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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the year ended December 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 __
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in any amendment to this Form 10-K or in
definitive proxy or information statements incorporated by reference in Part III
of the From 10-K. ___
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes No |X|
--- -----
The approximate aggregate market value of the common stock held by
non-affiliates of the Registrant, based upon the last sale price of the common
stock reported on the Nasdaq SmallCap Market on June 30, 2003 was $9,218,804.
The number of shares of common stock outstanding at March 11, 2004 was
3,542,736.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III of this Form 10-K will be incorporated by
reference from certain portions of Castelle's proxy statement relating to its
2003 Annual Meeting of Shareholders to be filed with the SEC or will be provided
in an amendment to this Form 10-K to be filed with the SEC no later than April
30, 2004.
FORM 10-K
TABLE OF CONTENTS
CASTELLE
FORM 10-K
TABLE OF CONTENTS
PAGE
PART I........................................................................1
ITEM 1. BUSINESS.................................................1
ITEM 2. PROPERTIES..............................................12
ITEM 3. LEGAL PROCEEDINGS.......................................12
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS...12
PART II .....................................................................13
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED
SHAREHOLDER MATTERS.....................................13
ITEM 6. SELECTED FINANCIAL DATA.................................14
ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATION......................16
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK....................................................32
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.............32
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE.....................32
ITEM 9A. CONTROLS AND PROCEDURES.................................32
PART III.....................................................................33
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT......33
ITEM 11. EXECUTIVE COMPENSATION..................................33
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT..............................................33
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS..........33
ITEM 14. PRINCIPAL AUDITOR FEES AND SERVICES.....................33
PART IV......................................................................34
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
FORM 8-K................................................34
SIGNATURES...................................................................36
FINANCIAL STATEMENTS........................................................F-2
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements, within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, that are based on our current expectations
about our company and our industry. All of our forward-looking statements
involve risks and uncertainties. Our actual results could differ significantly
from our expectations and from the results expressed in or implied by these
forward-looking statements. Factors that might cause such a difference include,
but are not limited to, those discussed elsewhere in this Annual Report on Form
10-K. We urge you to consider these cautionary statements carefully in
evaluating our forward-looking statements. Except as required by law, we
undertake no obligation to publicly update any forward-looking statements to
reflect subsequent events and circumstances. Important factors that may cause
results to differ from expectations include those discussed in Risk Factors
beginning on page 24 in this document.
PART I
ITEM 1. BUSINESS
The following summary should be read in conjunction with, and is
qualified in its entirety by, the more detailed information and Consolidated
Financial Statements and Notes thereto appearing elsewhere in this Annual Report
on Form 10-K.
OVERVIEW
Castelle was incorporated in California in 1987, and its principal
offices are located at 855 Jarvis Drive, Suite 100, Morgan Hill, California
95037. Unless the context otherwise requires, references in this Form 10-K to
"we," "us," or the "Company" refer to Castelle. Our telephone number is (408)
852-8000. Castelle(R), LANpress(R) and JetPress(R) are registered trademarks of
the Company. FaxPressTM, FaxPress PremierTM and InfoPressTM are trademarks of
the Company. This Annual Report on Form 10-K includes trademarks and trade names
of other companies. Our common stock is listed on the Nasdaq SmallCap Market
under the symbol CSTL. We maintain a Website with the address www.castelle.com.
We are not including the information contained on its website as a part of, or
incorporating it by reference into, this Annual Report on Form 10-K. We make
available free of charge through our website our Annual Reports on Form 10-K and
Quarterly Reports on Form 10-Q as soon as reasonably practicable after we
electronically file such material with, or furnish such material to, the
Securities and Exchange Commission. In addition, we intend to disclose on our
website any amendments to, or waivers from, our code of business conduct and
ethics, that are required to be publicly disclosed pursuant to rules of the
Securities and Exchange Commission and the Nasdaq Stock Market.
We develop, manufacture, market and support office automation systems
that allow organizations to implement faxing and printing over local area
networks and the Internet. A market leader in fax solutions for small to medium
sized workgroups, our FaxPress fax servers provide a simple way to integrate fax
with email, desktop and back-end applications. We also provides LANpress print
servers, which enable users to locate printers anywhere on the network, and the
InfoPress information-on-demand software suite. Our products are designed to be
easy to use and maintain, and provide an economical way for companies to share
resources over their networks.
Our products have historically centered on fax and print servers and
related technologies. Beginning in 1997, our revenues declined as competition
increased, primarily with the print server products in the Asia Pacific region,
while at the same time the Internet and other networking technologies advanced.
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As a result, we experienced annual operating losses during 1997 through 1999.
During the past five years, management has redirected our efforts to focus on
server appliances and on development efforts to integrate existing and future
products with the Internet and emerging networking technologies. Through the
introduction of enhanced fax automation products that generate higher gross
profits, restructuring and cost reductions, we were able to report operating
profits in the fourth quarter of 1999 and in each of the four quarters of 2000.
In 2000, we recorded a profit of $732,000 with sales at $14.8 million. We
incurred a loss of $591,000 in 2001 with sales of $9.4 million, resulting from a
decrease in demand for our products due in part to the slowness of the economy.
Our sales and profitability rebounded beginning in the third quarter of 2001,
and we recorded a profit of $659,000 in 2002 with sales at $9.8 million and a
profit of $1.6 million in 2003 with sales at $10.2 million. The pre-tax profit
for 2003 of $1.1 million is the highest since 1996.
Industry Background
In the mid-1980s, organizations began to interconnect personal
computers into local area networks (known as "LANs") in order to allow
workgroups to share files, peripherals such as printers, and other specialized
applications. As LANs have proliferated throughout organizations and
client/server architectures have gained acceptance, they have become
increasingly complex and the applications operating on computer networks have
become more critical to the success of the business enterprise. The further
proliferation of the Internet and Intranets and popularity of electronic
communications expanded the role of LANs as a means to provide common access to
the Internet, email and other office automation applications. Installation,
maintenance and administration of LAN equipment required a staff of highly
skilled professionals. The costs associated with LANs and related equipment,
server-class hardware, specialized software, network integration and support
services are significant and typically affordable only by larger organizations.
Many businesses were not able to afford office automation applications beyond
basic email, such as integrating fax technology into the network. This has
created the opportunity for specialized networking equipment that would perform
a single application very well, known in the industry as a "server appliance."
It is similar to using a toaster instead of an oven, it does a specific job
better and it costs less. A server appliance is an integrated hardware and
software product designed to reduce the complexity and cost for a specific
server-based application. Internet routers, email servers, remote access
servers, communication servers, fax servers and print servers are examples of
server appliances used by businesses today.
We are a pioneer in server appliances, establishing a benchmark for
"plug-and-play" and ease of use with our fax and print server product families.
Fax Office Automation Products: Fax machines have become a basic method
of doing business worldwide. Fax is ubiquitous in business; many homes even have
fax machines. While computers have automated many business applications, faxing
remains as a basic method of business communication. We believe fax is here to
stay, just as the computer, in its quest for the paperless society, has not
replaced paper. Fax servers integrate legacy fax business methods into the
network to improve office productivity. Fax servers also provide the opportunity
for new business applications to be developed to take advantage of the inherent
strength and prevalence of fax machines. Virtually every business in the world
has a fax machine that can be used to receive information. Sending purchase
orders, invoices, order confirmations, etc. directly to a fax machine, as
compared to using the mail, is a growing segment of the fax server market.
The increasing popularity of email and the Internet has provided a
boost to all types of electronic communications as many users and organizations
become more comfortable and accustomed to their use. To further simplify and
improve inter- and intra-organizational communications, corporate Management
Information Services departments are looking for ways to integrate different
types of messaging into a
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unified messaging environment. Fax remains one of the key business communication
tools and is one of the essential components of the corporate messaging
environment. In corporate communication infrastructures, fax is being integrated
into email. To facilitate this capability companies install email-integrated fax
server systems.
Fax servers allow users to send and receive faxes as easily as emails,
using the same email application for both types of messages. A fax server can
sort incoming faxes directly and deliver them electronically and confidentially
to the electronic mailboxes of the intended recipients. A fax server can also be
used as an independent network shared system in environments that require high
volume incoming and outgoing faxes. Users are able to send and receive faxes
directly from their computers or workstations, eliminating the need to print a
document, take it to a stand-alone fax machine and wait for its transmission.
Fax servers can help reduce fax transmission costs by sending non-urgent faxes
at "off-peak" telephone rates and by utilizing fax over the Internet technology.
Many fax servers are implemented using complex software that requires
the installation of a Windows or UNIX network operating system, a server-class
computer, and specialized expensive fax modems. Our fax servers, FaxPress and
FaxPress Premier, are self-contained units with all the necessary hardware and
software to integrate fax into network, desktop, email and back-end
applications. As server appliances, they are designed to be easy to use and
maintain and we believe that they are more economical than other solutions.
Automated delivery of information is another popular application of fax
technology. Fax-on-demand is the ability to use a touch-tone phone and a fax
machine to request and receive copies of documents on demand. Although there are
a wide variety of applications installed, the two most common applications are
customer support and literature fulfillment applications. The largest industry
using fax-on-demand is the high-technology sector, with applications also
installed in travel, government, newspapers, manufacturing and non-profit
organizations. Essentially, any company with information to disseminate publicly
is a potential information-on-demand customer. Castelle's InfoPress product line
provides a comprehensive solution for automated information delivery via fax and
email.
Print Servers: The sharing of printers, which is a basic benefit of a
LAN, has traditionally been provided by connecting a printer either to a network
file server or to a dedicated personal computer on the network. However, direct
connection to the file server has several disadvantages, including the risk of
the file server being overburdened by the processing required to print large or
graphically complex files, lower print transfer speeds and location
inflexibility. Similarly, printer connection to a dedicated personal computer,
while providing better location flexibility, is more costly and offers
substantially lower print file transfer speed than a dedicated print server can
provide. A print server directly connects one or more printers to a LAN,
providing a cost-effective, high-speed solution to the demand for shared print
resources. In addition, print servers improve network performance by relieving
the burden on the file server. Print servers enable users to access essential
information about the status of the printer and their print files and to select
their desired printer configuration.
Server appliances, such as communications/messaging servers and print
servers, have emerged and gained market acceptance due to their ability to
significantly reduce complexity and cost associated with the installation and
maintenance of networking systems. These appliances also make the complex
functionality of Internet and Intranet communications available and affordable
to smaller businesses. As professionals in enterprises and small organizations
alike continue to recognize the benefits of server appliances, such as remote
access, scanning, faxing, electronic mail and related functions, we believe that
the demand for such network systems will increase.
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Our Strategy
Our objective is to be a leading worldwide supplier of network server
appliances. We established a benchmark for "plug-and-play" and ease of use with
our fax and print server product families. Our products are installed in many
Fortune 1000 firms, small and medium sized businesses worldwide, integrating
desktop fax automation, email, Internet connectivity, print and other shared
services.
Focus on Server Appliances: We focus exclusively on providing
innovative, reliable, easy-to-use network products. Since our inception, we have
focused on developing networking products that tightly integrate proprietary
hardware systems with standard computing platforms. As a result, we believe we
have developed a high level of expertise in networking, software development,
hardware design and telephony technology. We plan to capitalize on these
attributes by continuing to focus on providing network enhancement products that
enable users to communicate more effectively.
Focus on Application Solutions and Communications: We focus on
developing application solutions for inter and intra-company communications. We
believe that our focus on application servers rather than on infrastructure
systems enables us to offer products that bring higher value services to
customers and provide a higher margin to us.
Expand Product Line: We are leveraging our expertise in server
appliances to offer new easy-to-use, cost-effective solutions. We continue to
expand our fax server products and apply our proven technology to other areas.
Focus on E-commerce and Other High Volume Distribution Channels: We
have established a two-tier domestic and international distribution network of
leading national and regional network product distributors and resellers
including Ingram Micro and Tech Data. Our products are well suited for sale by
e-commerce vendors and we have been successful working with leading resellers
such as CDW and Insight. We are focused on maintaining and strengthening our
current distribution network in North America, Europe and Pacific Rim.
Leverage Strategic Relationships: We augment our product offerings by
establishing relationships with companies able to provide products in areas
outside of our core technical competencies or in instances where internal
development of such products is not cost-effective. We also establish
relationships with numerous leaders in hardware and software technology to
enable it to keep abreast of, and respond quickly to, technological changes that
may affect the network enhancement market.
Products
We develop and market a range of server appliances that enhance network
productivity, performance and functionality. Our current products are grouped
into two areas: fax servers and print servers.
Fax Server Products: We offer the FaxPress family of network fax
servers. We position FaxPress and FaxPress Premier as the easiest way to add
faxing to a company's network and integrate fax with email. FaxPress and
FaxPress Premier allow network users to send, receive, route, print, store, edit
and retrieve fax transmissions from their own personal computers on a network.
FaxPress and FaxPress Premier can be integrated into an email system creating a
unified fax/email environment. FaxPress and FaxPress Premier enable users to
transmit documents directly to a fax device as easily as if they were printing
to a laser printer or sending an email message. The product also provides
network administration features such as, monitoring, logging or configuring
FaxPress and FaxPress Premier users. Our fax server products are designed to
comply with current regulatory standards in the United States, Europe and the
4
Pacific Rim. During 2003, 2002, and 2001, fax products represented 97%, 95%, and
91%, respectively, of total net sales.
Key features of FaxPress and FaxPress Premier products (configured with
its current software versions) include:
o Easy Installation and maintenance: FaxPress and FaxPress
Premier are network fax servers that include all the necessary
hardware and software. The hardware system is a box with an
integrated 10/100 Base-T Ethernet interface and one to
seventy-two fax channels. FaxPress and FaxPress Premier
include all required server and client software.
o Support for popular network operating environments: FaxPress
and FaxPress Premier operate in any local area network based
on Microsoft Windows 98, ME, 2000 and 2003; Windows NT/XP, and
NT Terminal Server; Novell NetWare; or Linux servers.
o Ability to create a unified fax/email messaging environment:
FaxPress and FaxPress Premier have the ability to integrate
fax into a corporate email system, allowing users to send and
receive faxes in the same manner as emails. FaxPress and
FaxPress Premier support Microsoft Exchange/Outlook, Lotus
Notes, Novell GroupWise, Netscape and other SMTP compatible
email systems. Our unique Outlook Direct interface offloads
fax processing from the Microsoft Exchange Server while
maintaining tight integration with the Outlook client.
o Integration with many popular accounting and Customer
Relationship Management applications: FaxPress and FaxPress
Premier are available with the Reform-for-FaxPress software
package from FabSoft that allows users to send faxes from many
popular accounting, financial and payroll systems including
Oracle, SAP, PeopleSoft, Great Plains, ACCPAC and Macola.
Reform can support any application that supports form
printing.
o Ability to send faxes from many applications: Faxing from
within any Windows, Windows 95/98 and Windows NT/2000/XP
application such as Microsoft Office and Lotus Smart Suite.
o Electronic delivery of faxes to desktops: FaxPress and
FaxPress Premier support several methods to deliver incoming
faxes direct to the email or fax inbox of the intended
recipient. Such methods include Direct Inward Dialing, Dual
Tone Multifrequency, T.30 sub-addressing, and line routing.
o Internet faxing capabilities reduce transmission costs:
FaxPress and FaxPress Premier enable users to connect several
units via the Internet or the Intranet to form a private
Fax-over-IP network that can significantly reduce the cost of
fax transmissions.
o Integration into custom applications: We provide a software
development kit that allows programmers to integrate fax
functions into their current applications or to create new
customized applications that use the FaxPress or FaxPress
Premier servers.
o Software Options: We offer a range of value-added software
options that increase the functionality of our FaxPress and
FaxPress Premier systems and enable the FaxPress and FaxPress
Premier to address specialized applications as mentioned
above. Software
5
upgrades and options are available to the installed base of
FaxPress and FaxPress Premier units at prices starting at $495.
We offer a family of FaxPress and FaxPress Premier fax server systems
ranging from entry-level products targeted for small businesses with fewer than
50 users to high-end fax solutions capable of supporting enterprise-wide
installations. The suggested U.S. list prices for FaxPress and FaxPress Premier
fax servers range from $1,495 to $48,995. Server pricing is based on hardware
model, with no per-user costs. The FaxPress 2500, 5000 and 7000 families come
with the FaxPress 7.X network fax software that adds integration with popular
email packages, and many advanced fax management and integration features.
FaxPress 7.1.1 Email Integration is not included on FaxPress Small Business
Edition ("SBE"). The FaxPress Premier family comes with the FaxPress Premier 3.X
network fax software. The following table summarizes our FaxPress and FaxPress
Premier system products:
---------------------------------------
| Network Environment |
-----------------------------------------------------------------------------------------------------------------
NetWare
Number of Email Network 3.x, 4.x, 5.x,
Product Model Channels Integration Topology 6.x (IPX,IP) Windows NT/2000/XP/2003
-----------------------------------------------------------------------------------------------------------------
FaxPress SBE 1 Not available Ethernet x x
FaxPress 2500 2 x Ethernet x x
FaxPress 5000 2, 4 or 8 x Ethernet x x
FaxPress 7000 8 x Ethernet x x
FaxPress 7500 8 x Ethernet x x
FaxPress Premier Analog 8, 12, 16 x Ethernet n/a x
FaxPress Premier Digital T1 24, 48, 72 x Ethernet n/a x
FaxPress Premier ISDN 4, 8, 12 x Ethernet n/a x
-----------------------------------------------------------------------------------------------------------------
Information-on-demand systems: InfoPress software enables the access of
information via any touch-tone phone and a fax machine and allows the
dissemination of information via "broadcasting" to a select database of fax
numbers. InfoPress allows companies to use one source of documents in a Castelle
document library and to automatically publish the documents using either the
fax-on-demand and/or email-on-demand methods.
Our InfoPress is a software product designed to operate on Microsoft
Windows NT/2000/XP platforms. The system utilizes voice and fax processing
hardware, as well as telephone system interface (analog or T1) hardware with as
few as two and as many as 288 ports that are actually deployed at a customer
site.
o Fax-on-Demand: Fax-on-demand allows a user to request and
receive information on demand by dialing a telephone number.
The user interacts with a series of voice prompts to select
specific documents, by simply using the telephone keypad, and
requesting delivery of these documents to a fax number.
o Email-on-Demand: Email-on-demand allows a user to request and
receive information on demand by using email. Auto-reply email
exists today, but is limited to receiving one document,
usually in text format. The main benefit of email-on-demand is
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the ability to share the document library with fax-on-demand.
o Web Integration: InfoPress supports Web HTML documents in the
document library. The documents are automatically rendered
into a fax document when required.
Print Servers: Printer sharing continues to be one of the important
benefits of computer networking. Print servers are the most efficient and
economical way to share printers on a network. While demand for print servers in
various sizes of businesses continues to grow, the market is very competitive.
We have been involved in the print server business for more than thirteen years.
After continuous improvements to the cost and feature set, our LANpress has
become a well-received print server product line. Our latest print server models
incorporate a RISC microprocessor, Fast Ethernet, Windows, Internet Printing and
many other attractive features. The suggested U.S. list price for LANpress print
servers ranges from $165 to $280. During 2003, 2002 and 2001, print server
products represented 3%, 5% and 9%, respectively, of total net sales.
The following table summarizes our line of LANpress external print
servers:
-------------------------------------------------
| Network Environment |
- ----------------------------------------------------------------------------------------------------------------------
NetWare
Ethernet 3.x, Windows Flash Internet
Network 4.x, 95/ 98/ Apple Upgrade Printing
Product Configuration Interface 5.x, 6.x UNIX TCP/IP NT/2000/2003/XP Ethertalk Capability Protocol
- ----------------------------------------------------------------------------------------------------------------------
LANpress 2000 1P Direct 10/100 x x x x x x
LANpress 3P/100 10/100 x x x x x N/a
LANpress 2000 USB 10/100 x x x x x x
- ----------------------------------------------------------------------------------------------------------------------
Research and Product Development
We have invested substantially in research and product development
since inception. We believe our future performance will depend in large part on
our ability to enhance our current products, to expand our product offerings, to
maintain technological competitiveness and meet an expanding range of customer
requirements. We spent $1.6 million, $1.4 million and $1.8 million in research
and product development activities in 2003, 2002 and 2001, respectively.
We continue to invest in enhancing our server appliance product lines
by developing new versions of client and server software and server hardware.
The product feature set is driven by the increasing complexity of user needs.
The changing corporate communications/messaging environment and increasing
demand for easy-to-use networking systems define these needs. The development
efforts are focused on enhancing functionality of existing products and
developing other systems to expand our product offerings. Our development
efforts are focusing on high value applications, while relying on our partners
to provide basic functionality for some of our product lines.
In 2003, we developed and released version 7.1.1 of our FaxPress
software and version 3.0 of our FaxPress Premier software. The new releases of
FaxPress 7.1.1 and FaxPress Premier 3.0 Network Fax Software offer a new level
of email integration, expanded operating environments and fax automation. It
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includes a new gateway for IBM Lotus Notes email integration, improved
integration with Microsoft Exchange, enhanced Windows XP and Citrix MetaFrame XP
support, improved Novell client support, production faxing and fax automation
made easy.
The current FaxPress and FaxPress Premier fax server product lines are
continuously being enhanced to offer greater integration into corporate
networking environments.
Sales, Marketing and Distribution
We sell our products through multiple channels, determined by the
product, market and customer need. We have an established two-tier domestic and
international distribution network of leading national and regional network
product distributors and resellers. Software enhancements and options that
complement the FaxPress products are primarily marketed directly by us to
registered end users. The direct sales group works closely with distributors and
value-added resellers ("VARs") in qualifying sales opportunities for the fax and
print server products. We also sell some products through the on-line store on
our Web site. Demand for our products is created through a variety of marketing
programs. These programs are targeted toward end-users to stimulate demand for
the products and toward distributors, resellers, VARs and e-commerce vendors to
promote the product in the sales channel. These programs include targeted and
active participation in industry networking and communication trade shows, as
well as advertising in associated publications. We increase awareness of our
products by Internet marketing via targeted e-advertising, publishing and
sponsoring email newsletters, enhancing our Web presence, print advertising,
conducting direct mail campaigns, offering seminars, trade shows and
conferences, and other forms of public relations efforts. Our Web site has been
updated and designed to assist customers in obtaining information about our
products and contacting our sales personnel, and offers selected products and
services through our on-line store.
Our products are well suited for sale by e-commerce vendors, and we
have experienced success working with leading resellers such as CDW and Insight.
In 2003, Ingram Micro and Tech Data individually accounted for more
than 10% of our sales and collectively represented approximately 50% of our net
sales. In 2002 and 2001, the same distributors accounted for approximately 48%
and 46% of our net sales, respectively. Total sales to customers located in the
Pacific Rim, Europe and rest of Americas comprised approximately 19%, 21% and
25% of our net sales in 2003, 2002 and 2001, respectively.
Customer Service and Support
We provide customers with support services, which are available to
assist customers with installation, use and operation issues in an effort to
ensure smooth and reliable operation of our products. Our network engineers,
located at corporate headquarters, provide technical support via telephone, fax
and email during normal Company business days from 6:00 a.m. to 5:00 p.m.
(Pacific Time). As part of our global partner program, VARs have access to
"priority technical support" via a special toll-free number that provides
immediate access to our network engineers. Support is provided under warranty
terms as well as through extended warranty agreements sold directly to the
customer by us. We also provide other customer support through our Web site. We
have an automated call management distribution system that provides improved
levels of support to help resolve customer issues.
Manufacturing
Our current in-house manufacturing operations consist primarily of
material planning, assembly, final testing, quality control and service repair.
Certain of our products are manufactured by third-party
8
manufacturers that provide customized, integrated manufacturing services,
including procurement, manufacturing, printed circuit board assembly and final
testing. We also rely on SerComm to manufacture certain of our print server
products. These arrangements enable us to shift certain costs to such providers,
thereby allowing us to focus resources on our product development efforts. The
failure of such manufacturers, to meet their contractual commitments to us could
cause delays in product shipments, thereby potentially adversely affecting our
business, operating results and financial condition.
We do not currently have any material long-term supply contracts with
any of our manufacturing subcontractors or component suppliers. We purchase
finished products and components on a purchase order basis. We own all
engineering, sourcing documentation, functional test equipment and tooling used
in manufacturing our products and believes that it could shift product assembly
to alternate suppliers if necessary. Certain key components of our products,
including a modem chip set from Conexant, microprocessors from Motorola,
integrated circuits from Intel and Kendin, are currently available from single
sources. Other components of our products are currently available from only a
limited number of sources. In addition, certain manufacturers have announced the
end-of-life of certain standard off-the-shelf components which are being used by
us in the making of our FaxPress Products. However, we have purchased at least
two years worth of supplies of these end-of-life components in an effort to
guarantee an uninterrupted supply of FaxPress Products to our customers for the
next two years, while we decide whether to re-engineer our Products with the
manufacturers' suggested replacement parts, or develop new replacement products.
Competition
The network enhancement products and computer software markets are
highly competitive, and we believe that such competition will intensify in the
future. The competition is characterized by rapid change and improvements in
technology along with constant pressure to reduce the prices of products. We
currently compete principally in the market for network fax servers, network
print servers and fax-on-demand software.
The principal competitive factors affecting the market for our products
include product functionality, performance, quality, reliability, ease of use,
quality of customer training and support, name recognition, price, and
compatibility and conformance with industry standards and changing operating
system environments. Several of our existing and potential competitors, have
substantially greater financial, engineering, manufacturing and marketing
resources than us. We also experience competition from a number of other
software, hardware and service companies. In addition to our current
competitors, we may face substantial competition from new entrants into the
network enhancement market, including established and emerging computer,
computer peripheral, communications and software companies. In the fax server
market we compete with companies such as Captaris, Inc., Omtool, Ltd. and Esker
Software. In addition, certain competing methods of communications such as the
Internet or electronic mail could adversely affect the market for fax products.
Certain of our existing and potential competitors in the print server market are
manufacturers of printers and other peripherals, and these competitors may
develop closed systems accessible only through their own proprietary servers.
Proprietary Rights
Our success depends to a certain extent 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. Additionally, we generally enter into
confidentiality agreements with those employees, distributors, customers and
suppliers who have access to sensitive information and limits access to and
distribution of our software documentation and other proprietary information.
Because of the rapid pace of technological change in the LAN product industry,
we believe
9
that patent protection for our products is less significant to our success than
the knowledge, ability and experience of our employees, the frequent
introduction and market acceptance of new products and product enhancements, and
the timeliness and quality of our support services. We may not be able to obtain
the necessary intellectual property rights and other parties may contest our
intellectual property rights.
Government Regulation
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, particularly in foreign countries could have a
material, adverse effect on our business, operating results and financial
condition. Additionally, our products must comply with a variety of equipment,
interface and installation standards promulgated by communications regulatory
authorities in different countries.
Employees
As of March 1, 2004, we employed a total of 43 full-time equivalent
personnel, 10 in operations, 11 in sales and marketing, 8 in engineering, 8 in
customer service and 6 in finance and administration. We have not experienced a
work stoppage, no employees are represented by a labor organization and we
consider our employee relations to be good.
Executive Officers
The names and ages of our executive officers as of February 28, 2004
are set forth below:
Name Age Position
Scott C. McDonald 50 President, Chief Executive Officer
Eric Chen 51 Senior Vice President, Engineering and
Business Development
Paul Cheng 55 Vice President, Finance and Adminis-
tration, Chief Financial Officer and
Secretary
Richard Fernandez 44 Vice President, Operations
Edward J. Heinze 58 Vice President, Sales, U.S.
Michael Petrovich 42 Vice President, Sales, International
Scott C. McDonald
Mr. McDonald has served as our President and Chief Executive Officer
since April 2002. Mr. McDonald has served as director of since April 1999.
From May 2001 to the first quarter of 2002, Mr. McDonald served on the
board of directors for Octant Technologies and Digital Power Corporation
and provided consulting services. Mr. McDonald served as the Chief
Financial and Administrative Officer at Conxion Corporation, a network and
Internet services company, from December 1999 to April 2001. From 1997 to
1999, Mr. McDonald served on the board of directors for CIDCO, Inc, Octant
Technologies Inc. and Digital Power Corporation; in addition to providing
consulting services to CIDCO, Inc. Mr. McDonald currently serves on the
board of directors of privately held Octant Technologies, Inc. Mr. McDonald
holds a BS in Accounting from the University of Akron and an MBA from
Golden Gate University.
10
Eric Chen
Mr. Chen has served as our Senior Vice President, Engineering and
Business Development since May 2002. From May 2000 to May 2002, Mr. Chen
served as our Vice President, Engineering. Upon joining us in 1989, Mr.
Chen initially worked on software development projects including developing
the first FaxPress e-mail gateways, porting FaxPress to non-Novell
platforms, and the first menu-driven installation and configuration
programs for both FaxPress and LANpress. Most recently, Mr. Chen served as
the Director of Print Server Product Marketing and Business Unit and has
managed the engineering development and manufacturing business
relationships with our partners. Before joining our company, Mr. Chen was
with 3COM, a network solutions provider. Mr. Chen has a BS in Engineering
from Taiwan and an MS in Computer Science from the University of
Massachusetts.
Paul Cheng
Mr. Cheng has served as our Vice President, Finance and Administration
since April 2000. In March 2001, Mr. Cheng was appointed as Chief Financial
Officer and Secretary. Mr. Cheng brings more than 20 years of financial
experience from a career that was launched in Hong Kong where he was the
Plant Controller of Fairchild Semiconductor Hong Kong Ltd. Before joining
our company, he served as the Vice President of Finance and Administration
at Eclipse International, Inc., a systems development company, from April
1997 to March 2000. In addition, he has held various executive positions
including Vice President of Finance at Quintus Corporation, a developer of
customer relations management software from 1993 to 1995 and Corporate
Controller at Power Integration, Inc., a semiconductor manufacturer from
1995 to 1997. Mr. Cheng is a member of the Chartered Certified Accountants
and holds a BS in Accounting from Hong Kong.
Richard Fernandez
Mr. Fernandez has served as our Vice President of Operations since
December 2002. From June 2002 to December 2002, Mr. Fernandez served as our
Director of Operations. Mr. Fernandez has more than 22 years of
manufacturing and materials planning experience prior to joining the
Company. Prior to joining our company, Mr. Fernandez managed the
acquisition of servers and storage devices for Conxion Corporation from
June 2000 to May 2002. Prior to joining Conxion, Mr. Fernandez was Director
of Operations with CIDCO, Inc. since March 1994. In addition, Mr. Fernandez
has held various management positions with Computer Products Inc., MAD
Intelligent Systems and Sperry Univac.
Edward J. Heinze
Mr. Heinze has served as our Vice President, Sales, U.S. since January
2000. From 1994 to January 2000, Mr. Heinze served in several capacities
including Product Manager of the Fax Product Line, and Regional Sales
Manager. Before joining our company, Mr. Heinze served in several
capacities at Visual/White Pine Software, a software developer, including
Vice President of Sales. Prior to his tenure at White Pine, he was Chief
Operations Officer for XMARK, a computer systems manufacturer, and Vice
President of Sales and Marketing at EIT, Millicom, Olympia, and Ontel. He
holds a BS degree from Waynesburg College.
Michael Petrovich
Mr. Petrovich has served as our Vice President, Sales, International
since October 2000 and has been with us since 1992. Mr. Petrovich
concentrates on developing the sales channels for all sales outside of the
Americas, including Asia, the Asia Pacific and Europe. Prior to joining us,
Mr. Petrovich was the marketing communications manager for Novell's
National Reseller Organization, a software company.
11
In this role Mr.Petrovich focused on business strategies and development of
Novell's direct reseller sales channel. Before joining Novell, Mr.
Petrovich held sales and marketing positions at Excelan, a LAN manufacturer
and International Microcircuits Incorporated, a semiconductor company. Mr.
Petrovich holds a BA in Behavioral Sciences from San Jose State University.
ITEM 2. PROPERTIES
Our headquarters, including our executive offices and corporate
administration, development, manufacturing, marketing, sales and technical
services/support facilities, are located in Morgan Hill, California in
approximately 16,600 square-feet of leased office space. We occupy this facility
under a lease, the term of which expires in December 2005 with one conditional
three-year option, which if exercised, would extend the lease to December 2008.
We also rent office space for sales and customer support in Illinois. We believe
our existing facilities will be adequate to meet our requirements for the
foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
From time to time and in the ordinary course of business, we are
involved in various legal proceedings and third party assertions of patent or
trademark infringement claims against us in the form of letters and other forms
of communication. We are not currently involved in any litigation which, in our
opinion, would have a material adverse effect on our 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 our
business in the future.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
Subsequent to our Annual Meeting of Shareholders held on May 29, 2003,
there were no matters submitted to a vote of securities holders in the remainder
of 2003.
12
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
Our common stock (Nasdaq symbol "CSTL") began trading on the Nasdaq
National Market on December 20, 1995 and was transferred to the Nasdaq SmallCap
Market as of April 1999. The following table shows the closing high and low sale
prices per share of our common stock as reported on the Nasdaq SmallCap Market.
Such quotations do not include retail markups, markdowns or commissions.
2002 HIGH LOW
First Quarter $1.01 $0.64
Second Quarter $0.80 $0.57
Third Quarter $0.85 $0.50
Fourth Quarter $1.15 $0.47
2003 HIGH LOW
First Quarter $2.91 $1.03
Second Quarter $3.86 $1.95
Third Quarter $4.90 $3.01
Fourth Quarter $3.50 $2.61
The market price of our common stock has been volatile. See "Risk
Factors - Our stock price has been volatile, and is likely to continue to be
volatile in the future."
As of March 3, 2004 there were 1,081 holders of record of our common
stock. On March 3, 2004 the last sale price reported on the Nasdaq SmallCap
Market for our common stock was $5.46 per share.
Stock Buyback
In the fourth quarter of 2002, our Board of Directors authorized us,
from time to time, to repurchase at market prices, up to $2.25 million of our
common stock for cash in open market, negotiated or block transactions. The
timing of these transactions will depend on market conditions, other corporate
strategies and will be at the discretion of management. No time limit was set
for the completion of this program. At the time of the approval by the Board of
Directors, we had approximately 4.8 million shares of common stock outstanding
and as of the end of the third quarter 2002, cash and cash equivalents were
approximately $4.8 million. During the fourth quarter of 2002, we repurchased
from open market and negotiated transactions a total of 1.62 million shares for
$1.8 million, at an average per share price of $1.10. During the first quarter
of 2003, we repurchased from open market transactions a total of 46,500 shares
for $48,000, at an average per share price of $1.04. We performed no stock
repurchases during the rest of 2003. However, we may continue to execute our
buyback program as we deem necessary.
Dividend Policy
We have not paid cash dividends on our common stock. The Board of
Directors currently intends to retain any and all earnings for use in our
business and we do not anticipate paying cash dividends in the foreseeable
future.
Equity Compensation Plan Information
The following table sets forth a summary of our equity compensation
plans as of December 31, 2003. Details of the plans are discussed in Note 6 to
the Consolidated Financial Statements.
13
Number of securities to Weighted average
be issued upon exercise exercise price of Number of
of outstanding options, outstanding options, securities remaining
warrants and rights warrants and rights for future
issuance
1988 Equity compensation plan approved 7,000 $2.38 -0-
by security holders
1998 (1988) Equity compensation plan
(As Amended) approved by security 1,279,706 $1.01 -0-
holders
2002 Equity compensation plan approved 303,500 $2.94 546,500
by security holders
Equity compensation plans not approved -0- n/a -0-
by security holders
--------------------------- -------------------------- ---------------------
Total 1,590,206 $1.38 546,500
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial information has been derived from the
audited Consolidated Financial Statements. The information set forth below is
not necessarily indicative of results of future operations, and should be read
in conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements and related
Notes thereto included elsewhere in this Annual Report on Form 10-K.
Years ended December 31,
...................................................................
2003 2002 2001 2000 1999
-------------- ------------- -------------- ------------ ------------
(in thousands, except per share amounts)
INCOME STATEMENT DATA:
Net Sales $10,214 $9,759 $9,354 $14,832 $16,116
Gross Profit $7,729 $6,923 $6,265 $9,380 $ 8,404
Gross Profit as a % of Net Sales 76% 71% 67% 63% 52%
Net income/(loss) $1,633(1) $659 ($591)(3) $732 ($3,555)(3)
Net income/(loss) as a % of Net Sales 16%(1) 7% (6%) 5% (22%)
Net income/(loss) per share - diluted $0.39(1) $0.14 ($0.12) $0.14 ($0.78)
BALANCE SHEET DATA:
Cash and Cash Equivalents $4,614 $3,460(2) $4,568 $3,893 $4,714
Working Capital $4,180 $2,434 $3,560 $3,969 $3,555
Total Assets $7,803 $5,635 $7,010 $8,543 $8,502
Long-term Liabilities $29 $44 $64 $63 --
Shareholders' Equity $4,776 $2,923(2) $4,202 $4,776 $4,020
(1) In the fourth quarter of 2003, we recorded a non-cash tax benefit
of $526,000, or $0.12 per diluted share, resulting from the release of a portion
of our tax valuation allowance. Prior to the fourth quarter, we had not reported
significant income tax expenses because we had utilized available Net Operating
Loss ("NOL") and tax credit carryforwards. These NOLs were fully reserved by a
valuation allowance due to uncertainly surrounding the likelihood of their
realization. Due to our continued profitability over the past ten quarters and a
determination that it is more likely than not that certain future tax benefits
will be realized, a portion of the deferred tax assets were recognized in the
fourth quarter.
14
(2) In 2002, cash and cash equivalents and shareholders' equity reflect
the use of $2 million of cash for the repurchase of 1.62 million shares of our
common stock and the associated expenses.
(3) Net loss for 2001 and 1999 includes net charges for restructuring
and other non-recurring items of $239,000 and $400,000, respectively.
Quarterly Results of Operations
The following table sets forth certain consolidated quarterly financial
data for the eight quarters ended December 31, 2003. This information is
unaudited, but in our opinion, has been prepared on the same basis as the
audited consolidated financial statements appearing elsewhere in this report,
and all necessary adjustments, consisting only of normal recurring adjustments,
have been included in the amounts stated below to present fairly the unaudited
interim results. The results of operations for any quarter are not necessarily
indicative of the results of operations for any future period.
Selected Quarterly Data (unaudited)
Year 2003, Quarter Ended
---------------------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
---------------------------------------------------------
(in thousands, except per share data)
Net sales $2,500 $2,511 $2,566 $2,637
Gross profit 1,803 1,938 2,011 1,977
Operating income 256 240 241 369
Net income 243 228 241 921(1)
Net income per share, basic 0.08 0.07 0.07 0.27(1)
Net income per share, diluted 0.06 0.06 0.06 0.21(1)
(1) Includes a non-cash tax benefit of $526,000, or $0.16 per basic share, and
$0.12 per diluted share, resulting from the release of a portion of our tax
valuation allowance.
Year 2002, Quarter Ended
--------------------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
----------------------------- --------------------------
(in thousands, except per share data)
Net sales $2,368 $2,261 $2,543 $2,587
Gross profit 1,591 1,592 1,808 1,932
Operating income 11 53 222 335
Net income 32 62 228 337
Net income per share, basic 0.01 0.01 0.05 0.09
Net income per share, diluted 0.01 0.01 0.05 0.08
15
ITEM 7. 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" at the
front of this Annual Report on Form 10-K.
Our products have historically centered on fax and print servers and
related technologies. Starting in 1997, our revenues have declined as
competition increased, primarily with the print server products in the Asia
Pacific Region, while at the same time the Internet and other networking
technologies advanced. As a result, we experienced annual operating losses
beginning in 1997 through 1999. We redirected our efforts to focus on server
appliances and on development efforts to integrate existing and future products
with the Internet and emerging networking technologies. We introduced our new
products, the FaxPress 5000 in February 1999, FaxPress 2500 in November 1999,
FaxPress SBE in February 2000 and the FaxPress 7500 in September 2000. In
September 2003, we launched our newest enterprise level fax servers, the
FaxPress Premier Analog and FaxPress Premier Digital, which can provide up to 16
analog fax channels and 71 T1 fax channels, respectively. In support of our
hardware, we introduced a major release of our FaxPress software, FaxPress 7.0,
in November 2002 and FaxPress Premier 3.0, in September 2003. Through mainly the
release of these enhanced products in the fax messaging family and continuous
efforts in product cost reductions, our gross profit margins improved from 52%
in 1999 to 76% in 2003.
Additionally, improved cash management and operating results resulted
in positive operating cash flows in 2001, 2002 and 2003. Cash balances increased
to $4.6 million at December 31, 2003 from $3.5 million at December 31, 2002.
From time to time, component manufacturers announce the end of life of
certain of their products and at the same time introduce replacement components
which are usually more efficient or cost effective. We have been informed by
several of our component suppliers that new components are available to replace
certain of their end-of-life components currently used in our FaxPress products.
We have purchased approximately two years worth of these end-of-life components
in an effort to guarantee a smooth supply of our FaxPress Products to our
customers. We believe this will give us ample time to decide whether to
re-engineer our Products with the manufacturers' suggested replacement parts, or
develop new replacement products. Even though we believe we have secured enough
components for the next two years, there is no assurance that we will be able to
secure additional components in the future, or be able to redesign new products
in a timely manner.
Critical Accounting Policies
We have identified the policies below as critical to our business
operations and to the understanding of our results of operations. We have
defined a critical accounting policy as one that is both important to the
portrayal of our financial condition and results of operations and requires our
management to make difficult, subjective or complex judgments. The impact of
risks associated with these policies on our business operations is discussed in
Management's Discussion and Analysis of Financial Condition and Results of
Operations. For a detailed discussion on the application of these and other
accounting policies, see Note 2 in the Notes to the Consolidated Financial
Statements of this Annual Report on Form 10-K, beginning on page F-6. Note that
preparation of this Annual Report on Form 10-K requires us to make estimates and
assumptions that affect the reported amount of assets and liabilities, and
disclosure of contingent assets and liabilities at the date of our financial
statements, and reported amounts of revenue and expenses during the reporting
period. Estimates about future events and their effects
16
cannot be made with certainty. We based our estimates on historical experience
and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments. These
estimates may change as new events occur, as more experience is acquired, as
additional information is obtained and as our operating environment changes.
Revenue recognition
We recognize revenue based on the provisions of Staff Accounting
Bulletin ("SAB") No. 104 "Revenue Recognition" 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 or 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.
We enter into agreements with some of our distributors which 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. End-user customers who purchase our products directly from us also
have limited return rights, which expire 30 days from product shipment. Revenues
subject to stock rotation or other return rights are reduced by our estimates of
anticipated exchanges and returns. We establish our reserve for sales returns
for distributors and direct end-user customers based on historic return rates.
If the historical data used by the Company to calculate these estimates does not
properly reflect future returns, these estimates could be revised.
Pursuant to our agreements with distributors, we also protect our
distributors' exposure related to the impact of price reductions. Price
adjustments are recorded at the time price reductions are communicated to our
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.
We recognize revenue from the sale of extended warranty contracts
ratably over the period of the contracts.
We recognize 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.
Distributor Programs and Incentives
We record estimated reductions to revenues for distributor programs and
incentive offerings including special pricing agreements, trade-in credits,
promotions and other volume-based incentives. If market conditions were to
change, we may take actions to increase distributor incentive offerings possibly
resulting in an incremental reduction of revenues at the time the incentive is
offered.
17
Warranty
Provisions for estimated warranty costs are recorded at the time
products are shipped as a charge to cost of sales. While we engage in extensive
product quality programs and processes, our warranty obligation is affected by
product failure rates, material usage and service delivery costs incurred in
correcting a product failure. Should product failure rates, material usage or
service delivery cost differ from our estimates, revision to the estimated
warranty liability would be required, which could affect the amount of gross
profit reported.
Credit, collection and allowance for doubtful accounts
We perform ongoing customer credit evaluations based on a number of
factors, including past transaction history with the customer and the
credit-worthiness of the customer. When credit criteria are not met, we require
cash-on-delivery or payment by credit card before products are shipped. On a
quarterly basis, we specifically analyze accounts receivable, historical bad
debts, customer concentration, and changes in our customer payment terms when
evaluating the adequacy of the allowance for doubtful accounts. Such losses have
generally been within our expectations. If the financial condition of our
customers were to deteriorate, resulting in an impairment of their ability to
make payments, additional allowances may be required. Three customers accounted
for 69% and 68% of accounts receivable at December 31, 2003 and 2002,
respectively.
Inventories and related write-downs for excess and obsolete inventory
Inventories are stated at the lower of standard cost (which
approximates cost on a first-in, first-out basis) or market. Inventories are
reduced for excess and obsolete inventories. These write-downs are based on
management's review of inventories on hand on a quarterly basis, compared to
management's assumptions about future demand, market conditions and anticipated
timing of the release of product upgrades or next generation products. If actual
market conditions for future demand are less favorable than those projected by
us or if product upgrades or next generation products are released earlier than
anticipated, additional inventory write-downs may be required.
Income taxes
We account for income taxes in accordance with the liability method.
Under the liability method, deferred assets and liabilities are recognized based
upon anticipated future tax consequences attributable to differences between
financial statement carrying amounts of assets and liabilities and their
respective tax bases. The provision for income taxes is comprised of the current
tax liability and the change in deferred tax assets and liabilities. We assess
the likelihood that our deferred tax assets will be recovered from future
taxable income and to the extent we believe that recovery is not likely, we must
establish a valuation allowance against these tax assets. Significant management
judgment is required in determining the provision for income taxes and any
valuation allowance recorded against our deferred tax assets. The establishment
or reversal of any valuation allowance is based in large part on projected
future taxable income.
Results of Operations
Comparison of Years Ended December 31, 2003 and 2002
Net Sales
Net sales increased 5% to $10.2 million in 2003 from $9.8
million in 2002. The increase of $455,000 resulted primarily from sales
of our enterprise level FaxPress Premier fax server products, which
were launched in September 2003.
18
Domestic sales were $8.3 million in 2003 as compared to $7.7
million in 2002, representing 81% and 79%, respectively, of total net
sales. The increase in sales was mostly attributable to the
introduction of the new FaxPress Premier fax server products.
International sales (excluding sales to the rest of the
Americas) were $1.6 million in 2003 as compared to $1.7 million in
2002, representing 16% and 18%, respectively, of total net sales.
International sales were lower largely due to lower sales of our
FaxPress server products to Europe. Most of our international sales are
denominated in U.S. dollars and thus could be adversely affected by
changes in demand resulting from fluctuations in currency exchange
rates.
Sales to the rest of the Americas, excluding the United
States, were $371,000 in 2003, as compared to $347,000 in 2002,
representing 4% and 3% of total net sales in both 2003 and 2002,
respectively.
In 2003, Ingram Micro, Tech Data and Macnica, our top three
customers accounted for approximately 57% of our net sales. In 2002,
the same three distributors accounted for 56% of net sales.
Cost of Sales; Gross profit
Gross profit is equal to net sales less cost of sales. Cost of
sales includes cost of materials, including components, manuals,
diskettes, packaging materials and shipping. Cost of sales also
includes compensation costs and overhead related to our manufacturing
operations, inventory obsolescence and warranty expenses. Gross profit
was $7.7 million, or 76% of net sales, in 2003, compared to $6.9
million, or 71% of net sales, in 2002. Sales growth, continuous product
cost reductions in 2003, increased outsourcing of manufacturing and
higher sales of our fax server products, which have better gross profit
relative to our print server products contributed to the improvement in
gross profit in 2003.
Research and Development
Research and development expenses represent costs associated
with the development of new products and consist primarily of
employee-related expenses, material costs and allocated facility costs.
Research and product development expenses were $1.6 million in 2003,
compared to $1.4 million in 2002, and represented 16% and 14% of net
sales for those periods, respectively. The higher research and
development expenses in 2003 were mostly due to additional material
costs of $106,000 used in the development of our FaxPress Premier
server products that were launched in September 2003, and higher
compensation expense of $82,000 due to increased headcount. Research
and development spending has supported both existing products and the
development of new server appliances. We remain committed to the
development of highly competitive new products and services through the
efficient utilization of our engineering resources.
Sales and Marketing
Sales and marketing expenses consist primarily of
employee-related expenses, commissions to sales representatives,
product promotion expenses, and allocated facilities expenses,
including expenses associated with our regional sales and support
offices. Sales and marketing expenses were $3.1 million and $3.0
million for 2003 and 2002, respectively, and represented 31% of net
sales for both periods. The slight increase in sales and marketing
expenses was largely due to increased promotional and travel related
expenses of $235,000 and higher compensation expenses of $76,000 due to
increased headcount, offset in part by lower consulting expenses of
$173,000.
19
General and Administrative
General and administrative expenses consist primarily of
employee-related expenses for administration, finance, human resources
and general management, as well as consulting, outside services, legal
and accounting expenses, and allocated facilities expenses. General and
administrative expenses were $1.9 million in both 2003 and 2002, and
represented 19% and 20% of net sales for those periods. The slightly
lower expenses in 2003 as compared to 2002 were mainly attributable to
lower consulting expenses of $180,000 and legal and accounting fees of
$166,000, offset partially by higher compensation expenses of $151,000
and investor relation expenses of $86,000. General and administrative
expenses in 2002 included legal expenses of $128,000 and outside
consulting expenses of $209,000, which were chiefly attributable to our
stock repurchase and Nasdaq listing issues.
Interest and other income
Interest and other income consist primarily of interest income
earned from our invested cash balances, interest expense on capital
leases, bank service fees, and miscellaneous income and expenses.
Interest and other expenses for 2003 were $10,000 as compared to income
of $44,000 in 2002. The decrease in interest and other income was
chiefly due to a $29,000 reduction in interest income due to lower
interest rates and decreased miscellaneous income of $26,000.
Provision for Income Tax
In the fourth quarter of 2003, we recorded a non-cash tax
benefit of $526,000, resulting from the release of a portion of our tax
valuation allowance. Prior to the fourth quarter, we had not reported
significant income tax expenses because we had utilized available Net
Operating Loss ("NOL") and tax credit carryforwards. These NOLs were
fully reserved by a valuation allowance due to uncertainly surrounding
the likelihood of their realization. Due to our continued profitability
over the past ten quarters and a determination that it is more likely
than not that certain future tax benefits will be realized, a portion
of the deferred tax assets were recognized in the fourth quarter.
In 2002, our provision for income taxes was $6,000,
representing state income taxes. The tax provision for federal income
taxes was offset by utilization of our net operating loss
carryforwards.
Comparison of Years Ended December 31, 2002 and 2001
Net Sales
Net sales increased 4% to $9.8 million in 2002 from $9.4
million in 2001. The increase of $405,000 in net sales resulted
primarily from an increase in sales of our FaxPress fax server products
to the domestic channels of $763,000, offset partially by a decrease in
our print server product sales to international markets of $358,000.
Domestic sales were $7.7 million in 2002 as compared to $7.0
million in 2001, representing 79% and 75%, respectively, of total net
sales. The increase was mostly attributable to higher sales of our
FaxPress fax server products.
International sales (excluding sales to the rest of the
Americas) were $1.7 million in 2002 as compared to $2.0 million in
2001, representing 18% and 21%, respectively, of total net sales. Lower
international sales were largely due to reduced demand for our print
server products in the
20
Asia Pacific region. Most of our international
sales are denominated in U.S. dollars and thus could be adversely
affected by changes in demand resulting from fluctuations in currency
exchange rates.
Sales to the rest of the Americas, excluding the United
States, were $347,000 in 2002, as compared to $321,000 in 2001,
representing 3% and 4% of total net sales in 2002 and 2001,
respectively.
In 2002, Ingram Micro, Tech Data and Macnica, our top three
customers accounted for approximately 56% of our net sales. In 2001,
the same three distributors accounted for 55% of net sales.
Cost of Sales; Gross profit
Gross profit was $6.9 million, or 71% of net sales, in 2002,
compared to $6.3 million, or 67% of net sales, in 2001. Efficiencies
realized from the restructuring in 2001, continuous product cost
reductions in 2002, increased outsourcing of manufacturing and an
increase in the mix of sales of our fax server products, which have
higher gross profit relative to our print server products, contributed
to the improvement in gross profit in 2002.
Research and Development
Research and product development expenses were $1.4 million in
2002, compared to $1.8 million in 2001, and represented 14% and 19% of
net sales for those periods, respectively. The lower research and
development expenses in 2002 were mostly due to lower support costs of
$213,000 and reduced use of outside consulting, resulting in a savings
of $244,000.
Sales and Marketing
Sales and marketing expenses were $3.0 million and $3.6
million for 2002 and 2001, respectively, and represented 31% and 38% of
net sales for those periods. The reduction in sales and marketing
expenses was largely due to a reduction in personnel related costs of
$395,000, which was partly realized from the restructuring actions in
2001 and lower product promotional expenses of $291,000, offset in part
by higher support costs of $55,000.
General and Administrative
General and administrative expenses were $1.9 million and $1.3
million for 2002 and 2001, respectively, or 20% and 14% of net sales
for those periods. The increase in expenses in 2002 was mostly due to
higher legal expenses of $128,000 and outside consulting expenses of
$209,000, which were chiefly attributable to our stock repurchase and
Nasdaq listing issues. Increased accounting fees of $81,000,
compensation to our board of directors of $49,000, investor relations
expenses of $72,000 and the absence of benefit obtained from the
collection of bad debts previously written-off in 2001 of $115,000 also
contributed to the higher general and administrative expenses in 2002.
Restructuring Expenses
In April 2001, we terminated 17 regular, temporary and
contractor positions, which constituted approximately 25% of our
workforce. This action resulted in a restructuring charge of $239,000
in 2001. In the second quarter of 2002, a non-recurring benefit of
$40,000 arising from the reversal of previously recorded restructuring
charges was included in our results of operations, following the
completion of our 2001 restructuring program for less than previously
anticipated. The following table sets forth an analysis of the
components of the reserve balance carried-forward from fiscal 2001 (in
thousands of dollars):
21
Asset Write
Employee Costs Facilities Down Other Total
--------------------------------------------------------------------
Balance as of December 31, 2001 $36 $28 $ - $ 25 $ 89
Cash payments (36) - - (13) (49)
Reversal of excess accrual - (28) - (12) (40)
--------------------------------------------------------------------
Balance as of 12/31/2002 $ - $ - $ - $ - $ -
Interest and other income
Interest and other income consist primarily of interest income
earned from our invested cash balances, interest expense on capital
leases, bank service fees, and miscellaneous income and expenses.
Interest and other income was $44,000 and $111,000 in 2002 and 2001,
respectively. The decrease in other income in 2002 when compared to
2001 primarily reflected lower interest income of $52,000 due to the
decline in interest rates during 2002 and miscellaneous income of
$64,000, offset in part by lower bank fees of $51,000.
Provision for Income Tax
In fiscal 2002, our provision for income taxes was $6,000,
representing state income taxes. The tax provision for federal income
taxes was offset by utilization of our net operating loss
carryforwards.
In fiscal 2001, we incurred a loss and there were no
substantial federal or state income taxes recognized.
Liquidity and Capital Resources
Since our initial public offering of common stock in December 1995, our
principal source of funding has been cash from our operations, with some funding
from capital equipment lease lines. As of December 31, 2003, we had $4.6 million
of cash and cash equivalents, an increase of $1.2 million from December 31,
2002. The increase in cash and cash equivalents was primarily attributable to
the increase in income before tax of $1.1 million and $268,000 in proceeds from
the exercise of stock options, offset in part by $164,000 of investment in new
computers and other production equipment.
On March 12, 2002, we received a notice from the Nasdaq Stock Market
that our common stock had failed to maintain the minimum bid price of $1.00 per
share required for continued listing on the Nasdaq SmallCap Market. On November
18, 2002, we were granted a temporary exception to Nasdaq's minimum bid price
requirement, subject to us meeting certain conditions during the term of the
exception. On December 30, 2002, our common stock bid price closed at $1.00 per
share and since then the bid price has closed above $1.00. On January 16, 2003,
we received a letter from the Nasdaq stating that we have demonstrated full
compliance with the Nasdaq Qualifications Exception issued to us on November 18,
2002.
In the fourth quarter of 2002, our Board of Directors authorized us,
from time to time, to repurchase at market prices, up to $2.25 million shares of
our common stock for cash in open market, negotiated or block transactions. The
timing of such transactions has depended and will depend on market conditions,
other corporate strategies and has been and will be at the discretion of our
management. No time limit was set for the completion of this program. As of
December 31, 2003, we have repurchased from open market and negotiated
transactions a total of 1.67 million shares for $1.8 million, at an average per
share price of $1.10.
22
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 December 31, 2003, the future minimum payments are $50,000.
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
December 31, 2003, the future minimum payments are $2,000.We have entered into a
noncancelable operating lease that expires in 2005 and other capital leases that
expire at various stages in 2006, and are responsible for certain maintenance
costs, taxes and insurance under the leases. We lease our headquarters in Morgan
Hill, California.. The lease 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 following represents combined aggregate maturities for all our
financing and commitments as of December 31, 2003:
Payments Due by Period
---------- ------------- --------------- ------------- ---------------
Contractual Obligations Total Less Than 1 1 - 3 Years 3 - 5 Years More than 5
Year Years
---------- ------------- --------------- ------------- ---------------
Capital (Finance) Lease Obligations $ 53 $ 20 $ 33 - -
Operating Lease Obligations $ 532 $ 269 $ 263 - -
---------- ------------- --------------- ------------- ---------------
Total contractual cash obligations $ 585 $ 289 $ 296 - -
========== ============= =============== ============= ===============
In addition to the commitments shown above, we have a $3.0 million
secured revolving line of credit with a bank, which expires in March 2005,
pursuant to which we may borrow 100% against pledges of cash at the bank's prime
rate (4% at December 31, 2003). Borrowings under this line of credit agreement
are collateralized by all of our assets. Under the agreement, we must comply
with certain financial and other covenants. As of December 31, 2003, we have not
drawn down on the line of credit, were in compliance with these covenants and
have no borrowings outstanding under the line of credit.
Net cash provided by operations in 2003 was $1.1 million as compared to
$882,000 in 2002. The increase was largely a result of sales increases, and
better gross profit arising from improved operational efficiencies and cost
reductions.
Net cash used in financing activities of $2.0 million in 2002 was
largely for the repurchase of our stock and the professional fees associated
with such repurchase. In the first quarter of 2003, we repurchased $48,000 of
our stock from open market transactions. We acquired additional property and
equipment of $164,000, $34,000 and $105,000 in 2003, 2002 and 2001,
respectively.
We believe that our existing cash balances, anticipated cash flows from
operations and available lines of credit will be sufficient to meet our
anticipated capital requirements for the next 12 months. 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
23
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 of our dependency 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.
RISK FACTORS
Shareholders or investors considering the purchase of shares of the our
common stock should carefully consider the following risk factors, in addition
to other information in this Annual Report on Form 10-K. 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 we inaccurately forecast demand for our products,
the impact on net income may be magnified by our inability to adjust spending
quickly enough to compensate for the net sales shortfall.
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 and acceptance 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 service revenue,
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.
24
We have a history of losses and may not be able to sustain profitability.
We have experienced significant operating losses and, as of December
31, 2003, had an accumulated deficit of $22 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 conditions. We
were able to recover and have been profitable since the third quarter of 2001,
with total net income of $659,000 and $1.6 million in 2002 and 2003,
respectively. 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.
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.
Substantially all of our revenue comes from the sale of fax server products, and
a decline in demand for those products would harm our business, operating
results and financial condition.
We derive substantially all of our revenue from the sale of fax and
print server products, with fax server products accounting for 97% of total
sales in 2003. We expect that our current products will continue to account for
most of our sales in the near future. A decline in demand for our fax server
products as a result of competition, technological change, shortages of
components or other factors, or a delay in the development and market acceptance
of new features and products, would have a material adverse effect on our
business, operating results and financial condition.
We sell our products through a limited number of distributors, and any
deterioration in our relationship with those distributors would harm our
business, operating results and financial condition.
We sell our products primarily through a two-tier domestic and
international distribution network. Our distributors sell our products to VARs,
e-commerce vendors and other resellers. The distribution of personal computers
and networking products has been characterized by rapid change, including
consolidations due to the financial difficulties of distributors and the
emergence of alternative distribution channels. An increasing number of
companies are competing for access to these channels. Our distributors typically
represent other products that are complementary to, or compete with, our
products. Our distributors are not contractually committed to future purchases
of our products and could discontinue carrying our products at any time for any
reason. 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
25
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 have a stock rotation policy with certain of our
distributors that allows them to return marketable inventory against offsetting
orders. If we reduce our prices, we credit certain distributors for the
difference between the purchase price of products remaining in their inventory
and our reduced price for these products. In addition, inventory levels of our
products held by distributors could become excessive due to industry conditions
or the actions of competitors, resulting in product returns and inventory
write-downs.
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 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 which
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.
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. Replacement of
discontinued components used in our products could lead to further defects and
errors. There can be no assurance that despite testing by us and by third-party
test sites, errors and defects 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.
26
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 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 markets for our products are highly competitive and may become more
competitive in the future.
The network enhancement products and computer software markets are
highly competitive, and we believe that competition will intensify in the
future. The competition is characterized by rapid change and improvements in
technology along with constant pressure to reduce the prices of products. We
currently compete principally in the market for network fax servers, network
print servers and fax-on-demand software. Both direct and indirect competition
could adversely affect our business and operating results through pricing
pressure, loss of market share and other factors. In particular, we expect that,
over time, average selling prices for our print server products will continue to
decline, as the market for these products becomes increasingly competitive. Any
material reduction in the average selling prices of our products would adversely
affect gross margins. There can be no assurance we will be able to maintain the
current average selling prices of our products or the related gross margins.
The principal competitive factors affecting the market for our products
include:
o product functionality;
o performance;
o quality;
o reliability;
o ease of use;
o quality of customer training and support;
o name recognition;
o price; and
o compatibility and conformance with industry standards and changing
operating system environments.
Several of our existing and potential competitors have substantially
greater financial, engineering, manufacturing and marketing resources than us.
We also experience competition from a number of other software, hardware and
service companies. In addition to our current competitors, we may face
substantial competition from new entrants into the network enhancement market,
including established and emerging computer, computer peripheral, communications
and software companies. In the fax server market we compete with companies such
as Captaris Inc., Omtool, Ltd. and Esker Software. There can be no assurance
that competitors will not introduce products incorporating technology more
advanced than the technology used by us in our products. In addition, certain
competing methods of communications such as the Internet or electronic mail
could adversely affect the market for fax products. Certain of our existing and
potential competitors in the print server market are manufacturers of printers
and other peripherals, and these competitors may develop closed systems
accessible only through their own proprietary servers. There can be no assurance
that we will be able to compete successfully or that competition will not have a
material adverse effect on our business, operating results and financial
condition.
27
We depend on sales in foreign markets, and political or economic changes in
these markets could affect our business, operating results and financial
condition.
Sales to customers located outside the United States accounted for
approximately 19%, 21% and 25% of our net sales in 2003, 2002 and 2001,
respectively. We sell our products in approximately 40 foreign countries through
approximately 50 international distributors. Our principal Japanese distributor
accounted for approximately 38%, 27% and 40% of our international sales in 2003,
2002 and 2001, respectively, and 7%, 6% and 10% of our total net sales in 2003,
2002 and 2001, respectively. We expect that international sales will continue to
represent a significant portion of our product revenues and that we will be
subject to the normal risks of international sales, such as export laws,
currency fluctuations, longer payment cycles, greater difficulties in accounts
receivable collections and the requirement of complying with a wide variety of
foreign laws. There can be no assurance that we will not experience difficulties
resulting from changes in foreign laws relating to the export of our products in
the future. In addition, because we primarily invoice foreign sales in U.S.
dollars, fluctuations in exchange rates could affect demand for our products by
causing prices to be out of line with products priced in the local currency.
Additionally, any such difficulties would have a material adverse effect on our
international sales and a resulting material adverse effect on our business,
operating results and financial condition. We may experience fluctuations in
European sales on a quarterly basis because European sales may be weaker during
the third quarter than the second quarter due to extended holiday shutdowns in
July and August. There can be no assurance that we will be able to maintain the
level of international sales in the future. Any fluctuations in international
sales will significantly affect our operating results and financial condition.
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. From time to time, component manufacturers announce the end
of life of certain of their products and may or may not have replacement
products. If we are unable to secure enough inventories of the end-of-life
components or their replacements, we might not be able to deliver our products
to our customers and could adversely affect our revenue and net income.
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.
28
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.
Our success depends to a certain extent 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. Despite the precautions taken by us, 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 we 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 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
29
volatility has had a substantial effect on the market price of the common stock
of us 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 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. 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. The issuance of equity
or convertible debt securities to raise additional capital would result in
additional dilution to our shareholders.
Recent terrorist activity in the United States and the military action to
counter terrorism could adversely impact our business.
Terrorist acts or acts of war (wherever located around the world) could
significantly impact our revenue, costs and expenses, and financial condition.
The terrorist attacks that took place in the United States on September 11, 2001
have created many economic and political uncertainties, some of which may
materially harm our business, operating results and financial condition. The
long-term effects on our business of the September 11, 2001 attacks and the
ensuing war on terror are unknown. The potential for future terrorist attacks,
the national and international responses to terrorist attacks or perceived
threats to national security, and other actual or potential conflicts, acts of
war or hostility, including the United States' activities in Iraq, have created
many economic and political uncertainties that could adversely affect our
business, operating results and financial condition in ways that cannot
presently be predicted.
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 Nasdaq National Stock Market. We may not be successful 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. We are presently evaluating and monitoring regulatory
developments and cannot estimate the timing or magnitude of additional costs we
may incur as a result, or the effect that these increased costs may have on our
operating results.
Voting control by officers, directors and affiliates may delay, defer or
prevent a change of control.
At February 29, 2004, 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.
30
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.
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 our 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 our 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." SFAS
No. 150 establishes standards for how an issuer classifies and measures 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. Many of those instruments were
previously classified as equity. SFAS No. 150 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. 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 SFAS No. 150 and still existing at the beginning of the interim period
of adoption. While the effective date of certain elements of SFAS No. 150 has
been deferred, we do not expect the adoption of SFAS No. 150 to have a material
impact upon our financial position, cash flows or results of operations.
In December 2003, the FASB issued a revised FASB interpretation No. 46
(FIN 46R), "Consolidation for Variable Interest Entities, and interpretation of
ARB No. 51" The FASB published the revision to clarify and amend some of the
original provisions of FIN 46, which was issued in January 2003, and to exempt
certain entities from its requirements. A variable interest Entity ("VIE")
refers to an entity subject to consolidation according to the provisions of the
Interpretation. FIN 46R applies to entities whose equity investment at risk is
insufficient to finance that entity's activities without receiving additional
subordinated financial support provided by any parties, including equity
holders, or where the equity investors (if any) do not have a controlling
financial interest. FIN 46R provides that if an entity is the primary
beneficiary of a VIE, the assets, liabilities, and results of operations of the
VIE should be consolidated in the entity's financial statements. In addition,
FIN 46R requires that both the primary
31
beneficiary and all other enterprises with a significant variable interest in a
VIE provide additional disclosures. The provisions of FIN 46R are effective for
our fiscal 2004 first quarter. The Company does not expect the adoption of FIN
46R to have a material impact on our financial position or results of
operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We had no holdings of derivative financial or commodity instruments at
December 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, certain spending is 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 and related income would not be
significantly impacted by increases or decreases in interest rates due mainly to
the highly liquid nature of these investments. However, sharp declines in
interest rates could seriously harm interest earnings.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements and supplementary data required
by this Item are set forth at the pages indicated in Item 15 of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
ITEM 9A. 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 on their evaluation of our
disclosure controls and procedures as of the end of the period covered by this
report, concluded that our disclosure controls and procedures were effective for
this purpose.
Regulations under the Securities Exchange Act of 1934 require public
companies, including our company, to evaluate any change in our "internal
control over financial reporting," which is defined as a process to provide
reasonable assurance regarding the reliability of financial reporting and
preparation of financial statements for external purposes in accordance with
accounting principles generally accepted in the United States. In connection
with their evaluation of our disclosure controls and procedures as of the end of
the period covered by this report, our Chief Executive Officer and Chief
Financial Officer did not identify any change in our internal control over
financial reporting during the three-month period ended December 31, 2003 that
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
32
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Identification of Directors
The information required by this Item concerning our directors is
incorporated by reference from the sections captioned "Proposal 1: Election of
Directors" contained in our definitive Proxy Statement (the "Proxy Statement"),
related to our 2003 Annual Meeting of Shareholders to be filed by us with the
Securities and Exchange Commission ("SEC") no later than April 30, 2004 or will
be provided in an amendment to this Form 10-K to be filed with the SEC no later
than April 30, 2004.
Identification of Executive Officers
The information required by this Item concerning our executive officers
is set forth in Part I of this Report.
Section 16(a) Beneficial Ownership Reporting Compliance
The information concerning compliance with Section 16(a) of the
Exchange Act required by this Item is incorporated by reference to the section
captioned "Section 16(a) Beneficial Ownership Reporting Compliance" contained in
the Proxy Statement.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference to
the section captioned "Executive Compensation" in the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated by reference to
the section captioned "Security Ownership of Certain Beneficial Owners and
Management" contained in the Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In October 2002, the Company engaged W.R. Hambrecht + Co. ("WRH + Co."), an
investment bank in which Mr. Hambrecht, a director of the Company, is a partner,
to manage our stock buyback program approved by the Board of Directors. As of
March 10, 2004, WRH + Co. had received an insignificant amount of compensation
under this arrangement.
Other information required by this Item is incorporated by reference
from the sections captioned "Certain Transactions" and "Executive Compensation"
contained in the Proxy Statement.
ITEM 14. PRINCIPAL AUDITOR FEES AND SERVICES
Information regarding principal auditor fees and service is set forth
under "Ratification of Selection of Independent Auditors" in the Proxy
Statement, which information is incorporated hererin by reference.
33
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Annual Report on
Form 10-K:
1) Financial Statements
Page in
Form 10-K
Report of Independent Auditors................................................ F-1
Consolidated Balance Sheets as of December 31, 2003 and 2002.................. F-2
Consolidated Statements of Operations for the years ended
December 31, 2003, 2002 and 2001......................................... F-3
Consolidated Statements of Shareholders' Equity for the years ended
December 31, 2003, 2002 and 2001......................................... F-4
Consolidated Statements of Cash Flows for the years ended
December 31, 2003, 2002 and 2001......................................... F-5
Notes to Consolidated Financial Statements.................................... F-6
2) Financial Statement Schedules
The following financial statement schedule of Castelle for the
years ended December 31, 2003, 2002 and 2001 is filed as part of
this Form 10-K and should be read in conjunction with the Company's
Financial Statements.
Page in
Form 10-K
Schedule II - Valuation and Qualifying Accounts............................... F-23
3) Additional Exhibits
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 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
Schedules not listed above have been omitted because they are
not applicable or are not required or because the required
information is included in the Financial Statements or Notes
thereto.
34
(b) Reports on Form 8-K
During the fourth quarter of 2003, Castelle filed a Form 8-K
on October 24, 2003. Furnished under Item 12, "Results of
Operations and Financial Condition", Castelle filed a press
release regarding its financial results for its fiscal quarter
ended September 30, 2003.
(c) Exhibits
Incorporated by Reference
Exhibit Date of Exhibit Filed
Number Exhibit Description Form File No. First Filing Number Herewith
-------- ------------ ------ --------
3.1 Registrant's Amended and Restated Articles of Incorporation. SB-2/A 33-99628-LA- 12/8/1995 3.3
3.2 Registrant's Amended and Restated Bylaws. 10-K 000-22020 12/31/2000 3.2
4.1 Specimen Stock Certificate representing shares of SB-2/A 33-99628-LA- 12/14/1995 4.1
Registrant's Common Stock.
10.1* 1995 Non-Employee Directors' Stock Option Plan, as amended, SB-2/A 111-22020 12/14/1995 10.2
and form of Director Stock Option Agreement
10.2 Form of Indemnity Agreement between the Registrant and each SB-2/A 33-99628-LA- 12/8/1995 10.4
of its directors and executive officers.
10.3 OEM Purchase Agreement dated May 23, 1995, by and between SB-2/A 33-99628-LA- 12/8/1995 10.7
the Registrant and SerComm Corporation.
10.4 Distribution Agreement dated February 26, 1990, by and SB-2/A 33-99628-LA- 12/8/1995 10.8
between the Registrant and Ingram Micro D Inc.
10.5 Distributor Contract dated June 25, 1991, as amended June SB-2/A 33-99628-LA- 12/8/1995 10.9
25, 1991, by and between the Registrant and Tech Data
Corporation.
10.6 International Distributor Agreement dated February 24, 1994, SB-2/A 33-99628-LA- 12/8/1995 10.12
by and between the Registrant and Macnica.
10.7* 1988 Equity Incentive Plan, as amended, and form of option S-8 333-75247 3/29/1999 99.1
agreement
10.8 International Distributor Agreement dated April 24, 2001 by 10-K 000-22020 3/29/2002 10.11
and between the Registrant and AMS Limited.
10.9 Commercial Tenant Lease Agreement dated August 16, 2000 by 10-K 000-22020 3/29/2002 10.12
and among the Registrant and Kyung S. Lee and Ieesun Kim Lee.
10.10* Summary of Severance Agreements with Named Executive 10-K 000-22020 3/29/2002 10.13
Officers.
10.11 Employment agreement dated April 22, 2002 by and between the 10-K 000-22020 3/28/2003 10.16
Registrant and Scott McDonald.
10.12 Form of Executive Severance and Transition Benefits 10-K 000-22020 3/28/2003 10.16
Agreement dated April 22, 2002 by and between the Registrant
and Scott McDonald.
10.13* 2002 Equity Incentive Plan. 10-K 000-22020 3/28/2003 10.16
10.14 Loan and Security Agreement dated March 18, 1999 by and 10-K 000-22020 3/28/2003 10.17
between the Registrant and Silicon Valley Bank.
10.15 Loan Modification Agreement dated March 16, 2003 by and 10-K 000-22020 3/28/2003 10.18
between the Registrant and Silicon Valley Bank.
10.16 Loan Modification Agreement dated March 15, 2004 by and X
between the Registrant and Silicon Valley Bank. -- -- -- --
23.1 Consent of PricewaterhouseCoopers LLP, Independent Auditors. -- -- -- -- X
* Indicates management contracts or compensatory plans or arrangements
filed pursuant to Item 601(b)(10) of Regulation S-K
35
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Act of 1934, as amended, the Registrant has duly caused this Annual Report on
Form 10-K to be signed on its behalf by the undersigned, thereunto duly
authorized on the twenty-ninth day of March 2004.
By: /S/ SCOTT C. MCDONALD
--------------------------------------------
Scott C. McDonald
Chief Executive Officer and President
KNOW BY ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Scott C. McDonald, as his true and lawful
attorney-in-fact and agent, with full power of substitution for him, and in his
name in any and all capacities, to sign any and all amendments to this Annual
Report on Form 10-K, and to file the same, with exhibits thereto and other
documents in connection therewith, with the Securities and Exchange Commission,
granting unto said attorney-in-fact and agent, full power and authority to do
and perform each and every act and thing requisite and necessary to be done
therewith, as fully to all intents and purposes as he might or could do in
person, hereby ratifying and confirming all that said attorney-in-fact and
agent, and any of them, or his substitute or substitutes, may lawfully do or
cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Annual Report on Form 10-K has been signed below by the following persons
on behalf of the Registrant and in the capacities and on the dates indicated:
Name Title Date
/S/ SCOTT C. MCDONALD Chief Executive Officer, President March 29, 2004
- --------------------- (principal executive officer), Director
Scott C. McDonald
/S/ PAUL CHENG Vice President, Finance and Administration, March 29, 2004
- -------------- Chief Financial Officer (principal accounting officer),
Paul Cheng Secretary
/S/ DONALD L. RICH Chairman of the Board and Director March 29, 2004
- ------------------
Donald L. Rich
/S/ ROBERT H. HAMBRECHT Director March 29, 2004
- -----------------------
Robert H. Hambrecht
/S/ ROBERT O. SMITH Director March 29, 2004
- -------------------
Robert O. Smith
/S/ PETER R. TIERNEY Director March 29, 2004
- --------------------
Peter R. Tierney
36
Report of Independent Auditors
To the Board of Directors and
Shareholders of Castelle
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15 (a)(1) present fairly, in all material respects, the
financial position of Castelle and its subsidiary at December 31, 2003 and 2002,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2003 in conformity with accounting
principles generally accepted in the United States of America. In addition, in
our opinion, the financial statement schedule listed in the index appearing
under Item 15(a)(2) presents fairly, in all material respects, the information
set forth therein when read in conjunction with the related consolidated
financial statements. These financial statements and financial statement
schedule are the responsibility of the Company's management; our responsibility
is to express an opinion on these financial statements and financial statement
schedule based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
San Jose, California
March 29, 2004
Castelle
Consolidated Balance Sheets
(in thousands)
- -------------------------------------------------------------------------------------------------------------------
December 31,
....................................
2003 2002
---------------- -----------------
Assets
Current assets:
Cash and cash equivalents $ 4,614 $ 3,460
Accounts receivable, net 873 444
Inventories 1,177 1,110
Prepaid expenses and other current assets 134 88
Deferred taxes 380 -
---------------- -----------------
Total current assets 7,178 5,102
Property and equipment, net 376 425
Other assets 103 108
Deferred taxes 146 -
---------------- -----------------
Total assets $ 7,803 $ 5,635
================ =================
Liabilities and Shareholders' Equity
Current liabilities:
Current portion of long-term debt $ 16 $ 21
Accounts payable 314 359
Accrued liabilities 1,759 1,696
Deferred Revenue 909 592
---------------- -----------------
Total current liabilities 2,998 2,668
Long-term debt, net of current portion 29 44
---------------- -----------------
Total liabilities 3,027 2,712
---------------- -----------------
Commitments and contingencies (Note 4)
Shareholders' equity:
Preferred stock, no par value:
Authorized: 2,000 shares in 2003 and 2002
Issued and outstanding: none in 2003 and 2002 - -
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 3,425 shares at December 31, 2003
and 3,187 shares at December 31, 2002 27,258 27,038
Accumulated deficit (22,482) (24,115)
---------------- -----------------
Total shareholders' equity 4,776 2,923
---------------- -----------------
Total liabilities and shareholders' equity $ 7,803 $ 5,635
================ =================
F-2
The accompanying notes are an integral part of these financial statements.
Castelle
Consolidated Statements of Operations
(in thousands, except per share data)
- -------------------------------------------------------------------------------------------------------------------
Year Ended December 31
........................................................
2003 2002 2001
----------------- ----------------- -----------------
Net sales $ 10,214 $ 9,759 $ 9,354
Cost of sales 2,485 2,836 3,089
----------------- ----------------- -----------------
Gross profit 7,729 6,923 6,265
----------------- ----------------- -----------------
Operating expenses:
Research and development 1,590 1,383 1,805
Sales and marketing 3,131 3,016 3,588
General and administrative 1,902 1,943 1,335
Restructuring charge/(recovery) - (40) 239
----------------- ----------------- -----------------
6,623 6,302 6,967
----------------- ----------------- -----------------
Operating income/(loss) 1,106 621 (702)
Interest income, net 16 43 94
Other income/(expense), net (26) 1 17
----------------- ----------------- -----------------
Income/(loss) before provision for/(benefit from)
income taxes 1,096 665 (591)
Provision (benefit) for income taxes (537) 6 -
----------------- ----------------- -----------------
Net income/(loss) $ 1,633 $ 659 $ (591)
================= ================= =================
Net income/(loss) per common share - basic $ 0.50 $ 0.15 $ (0.12)
================= ================= =================
Net income/(loss) per common share - diluted $ 0.39 $ 0.14 $ (0.12)
================= ================= =================
Shares used in per share calculation - basic 3,254 4,539 4,744
================= ================= =================
Shares used in per share calculation - diluted 4,186 4,586 4,744
================= ================= =================
F-3
The accompnaying notes are an integral part of these financial statements.
Castelle
Consolidated Statements of Shareholders' Equity
Years Ended December 31, 2003, 2002 and 2001
(in thousands)
- -------------------------------------------------------------------------------------------------------------------
Common Stock Deferred Accumulated
..........................
Shares Amount Compensation Deficit Total
------------ ------------ ------------- ------------ ------------
Balances, December 31, 2000 4,741 $ 28,976 $ (17) $ (24,183) $ 4,776
Issuance of common stock through
exercise of stock options 4 1 - - 1
Deferred compensation related to options issued to - 4 (4) - -
consultant
Revaluation of options issued to consultants (4) 4 -
Amortization of deferred compensation - - 16 - 16
Net loss - - - (591) 591
------------ ------------ ------------- ------------ ------------
Balances, December 31, 2001 4,745 28,977 (1) (24,774) 4,202
============ ============ ============= ============ ============
Issuance of common stock through
exercise of stock options 61 38 - - 38
Repurchase and cancellation of common stock (1,619) (1,977) - (1,977)
Amortization of deferred compensation - - 1 - 1
Net - - - 659 659
income
------------ ------------ ------------- ------------ ------------
Balances, December 31, 2002 3,187 27,038 - (24,115) 2,923
============ ============ ============= ============ ============
Issuance of common stock through
exercise of stock options 285 268 - - 268
Repurchase and cancellation of common stock (47) (48) - (48)
Net - - - 1,633 1,633
income
------------ ------------ ------------- ------------ ------------
Balances, December 31, 2003 3,425 $ 27,258 $ - $ (22,482) $ 4,776
============ ============ ============= ============ ============
F-4
The accompanying notes are an integral part of these financial statements.
Castelle
Consolidated Statements of Cash Flows
Years Ended December 31,2003, 2002 and 2001
(in thousands)
- ----------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
....................................................
2003 2002 2001
---------------- ---------------- ----------------
Cash flows from operating activities:
Net income/(loss) $ 1,633 $ 659 $ (591)
Adjustments to reconcile net income/(loss) to
net cash provided by operating activities:
Depreciation and amortization 213 206 230
Provision for doubtful accounts and sales returns 5 (21) 59
Write-downs of excess and obsolete inventory (167) (105) 148
Deferred taxes (526) - -
Compensation expense related to grant of stock options - 1 16
Loss on disposal of fixed assets - 1 44
Changes in assets and liabilities:
Accounts receivable (434) 257 1,344
Inventories 100 (79) 289
Prepaid expenses and other current assets (41) 42 79
Other assets - - (6)
Accounts payable (45) 79 (734)
Accrued liabilities 63 (306) (193)
Deferred revenue 317 148 (42)
---------------- ---------------- ----------------
Net cash provided by operating activities 1,118 882 643
---------------- ---------------- ----------------
Cash flows from investing activities:
Acquisition of property and equipment ( 164) (34) (105)
---------------- ---------------- ----------------
Net cash used in investing activities (164) (34) (105)
---------------- ---------------- ----------------
Cash flows from financing activities:
Return of restricted cash - - 125
Issuance/(repayment) of notes payable (20) (17) 11
Repurchase of common stock (48) (1,977) -
Proceeds from issuance of common stock 268 38 1
---------------- ---------------- ----------------
Net cash provided by/(used in) financing activities 200 (1,956) 137
---------------- ---------------- ----------------
Net increase/(decrease) in cash and cash equivalents 1,154 (1,108) 675
Cash and cash equivalents, beginning of period 3,460 4,568 3,893
---------------- ---------------- ----------------
Cash and cash equivalents, end of period $ 4,614 $ 3,460 $ 4,568
================ ================ ================
Supplemental information:
Cash paid during the period for:
Interest $ 9 $ 10 $ 12
Noncash investing and financing activities:
Note payable for fixed asset acquisition $ - $ - $ 25
F-5
The accompanying notes are an integral part of these financial statements.
Castelle
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
1. Business and Organization of the Company
Castelle develops, manufactures, markets and supports office automation
systems that allow organizations to easily implement faxing and printing
over local area networks and the Internet. Castelle's FaxPress and
FaxPress Premier fax servers provide simple ways to integrate fax with
email, desktop and back-end applications. The Company also provides
LANpress print servers, which enable users to locate printers anywhere on
the network, and the InfoPress information-on-demand software suite.
The Company distributes its products primarily through a two-tier
domestic and international distribution network, with its distributors
selling Castelle's products to value-added resellers, system integrators,
e-commerce retailers and other resellers in the United States, Europe and
the Pacific Rim. The Company also has relationships with selected
original equipment manufacturers and sells software enhancements and
upgrades directly to end-users.
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. 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
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. The Company's three largest distributors accounted for 57%,
56% and 55% of the Company's sales in 2003, 2002 and 2001, respectively.
2. Summary of Significant Accounting Policies
Use of estimates in preparation of financial statements
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States 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.
Basis of presentation
Certain reclassifications have been made to prior year balances in order
to conform to the current year presentation.
F-6
Principles of consolidation
The consolidated financial statements include the accounts of Castelle
and its wholly owned subsidiaries in the United States and the United
Kingdom. All intercompany balances and transactions have been eliminated.
Financial instruments
Cash equivalents consist of highly liquid investments with original or
remaining maturities of three months or less when purchased.
Carrying amounts of financial instruments consisting of cash and cash
equivalents, accounts receivable, accounts payable and accrued
liabilities included in the Company's financial statements approximate
fair value due to their short maturities.
Concentrations of credit risk
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of trade receivables
and cash equivalents. With respect to trade receivables, the Company
performs ongoing credit evaluations of its customers' financial
condition. Additionally, the Company establishes an allowance for
doubtful accounts based upon factors surrounding the credit risk of
specific customers, historical trends and other available information.
Three customers accounted for 69%, 68% and 72% of accounts receivable at
December 31, 2003, 2002 and 2001, respectively. The same three customers
accounted for 57%, 56% and 55% of the Company's total sales in 2003, 2002
and 2001, respectively. Although the Company does not require collateral
on certain accounts receivable on sales to large, well-established
companies, it does require prepayments on certain sales to foreign and
smaller companies.
With respect to cash equivalents, the Company has cash investment
policies that limit the amount of credit exposure to any one issuer and
restrict placement of these investments to issuers evaluated as
creditworthy.
Inventories and related write-downs for excess and obsolete inventory
Inventories are stated at the lower of standard cost (which approximates
cost on a first-in, first-out basis) or market. Inventories have also
been written down for excess and obsolete inventories. The write-downs
are based on management's review of inventories on hand, compared to
management's assumptions about future demand, market conditions and
anticipated timing of the release of product upgrades or next generation
products. If actual market conditions for future demand are less
favorable than those projected by us or if product upgrades or next
generation products are released earlier than anticipated, additional
inventory write-downs may be required.
Property and equipment
Property and equipment are stated at cost less accumulated depreciation
and amortization. Depreciation is provided using the straight-line method
over the estimated useful lives of the respective assets, generally three
to seven years. Amortization of leasehold improvements is provided on a
straight-line basis over the life of the related asset or the lease term,
if shorter. Gains and losses upon asset disposal are recognized in the
year of disposition. Expenditures for replacements and betterments are
capitalized, while expenditures for maintenance and repairs are charged
against earnings as incurred.
F-7
Accounting for long-lived assets
The Company reviews long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Recoverability is measured by comparison of its
carrying amount to undiscounted future net cash flows the assets are
expected to generate. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the
carrying amount of the asset exceeds its fair market value.
Revenue recognition
Castelle recognizes revenue based on the provisions of Staff Accounting
Bulletin No. 104 "Revenue Recognition" 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 or 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. End-user 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 and returns. Castelle establishes its returns
allowance for distributors and direct end-user 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.
Shipping and handling
Costs related to shipping and handling are included in cost of sales for
all periods presented.
Advertising costs
Advertising costs, included in sales and marketing expenses, are expensed
as incurred and were $345,000, $193,000 and $446,000 in 2003, 2002 and
2001, respectively.
F-8
Research and development expenses
Costs related to the conceptual formulation and design of both hardware
and software products are expensed as research and development while
costs incurred subsequent to establishing technological feasibility of
software products are capitalized until general release of the product.
Generally, technological feasibility is established upon completion of a
working model. No significant costs subsequent to such point have been
incurred, and all such costs have been expensed.
Income taxes
The Company accounts for income taxes in accordance with the liability
method. Under the liability method, deferred assets and liabilities are
recognized based upon anticipated future tax consequences attributable to
differences between financial statement carrying amounts of assets and
liabilities and their respective tax bases. The provision for income
taxes is comprised of the current tax liability and the change in
deferred tax assets and liabilities. The company establishes a valuation
allowance to the extent that all or some portion of the deferred tax
assets more likely than not will not be recoverable against future
taxable income.
Foreign currency translation
The functional currency of the Company's foreign subsidiary is the U.S.
dollar. Accordingly, all assets and liabilities are translated into U.S.
dollars at the current exchange rates as of the applicable balance sheet
date. Revenues and expenses are translated at the average exchange rates
prevailing during the period. Cumulative gains and losses from the
translation of the foreign subsidiaries' financial statements have not
been material to date. Foreign exchange gains and losses resulting from
foreign currency transactions were not material in any of the periods
presented.
Net income/(loss) per share
Basic net income/(loss) per share is computed by dividing net
income/(loss) by the weighted average number of common shares outstanding
for that period. Diluted net income/(loss) per share is computed giving
effect to all dilutive potential common shares that were outstanding
during the period. Dilutive potential shares consist of incremental
common shares issuable upon exercise of stock options.
F-9
Basic and diluted net income/(loss) per share are calculated as follows
for 2003, 2002 and 2001 (in thousands except per share amounts):
2003 2002 2001
--------------- ---------------- ----------------
Basic:
Weighted average shares 3,254 4,539 4,744
=============== ================ ================
Net income/(loss) $ 1,633 $ 659 $ (591)
=============== ================ ================
Net income/(loss) per share $ 0.50 $ 0.15 $ (0.12)
=============== ================ ================
Diluted:
Weighted average shares 3,254 4,539 4,744
Common equivalent shares from stock options 932 47 -
--------------- ---------------- ----------------
Shares used in per share calculation 4,186 4,586 4,744
=============== ================ ================
Net income/(loss) $ 1,633 $ 659 $ (591)
=============== ================ ================
Net income/(loss) per share $ 0.39 $ 0.14 $ (0.12)
=============== ================ ================
The calculation of diluted shares outstanding excludes 120,000, 1,153,000
and 901,000 shares of common stock for the years ended December 31, 2003,
2002, and 2001 respectively, as their effect was antidilutive in the
period.
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.
F-10
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 years ended December 31 (in thousands, except per
share data):
2003 2002 2001
--------------- -------------- -------------
Net income/(loss) - as reported $ 1,633 $ 659 $ (591)
Fair value of stock-based compensation (433) (176) (65)
--------------- -------------- -------------
Net income/(loss) - pro forma $ 1,200 $ 483 $ (656)
=============== ============== =============
Net income/(loss) per share - basic - as reported $ 0.50 $ 0.15 $ (0.12)
Net income/(loss) per share - diluted - as reported $ 0.39 $ 0.14 $ (0.12)
Net income/(loss) per share - basic - pro forma $ 0.37 $ 0.11 $ (0.14)
Net income/(loss) per share - diluted - pro forma $ 0.29 $ 0.11 $ (0.14)
Stock-based compensation included in net income/(loss), as
reported $ - $ 1 $ 16
The Company accounts for stock-based compensation arrangements with
non-employees in accordance with Emerging Issues Task Force ("EITF")
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 held by non-employees are
subject to revaluation at each balance sheet date based on the then
current fair market value.
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, and therefore, no
separate statement of comprehensive income has been presented.
Segment information
The Company uses one measurement of profitability of its business for
internal purposes and has determined that it operates in one business
segment: server appliances. The Company's sales by geographic area are
included in Note 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 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
F-11
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." SFAS No. 150 establishes standards for how an issuer classifies
and measures 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. Many of those instruments were previously classified as
equity. SFAS No. 150 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. 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 SFAS No. 150 and still existing at the beginning of the
interim period of adoption. While the effective date of certain elements
of SFAS No. 150 has been deferred, the Company does not expect the
adoption of SFAS No. 150 to have a material impact upon its financial
position, cash flows or results of operations.
In December 2003, the FASB issued a revised FASB interpretation No. 46
(FIN 46R), "Consolidation for Variable Interest Entities, and
interpretation of ARB No. 51" The FASB published the revision to clarify
and amend some of the original provisions of FIN 46, which was issued in
January 2003, and to exempt certain entities from its requirements. A
variable interest Entity refers to an entity subject to consolidation
according to the provisions of the Interpretation. FIN 46R applies to
entities whose equity investment at risk is insufficient to finance that
entity's activities without receiving additional subordinated financial
support provided by any parties, including equity holders, or where the
equity investors (if any) do not have a controlling financial interest.
FIN 46R provides that if an entity is the primary beneficiary of a VIE,
the assets, liabilities, and results of operations of the VIE should be
consolidated in the entity's financial statements. In addition, FIN 46R
requires that both the primary beneficiary and all other enterprises with
a significant variable interest in a VIE provide additional disclosures.
The provisions of FIN 46R are effective for the Company's fiscal 2004
first quarter. The Company does not expect the adoption of FIN 46R to
have a material impact on the Company's financial position or results of
operations.
3. Balance Sheet Detail (in thousands)
Accounts Receivable, net:
December 31,
..................................
2003 2002
---------------- ----------------
Accounts receivable $ 1,354 $ 1,149
Less: sales returns (442) (634)
Less: allowance for doubtful accounts (39) (71)
---------------- ----------------
Total accounts receivable, net $ 873 $ 444
================ ================
F-12
Inventories:
December 31,
..................................
2003 2002
---------------- ----------------
Raw material $ 610 $ 493
Work in process - 179
Finished goods 567 438
---------------- ----------------
Total inventories $ 1,177 $ 1,110
================ ================
Property and equipment:
December 31,
..................................
2003 2002
---------------- ----------------
Production, test and demonstration equipment $ 420 $ 353
Computer equipment 1,175 1,112
Office equipment 100 82
Leasehold improvements 442 436
---------------- ----------------
2,137 1,983
Less accumulated depreciation and amortization (1,761) (1,558)
---------------- ----------------
Total property and equipment $ 376 $ 425
================ ================
The Company recorded depreciation and amortization related to
property and equipment of $213,000, $206,000 and $230,000 in 2003,
2002 and 2001, respectively.
As of December 31, 2003 and 2002, the Company had $100,000 of
equipment under capital leases. Accumulated depreciation and
amortization associated with these capital leases was $65,000 and
$42,000 at December 31, 2003 and 2002, respectively.
Accrued liabilities:
December 31,
..................................
2003 2002
---------------- ----------------
Accrued compensation $ 484 $ 351
Accrued sales and marketing 378 377
Accrued professional fees 136 190
Other accruals 761 778
---------------- ----------------
Total accrued liabilities $ 1,759 $ 1,696
================ ================
F-13
4. Commitments and Contingencies
Lease Commitments
The Company has entered into a noncancelable operating lease that expires
in 2005 and other capital leases that expire at various dates ending in
2006, and is responsible for certain maintenance costs, taxes and
insurance under the leases. 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. Future minimum payments under noncancelable operating
leases are as follows (in thousands):
Year Ended December 31,
2004 $ 269
2005 263
----------------
$ 532
================
Rent expense, including the facility lease and equipment rental, was
$288,000, $298,000, and $360,000 for 2003, 2002 and 2001, respectively.
The Company leases certain of its equipment under various 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 December 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%. As of December 31, 2003, future minimum lease payments are as
follows (in thousands):
Year Ended December 31,
2004 $ 20
2005 18
2006 15
----------------
Total minimum lease payments 53
Less amount representing interest (8)
----------------
Present value of capital lease obligations 45
Less current portion (16)
----------------
Long-term portion of capital lease obligations $ 29
================
Product Warranties and Guarantor Arrangements
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 an 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 2003 is as follows (in thousands):
F-14
Warranty accrual at the beginning of the year $ 34
Accruals for warranties issued during the year 15
Settlements made in kind during the year (25)
----------------
Warranty accrual at the end of the year $ 24
================
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.
5. Bank Borrowings
The Company has a $3.0 million collateralized revolving line of credit
with a bank, which expires in March 2005, pursuant to which the Company
may borrow 100% against pledges of cash at the bank's prime rate (4% at
December 31, 2003). Borrowings under this line of credit agreement are
collateralized by all of the assets of the Company. Under the agreement,
the Company must comply with certain financial and other covenants. As of
December 31, 2003, the Company has not drawn down on the line of credit,
was in compliance with these covenants and has no borrowings outstanding
under the line of credit.
6. Common Stock
Stock Repurchase Program
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
F-15
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 $48,000, at an average per share price of $1.04. The Company
did not repurchase any of its common stock during the rest of 2003. The
Company intends to continue to execute its buyback program as it deems
necessary.
2002 Equity Incentive Plan
In December 2002, the shareholders of the Company approved the adoption
of the 2002 Equity Incentive Plan ("2002 Plan"). A total of 850,000
shares of common stock have been reserved for issuance under the 2002
Plan. The 2002 Plan provides for awards to employees, directors,
consultants and independent advisors. The adoption of the 2002 Plan was
necessitated by the use or expiration of all but an insignificant amount
of authorized shares under the prior option plans, (the 1995 Non-employee
Directors' Stock Option Plan ("Directors Plan") and the 1988 Incentive
Stock Plan ("1988 Plan")). Under the 2002 Plan, the Board of Directors
may grant either the right to purchase shares or options to purchase
shares of the Company's common stock at prices not less than the fair
market value at the date of grant for incentive stock options and 85% of
the fair market value at the date of grant for non-qualified options and
purchase rights. Options granted under the 2002 Plan as well as those
granted under the prior option plans generally become exercisable, and
the Company's right to repurchase shares issued and sold pursuant to
stock purchase rights generally lapses, at a rate of one-quarter of the
shares under option or purchased under stock purchase rights at the end
of the first year and thereafter ratably over the next three years.
Awards under the 2002 Plan and the prior option plans generally expire
seven years from the date of grant. No additional option grants will be
made under any prior option plan. As of December 31, 2003, 305,000
options have been granted under the 2002 Plan, while 1.3 million options
are outstanding under the prior plans.
F-16
The following table summarizes option activity under the Company's stock
option plans (in thousands):
Outstanding Options
Weighted
Average
Available Number Exercise
for Grant Outstanding Price
------------------ ------------------ ------------------
Balances, January 1, 2001 370 1,313 $1.11
Options granted (156) 156 $0.79
Options cancelled 61 (61) $1.11
Options exercised - (4) $0.20
------------------ ------------------ ------------------
Balances, December 31, 2001 275 1,404 $1.08
Options granted (405) 405 $0.71
Options cancelled 151 (175) $1.08
Options expired (21) -
Options exercised - (61) $0.63
------------------ ------------------ ------------------
Balances, December 31, 2002 - 1,573 $1.00
Additional shares reserved 850 -
Options granted (305) 305 $2.94
Options cancelled 1 (3) $2.05
Options exercised - (285) $0.94
------------------ ------------------ ------------------
Balances, December 31, 2003 546 1,590 $1.38
================== ================== ==================
At December 31, 2003, 2002 and 2001, 1,078,000, 1,087,000 and 1,035,000
options, respectively, were exercisable at a weighted average exercise
price of $1.15, $1.10 and $1.12, respectively.
F-17
Options to purchase common stock outstanding and currently exercisable by
exercise price at December 31, 2003, are as follows (in thousands, except
years and per share data):
Options Outstanding Options Exercisable
.................................................................... .................................
Weighted
Average Weighted Weighted
Range of Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Prices Outstanding Life Price Exercisable Price
----------------- ---------------- ---------------- ---------------- ---------------- ----------------
$0.00-$0.50 10 5.3 $0.34 10 $0.34
$0.51-$0.75 287 5.1 $0.69 86 $0.69
$0.76-$1.00 635 2.7 $0.92 598 $0.93
$1.01-$1.25 97 4.5 $1.12 91 $1.12
$1.26-$1.50 72 3.0 $1.32 65 $1.33
$1.51-$2.00 178 1.8 $1.64 178 $1.64
$2.01-$2.50 41 5.9 $2.38 7 $2.37
$2.51-$3.00 165 6.7 $2.77 43 $2.80
$3.01-$4.00 105 6.6 $3.40 - -
---------------- ----------------
1,590 3.9 $1.38 1,078 $1.15
================ ================
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes model with the following assumptions for 2003,
2002 and 2001:
2003 2002 2001
------------------- ------------------- -----------------
Risk-free interest rate 3.32%-4.48% 3.86%-5.43% 4.22%-5.25%
Expected life 4.1 years 6.9 years 7.0 years
Expected dividends - - -
Volatility 201% 146% 355%
The weighted average fair value of options granted in 2003, 2002 and 2001
was $2.95, $0.71 and $0.67 per share, respectively.
Option Grants to Non-employees
In addition to the options granted under the plans detailed above,
Castelle has granted options to purchase common stock to consultants
under special arrangements.
During the year ended December 31, 2001, the Company granted 3,000
options to non-employees. There were no grants to non-employees in 2002
and 2003. Under EITF 96-18, the unvested options are revalued at each
balance sheet date to reflect their current fair value. Compensation
expense is reflected in results of operations over the vesting period. In
connection with its grant of options to non-employees, the Company
recorded charges of $1,000 and $16,000 in 2002 and 2001, respectively,
and nothing in 2003.
Options to purchase 27,000, 33,000 and 35,000 shares of common stock were
held by non-employees at December 31, 2003, 2002 and 2001, respectively,
of which 27,000, 33,000 and
F-18
35,000 were exercisable for aggregate total
exercise proceeds of $44,000, $50,000 and $52,000, respectively.
7. Income Taxes
The provision (benefit) for income taxes is as follows
(amounts in thousands):
Years Ended December 31,
2003 2002 2001
Current
Federal $ 5 - -
State 1 6 -
---------------- ---------------- ---------------
Total Current $ 6 $ 6 -
Deferred
Federal $ (464) - -
State (79) - -
---------------- ---------------- ---------------
Total Deferred $ (543) - -
---------------- ---------------- ---------------
Total provision (benefit) for income taxes $ (537) $ 6 -
================ ================ ===============
The Company's tax provision (benefit) differs from the provision computed
using statutory income tax rates as follows (in thousands):
2003 2002 2001
---------------- -------------- --------------
Federal tax provision/(benefit) at statutory rate $ 386 $ 248 $ (201)
Alternative minimum tax 5 - -
Permanent difference due to
non-deductible expenses 12 7 8
State taxes provision/(benefit), net of federal benefit 1 6 (7)
Utilization of net operating loss carryovers (187) (122) -
Change in valuation allowance (694) (65) 258
General business credits (60) (68) (58)
---------------- -------------- --------------
$ (537) $ 6 $ -
================ ============== ==============
F-19
The components of the net deferred tax assets are as follows
(in thousands):
December 31,
...................................
2003 2002
---------------- -----------------
Inventory allowances and adjustments $ 77 $ 131
Accounts receivable allowances 16 28
Other liabilities and allowances 526 567
Net operating loss carryforwards 4,584 4,727
Tax credit carryforwards 1,615 1,825
Depreciation and amortization 396 411
Valuation allowance (6,688) (7,689)
---------------- -----------------
Total net deferred tax assets $ 526 $ -
================ =================
Significant management judgment is required in determining the provision
for income taxes, and in particular, any valuation allowance recorded
against the Company's deferred tax assets. During 2003, the Company
recorded a tax benefit of $537,000, which included a $526,000 reduction
in the valuation allowance. This portion of the valuation allowance was
reversed because the Company determined that it is more likely than not
that certain future tax benefits will be realized as a result of
projected future income. This determination was principally based on
cumulative profitability of the Company over the past 10 quarters and
projected future taxable income expected to be generated by the Company.
At December 31, 2003, the Company had net operating loss carryforwards of
approximately $12,868,000 and $3,583,000 available to offset future
federal and California taxable income, respectively. These loss
carryforwards will expire in varying amounts beginning in 2004 through
2021. In addition, at December 31, 2003, the Company had Federal and
California Research and Development credit carryforwards of approximately
$1,125,000 and $734,000, respectively. These credits expire in varying
amounts beginning in 2007.
For federal and state income tax purposes, the amount of benefit from the
Company's net operating loss and credit carryforwards may be impaired or
limited if the Company incurs a cumulative ownership change of more than
50%, as defined, over a three year period.
The Company's profit (loss) before provision for income taxes for all
periods presented was derived substantially from domestic operations.
8. Retirement Plan
The Company has a voluntary 401(k) plan covering substantially all
employees. The plan provides for employer contributions at the discretion
of the Board of Directors. In 2003, 2002 and 2001, the Company made no
contributions to the plan.
F-20
9. Major Customers and Segment Information
Revenues by geographic area are determined by the location of the
customer and are summarized as follows (in thousands):
Years Ended December 31,
...................................................
2003 2002 2001
---------------- ---------------- ---------------
United States $ 8,256 $ 7,699 $ 7,047
Europe 704 826 960
Pacific Rim 883 887 1,026
Rest of Americas, excluding United States 371 347 321
---------------- ---------------- ---------------
Total revenues $ 10,214 $ 9,759 $ 9,354
================ ================ ===============
Customers that individually accounted for greater than 10% of net sales
are as follows (in thousands):
Years Ended December 31,
..............................................................................................
2003 2002 2001
Customer Amount Percentage Amount Percentage Amount Percentage
----------------- -------------- --------------- --------------- --------------- --------------- -------------
A $ 2,200 22% $ 2,657 26% $ 2,591 28%
B $ 2,899 28% $ 2,257 22% $ 1,635 18%
C * * * * $ 915 10%
*In 2003 and 2002, this customer was responsible for less than 10% of net sales
10. Restructuring
In April 2001, in response to the continuing economic slowdown and
decrease in demand for the Company's products, the Company terminated 17
regular, temporary and contractor positions, which constituted
approximately 25% of the Company's workforce. The restructuring included
an asset write-off and other direct expenses associated with the
consolidation of operations in the United Kingdom and El Dorado Hills,
California.
In the second quarter of 2002, a non-recurring benefit of $40,000 arising
from the reversal of a portion of the previously recorded restructuring
charge was included in the results of operations, following the
completion of the Company's 2001 restructuring program for less than
previously anticipated. The following table sets forth an analysis of the
components of the restructuring charge, and subsequent activity (in
thousands):
F-21
Employee Asset Write
Costs Facilities Down Other Total
Provision for restructuring $ 98 $64 $ 26 $ 51 $ 239
Non-cash items - - (26) - (26)
Cash payments (62) (36) - (26) (124)
--------------------------------------------------------------------
Balance as of December 31, 2001 36 28 - 25 89
Cash payments (36) - - (13) (49)
Reversal of excess accrual - (28) - (12) (40)
--------------------------------------------------------------------
Balance as of December 31, 2002 $ - $ - $ - $ - $ -
11. Litigation
From time to time and in the ordinary course of business, the Company is
involved in various legal proceedings and third party assertions of
patent or trademark infringement claims against the Company in the form
of letters and other forms of communication. 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.
F-22
Castelle Schedule II
Valuation and Qualifying Accounts
(in thousands)
- -------------------------------------------------------------------------------------------------------------------
Additions
Balance at Charged to Balance at
Beginning Costs and End of
of Period Expenses Deductions Period
---------------- ---------------- ---------------- ----------------
Year Ended December 31, 2001:
Deducted from asset accounts:
Allowance for doubtful accounts $ 175 $ 59 $ (138) $ 96
Write-downs for excess and obsolete inventory $ 366 $ 148 $ 4 $ 518
Valuation allowance for deferred tax asset $ 7,717 $ 229 $ - $ 7,946
Year Ended December 31, 2002:
Deducted from asset accounts:
Allowance for doubtful accounts $ 96 $ (21) $ (5) $ 70
Write-downs for excess and obsolete inventory $ 518 $ - $ (202) $ 316
Valuation allowance for deferred tax asset $ 7,946 $ - $ (257) $ 7,689
Year Ended December 31, 2003:
Deducted from asset accounts:
Allowance for doubtful accounts $ 70 $ 5 $ (36) $ 39
Write-downs for excess and obsolete inventory $ 316 $ 66 $ (186) $ 196
Valuation allowance for deferred tax asset $ 7,689 $ - $(1,001) $ 6,688
F-23
Castelle
- --------------------------------------------------------------------------------
Exhibit
Number Description
10.16 Loan Modification Agreement with Silicon Valley Bank
23.1 Consent of Independent Auditors
F-24