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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 September 30, 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)
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 October 31, 2003 was
3,335,833.
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes __ No |X|
CASTELLE
FORM 10-Q
TABLE OF CONTENTS
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets 2
Condensed Consolidated Statements of Operations 3
Condensed Consolidated Statements of Cash Flows 4
Notes to Condensed 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 25
Signatures 26
Exhibit 31.1 - Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 E-1
Exhibit 31.2 - Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 E-2
Exhibit 32.1 - Certificate pursuant to 18 U.S.C. Sectionn 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 E-3
Exhibit 32.2 - Certificate pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 E-4
1
PART I - FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
CASTELLE
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands)
September 30, 2003 December 31, 2002
---------------------- --------------------
Assets:
Current assets:
Cash and cash equivalents $ 4,431 $ 3,460
Accounts receivable, net of allowance for doubtful accounts
of $30 and $70, respectively 591 444
Inventories 1,117 1,110
Prepaid expenses and other current assets 215 88
---------------------- --------------------
Total current assets 6,354 5,102
Property and equipment, net 405 425
Other non-current assets 108 108
---------------------- --------------------
Total assets $ 6,867 $ 5,635
====================== ====================
Liabilities and Shareholders' Equity:
Current liabilities:
Long-term debt, current portion $ 17 $ 21
Accounts payable 357 359
Accrued liabilities 2,684 2,288
---------------------- --------------------
Total current liabilities 3,058 2,668
Long term debt, net of current portion 32 44
---------------------- --------------------
Total liabilities 3,090 2,712
---------------------- --------------------
Shareholders' equity:
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 3,329 and 3,187, respectively 27,180 27,038
Accumulated deficit (23,403) (24,115)
---------------------- --------------------
Total shareholders' equity 3,777 2,923
---------------------- --------------------
Total liabilities and shareholders' equity $ 6,867 $ 5,635
====================== ====================
See accompanying notes to unaudited condensed consolidated financial statements.
2
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)
Three months ended Nine months ended
................................ ...............................
September 30, September 30, September 30, September 30,
2003 2002 2003 2002
---------------- -------------- --------------- ---------------
Net sales $ 2,566 $ 2,543 $ 7,577 $ 7,172
Cost of sales 555 735 1,825 2,181
---------------- -------------- --------------- ---------------
Gross profit 2,011 1,808 5,752 4,991
---------------- -------------- --------------- ---------------
Operating expenses:
Research and development 427 312 1,211 1,074
Sales and marketing 846 799 2,341 2,342
General and administrative 497 475 1,463 1,329
Restructuring charges - - - (40)
---------------- -------------- --------------- ---------------
Total operating expenses 1,770 1,586 5,015 4,705
---------------- -------------- --------------- ---------------
Income from operations 241 222 737 286
Interest income, net 5 13 13 35
Other income (expense), net (3) (7) (32) 1
---------------- -------------- --------------- ---------------
Income before provision for income taxes 243 228 718 322
Provision for income taxes 2 -- 6 --
---------------- -------------- --------------- ---------------
Net income $ 241 $ 228 $ 712 $ 322
================ ============== =============== ===============
Income per share:
Net income per common share - basic $ 0.07 $ 0.05 $ 0.22 $ 0.07
Net income per common share - diluted $ 0.06 $ 0.05 $ 0.17 $ 0.07
Shares used in per share calculation - basic 3,286 4,755 3,260 4,750
Shares used in per share calculation - diluted 4,344 4,787 4,154 4,778
See accompanying notes to unaudited condensed consolidated financial statements.
3
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Nine months ended
......................................
September 30, 2003 September 30, 2002
----------------- ------------------
Cash flows from operating activities:
Net income $ 712 $ 322
Adjustments to reconcile net income to net cash provided by
operating activities:
Loss on disposal of fixed assets -- 1
Depreciation and amortization 160 158
Provision for doubtful accounts and sales returns (227) (66)
Provision for excess and obsolete inventory (139) (49)
Changes in assets and liabilities:
Accounts receivable 80 135
Inventories 132 (18)
Prepaid expenses and other current assets (127) (44)
Accounts payable (2) (57)
Accrued liabilities 396 (68)
----------------- ------------------
Net cash provided by operating activities 985 314
----------------- ------------------
Cash flows from investing activities:
Purchase of property and equipment (140) (34)
----------------- ------------------
Net cash used in investing activities (140) (34)
----------------- ------------------
Cash flows from financing activities:
Repayment of long-term debt (16) (13)
Proceeds from issuance of common stock 191 3
Repurchase of common stock (49) --
----------------- ------------------
Net cash provided by/(used in) financing activities 126 (10)
----------------- ------------------
Net increase in cash and cash equivalents 971 270
Cash and cash equivalents at beginning of period 3,460 4,568
----------------- ------------------
Cash and cash equivalents at end of period $ 4,431 $ 4,838
================= ==================
See accompanying notes to unaudited condensed consolidated financial statements.
4
CASTELLE
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation:
The accompanying unaudited condensed 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 condensed
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 each of the first nine months of 2003 and 2002, Ingram Micro
and Tech Data, the
5
Company's two largest 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 and risk of loss is
transferred when the 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 or other
return 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 recognized when the products are sold
by the distributor to its end customer.
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 income
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.
Basic and diluted net income per share are calculated as follows for the
third quarter and first nine months of 2003 and 2002 (in thousands, except
per share amounts):
6
(in thousands, except per share amounts)
.......................................................
(Unaudited)
.......................................................
Three months ended Nine months ended
.......................... ............................
9/30/2003 9/30/2002 9/30/2003 9/30/2002
.......................... ............................
Basic:
Weighted average common shares outstanding 3,286 4,755 3,260 4,750
=========================== ============= ==============
Net income $ 241 $ 228 $ 712 $ 322
=========================== ============= ==============
Net income per common share - basic $ 0.07 $0.05 $ 0.22 $ 0.07
=========================== ============= ==============
Diluted:
Weighted average common shares outstanding 3,286 4,755 3,260 4,750
Common equivalent shares from stock options 1,058 32 894 28
--------------------------- ------------- --------------
Shares used in per share calculation - diluted 4,344 4,787 4,154 4,778
=========================== ============= ==============
Net income $ 241 $ 228 $ 712 $ 322
=========================== ============= ==============
Net income per common share - diluted $ 0.06 $0.05 $ 0.17 $0.07
=========================== ============= ==============
The calculation of diluted shares outstanding for the nine months ended
September 30, 2003 excludes 121,000 shares of common stock issuable upon
exercise of outstanding stock options, as their effect was antidilutive in
the period. The calculation of diluted shares outstanding for the three
months ended September 30, 2003 does not exclude any shares of common stock
that are antidilutive, as there were none for the period. The calculation
of diluted shares outstanding excludes 1,206,000 shares of common stock
issuable upon exercise of outstanding stock options for the three and nine
months ended September 30, 2002, as their effect was antidilutive.
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 would have been changed to the amounts indicated below
for the three and nine months ended September 30 (unaudited, in thousands,
except per share data):
Three months ended Nine months ended
............................. ...........................
9/30/2003 9/30/2002 9/30/2003 9/30/2002
----------------------------- ---------------------------
Net Income - as reported $ 241 $ 228 $ 712 $ 322
Fair value of stock-based compensation $ (86) $ (47) $ (173) $ (141)
Net income - pro forma $ 155 $ 181 $ 539 $ 181
Net income per share - basic - as reported $ 0.07 $ 0.05 $ 0.22 $ 0.07
Net income per share - diluted - as reported $ 0.06 $ 0.05 $ 0.17 $ 0.07
Net income per share - basic - pro forma $ 0.05 $ 0.04 $ 0.17 $ 0.04
Net income per share - diluted - pro forma $ 0.04 $ 0.04 $ 0.13 $ 0.04
The Company accounts for stock-based compensation arrangements with
non-employees in accordance with Emerging Issues Task Force ("EITF")
Abstract No. 96-18, Accounting
7
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 provisions for
excess and obsolete inventory. Inventory details are as follows (unaudited,
in thousands):
September 30, 2003 December 31, 2002
----------------------- -----------------------
Raw material $ 656 $ 493
Work in process 36 179
Finished goods 425 438
-----------------------------------------------
Total inventory $ 1,117 $ 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):
(Unaudited)
......................................................
Three months ended Nine months ended
.......................... ..........................
9/30/2003 9/30/2002 9/30/2003 9/30/2002
-------------------------- --------------------------
United States $1,966 $ 2,045 $ 5,974 $5,707
Europe 192 181 520 585
Pacific Rim 297 264 797 670
Rest of Americas, excluding United States 111 53 286 210
-------------------------- --------------------------
Total Revenues $2,566 $ 2,543 $ 7,577 $7,172
========================== ==========================
Customers that individually accounted for greater than 10% of net sales are
as follows (unaudited, in thousands):
Three months ended Nine Months Ended
................................................. .................................................
September 30, 2003 September 30, 2002 September 30, 2003 September 30, 2002
........................ ..................................................
Customer Amount Percentage Amount Percentage Amount Percentage Amount Percentage
-------- ------ ---------- ------ ---------- ------ ---------- ------ ----------
A $ 496 19% $ 620 24% $ 1,608 21% $ 1,923 27%
B $ 874 34% $ 547 22% $ 2,188 29% $ 1,669 23%
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.
8
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 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 under operating and capital leases as
of September 30, 2003 (unaudited, in thousands):
Capital Lease Total
Operating Leases Obligations Commitments
----------------------------------------------------
Three months ending December 31, 2003 $ 65 $ 7 $ 72
Year ending December 31, 2004 270 20 290
Year ending December 31, 2005 263 18 281
Year ending December 31, 2006 - 14 14
----------------------------------------------------
Total Commitments $ 598 $ 59 $ 657
====================================================
The lease on the Company's headquarters facility has a term of 5 years,
expiring in December 2005 with one conditional three-year renewal 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, escalation clauses and purchase
provisions, and require the Company to pay taxes, insurance and maintenance
costs. As of September 30, 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%, and the future minimum payments under
these agreements were $59,000.
The Company has a $3.0 million collateralized revolving line of credit with
a bank, which expires in March 2004, pursuant to which the Company 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 the
Company's assets. As of September 30, 2003, the Company was in compliance
with the terms of the agreement and had no borrowings outstanding under the
line of credit.
Product Warranties and Guarantor Arrangements
In November 2002, the Financial Accounting Standards Board ("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,
warranties and indemnifications it has issued.
9
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 statement of operations as a
cost of sales. A reconciliation of the changes in the Company's warranty
liability during the periods is as follows (in thousands):
(Unaudited)
........................................................
Three months ended Nine months ended
............................ ...........................
9/30/2003 9/30/2002 9/30/2003 9/30/2002
---------------------------- ---------------------------
Balance at beginning of period $31 $ 22 $ 34 $22
Accruals for warranties issued during the period 16 11 49 25
Actual warranty expense (8) (11) (44) (25)
---------------------------- ---------------------------
Balance at end of period $39 $ 22 $ 39 $22
============================ ===========================
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
indemnification agreements is unlimited; however, the Company has a
director and officer insurance policy that limits the Company's exposure
and enables the Company 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.
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 did not
10
repurchase any of its common stock during the second and third quarters of
2003. The Company intends to continue to execute its buyback program as it
deems necessary.
9. Recent Accounting Pronouncements:
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 apply to revenue arrangements entered
into in fiscal periods beginning after June 15, 2003. The adoption of this
interpretation has not had a material impact on the Company's consolidated
results of operations, financial position or cash flows.
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. FIN 46 applies immediately to variable interest entities created
after January 31, 2003, and applies in the first year or interim period
beginning after December 15, 2003 to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1,
2003. The adoption of this interpretation has not had a material impact on
the Company's consolidated results of operations, financial position or
cash flows.
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. 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 adoption of this interpretation has not had a material
impact on the Company's consolidated results of operations, financial
position or cash flows.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity."
This statement establishes standards for how an issuer classifies and
measures in its statement of financial position certain financial
instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its
scope as a liability (or an asset in some circumstances) because that
financial instrument embodies an obligation of the issuer. This statement
is effective for financial instruments entered into or modified after May
31, 2003 and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003, except for mandatorily redeemable
financial instruments of nonpublic entities. It is to be implemented by
reporting the cumulative effect of a change in an accounting principle for
financial instruments created before the issuance date of the statement and
still existing at the beginning of the interim period of adoption. The
impact of the effective provisions of SFAS No. 150 has not had a material
impact on the Company's results of operations, financial position or cash
flows. While the effective date of certain elements of SFAS No. 150 has
been deferred, the adoption of SFAS No. 150 when finalized, is not expected
to have a material impact on the Company's financial position, results of
operations or cash flows.
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 unaudited Condensed
Consolidated Financial Statements and the Notes thereto included in Item 1 of
this Quarterly Report on Form 10-Q and 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 Operations - As a Percentage of Net Sales
Three months ended Nine months ended
................................ ................................
September 30, September 30, September 30, September 30,
2003 2002 2003 2002
---------------- -------------- ---------------- --------------
Net sales 100% 100% 100% 100%
Cost of sales 22% 29% 24% 30%
---------------- -------------- ---------------- --------------
Gross profit 78% 71% 76% 70%
---------------- -------------- ---------------- --------------
Operating expenses:
Research and development 17% 12% 16% 15%
Sales and marketing 33% 31% 31% 33%
General and administrative 19% 19% 19% 19%
Restructuring charges -- -- -- (1%)
---------------- -------------- ---------------- --------------
Total operating expenses 69% 62% 66% 66%
---------------- -------------- ---------------- --------------
Income from operations 9% 9% 10% 4%
Interest income, net * * * 1%
Other income (expense), net (1%)
* * *
---------------- -------------- ---------------- --------------
Income before provision for income taxes 9% 9% 9% 5%
Provision for income taxes * * * --
---------------- -------------- ---------------- --------------
Net income 9% 9% 9% 5%
================ ============== ================ ==============
* Less than 1%
13
Results of Operations
Net Sales
Net sales were essentially flat at approximately $2.6 million in
each of the third quarters of 2003 and 2002. Net sales for the first nine
months of 2003 increased 6% to $7.6 million from $7.2 million for the same
period in 2002. The increase of $405,000 was mainly attributable to
increased shipments of our products to domestic customers.
Domestic sales in each of the third quarters of 2003 and 2002 were
$2.0 million, which represents 77% and 80% of total sales in the third
quarter of 2003 and 2002, respectively. Domestic sales for the first nine
months of 2003 were $6.0 million as compared to $5.7 million for the same
period in 2002, which represents 79% and 80%, respectively, of total sales
in each period.
International sales (excluding sales to the rest of the Americas)
in the third quarter of 2003 were $489,000 as compared to $445,000 for the
same period in 2002, which represents 19% and 18% of total sales in the
third quarters of 2003 and 2002, respectively. International sales
(excluding sales to the rest of the Americas) in each of the first nine
months of 2003 and 2002 were $1.3 million, which represents 17% of total
sales for both periods.
Sales to the rest of the Americas, excluding the United States,
were $111,000, or 4% of total sales, in the third quarter of 2003, as
compared to $53,000, or 2% of total sales, for the same period in 2002. For
the first nine months of 2003, sales were $286,000, or 4% of total sales,
as compared to $210,000, or 3% of total sales, in the same period in 2002.
Cost of Sales; Gross Profit
Gross profit was $2.0 million, or 78% of net sales, for the third
quarter of 2003, as compared to $1.8 million, or 71% of net sales, for the
same period of 2002. Gross profits for the first nine months of 2003 and
2002 were $5.8 million and $5.0 million, or 76% and 70% of net sales,
respectively. Product cost reductions, outsourcing of our manufacturing
operations, improved overhead absorption due to an increase in the volume
of products received from our contract manufacturer 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 a higher gross
margin, contributed to the improvements in gross profit.
Research & Development
Research and product development expenses for the third quarter of
2003 were $427,000, or 17% of net sales, as compared to $312,000, or 12% of
net sales, for the same period in 2002. The increase was primarily due to
higher compensation expense of $47,000 as a result of hiring more
development engineers and materials consumed in connection with the
development of our newly launched FaxPress PremierTM fax server products of
$47,000. For the first nine months of 2003, research and development
expenses were $1.2 million, as compared to $1.1 million for the same period
in 2002, or 16% and 15%, respectively, of net sales in each period, due
mainly to materials consumed for product development.
14
Sales & Marketing
Sales and marketing expenses for the third quarter of 2003 were
$846,000, or 33% of net sales, as compared to $799,000, or 31% of net
sales, for the same period in 2002. The increase was largely attributable
to higher product promotion and trade show related expenses associated with
the launch of our FaxPress Premier fax server products. Sales and marketing
expenses were $2.3 million, in each of the first nine months of 2003 and
2002, which represents 31% and 33% of net sales, respectively.
General & Administrative
General and administrative expenses were $497,000, or 19% of net
sales, for the third quarter of 2003, as compared to $475,000, or 19% of
net sales, for the same period in 2002. For the first nine months of 2003,
general and administrative expenses were $1.5 million, or 19% of net sales,
as compared to $1.3 million, or 19% of net sales, for the same period in
2002. The increase of $134,000 for the nine month period was chiefly due to
higher levels of compensation of $141,000, investor relations expenses of
$106,000 and legal and accounting expenses of $26,000, offset partially by
lower consulting expenses of $153,000 and a lower provision for doubtful
accounts of $49,000.
Liquidity and Capital Resources
As of September 30, 2003, we had approximately $4.4 million of cash and
cash equivalents, an increase of $971,000 from December 31, 2002. The increase
in cash and cash equivalents was mostly attributable to positive cash flows from
operations of $985,000 due to improved net income, and proceeds from employees
exercising stock options of $191,000, offset in part by purchases of equipment
of $140,000 and cash used to buyback shares of our common stock on the open
market in the first quarter of 2003 of $49,000.
As of September 30, 2003, net accounts receivable were $591,000,
compared to $444,000 as of December 31, 2002. The increase in net accounts
receivable was mainly attributable to higher sales.
Net inventories as of September 30, 2003 were $1.1 million, the same
level as December 31, 2002.
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 renewal option, which if exercised would
extend the lease to December 2008 commencing with rent at 95% of fair market
value. As of September 30, 2003, future minimum payments under the lease were
$598,000.
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 bears interest at 12.8% and is repayable by December 2006. As
of September 30, 2003, the aggregate value of future minimum payments was
$54,000.
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 bears interest at 12.5% and is repayable by April 2004. As of
September 30, 2003, the aggregate value of future minimum payments was $5,000.
15
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. As of September 30, 2003, we
were in compliance with the terms of the agreement and had no borrowings
outstanding under the line of credit.
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.
Recent Accounting Pronouncements:
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 apply to revenue arrangements entered into in fiscal
periods beginning after June 15, 2003. The adoption of this interpretation has
not had a material impact on the Company's consolidated results of operations,
financial position or cash flows.
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. FIN 46 applies
immediately to variable interest entities created after January 31, 2003, and
applies in the first year or interim period beginning after December 15, 2003 to
variable interest entities in which an enterprise holds a variable interest that
it acquired before February 1, 2003. The adoption of this interpretation has not
had a material impact on the Company's consolidated results of operations,
financial position or cash flows.
16
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. 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 adoption of this interpretation has not had a material impact on
the Company's consolidated results of operations, financial position or cash
flows.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." This
statement establishes standards for how an issuer classifies and measures in its
statement of financial position certain financial instruments with
characteristics of both liabilities and equity. It requires that an issuer
classify a financial instrument that is within its scope as a liability (or an
asset in some circumstances) because that financial instrument embodies an
obligation of the issuer. This statement is effective for financial instruments
entered into or modified after May 31, 2003 and otherwise is effective at the
beginning of the first interim period beginning after June 15, 2003, except for
mandatorily redeemable financial instruments of nonpublic entities. It is to be
implemented by reporting the cumulative effect of a change in an accounting
principle for financial instruments created before the issuance date of the
statement and still existing at the beginning of the interim period of adoption.
The impact of the effective provisions of SFAS No. 150 has not had a material
impact on the Company's results of operations, financial position or cash flows.
While the effective date of certain elements of SFAS No. 150 has been deferred,
the adoption of SFAS No. 150 when finalized, is not expected to have a material
impact on the Company's financial position, results of operations or cash flows.
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:
0 changes in our product sales and customer mix;
0 constraints in our manufacturing and assembling operations;
0 shortages or increases in the prices of raw materials and components;
0 changes in pricing policy by us or our competitors;
0 a slowdown in the growth of the networking market;
0 seasonality;
0 timing of expenditures; and
0 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
17
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.
Other factors contributing to fluctuations in our quarterly operating
results include:
0 changes in the demand for our products;
0 customer order deferrals in anticipation of new versions of our products;
0 returns of our products by our customers;
0 the introduction of new products and product enhancements by us or our
competitors;
0 the effects of filling the distribution channels following introductions
of new products and product enhancements;
0 potential delays in the availability of announced or anticipated products;
0 returns of newly released products by our customers following product
introduction;
0 the mix of product and revenue derived from the sale of extended warranty
contracts;
0 the commencement or conclusion of significant development contracts;
0 changes in foreign currency exchange rates; and
0 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 September
30, 2003, had an accumulated deficit of $23.4 million. Our development and
marketing of current and new products will continue to require substantial
expenditures. We incurred $591,000 of losses in 2001 attributable to a slowdown
in demand for our products due in part to industry-wide adverse economic
factors. We have been profitable since the third quarter of 2001, with total net
income of $659,000 in 2002 and $712,000 in the first nine months 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
18
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.
The market for our products is affected by rapidly changing networking
technology, evolving industry standards and 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
0 conform to or support emerging network telecommunications standards;
0 are compatible with a growing array of computer and peripheral devices;
0 support popular computer and network operating systems and applications
0 meet a wide range of evolving user needs; and
0 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.
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 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
19
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
assembled finished products from our 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 for the assembly of finished products, and there can be no
assurance that these subcontractors will be able to support our manufacturing
requirements, at acceptable qualities and to deliver them to us in a timely
manner. 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.
Defects and errors in our products could reduce market acceptance of these
products.
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.
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
20
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.
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 our common 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 may result in the initiation of securities litigation against us,
which may divert
21
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
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 officers, directors and affiliates may delay, defer or prevent
a change of control.
At October 31, 2003, our officers and directors and their affiliates
beneficially owned approximately 24% 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
22
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.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We had no holdings of derivative financial or commodity instruments at
September 30, 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, concluded that as of the end of the period
covered by this report, 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 have materially affected, or are reasonably
likely to materially 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 32.1 and
32.2 are to be treated as "accompanying" this report rather
than "filed" as part of the report.
31.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002,
executed by Scott C. McDonald, Chief Executive Officer and
President of Castelle
31.2 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002,
executed by Paul Cheng, Chief Financial Officer of Castelle
32.1 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
32.2 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
24
(b) Reports on Form 8-K
During the third quarter of 2003, Castelle filed a Form 8-K on
July 25, 2003. Furnished under Item 9, "Regulation FD
Disclosure", Castelle filed a press release regarding its
financial results for its second fiscal quarter ended June 30,
2003.
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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.
CASTELLE
By: /s/ Scott C. McDonald Date: November 12, 2003
Scott C. McDonald
Chief Executive Officer and President
(Principal Executive Officer)
By: /s/ Paul Cheng Date: November 12, 2003
Paul Cheng
Vice President of Finance and Administration
Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
26