by the
factors identified above, and that these factors may continue to affect the
market price of our common stock. Additionally, stock markets have experienced
extreme price volatility in recent years. This volatility has had a substantial
effect on the market price of ourcommon stock and other high technology
companies, often for reasons unrelated to operating performance. We anticipate
that prices for our common stock may continue to be volatile. Future stock price
volatility for may result in the initiation of securities litigation against us,
which may divert substantial management and financial resources and have an
adverse effect on our business, operating results and financial condition.
We may require additional capital in the future, and may be unable to obtain
this capital at all or on commercially reasonable terms.
The development and marketing of products requires significant amounts
of capital. A decline in future orders and revenues might require us to seek
additional capital to meet our working capital needs during or beyond the next
twelve months if we are unable to reduce expenses to the degree necessary to
avoid incurring losses. If we need additional capital resources, we may be
required to sell additional equity or debt securities, secure additional lines
21
of credit or obtain other third party financing. The timing and amount of such
capital requirements cannot be determined at this time and will depend on a
number of factors, including demand for our existing and new products and
changes in technology in the networking industry. There can be no assurance that
additional financing will be available on satisfactory terms when needed, if at
all. Failure to raise such additional financing, if needed, may result in our
inability to achieve our long-term business objectives. To the extent that
additional capital is raised through the sale of additional equity or
convertible debt securities, the issuance of these securities would result in
additional dilution to our shareholders.
The costs of compliance with recent developments in corporate governance
regulation may affect our business, operating results and financial condition in
ways that presently cannot be predicted.
Beginning with the enactment of the Sarbanes-Oxley Act of 2002, a
significant number of new corporate governance requirements have been adopted or
proposed through legislation and regulation by the Securities and Exchange
Commission and the Nasdaq National Stock Market. We may have difficulty in
complying with these requirements at all times in the future. Additionally, we
expect these developments to increase our legal compliance and accounting costs,
and to make some activities more difficult, such as stockholder approval of new
stock option plans. We expect these developments to make it more difficult and
more expensive for us to obtain director and officer liability insurance, and we
may be required to accept reduced coverage or incur substantially higher costs
to obtain coverage. These developments could make it more difficult for us to
attract and retain qualified members of our board of directors, or qualified
executive officers.
Voting control by officer, directors and affiliates may delay, defer or prevent
a change of control.
At April 30, 2003, our officers and directors and their affiliates
beneficially owned approximately 25% of the outstanding shares of common stock.
Accordingly, together they had the ability to significantly influence the
election of our directors and other corporate actions requiring shareholder
approval. Such concentration of ownership may have the effect of delaying,
deferring or preventing a change in control.
Provisions in our charter documents might deter a company from acquiring us,
which could inhibit your ability to receive an acquisition premium for your
shares.
Our Board of Directors has authority to issue shares of preferred stock
and to fix the rights, including voting rights, of these shares without any
further vote or action by the shareholders. The rights of the holders of our
common stock will be subject to, and may be adversely affected by, the rights of
the holders of any preferred stock that may be issued in the future. The
issuance of preferred stock, while providing desirable flexibility in connection
with possible acquisitions and other corporate purposes, could have the effect
of making it more difficult for a third party to acquire a majority of our
outstanding voting stock, thereby delaying, deferring or preventing a change in
control. Furthermore, such preferred stock may have other rights, including
economic rights, senior to the common stock, and as a result, the issuance
thereof could have a material adverse effect on the market.
22
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We considered the provision of Financial Reporting Release No. 48
"Disclosure of Accounting Policies for Derivative Financial Instruments and
Derivative Commodity Instruments, and Disclosure of Quantitative and Qualitative
Information about Market Risk Inherent in Derivative Financial Instruments,
Other Financial Instruments and Derivative Commodity Instruments." We had no
holdings of derivative financial or commodity instruments at March 31, 2003.
However, we are exposed to financial market risks, including changes in interest
rates and foreign currency exchange rates. While much of our revenue is
transacted in U.S dollars, some revenues and capital spending are transacted in
Pounds Sterling. These amounts are not currently material to our financial
statements; therefore we believe that foreign currency exchange rates should not
materially affect our overall financial position, results of operations or cash
flows. The fair value of our money market accounts or related income would not
be significantly impacted by increases or decreases in interest rates due mainly
to the highly liquid nature of this investment.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Regulations under the Securities Exchange Act of 1934 require public
companies, including our company, to maintain "disclosure controls and
procedures," which are defined to mean a company's controls and other procedures
that are designed to ensure that information required to be disclosed in the
reports that it files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported, within the time periods specified
in the Securities and Exchange Commission's rules and forms. Our chief executive
officer and our chief financial officer, based upon their evaluation of our
disclosure controls and procedures within 90 days before the filing date of this
report, concluded that as of their evaluation date, our disclosure controls and
procedures were effective for this purpose.
Changes in Internal Controls
There were no significant changes in our internal controls or to our
knowledge, in other factors that could significantly affect these controls
subsequent to the date of their evaluation, which occurred as of the evaluation
date referenced in the above paragraph.
23
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Additional Exhibit
In accordance with SEC Release No. 33-8212, Exhibits 99.1 and
99.2 are to be treated as "accompanying" this report rather
than "filed" as part of the report.
99.1 Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-
Oxley Act of 2002, executed by Scott C. McDonald,
Chief Executive Officer and President of Castelle
99.2 Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-
Oxley Act of 2002, executed by Paul Cheng, Chief
Financial Officer of Castelle
(b) Reports on Form 8-K
During the first quarter of 2003, Castelle filed an 8-K on
January 17, 2003. Under Item 5, Castelle filed a press release
that announced its receipt of a letter from Nasdaq Listing
Qualifications Hearings Counsel dated January 16, 2003. The
letter reported that Castelle had demonstrated compliance with
the Nasdaq Qualifications Exception issued to Castelle on
November 18, 2002, and with all the requirements for continued
listing on the Nasdaq SmallCap Market.
24
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.
CASTELLE
By: /s/ Scott C. McDonald Date: May 14, 2003
Scott C. McDonald
Chief Executive Officer and President
(Principal Executive Officer)
By: /s/ Paul Cheng Date: May 14, 2003
Paul Cheng
Vice President of Finance and Administration
Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
25
CERTIFICATION PURSUANT TO
SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
I, SCOTT C. MCDONALD, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Castelle;
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 officer 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 officer 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
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 officer 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.
Date: May 14, 2003 By: /s/ Scott C. McDonald
Scott C. McDonald
Chief Executive Officer and President
26
CERTIFICATION PURSUANT TO
SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
I, PAUL CHENG, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Castelle;
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 officer 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 officer 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
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 officer 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.
Date: May 14, 2003 By: /s/ Paul Cheng
Paul Cheng
Chief Financial Officer
27
Certification Pursuant to 18 U.S.C. Section 1350,
As Adopted Pursuant To
Section 906 of the Sarbanes-Oxley Act of 2002
In connection with the Quarterly Report of Castelle (the "Company") on
Form 10-Q for the period ended March 31, 2003, as filed with the Securities and
Exchange Commission on the date hereof (the "Report"), I, Scott C. McDonald,
Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350,
as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that to my
knowledge:
(1) The Report fully complies with the requirements of section 13(a) or
15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations
of the Company.
/s/ Scott C. McDonald
Name: Scott C. McDonald
Title: Chief Executive Officer
Date: May 14, 2003
A signed original of this written statement required by Section 906 has been
provided to Castelle and will be retained by Castelle and furnished to the
Securities and Exchange Commission or its staff upon request.
E-1
Certification Pursuant to 18 U.S.C. Section 1350,
As Adopted Pursuant To
Section 906 of the Sarbanes-Oxley Act of 2002
In connection with the Quarterly Report of Castelle (the "Company") on
Form 10-Q for the period ended March 31, 2003, as filed with the Securities and
Exchange Commission on the date hereof (the "Report"), I, Paul Cheng, Chief
Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as
adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that to my
knowledge:
(1) The Report fully complies with the requirements of section 13(a) or
15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations
of the Company.
/s/ Paul Cheng
Name: Paul Cheng
Title: Chief Financial Officer
Date: May 14, 2003
A signed original of this written statement required by Section 906 has been
provided to Castelle and will be retained by Castelle and furnished to the
Securities and Exchange Commission or its staff upon request.
E-2