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, 2004
|_| 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, 2004 was $10,086,628.
The number of shares of common stock outstanding at March 14, 2005 was
3,832,796.
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
2004 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, 2005.
Castelle
Table of Contents
PAGE
PART I.........................................................................3
ITEM 1. BUSINESS...........................................................3
ITEM 2. PROPERTIES........................................................12
ITEM 3. LEGAL PROCEEDINGS.................................................12
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS.............13
PART II.......................................................................14
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED
SHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES....14
ITEM 6. SELECTED FINANCIAL DATA...........................................15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS...............................19
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........37
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.......................37
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE..............................................38
ITEM 9A. CONTROLS AND PROCEDURES...........................................38
ITEM 9B. OTHER INFORMATION.................................................39
PART III......................................................................40
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................40
ITEM 11. EXECUTIVE COMPENSATION............................................40
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT....40
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................40
ITEM 14. PRINCIPAL AUDITOR FEES AND SERVICES...............................40
PART IV.......................................................................41
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K...41
SIGNATURES....................................................................44
FINANCIAL STATEMENTS.........................................................F-3
i
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 28 in this document.
EXPLANATORY NOTE
This Annual Report on Form 10-K for the year ended December 31, 2004 includes
restated financial statements as of December 31, 2003 and for each of the two
fiscal years in the period ended December 31, 2003.
In April 2005, the Company completed a review of its accounting practices with
respect to the historical classification of cost of service revenues, procedures
for recognizing revenue associated with extended support contracts and
procedures for establishing the accrual for paid-time-off, and determined that
its historical financial statements as of and for the years ended December 31,
2002 and 2003 contained certain errors in the application of generally accepted
accounting principles as described below:
1. Classification of cost of service revenues
The Company has concluded that its historical classification of cost
of service revenues did not conform to Generally Accepted Accounting
Principles. Historically, such costs have been improperly included
as a component of sales and marketing expenses on the Company's
consolidated statements of earnings; however under generally
accepted accounting principles, such costs are required to be
classified as cost of service revenues. The Company has reclassified
$711,000 and $729,000 in fiscal 2002 and 2003 out of sales and
marketing and included these amounts within cost of service revenues
in its statements of earnings. The reclassification had no impact on
reported sales, net income, earnings per share, or cash flows from
operations for the respective periods. The misclassification,
however, did result in cost of sales being understated, and gross
profit and operating expenses being overstated by equal amounts. The
Company has concluded that the internal control deficiency that led
to the errors in the historical classification of cost of service
revenues is a "material weakness" as defined by the Public Company
Accounting Oversight Board's Auditing Standard No. 2.
Effective January 1, 2005, the Company established a separate cost
center to capture solely the cost of service revenues and such costs
will be classified as a component of cost of sales.
The Company's review of such costs was prompted in part by the
receipt in November 2004 and thereafter of a series of comment
letters issued by the Division of Corporation Finance of the
Securities and Exchange Commission to the Company.
1
2. Revenue recognition related to extended support contracts
The Company has determined that as a result of an internal control
deficiency, service revenues attributable to extended support
contracts were overstated by approximately $39,000 and $34,000 for
fiscal 2002 and fiscal 2003, respectively. These amounts should have
been deferred and recognized as service revenues in subsequent
periods. Such errors were the result of inadequate procedures in
place to correctly recognize sales related to extended support
contracts. The revenue overstatements represent less than 1% of the
Company's total sales for the respective periods. In connection with
their audit of the Company's consolidated financial statements for
the year ended December 31, 2004, the Company's independent
registered public accounting firm, Grant Thornton LLP, concluded
that the internal control deficiency that led to the aforementioned
revenue recognition errors is a "material weakness" as defined by
the Public Company Accounting Oversight Board's Auditing Standard
No. 2.
During the first quarter of 2005, the Company enhanced its internal
accounting system to ensure that revenue is recognized over the
actual contract term.
3. Accrual for paid-time-off
The Company has also identified an error that resulted in an
overstatement of its accrual for paid-time-off beginning in 2002 and
continuing through 2004. This error resulted in the overstatement of
expenses by approximately $15,000 and $7,000 in fiscal 2002 and
2003, respectively. During the first quarter of 2005, the Company
corrected the error that led to such over-accrual. The reported
results as of and for the year ended December 31, 2004 reflect the
appropriate accrual and expense for paid-time-off.
The Company has restated its consolidated financial statements for fiscal 2002
and 2003 in this 2004 Annual Report on Form 10-K to correct for these errors.
The Company has also restated the unaudited quarterly consolidated financial
statements for each of the 2003 and 2004 periods included in Item 8 in this 2004
Annual Report on Form 10-K to correct for the quarterly impact of such errors.
Consequently, the historical financial statements and related financial
information contained in Castelle's Annual Report on Form 10-K for the year
ended December 31, 2003 and each of Castelle's Forms 10-Q for the year ended
December 31, 2004 should no longer be relied upon and are superceded by the
financial statements and financial information in this Annual Report on Form
10-K.
Note 3, Restatement of Previously Issued Financial Statements, to the notes to
the consolidated financial statements discloses the impact of the adjustments
arising from the accounting errors described above on the statements of earnings
and balance sheets for the restated annual periods. In addition, Note 3 to the
consolidated financial statements discloses the effect of the restatement on
opening retained earnings as of January 1, 2002, which adjustment reflects the
impact of the restatement on periods prior to 2002. This adjustment decreased
previously reported accumulated deficit by $27,000 with a corresponding decrease
to deferred revenue relating to extended support contracts. For information on
the impact of the restatement on fiscal 2000 and 2001, reference is made to Item
6, Selected Financial Data, in Part II of this Form 10-K.
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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 our 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 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. 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.
As a result, we experienced annual operating losses during 1997 through 1999.
During the past eight 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. During 2004, we
discontinued our LANpress print server and InfoPress product lines, but will
continue to provide support to our customers during the warranty periods.
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 since then, we have recorded fourteen straight quarters of
profitability.
3
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, as 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 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-
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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.
Server appliances, such as communications/messaging 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.
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 server product family. Our products are installed in many Fortune 1000
firms, small and medium sized businesses worldwide, integrating desktop fax
automation, email, Internet connectivity 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 keep
abreast of, and respond
5
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.
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 Pacific Rim.
During 2004, 2003, and 2002, fax products represented 99%, 97%, and 95%,
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
6
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 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 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 8.X network fax software that adds integration with popular email
packages, and many advanced fax management and integration features. Our
FaxPress Small Business Edition ("SBE") fax server does not include email
integration started with our FaxPress 7.1.1 network fax software. 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, Windows
Product Model Channels Integration Topology 6.x (IPX,IP) 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 4, 8, 12, 16 x Ethernet n/a x
FaxPress Premier Digital T1 8, 24, 48, 72 x Ethernet n/a x
FaxPress Premier ISDN 4, 8, 12 x Ethernet n/a x
FaxPress Premier Digital E1 10, 30, 60, 90 x Ethernet n/a 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
7
our product offerings, to maintain technological competitiveness and meet an
expanding range of customer requirements. We spent $1.7 million, $1.6 million
and $1.4 million in research and product development activities in 2004, 2003
and 2002, 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 2004, we developed and released version 8.0 of our FaxPress software
and version 3.0 of our FaxPress Premier software. The new releases of FaxPress
8.0 and FaxPress Premier 3.0 Network Fax Software offer a new level of email
integration, expanded operating environments and fax automation. It 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
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.
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 2004, Ingram Micro and Tech Data individually accounted for more than
10% of our sales and collectively represented approximately 44% of our net
sales. In 2003 and 2002, the same distributors accounted for approximately 50%
and 51% of our net sales for the respective years. Total sales to customers
located in the Pacific Rim, Europe and rest of Americas comprised approximately
18%, 19%, and 21% of our net sales in 2004, 2003 and 2002, respectively.
8
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.
Most of our products are manufactured by third-party manufacturers that provide
customized, integrated manufacturing services, including procurement,
manufacturing, printed circuit board assembly and final testing. 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 believe that we 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, and are constantly
replenishing our inventory from secondary markets too, 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 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
9
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.
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 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, 2005, we employed a total of 48 full-time equivalent
personnel, 9 in operations, 13 in sales and marketing, 9 in engineering, 11 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, 2005 are
set forth below:
10
Name Age Position
Scott C. McDonald 51 President, Chief Executive Officer
Eric Chen 52 Senior Vice President, Engineering
and Business Development
Paul Cheng 56 Vice President, Finance and Administration,
Chief Financial Officer and Secretary
Richard Fernandez 45 Vice President, Operations
Edward J. Heinze 59 Vice President, Sales, U.S.
Michael Petrovich 43 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 a director 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.
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 i(n) 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.
11
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. 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 May 31, 2009 with one conditional
three-year option, which if exercised, would extend the lease to May 31, 2012.
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.
12
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
Subsequent to our Annual Meeting of Shareholders held on May 28, 2004,
there were no matters submitted to a vote of securities holders during the
remainder of 2004.
13
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS,
AND ISSUER PURCHASES OF EQUITY SECURITIES
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.
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
2004 HIGH LOW
First Quarter $7.80 $2.95
Second Quarter $5.35 $2.77
Third Quarter $3.39 $2.31
Fourth Quarter $4.29 $2.71
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 April 12, 2005 there were 700 holders of record of our common stock.
On April 12, 2005 the last sale price reported on the Nasdaq SmallCap Market for
our common stock was $3.25 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 have performed no stock
repurchases since then. 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.
14
Equity Compensation Plan Information
The following table sets forth a summary of our equity compensation plans
as of December 31, 2004. Details of the plans are discussed in Note 7 to the
Consolidated Financial Statements.
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 by security holders 7,000 $2.38 -0-
1998 (1988) Equity compensation
plan (As Amended) approved by
security holders 896,391 $0.98 -0-
2002 Equity compensation plan
approved by security holders 389,205 $3.07 460,045
Equity compensation plans not
approved by security holders -0- n/a -0-
-------------------------------------------------------------------------
Total 1,292,596 $1.61 460,045
ITEM 6. SELECTED FINANCIAL DATA
The five-year financial summary in this Item 6 has been revised to reflect
the Company's restatement of previously reported results (see Note 3 to the
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.
15
Years ended December 31,
----------------------------------------------------------------------
2004 2003 2002 2001 2000
------- ------- --------- ------- -------
(Restated) (Restated) (Restated) (Restated)
(in thousands, except per share amounts)
STATEMENT OF EARNINGS DATA:
Net Sales $10,457 $10,180 $ 9,720 $ 9,381(5) $14,832
Gross Profit $ 7,075 $ 6,969 $ 6,180 $ 5,479(6) $ 8,360(6)
Gross Profit as a % of Net Sales 68% 68% 64% 58% 56%
Net income (loss) $ 2,119(1) $ 1,606(2) $ 635 ($564)(4) $ 732
Net income (loss) as a % of Net Sales 20%(1) 16%(2) 7% (6%) 5%
Net income (loss) per share - diluted $ 0.48(1) $ 0.38(2) $ 0.14 ($0.12) $ 0.14
BALANCE SHEET DATA:
Cash and Cash Equivalents $ 5,599 $ 4,614 $ 3,460(3) $ 4,568 $ 3,893
Working Capital $ 5,750 $ 4,156 $ 2,437 $ 3,587 $ 3,969
Total Assets $10,147 $ 7,803 $ 5,635 $ 7,010 $ 8,543
Long-term Liabilities $ 14 $ 29 $ 44 $ 64 $ 63
Shareholders' Equity $ 7,281 $ 4,752 $ 2,926(3) $ 4,229 $ 4,776
(1) In 2004, we recorded a non-cash tax benefit of $1.1 million, or $0.24
per diluted share. This was a result of releasing a portion of our tax valuation
allowance due to our continued profitability and a determination that it is more
likely than not that certain future tax benefits will be realized.
(2) 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 of 2003, 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 was 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.
(3) 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.
(4) Net loss for 2001 includes net charges for restructuring and other
non-recurring items of $239,000.
(5) Net sales in 2001 have been restated to increase service revenues by
$27,000 as compared to previously reported net sales in relation to the extended
support contracts adjustment. Consequently, the net loss for 2001 decreased to
$564,000 as compared to the previously reported net loss of $591,000. There was
no impact on previously reported net loss per share for 2001.
(6) Gross profit and operating expenses for 2001 and 2000 have been
restated to reduce such balances by equal amounts of $813,000 and $1 million,
respectively, as compared to previously reported amounts, as a result of the
reclassification of cost of service revenues from operating expenses to cost of
sales.
Unaudited Quarterly Results of Operations
The following table sets forth certain consolidated quarterly financial data for
the eight quarters ended December 31, 2004. 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
16
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.
The consolidated quarterly financial data presented below reflects the
restatement of the periods through September 30, 2004 to reflect the adjustment
for certain errors noted by the Company during the fourth quarter of fiscal
2004. For a description of the restatement items and the effect on annual
periods for fiscal 2003 and 2002, see Note 3 to the Company's consolidated
financial statements.
Selected Quarterly Data (unaudited)
Year 2004, Quarter Ended
-------------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
---------- ---------- ---------- ----------
(in thousands, except per share data)
(Restated) (Restated) (Restated)
Net sales (1) $2,539 $2,691 $2,685 $2,542
Gross profit (2) 1,702 1,883 1,804 1,686
Operating income (3) 228 272 236 330
Net income(4) 129 146 130 1,714(5)
Net income per share, basic (4) 0.04 0.04 0.04 0.46(5)
Net income per share, diluted (4) 0.03 0.03 0.03 0.39(5)
(1) Net sales in the 2004 quarters ended March 31, June 30 and September
30 have been restated to reduce service revenues by $19,000, $26,000
and $13,000, respectively, as compared to previously reported net
sales in relation to the extended support contract adjustments.
(2) Gross profit and operating expenses for the quarters ended March 31,
June 30 and September 30, 2004 have been restated to reduce such
balances by equal amounts of $198,000, $216,000 and $207,000,
respectively, as compared to previously reported amounts, as a
result of the reclassification of cost of service revenues from
operating expenses to cost of sales.
(3) Operating income for the quarters ended March 31, June 30, and
September 30, 2004 has been increased by an additional $1,000 in
each of the three quarters, as compared to previously reported
amounts to correct the overstatement of the Company's paid-time-off
accrual.
(4) The restatement adjustments referred to above reduced previously
reported net income by $18,000, $25,000 and $12,000 in 2004 for the
quarters ended March 31, June 30 and September 30, respectively.
Both basic and diluted net income per share as restated decreased by
$0.01 for the quarter ended June 30, 2004 as compared to the amounts
previously reported. Basic and diluted net income per share as
restated did not change from the amounts previously reported for the
quarters ended March 31 and September 30.
(5) Includes a non-cash tax benefit of $1.4 million, or $0.37 per basic
share, and $0.31 per diluted share, resulting from the release of a
portion of our tax valuation allowance.
Year 2003, Quarter Ended
--------------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
---------- ---------- ---------- ----------
(in thousands, except per share data)
(Restated) (Restated) (Restated) (Restated)
Net sales (1) $2,495 $2,501 $2,561 $2,623
Gross profit (2) 1,626 1,752 1,814 1,777
Operating income (3) 252 232 238 357
Net income (4) 239 220 238 909(5)
Net income per share, basic (4) 0.07 0.07 0.07 0.27(5)
Net income per share, diluted (4) 0.06 0.05 0.05 0.21(5)
17
(1) Net sales in the 2003 quarters ended March 31, June 30, September 30 and
December 31 have been restated to reflect the reduction of service
revenues by $5,000, $10,000, $5,000 and $14,000, respectively, as compared
to previously reported amounts in relation to the extended support
contract adjustments.
(2) Gross profit and operating expenses for the quarters ended March 31, June
30, September 30 and December 31, 2003 have been restated to reduce such
balances by equal amounts of $172,000, $177,000, $193,000 and $187,000,
respectively, as compared to previously reported amounts, as a result of
the reclassification of cost of service revenues from operating expenses
to cost of sales.
(3) Operating income has been increased by $1,000 in the quarter ended March
31, 2003 and $2,000 in each of the remaining quarters of 2003, as compared
to previously reported amounts, to correct the overstatement of the
Company's paid-time-off accrual.
(4) The restatement adjustments referred to above reduced previously reported
net income by $4,000, $8,000, $3,000 and $12,000 for the quarters ended
March 31, June 30, September 30 and December 31, respectively. Basic net
income per share as restated decreased by $0.01 for the quarter ended
March 31 and did not change for the quarters ended June 30, September 30
or December 31, as compared to the amounts previously reported. Diluted
net income per share as restated decreased by $0.01 for the quarters ended
June 30 and September 30 and did not change for the quarters ended March
31 or December 31, as compared to the amounts previously reported.
(5) 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.
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
(All tabular amounts in thousands except per share amounts and as noted)
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 began to decline 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. Today, our analog fax
servers can provide up to 16 fax channels, the digital servers up to 71 T1 fax
channels, the ISDN servers up to 12 fax channels and the E1 servers up to 90 fax
channels. Our current FaxPress and FaxPress Premier software versions are 8.0
and 3.0, respectively, to support our hardware.
In April 2005, we completed a review of our accounting practices with
respect to the historical classification of cost of service revenues, procedures
for recognizing revenue associated with extended support contracts and
procedures for establishing the accrual for paid-time-off, and determined that
our historical financial statements as of and for the years ended December 31,
2002 and 2003 contained certain errors in the application of generally accepted
accounting principles. Consequently, we have restated our consolidated financial
statements for fiscal 2002 and 2003 in this 2004 Annual Report on Form 10-K to
correct for these errors. This Management's Discussion and Analysis of Financial
Condition and Results of Operations reflects the restated amounts. Note 3 to the
consolidated financial statements discloses the impact of the adjustments
arising from the accounting errors described above on the statements of earnings
and balance sheets for the restated annual periods.
Improved cash management and operating results resulted in positive
operating cash flows in 2002, 2003 and 2004. Cash balances increased to $5.6
million at December 31, 2004 from $4.6 million and $3.5 million at December 31,
2003 and December 31, 2002, respectively.
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 been replenishing, through secondary markets, and keeping 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.
We believe that most of these end-of-life components will be utilized in the
following two years, resulting in insignificant amounts of excessive inventory,
or none at all. We believe that Castelle's liquidity continues to be strong
despite these purchases, as our cash reserves have increased during the periods
when the parts were purchased. 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. These end-of-life products represent $675,000 of the ending
inventory balance.
19
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. 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-7. Note that preparation of this Annual Report on
Form 10-K requires us 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 our financial statements, and reported amounts of
revenue and expenses during the reporting period. Estimates about future events
and their effects 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
No. 104 "Revenue Recognition," AICPA Statement of Position No. 97-2 ("SOP 97-2")
"Software Revenue Recognition," as amended by SOP 98-9, "Modification of SOP
97-2, Software Revenue Recognition with Respect to Certain Transactions," and
Statement of Financial Accounting Standards ("SFAS") No. 48 "Revenue Recognition
When Right of Return Exits."
The Company uses the residual method to recognize revenue when an
agreement includes one or more elements to be delivered at a future date. If
there is an undelivered element under the arrangement, the Company defers
revenue based on vendor-specific objective evidence of the fair value of the
undelivered element, as determined by the price charged when the element is sold
separately. If vendor-specific objective evidence of fair value does not exist
for all undelivered elements, the Company defers all revenue until sufficient
evidence exists or all elements have been delivered.
Product revenue is recognized when all of the following criteria are met:
persuasive evidence of an arrangement exists; delivery has occurred; the fee is
fixed or determinable; collection is probable; and returns can be reasonably
estimated. If an acceptance period or other contingency exists, revenue is
recognized upon satisfaction of the contingency, customer acceptance or
expiration of the acceptance period. Shipment generally occurs and title and
risk of loss is transferred when the product is delivered to a common carrier.
We enter into agreements with some of our distributors that permit limited
stock rotation rights. These stock rotation rights allow the distributor to
return products for credit but require the purchase of additional products of
equal value. Customers who purchase products directly from 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.
Pursuant to our agreements with distributors, we also protect our
distributors' exposure related to the impact of price reductions. Future price
adjustments are estimated and accrued at the time of sale as a reduction in
revenue.
We generally provide our distributors the opportunity to earn volume
incentive rebates based on sales volume achieved during the fiscal quarter.
These incentive rebates are accrued in the quarter incurred and recorded as a
reduction in revenue.
We also provide co-op and market development funds to our distributors.
These incentives are accrued at the time revenue is recognized and recorded as a
reduction in revenue.
20
We offer a standard trade-in discount to all of our end-user customers
under which the customer, upon trade-in of any previously purchased product, is
entitled to a discount from our published price list on any product included in
our current product offerings. We require our customers to physically return the
previously purchased products to qualify for the trade-in discount. We account
for the trade-in discount as a reduction of revenue at the time the product is
traded in and a new product is purchased.
Payment terms to our distributors and customers are generally thirty days,
cash in advance, or by credit card.
We evaluate product sales through our distribution channels and the
related reserve requirement to establish an estimate for our sales returns
reserve by reviewing detailed point-of-sales and on-hand inventory reports
provided to us by our channel partners. Based on a combination of historical
return experience, the sales activities to end-user customers by our channel
partners and the level of inventories on hand at the channel partners, we
determine our returns reserve at the end of each financial period, and increases
or reduce the reserve balance accordingly.
We provide standard support to our customers for an initial period of
sixty days, which includes advance swap of the defective hardware and software,
bug fixes, software upgrades and technical support. In addition to standard
support, we also offer our customers the option to purchase extended support at
the time of product purchase or anytime thereafter. Extended support covers
hardware and software for a period of one year. We have established
vendor-specific objective evidence with respect to the fair value of the
standard support contracts based on standalone sales and renewals of our
one-year extended support contracts. The fair value of our sixty day support
contracts included with product sales is determined by pro-rating the related
one-year extended support contracts. We recognize revenue from extended support
contracts ratably over the period of the contract.
We do not sell software, which is incorporated into our hardware,
separately, other than for our customers to purchase as an upgrade to their
existing products when we announce a major release of the software.
Product Warranty
Hardware is warranted for one year from the date of sale and is repaired
free-of-charge. 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.
Distributor Programs and Incentives
We enter into agreements with some of our 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. We also protect our distributors' exposure related to the impact of
price reductions. We generally provide our distributors the opportunity to earn
volume incentive rebates based upon the amount of sales volume achieved during
the fiscal quarter. We also provide co-op and market development funds to our
distributors.
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. Moreover, if the actual
incentive offerings are different from our estimates, or if the actual incentive
claims are significantly higher than our historical experience, then revisions
to the estimated incentive programs may be required resulting in additional
reductions to revenue.
21
We record estimated reductions to revenues for these distributor programs
and incentive offerings including special pricing agreements, promotions and
other volume-based incentives.
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 60%, 69% and 68% of accounts receivable at December 31, 2004, 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. We record write downs for excess
and obsolete inventory equal to the difference between the cost of inventory and
the estimated fair value based on assumptions about future product life-cycles,
product demand and market conditions. If actual product life cycles, product
demand and market conditions are less favorable than those projected by
management, additional inventory write-downs may be required. At the point of
the loss recognition, a new, lower-cost basis for that inventory is established,
and subsequent changes in facts and circumstances do not result in the
restoration or increase in that newly established cost basis.
In light of the approximately two years worth of end-of-life components we
have purchased to ensure a smooth supply of our FaxPress Products to our
customers, our management periodically reviews the usage, supply and inventory
levels of these parts to determine whether additional purchases or excessive
inventory provisions are necessary. As of December 31, 2004, we have
approximately $675,000 worth of end-of-life components on hand and we believe
that most of these components will be utilized in the following two years,
resulting in insignificant amounts of excessive inventory, or none at all.
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.
22
Results of Operations
Comparison of Years Ended December 31, 2004 and 2003
Net Sales
Year Ended December 31,
-----------------------------------------
2004 2003 2002
--------- --------- ---------
Net Sales: (Restated) (Restated)
Products $ 8,011 $ 8,337 $ 8,617
Services 2,446 1,843 1,103
--------- --------- ---------
Total net sales $ 10,457 $ 10,180 $ 9,720
========= ========= =========
Year Ended December 31,
-----------------------------------------
2004 2003 2002
--------- --------- ---------
Net Sales: (Restated) (Restated)
United States $ 8,574 $ 8,222 $ 7,660
Europe 785 704 826
Pacific Rim 804 883 887
Rest of Americas, excluding United States 294 371 347
--------- --------- ---------
Total net sales $ 10,457 $ 10,180 $ 9,720
========= ========= =========
Net sales increased 3% to $10.5 million in 2004 from $10.2 million
in 2003. The increase of $277,000 was primarily from increased sales
derived from services of $603,000, offset by a reduction in products sales
of $326,000.
Products sales of $8.0 million in 2004, which represents 77% of
total sales, declined by 4% as compared to $8.3 million in 2003, which
represents 82% of total sales. The lower sales in 2004 are due largely to
the Company's decision to divest its legacy products as part of its
overall strategy to transition to its new generation of network fax
servers, FaxPress Premier. We anticipate sales of our FaxPress Premier fax
servers to grow as we continue to expand into Japan, Hong Kong and
Mainland China markets. Product sales in 2004 also included a one-time
pre-tax benefit of $126,000 from an adjustment of certain accruals related
to a sales development program.
Service revenues are comprised of extended warranty and support
programs as well as 60-days of maintenance included with initial product
sales. Revenue related to these arrangements is recognized ratably over
the period of the arrangement. Service revenues in 2004, which represents
23% of total sales, increased 33% to $2.4 million from $1.8 million in
2003, which represents 18% of total sales. The increase in service
revenues was primarily due to increased sales of extended warranty
contracts due to an increase in our installed customer base as well as the
launch of our FaxPress Premier fax server products in the second half of
2003. We anticipate service revenue to increase as more FaxPress Premier
fax servers are sold.
Domestic sales were $8.6 million in 2004 as compared to $8.2 million
in 2003, representing 82% and 81%, respectively, of total net sales. The
increase in sales was mostly attributable to the introduction of the new
FaxPress Premier fax server products, which carry higher selling prices,
an
23
increase in service revenues and a benefit of $126,000 from a sales
development program adjustment.
International sales (excluding sales to the rest of the Americas)
were $1.6 million in 2004 and 2003, representing 15% and 16%,
respectively, of total net sales. 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
$294,000 in 2004, as compared to $371,000 in 2003, representing 3% and 4%
of total net sales in 2004 and 2003, respectively. The decrease in sales
was mostly due to lower sales of our FaxPress fax server products.
In 2004, Ingram Micro, Tech Data and Macnica, our top three
customers accounted for approximately 51% of our net sales. In 2003, the
same three distributors accounted for 57% of net sales.
Cost of Sales; Gross profit
Year Ended December 31
-------------------------------------------
2004 2003 2002
--------- --------- ---------
Cost of sales: (Restated) (Restated)
Products $ 2,556 $ 2,485 $ 2,833
Services 826 726 707
Total cost of sales 3,382 3,211 3,540
Gross profit $ 7,075 $ 6,969 $ 6,180
Gross profit as % of sales 68% 68% 64%
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 from service revenues in
fiscal 2004 increased by $503,000 from fiscal 2003 due mostly to higher
sales while cost of sales increased moderately. The higher gross profit
from service revenues was offset by lower gross profit of $397,000 from
product sales due to product mix. Gross profit in 2004 included the
benefit of $126,000 from the sales development program adjustment.
Periodically we review obsolete and unmarketable products in our
inventory and make appropriate allowances for excess and obsolete
inventory. Products that are determined to be obsolete and unmarketable
are physically scrapped when it is determined that such inventories are no
longer usable or salable. In 2004, we identified $35,000 of unmarketable
products, which were scrapped, as compared to $154,000 worth of
unmarketable products scrapped in 2003.
Research and Development
Year Ended December 31
-------------------------------------------
2004 2003 2002
--------- --------- ---------
(Restated) (Restated)
Research and development expenses $ 1,722 $ 1,590 $ 1,379
Research and development expenses as % of sales 17% 15% 14%
24
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. The higher research
and development expenses in 2004 were mostly due to higher outside
consulting expenses of $154,000 to enhance our current product features
and $71,000 in higher compensation due to increased headcount, offset by a
decrease in materials expense of $61,000. The employment of consultants is
expected to continue until the short-term projects are completed. 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
Year Ended December 31
-------------------------------------------
2004 2003 2002
--------- --------- ---------
(Restated) (Restated)
Sales and marketing expenses $ 2,486 $ 2,398 $ 2,301
Sales and marketing expenses as % of sales 24% 24% 23%
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. The increase in sales and
marketing expenses was largely due to increased compensation expenses of
$216,000 related to headcount additions, offset in part by lower
advertising and promotional expenses of $129,000. Sales and marketing
expenses are anticipated to remain relatively stable.
General and Administrative
Year Ended December 31
-------------------------------------------
2004 2003 2002
--------- --------- ---------
(Restated) (Restated)
General and administrative expenses $ 1,801 $ 1,902 $ 1,943
General and administrative expenses as % of sales 17% 18% 20%
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. The lower expenses
in 2004, as compared to 2003, were mainly attributable to lower
compensation expenses of $88,000 mostly because of lower incentive
payments due to performance goals that were not met. General and
administrative expenses are expected to increase in fiscal 2005 in
relation to Sarbanes-Oxley internal control compliance.
Interest and Other Income (Expenses)
Interest and other income (expense) consists 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 (expense) for 2004 was $14,000 as compared $10,000 in
2003.
Provision for Income Tax
In fiscal 2004 and 2003, we recorded non-cash tax benefits of $1.1
million and $526,000, respectively, as a result of releasing portions of
our tax valuation allowance. Consequently, as of December 31, 2004, we
have recorded a total of $1.5 million of deferred tax assets. We have not
25
reported significant income tax expenses because we have been able to
utilize available Net Operating Loss ("NOL") and tax credit carryforwards
to offset taxable income. Prior to December 31, 2003, the Company's NOLs
were fully offset by a valuation allowance due to uncertainly surrounding
the likelihood of their realization. Due to our continued profitability
over the past 14 quarters and a determination that it is more likely than
not that certain future tax benefits will be realized, a portion of the
Company's deferred tax assets have been recognized during the fourth
quarters of fiscal 2003 and 2004.
Comparison of Years Ended December 31, 2003 and 2002
Net Sales
Net sales increased 5% to $10.2 million in 2003 from $9.7 million in
2002. The increase of $460,000 resulted primarily from increased sales
derived from services of $740,000 offset by a reduction in product sales
of $280,000.
Products sales of $8.3 million in 2003, which represents 82% of
total sales, declined by 3% as compared to $8.6 million in 2002, which
represents 89% of total sales, mostly due to lower sales of our FaxPress
fax servers.
Service revenues in 2003, which represents 18% of total sales,
increased 67% to $1.8 million from $1.1 million in 2002, which represents
11% of total sales. The increase in service revenues was primarily due to
increased sales of extended warranty contracts due to an increase in our
installed customer base.
Domestic sales were $8.2 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 in the fourth quarter of 2003, which
carry higher selling prices, and an increase in service revenues.
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.
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% of
total net sales in both 2003 and 2002.
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 was $7.0 million, or 68% of net sales, in 2003,
compared to $6.2 million, or 64% of net sales, in 2002. Gross profit from
service revenues in fiscal 2003 increased by $721,000 from fiscal 2002 due
mostly to higher sales while cost of sales was relatively flat. Continuous
product cost reductions in 2003 and increased outsourcing of manufacturing
contributed to the improvement in gross profit from product sales in 2003
by $68,000.
In 2003, we identified $154,000 of unmarketable products, which were
scrapped, as compared to $158,000 in 2002.
Research and Development
26
Research and product development expenses were $1.6 million in 2003,
as compared to $1.4 million in 2002, and represent 15% 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.
Sales and Marketing
Sales and marketing expenses were $2.4 million and $2.3 million for
2003 and 2002, respectively, and represent 24% and 23% of net sales for
those 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.
General and Administrative
General and administrative expenses were $1.9 million in both 2003
and 2002, and represent 18% 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(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 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 of fiscal 2003.
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.
LIQUIDITY AND CAPITAL RESOURCES
December 31, 2004 December 31, 2003
----------------- -----------------
(dollars in thousands)
(Restated)
Cash and cash equivalents $ 5,599 $ 4,614
Working capital $ 5,750 $ 4,156
Working capital ratio 3.0 2.4
27
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, 2004, we had $5.6 million
of cash and cash equivalents, an increase of $985,000 from December 31, 2003.
The increase in cash and cash equivalents was primarily attributable to cash
provided by operating activities of $626,000 and $410,000 in proceeds from the
exercise of stock options.
Even though cash and cash equivalents in 2004 improved over 2003, cash
provided by operating activities declined by $492,000 primarily due to a planned
increase in inventory of $608,000, mostly attributable to the purchase, net of
usage, of $675,000 worth of end-of-life parts used in our FaxPress products in
an effort to guarantee a smooth supply to our customers for the next two years,
and the timing of accounts payable. The increase in cash provided by operating
activities in 2003 as compared to 2002 was mainly due to higher earnings.
In 2004, net cash provided by financing activities was $394,000 primarily
from proceeds from issuance of common stock. In the first quarter of 2003, we
repurchased $48,000 of our stock from open market transactions. We acquired
additional property and equipment of $35,000, $164,000 and $34,000 in 2004, 2003
and 2002, respectively. 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 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. We performed no stock repurchases during the rest of 2003
and 2004. However, we may continue to execute our buyback program as we deem
necessary.
In September, 2004, we entered into a $4.0 million collateralized
revolving line of credit with a bank, which is to expire in August 2005. The
revolving line of credit provides for borrowings of up to $4.0 million.
Borrowings under this line of credit agreement are collateralized by all of our
assets and bear interest at the bank's prime rate plus 0.50%. Under the new
facility we are required to maintain certain minimum cash and investment
balances with the bank and meet certain other financial covenants. As of
December 31, 2004, we have not drawn down on the line of credit and were in
compliance with the terms of the agreement.
We lease certain of our equipment under various operating and capital
leases that expire at various dates through 2006. The lease agreements
frequently include renewal, escalation clauses and purchase provisions, and
require us to pay taxes, insurance and maintenance costs. As of December 31,
2004, we had $32,000 outstanding under a loan and security agreement, which is
subject to an interest rate of 12.8%.
We lease our headquarters in Morgan Hill, California. We have extended our
building lease for a term of five years commencing on June 1, 2004 and expiring
on May 31, 2009, with one conditional three-year renewal option, which if
exercised, would extend the lease to May 31, 2012 commencing with rent at
ninety-five percent of fair market value. As of December 31, 2004, future
minimum payments under the lease were $915,000.
The following represents combined aggregate maturities for all our
financing and commitments as of December 31, 2004:
28
Payments Due by Period
--------------------------------------------------------------------
Contractual Obligations Less Than More than 5
Total 1 Year 1 - 3 Years 3 - 5 Years Years
--------------------------------------------------------------------
Capital (Finance) Lease Obligations $ 32 $ 18 $ 14 -- --
Operating Lease Obligations $ 915 $ 207 $ 622 $ 86 --
--------------------------------------------------------------------
Total contractual cash obligations $ 947 $ 225 $ 636 $ 86 --
====================================================================
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
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.
29
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.
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,
2004, had an accumulated deficit of $20 million. Our development and marketing
of current and new products will continue to require substantial expenditures.
We incurred $591,000 of losses as recently as 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.
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.
30
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 server
products in 2004. 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
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
31
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.
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 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. 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
32
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. 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.
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 18%, 19% and 21% of our net sales in 2004, 2003 and 2002,
respectively. We sell our products in approximately 40 foreign countries through
approximately 50 international distributors. 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
33
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.
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
34
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 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 further. In the event we are unable to
satisfy regulatory requirements relating to internal controls, or if these
internal controls over financial reporting are not effective, our business could
suffer.
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 have incurred and expect to
35
continue to incur significant costs in connection with compliance with Section
404 of that law regarding internal controls over financial reporting. 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.
We have identified and may from time to time identify a number of
deficiencies in our disclosure controls and procedures. In connection with the
audit of the consolidated financial statements for the year ended December 31,
2004, our independent registered public accounting firm, Grant Thornton LLP,
determined that we had internal control deficiencies that constituted a
"material weakness." Furthermore, we cannot assure you that we will be able to
implement enhancements on a timely basis in order to prevent a failure of our
internal controls or enable us to furnish future unqualified certifications. A
material weakness or deficiency in internal control over financial reporting
could materially impact our reported financial results and the market price of
our stock could significantly decline. Additionally, adverse publicity related
to the disclosure of a material weakness or deficiency in internal controls over
financial reporting could have a negative impact on our reputation, business and
stock price. Any internal control or procedure, no matter how well designed and
operated, can provide only reasonable assurance of achieving desired control
objectives.
Voting control by officers, directors and affiliates may delay, defer or prevent
a change of control.
At February 28, 2005, our officers and directors and their affiliates
beneficially owned approximately 25% of the outstanding shares of common stock.
Accordingly, together they had the ability to significantly influence the
election of our directors and other corporate actions requiring shareholder
approval. Such concentration of ownership may have the effect of delaying,
deferring or preventing a change in control.
Provisions in our charter documents might deter a company from acquiring us,
which could inhibit your ability to receive an acquisition premium for your
shares.
Our Board of Directors has authority to issue shares of preferred stock
and to fix the rights, including voting rights, of these shares without any
further vote or action by the shareholders. The rights of the holders of our
common stock will be subject to, and may be adversely affected by, the rights of
the holders of any preferred stock that may be issued in the future. The
issuance of preferred stock, while providing desirable flexibility in connection
with possible acquisitions and other corporate purposes, could have the effect
of making it more difficult for a third party to acquire a majority of our
outstanding voting stock, thereby delaying, deferring or preventing a change in
control. Furthermore, such preferred stock may have other rights, including
economic rights, senior to the common stock, and as a result, the issuance
thereof could have a material adverse effect on the market.
RECENT ACCOUNTING PRONOUNCEMENTS
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
36
beneficiary and all other enterprises with a significant variable interest in a
VIE provide additional disclosures. The provisions of FIN 46R were effective for
our fiscal 2004 first quarter. The adoption of FIN 46R did not have an impact on
our financial position or results of operations.
In March 2004, the FASB issued EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments,
which provides new guidance for assessing impairment losses on debt and equity
investments. Additionally, EITF Issue No. 03-1 includes new disclosure
requirements for investments that are deemed to be temporarily impaired. In
September 2004, the FASB delayed the accounting provisions of EITF Issue No.
03-1; however, the disclosure requirements remain effective. The Company does
not expect the adoption of EITF 03-1 to have a material impact on our financial
position or results of operations.
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment," a
revision of SFAS No. 123, "Accounting for Stock-Based Compensation" and
superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS
No. 123R requires the Company to expense grants made under the Company's stock
option program. That cost will be recognized over the vesting period of the
plans. SFAS No. 123R is effective for interim periods beginning after June 15,
2005. The Company is evaluating the alternatives allowed under the standard,
which the Company is required to adopt effective for its third quarter of fiscal
2005.
In December 2004, the FASB issued Staff Position SFAS No. 109-1,
Application of FASB Statement No. 109, Accounting for Income Taxes (FSP No.
109-1) to the Tax Deduction on Qualified Production Activities Provided by the
American Jobs Creation Act of 2004 which was signed into law by the President of
the United States on October 22, 2004. Companies that qualify for the recent tax
law's deduction for domestic production activities must account for it as a
special deduction under SFAS No. 109 and reduce their tax expense in the period
or periods the amounts are deductible, according to FSP No. 109-1, effective for
the Company in its fiscal year 2005. The FASB's guidance is not expected to have
a material impact to the Company's financial results.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We had no holdings of derivative financial or commodity instruments at
December 31, 2004. 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
In April 2005, Castelle completed a review of its accounting practices
with respect to the historical classification of cost of service revenues,
procedures for recognizing revenue associated with extended support contracts
and procedures for establishing the accrual for paid-time-off, and determined
that its historical financial statements as of and for the years ended December
31, 2002 and 2003 contained certain errors in the application of generally
accepted accounting principles. The outcome of this review has resulted in
adjustments to Castelle's previously filed financial statements. Consequently,
the historical financial statements and related financial information contained
in Castelle's Annual Report on Form 10-K for the year ended December 31, 2003
and each of Castelle's Forms 10-Q for the year ended December 31, 2004 should no
longer be relied upon and are superceded by the financial statements and
financial information in the Annual Report on Form 10-K.
37
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
On September 24, 2004, the Audit Committee of the Board of Directors
dismissed PricewaterhouseCoopers LLP (PwC) as Castelle's independent registered
public accounting firm. On September 24, 2004, the Audit Committee engaged Grant
Thornton LLP as Castelle's new independent registered public accounting firm for
the fiscal year ended December 31, 2004. The change in independent registered
public accounting firm was reported in a Current Report on Form 8-K dated
September 30, 2004.
PwC's reports on the consolidated financial statements of Castelle for the
fiscal years 2002 and 2003 contained no adverse opinion or disclaimer of opinion
and were not qualified or modified as to uncertainty, audit scope or accounting
principle. In connection with its audits of Castelle's consolidated financial
statements as of and for the fiscal years ended December 31, 2002 and 2003 and
through September 24, 2004, there were no disagreements with PwC on any matter
of accounting principles or practices, financial statement disclosure, or
auditing scope or procedure, which disagreements, if not resolved to the
satisfaction of PwC, would have caused PwC to make reference thereto in its
reports on the consolidated financial statements for such years. During
Castelle's fiscal years ended December 31, 2002 and 2003 and through September
24, 2004, there were no "reportable events," as that term is defined in Item
304(a)(1)(v) of Regulation S-K.
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.
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.
Our management evaluated, with the participation of our Chief Executive
Officer and our Chief Financial Officer, the effectiveness of our disclosure
controls and procedures as of the end of the period covered by this Annual
Report on Form 10-K and as of the periods affected by the restatement referred
to elsewhere in this Form 10-K. Based on this evaluation, our Chief Executive
Officer and our Chief Financial Officer have concluded that our disclosure
controls and procedures were not effective to ensure that information we are
required to disclose in reports that we file or submit under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in Securities and Exchange Commission rules and forms due
to the following:
(1) Through September 30, 2004, our historical classification of cost of
service revenues did not conform to generally accepted accounting
principles as such costs were classified as a component of sales and
marketing expenses rather than as a component of cost of sales, due
primarily to the fact that our internal financial reporting system
did not track this information separately from certain sales and
marketing expenses. This internal control deficiency that led to the
errors in the historical classification of cost of service revenues
is deemed to constitute a
38
"material weakness" as defined by the Public Company Accounting
Oversight Board's Auditing Standard No. 2.
(2) Through September 30, 2004, service revenues attributable to
extended support contracts were overstated due to inadequate
procedures in place to correctly recognize sales related to extended
support contracts. The Company's independent registered public
accounting firm, Grant Thornton LLP, has concluded that the internal
control deficiency that led to the revenue recognition errors is
also a "material weakness" as defined by the Public Company
Accounting Oversight Board's Auditing Standard No. 2.
Effective January 1, 2005, the Company established a cost center to
separately capture the cost of service revenues as a component of cost of sales.
During the first quarter of fiscal 2005, the Company also enhanced its internal
accounting system and related controls to ensure that revenue relating to
extended support contracts is recognized over the actual contract term.
In designing and evaluating our disclosure controls and procedures, our
management recognized that any controls and procedures, no matter how well
designed and operated, can provide only reasonable assurance of achieving their
objectives, and our management necessarily applied its judgment in evaluating
the cost-benefit relationship of possible controls and procedures.
ITEM 9B. OTHER INFORMATION
None
39
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 2004 Annual Meeting of Shareholders to be filed by us with the
Securities and Exchange Commission ("SEC") no later than April 30, 2005 or will
be provided in an amendment to this Form 10-K to be filed with the SEC no later
than April 30, 2005.
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, to manage our stock buyback program approved by the Board of
Directors. Mr. Robert Hambrecht, a director of Castelle, is also a director of
W.R. Hambrecht + Co. Through March 31, 2003, WRH + Co. had received an
insignificant amount of compensation under this arrangement. There were no stock
buyback activities from March 2003 through March 10, 2005.
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 herein by reference.
40
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 Grant Thornton LLP, Independent Registered
Public Accounting Firm........................................................ F-1
Report of Pricewaterhouse Coopers LLP, Independent Registered
Public Accounting Firm........................................................ F-2
Consolidated Balance Sheets as of December 31, 2004 and 2003.................. F-3
Consolidated Statements of Earnings for the years ended
December 31, 2004, 2003 and 2002......................................... F-4
Consolidated Statements of Shareholders' Equity for the years ended
December 31, 2004, 2003 and 2002......................................... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 2004, 2003 and 2002......................................... F-6
Notes to Consolidated Financial Statements.................................... F-7
2) Financial Statement Schedules
The following financial statement schedule of Castelle for the
years ended December 31, 2004, 2003 and 2002 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-29
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
41
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.
(b) Reports on Form 8-K
During the fourth quarter of 2004, Castelle filed a Form 8-K on
October 27, 2004. 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,
2004.
(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 SB-2/A 33-99628-LA- 12/8/1995 3.3
Incorporation.
3.2 Registrant's Amended and Restated Bylaws. 10-K 000-22020 12/31/2000 3.2
4.1 Specimen Stock Certificate representing shares SB-2/A 33-99628-LA- 12/14/1995 4.1
of Registrant's Common Stock.
10.1* 1995 Non-Employee Directors' Stock Option Plan, SB-2/A 111-22020 12/14/1995 10.2
as amended, and form of Director Stock Option
Agreement
10.2 Form of Indemnity Agreement between the SB-2/A 33-99628-LA- 12/8/1995 10.4
Registrant and each of its directors and
executive officers.
10.3 OEM Purchase Agreement dated May 23, 1995, by SB-2/A 33-99628-LA- 12/8/1995 10.7
and between the Registrant and SerComm
Corporation.
10.4 Distribution Agreement dated February 26, 1990, SB-2/A 33-99628-LA- 12/8/1995 10.8
by and between the Registrant and Ingram Micro D
Inc.
10.5 Distributor Contract dated June 25, 1991, as SB-2/A 33-99628-LA- 12/8/1995 10.9
amended June 25, 1991, by and between the
Registrant and Tech Data Corporation.
10.6 International Distributor Agreement dated SB-2/A 33-99628-LA- 12/8/1995 10.12
February 24, 1994, by and between the Registrant
and Macnica.
10.7* 1988 Equity Incentive Plan, as amended, and form S-8 333-75247 3/29/1999 99.1
of option agreement
10.8 International Distributor Agreement dated April 10-K 000-22020 3/29/2002 10.11
24, 2001 by and between the Registrant and AMS
Limited.
10.9 Commercial Tenant Lease Agreement dated August 10-K 000-22020 3/29/2002 10.12
16, 2000 by and among the Registrant and Kyung
S. Lee and Ieesun Kim Lee.
10.10 First Amendment to Lease Agreement dated June 1, 10-Q 000-22020 8/11/2004 10.1
2004 by and among the Registrant and by and
between Kyung S. Lee and Ieesun Kim Lee.
10.11* Summary of Severance Agreements with Named - - - - X
Executive Officers.
10.12 Employment agreement dated April 22, 2002 by and 10-K 000-22020 3/28/2003 10.16
between the Registrant and Scott McDonald.
10.13 Form of Executive Severance and Transition 10-K 000-22020 3/28/2003 10.16
Benefits Agreement dated April 22, 2002 by and
between the Registrant and Scott McDonald.
10.14* 2002 Equity Incentive Plan. 10-K 000-22020 3/28/2003 10.16
10.15 Loan and Security Agreement dated March 18, 1999 10-K 000-22020 3/28/2003 10.17
by and between the Registrant and Silicon Valley
Bank.
10.16 Loan Modification Agreement dated March 16, 2003 10-K 000-22020 3/28/2003 10.18
by and between the Registrant and Silicon Valley
Bank.
10.17 Loan Modification Agreement dated March 15, 2004 10-K 000-22020 3/29/2004 10.16
by and between the Registrant and Silicon Valley
Bank.
42
10.18 Loan and Security Agreement dated August 2, 2004 10-Q 000-22020 8/11/2004 10.2
by and between the Registrant and Silicon Valley
Bank.
23.1 Consent of Grant Thornton LLP, Independent X
Registered Public Accounting Firm
23.2 Consent of PricewaterhouseCoopers LLP, X
Independent Registered Public Accounting Firm
* Indicates management contracts or compensatory plans or
arrangements filed pursuant to Item 601(b)(10) of Regulation
S-K
43
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 fifteenth day of April 2005.
By: /S/ SCOTT C. MCDONALD
-------------------------------------
Scott C. McDonald
President and Chief Executive Officer
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 President, Chief Executive Officer April 15, 2005
----------------------- (principal executive officer) and Director
Scott C. McDonald
/S/ PAUL CHENG Vice President, Finance and Administration, April 15, 2005
----------------------- Chief Financial Officer (principal accounting
Paul Cheng officer) and Secretary
/S/ DONALD L. RICH Chairman of the Board April 15, 2005
-----------------------
Donald L. Rich
/S/ ROBERT H. HAMBRECHT Director April 15, 2005
-----------------------
Robert H. Hambrecht
/S/ ROBERT O. SMITH Director April 15, 2005
-----------------------
Robert O. Smith
/S/ PETER R. TIERNEY Director April 15, 2005
-----------------------
Peter R. Tierney
44
Report of Independent Registered Public Accounting Firm
To the Board of Directors and
Shareholders of Castelle
We have audited the accompanying balance sheet of Castelle and its subsidiary
(the "Company") as of December 31, 2004 and the related statements of earnings,
stockholders' equity, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes, assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Castelle and its subsidiary as
of December 31, 2004 and the results of its operations and its cash flows for
the year then ended in conformity with accounting principles generally accepted
in the United States of America.
We have also audited Schedule II for the year ended December 31, 2004. In our
opinion, this schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly, in all material respects, the
information therein.
Grant Thornton LLP
San Francisco, California
March 3, 2005, except
for Note 3, as to which the
date is March 31, 2005
Report of Independent Registered Public Accounting Firm
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 the
results of their operations and their cash flows for each of the two 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 the
standards of the Public Company Accounting Oversight Board (United States).
Those standards 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.
As described in Note 3, the Company has restated its financial statements for
each of the two years in the period ended December 31, 2003
PricewaterhouseCoopers LLP
San Jose, California
March 29, 2004,
except for Note 3,
as to which the date is
April 13, 2005
Castelle
Consolidated Balance Sheets
(in thousands)
--------------------------------------------------------------------------------
December 31,
------------------------------
2004 2003
----------- -----------
Assets (Restated)
Current assets:
Cash and cash equivalents $ 5,599 $ 4,614
Accounts receivable, net 857 873
Inventories 1,785 1,177
Prepaid expenses and other current assets 130 134
Deferred taxes 231 380
----------- -----------
Total current assets 8,602 7,178
Property and equipment, net 203 376
Other assets 50 103
Deferred taxes 1,292 146
----------- -----------
Total assets $ 10,147 $ 7,803
=========== ===========
Liabilities and Shareholders' Equity
Current liabilities:
Current portion of long-term debt $ 15 $ 16
Accounts payable 511 314
Accrued liabilities 1,073 1,737
Deferred revenue 1,253 955
----------- -----------
Total current liabilities 2,852 3,022
Long-term debt, net of current portion 14 29
----------- -----------
Total liabilities 2,866 3,051
----------- -----------
Commitments and contingencies (Note 5)
Shareholders' equity:
Preferred stock, no par value:
Authorized: 2,000 shares in 2004 and 2003
Issued and outstanding: none in 2004 and 2003 -- --
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 3,799 shares at December 31, 2004
and 3,425 shares at December 31, 2003 27,668 27,258
Accumulated deficit (20,387) (22,506)
----------- -----------
Total shareholders' equity 7,281 4,752
----------- -----------
Total liabilities and shareholders' equity $ 10,147 $ 7,803
=========== ===========
F-3
The accompanying notes are an integral part of these financial statements.
Castelle
Consolidated Statements of Earnings
(in thousands, except per share data)
--------------------------------------------------------------------------------
Year Ended December 31
-------------------------------------------------
2004 2003 2002
----------- ----------- -----------
(Restated) (Restated)
Net sales:
Products $ 8,011 $ 8,337 $ 8,617
Services 2,446 1,843 1,103
----------- ----------- -----------
Total net sales 10,457 10,180 9,720
----------- ----------- -----------
Cost of sales:
Products 2,556 2,485 2,833
Services 826 726 707
----------- ----------- -----------
Total cost of sales 3,382 3,211 3,540
----------- ----------- -----------
Gross profit 7,075 6,969 6,180
----------- ----------- -----------
Operating expenses:
Research and development 1,722 1,590 1,379
Sales and marketing 2,486 2,398 2,301
General and administrative 1,801 1,902 1,943
Restructuring recovery -- -- (40)
----------- ----------- -----------
6,009 5,890 5,583
----------- ----------- -----------
Operating income 1,066 1,079 597
Interest income, net 36 16 43
Other income (expense), net (50) (26) 1
----------- ----------- -----------
Income before provision for (benefit from)
income taxes 1,052 1,069 641
Provision for (benefit from) income taxes (1,067) (537) 6
----------- ----------- -----------
Net income $ 2,119 $ 1,606 $ 635
=========== =========== ===========
Net income per common share - basic $ 0.59 $ 0.49 $ 0.14
=========== =========== ===========
Net income per common share - diluted $ 0.48 $ 0.38 $ 0.14
=========== =========== ===========
Shares used in per share calculation - basic 3,616 3,254 4,539
=========== =========== ===========
Shares used in per share calculation - diluted 4,417 4,186 4,586
=========== =========== ===========
F-4
The accompanying notes are an integral part of these financial statements.
Castelle
Consolidated Statements of Shareholders' Equity
Years Ended December 31, 2004, 2003 and 2002
(in thousands)
--------------------------------------------------------------------------------
Common Stock
----------------------------- Deferred Accumulated
Shares Amount Compensation Deficit Total
----------- ----------- ------------ ----------- -----------
Balances, December 31, 2001, restated 4,745 $ 28,977 $ (1) $ (24,747) $ 4,229
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 income, as restated -- -- -- 635 635
----------- ----------- ----------- ----------- -----------
Balances, December 31, 2002, restated 3,187 27,038 -- (24,112) 2,926
=========== =========== =========== =========== ===========
Issuance of common stock through
exercise of stock options 285 268 -- -- 268
Repurchase and cancellation of common stock (47) (48) -- -- (48)
Net income, as restated -- -- -- 1,606 1,606
----------- ----------- ----------- ----------- -----------
Balances, December 31, 2003, restated 3,425 27,258 -- (22,506) 4,752
=========== =========== =========== =========== ===========
Issuance of common stock through
exercise of stock options 374 410 -- -- 410
Net income -- -- -- 2,119 2,119
----------- ----------- ----------- ----------- -----------
Balances, December 31, 2004 3,799 $ 27,668 $ -- $ (20,387) $ 7,281
=========== =========== =========== =========== ===========
F-5
The accompanying notes are an integral part of these financial statements.
Castelle
Consolidated Statements of Cash Flows
Years Ended December 31, 2004, 2003 and 2002
(in thousands)
--------------------------------------------------------------------------------
Year Ended December 31,
--------------------------------------------------
2004 2003 2002
------------ ------------ ------------
Cash flows from operating activities: (Restated) (Restated)
Net income $ 2,119 $ 1,606 $ 635
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation and amortization 206 213 206
Provision for doubtful accounts (1) 5 (21)
Allowance for sales returns and stock rotation 886 524 660
Write-downs of excess and obsolete inventory 72 (167) (105)
Deferred taxes (997) (526) --
Compensation expense related to grant of stock options -- -- 1
Loss on disposal of fixed assets 2 -- 1
Changes in assets and liabilities:
Accounts receivable (869) (958) (403)
Inventories (680) 100 (79)
Prepaid expenses and other current assets 57 (41) 42
Accounts payable 197 (45) 79
Accrued liabilities (663) 56 (321)
Deferred revenue 297 351 187
------------ ------------ ------------
Net cash provided by operating activities 626 1,118 882
------------ ------------ ------------
Cash flows from investing activities:
Acquisition of property and equipment (35) (164) (34)
------------ ------------ ------------
Net cash used in investing activities (35) (164) (34)
------------ ------------ ------------
Cash flows from financing activities:
Repayment of notes payable (16) (20) (17)
Repurchase of common stock -- (48) (1,977)
Proceeds from issuance of common stock 410 268 38
------------ ------------ ------------
Net cash provided by (used in) financing activities 394 200 (1,956)
------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents 985 1,154 (1,108)
Cash and cash equivalents, beginning of period 4,614 3,460 4,568
------------ ------------ ------------
Cash and cash equivalents, end of period $ 5,599 $ 4,614 $ 3,460
============ ============ ============
Supplemental information:
Cash paid during the period for:
Interest $ 5 $ 9 $ 10
F-6
The accompanying notes are an integral part of these financial statements.
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Throughout these notes to the financial statements, all referenced amounts
reflect the balances and amounts on a restated basis with respect to fiscal 2003
and 2002.
1. Business and Organization of the Company
Castelle develops, manufactures, markets and supports office automation
systems that allow organizations to easily implement faxing 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 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 51%, 57%
and 56% of the Company's sales in 2004, 2003 and 2002, respectively.
Customers accounting for more than 10% of net sales are presented in Note
9, Major Customers and Geographic Information
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.
F-7
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
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 60%, 69% and 68% of accounts receivable at December 31,
2004, 2003 and 2002, respectively. The same three customers accounted for
51%, 57% and 56% of the Company's total sales in 2004, 2003 and 2002,
respectively. Although the Company does not require collateral on accounts
receivable arising from 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. We record write downs for
excess and obsolete inventory equal to the difference between the cost of
inventory and the estimated fair value based on assumptions about future
product life-cycles, product demand and market conditions. If actual
product life cycles, product demand and market conditions are less
favorable than those projected by management, additional inventory
write-downs may be required. At the point of the loss recognition, a new,
lower-cost basis for that inventory is established, and subsequent changes
in facts and circumstances do not result in the restoration or increase in
that newly established cost basis.
We have purchased approximately two years worth of end-of-life components
to ensure a smooth supply of our FaxPress Products to our customers.
Accordingly, our management reviews periodically the usage, supply and
inventory levels of these parts to determine whether additional purchases
or excessive inventory provisions are necessary. As of December 31, 2004,
we have approximately $675,000 worth of end-of-life components on hand and
we believe that most of these components will be utilized in the following
two years, resulting in insignificant amounts of excessive inventory, or
none at all.
F-8
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
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.
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 the
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
We recognize revenue based on the provisions of Staff Accounting Bulletin
No. 104 "Revenue Recognition," AICPA Statement of Position No. 97-2 ("SOP
97-2") "Software Revenue Recognition," as amended by SOP 98-9,
"Modification of SOP 97-2, Software Revenue Recognition with Respect to
Certain Transactions," and Statement of Financial Accounting Standards
("SFAS") No. 48 "Revenue Recognition When Right of Return Exits."
The Company uses the residual method to recognize revenue when an
agreement includes one or more elements to be delivered at a future date.
If there is an undelivered element under the arrangement, the Company
defers revenue based on vendor-specific objective evidence of the fair
value of the undelivered element, as determined by the price charged when
the element is sold separately. If vendor-specific objective evidence of
fair value does not exist for all undelivered elements, the Company defers
all revenue until sufficient evidence exists or all elements have been
delivered.
Product revenue is recognized when all of the following criteria are met:
persuasive evidence of an arrangement exists; delivery has occurred; the
fee is fixed and determinable; collection is probable; and returns can be
reasonably estimated. If an acceptance period or other contingency exists,
revenue is recognized upon satisfaction of the contingency, customer
acceptance or expiration of the acceptance period. Shipment generally
occurs and title and risk of loss is transferred when the product is
delivered to a common carrier.
We enter into agreements with some of our distributors that permit limited
stock rotation rights. These stock rotation rights allow the distributor
to return products for credit but require the purchase of additional
products of equal value. Customers who purchase products directly from 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.
Pursuant to our agreements with distributors, we also protect our
distributors' exposure related to the impact of price reductions. Future
price adjustments are estimated and accrued at the time of sale as a
reduction in revenue.
F-9
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
We generally provide our distributors the opportunity to earn volume
incentive rebates based on sales volume achieved during the fiscal
quarter. These incentive rebates are accrued in the quarter incurred and
recorded as a reduction in revenue.
We also provide co-op and market development funds to our distributors.
These incentives are accrued at the time revenue is recognized and
recorded as a reduction in revenue.
We offer a standard trade-in discount to all of our end-user customers
under which the customer, upon trade-in of any previously purchased
product, is entitled to a discount from our published price list on any
product included in our current product offerings. We require our
customers to physically return the previously purchased products to
qualify for the trade-in discount. We account for the trade-in discount as
a reduction of revenue at the time the product is traded in and a new
product is purchased.
Payment terms to our distributors and customers are generally thirty days,
cash in advance, or by credit card.
We evaluate product sales through our distribution channels and the
related reserve requirement to establish an estimate for our sales returns
reserve by reviewing detailed point-of-sales and on-hand inventory reports
provided to us by our channel partners. Based on a combination of
historical return experience, the sales activities to end-user customers
by our channel partners and the level of inventories on hand at the
channel partners, we determine our returns reserve at the end of each
financial period, and increase or reduce the reserve balance accordingly.
We provide standard support to our customers for an initial period of
sixty days, which includes advance swap of the defective hardware and
software, bug fixes, software upgrades and technical support. In addition
to standard support, we also offer our customers the option to purchase
extended support at the time of product purchase or anytime thereafter.
Extended support covers hardware and software for a period of one year. We
have established vendor-specific objective evidence with respect to the
fair value of the standard support contracts based on standalone sales and
renewals of our one-year extended support contracts. The fair value of our
sixty day support contracts included with product sales is determined by
pro-rating the related one-year extended support contracts. We recognize
revenue from extended support contracts ratably over the period of the
contract.
Hardware is warranted for one year from the date of sale and is repaired
free-of-charge. 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.
We do not sell software, which is incorporated into our hardware,
separately, other than for our customers to purchase as an upgrade to
their existing products when we announce a major release of the software.
Shipping and handling
Costs related to shipping and handling are included in cost of sales for
all periods presented.
F-10
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Advertising costs
Advertising costs, included in sales and marketing expenses, are expensed
as incurred and were $219,000, $345,000 and $193,000 in 2004, 2003 and
2002, respectively.
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 per share
Basic net income per share is computed by dividing net income by the
weighted average number of common shares outstanding for that period.
Diluted net income 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.
Basic and diluted net income per share are calculated as follows (in
thousands except per share amounts):
F-11
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
2004 2003 2002
----------- ----------- -----------
Basic: (Restated) (Restated)
Weighted average shares 3,616 3,254 4,539
=========== =========== ===========
Net income $ 2,119 $ 1,606 $ 635
=========== =========== ===========
Net income per share $ 0.59 $ 0.49 $ 0.14
=========== =========== ===========
Diluted:
Weighted average shares 3,616 3,254 4,539
Common equivalent shares from stock options 801 932 47
----------- ----------- -----------
Shares used in per share calculation 4,417 4,186 4,586
=========== =========== ===========
Net income $ 2,119 $ 1,606 $ 635
=========== =========== ===========
Net income per share $ 0.48 $ 0.38 $ 0.14
=========== =========== ===========
The calculation of diluted shares outstanding excludes 123,000, 120,000,
and 1,153,000 shares of common stock for the years ended December 31,
2004, 2003, and 2002 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.
Had compensation costs been determined consistent with SFAS No. 123, the
Company's net income would have been changed to the amounts indicated
below for the years ended December 31 (in thousands, except per share
data):
2004 2003 2002
----------- ----------- -----------
(Restated) (Restated)
Net income - as reported $ 2,119 $ 1,606 $ 635
Fair value of stock-based compensation (520) (433) (176)
----------- ----------- -----------
Net income - pro forma $ 1,599 $ 1,173 $ 459
=========== =========== ===========
Net income per share - basic - as reported $ 0.59 $ 0.49 $ 0.14
Net income per share - diluted - as reported $ 0.48 $ 0.38 $ 0.14
Net income per share - basic - pro forma $ 0.44 $ 0.36 $ 0.10
Net income per share - diluted - pro forma $ 0.36 $ 0.28 $ 0.10
F-12
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
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 December 2003, the FASB issued a revised FASB interpretation No. 46
(FIN 46R), "Consolidation for Variable Interest Entities, an
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 were effective for the Company's fiscal 2004
first quarter. The adoption of FIN 46R did not have a material impact on
the Company's financial position or results of operations.
In March 2004, the FASB issued EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain
Investments, which provides new guidance for assessing impairment losses
on debt and equity investments. Additionally, EITF Issue No. 03-1 includes
new disclosure requirements for investments that are deemed to be
temporarily impaired. In September 2004, the FASB delayed the accounting
provisions of EITF Issue No. 03-1; however, the disclosure requirements
remain effective. The Company does not expect the adoption of EITF 03-1 to
have a material impact on our financial position or results of operations.
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment," a
revision of SFAS No. 123, "Accounting for Stock-Based Compensation" and
superseding APB Opinion No. 25, "Accounting for Stock Issued to
Employees." SFAS No. 123R requires the Company to expense grants made
under the Company's stock option program. That cost will be recognized
over the vesting period of the grants. SFAS No. 123R is effective for
interim periods beginning
F-13
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
after June 15, 2005.. The Company is evaluating the alternatives allowed
under the standard, which the Company is required to adopt effective for
its third quarter of fiscal 2005.
In December 2004, the FASB issued Staff Position SFAS No. 109-1,
Application of FASB Statement No. 109, Accounting for Income Taxes (FSP
No. 109-1) to the Tax Deduction on Qualified Production Activities
Provided by the American Jobs Creation Act of 2004 which was signed into
law by the President of the United States on October 22, 2004. Companies
that qualify for the recent tax law's deduction for domestic production
activities must account for it as a special deduction under SFAS No. 109
and reduce their tax expense in the period or periods the amounts are
deductible, according to FSP No. 109-1, effective for the Company in
fiscal year 2005. The FASB's guidance is not expected to have a material
impact to the Company's financial results.
3. Restatement of Previously Issued Financial Statements
In March and April 2005, the Company conducted a review of its accounting
practices with respect to the historical classification of cost of service
revenues, procedures for recognizing revenue associated with extended
support contracts and procedures for establishing the accrual for
paid-time-off, and determined that its historical financial statements as
of and for the years ended December 31, 2003 and 2002 contained certain
errors in the application of generally accepted accounting principles as
described below:
o Classification of cost of service revenues
The Company has concluded that its historical classification of cost
of service revenues did not conform to generally accepted accounting
principles. Historically, such costs were improperly included as a
component of sales and marketing expenses on the Company's
consolidated statements of earnings; however under generally
accepted accounting principles, such costs are required to be
classified as cost of service revenues. Accordingly, the
accompanying consolidated statements of earnings for the years ended
December 31, 2003 and 2002 reflect the reclassification of $729,000
and $711,000, respectively, out of sales and marketing and into cost
of service revenues. The reclassifications had no impact on
previously reported sales, net income, earnings per share or cash
flows from operations for the respective periods. The
misclassification, however, did result in cost of sales being
understated, and gross profit and operating expenses being
overstated by equal amounts.
o Revenue recognition related to extended support contracts
The Company has determined that service revenues attributable to
extended support contracts were overstated by approximately $34,000
and $39,000 for the years ended December 31, 2003 and 2002,
respectively. These amounts should have been deferred and recognized
as service revenues in subsequent periods. Accordingly, the
accompanying consolidated statements of earnings for the years ended
December 31, 2003 and 2002 reflect reductions to previously reported
service revenues of $34,000 and $39,000, respectively. The error
that led to these revenue overstatements in 2003 and 2002 also
affected 2001, resulting in revenue being understated in 2001.
Consequently, opening retained earnings as of January 1, 2002 have
been adjusted to reflect the impact of the error on 2001. This
adjustment decreased previously reported accumulated deficit by
$27,000 with a corresponding decrease to deferred revenue. The
F-14
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
accompanying balance sheets reflect the aggregate impact of the
restatement adjustments on deferred revenue as of the periods
presented.
o Accrual for paid-time off
The Company has also determined that its accrual for paid-time-off
was overstated as of December 31, 2003 and 2002. This error resulted
in the overstatement of expenses by $7,000 and $15,000 for the years
ended December 31, 2003 and 2002, respectively. Accordingly, the
accompanying consolidated statements of earnings for the years ended
December 31, 2003 and 2002 reflect reductions to previously reported
operating expenses of $7,000 and $15,000, respectively. The
accompanying balance sheets reflect the aggregate impact of the
restatement adjustments on accrued liabilities as of the periods
presented.
The following tables set forth the previously reported amounts and the
restated amounts reflected in the accompanying financial statements:
F-15
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Castelle
Reconciliation of Statements of Earnings
(amounts in thousands, except per share data)
Year-ended Year-ended Year-ended Year-ended
---------- ---------- ---------- ----------
December 31, December 31,
2003 December 31, 2002 December 31,
as previously 2003 as previously 2002
reported adjustments as restated reported adjustments as restated
------------- ----------- ------------ ------------- ----------- ------------
Sales:
Products $ 8,337 -- $ 8,337 $ 8,617 -- $ 8,617
Services 1,877 (34) 1,843 1,142 (39) 1,103
-------- -------- -------- -------- -------- --------
Net sales 10,214 (34) 10,180 9,759 (39) 9,720
Cost of sales:
Products 2,485 -- 2,485 2,836 (3) 2,833
Services -- 726 726 -- 707 707
-------- -------- -------- -------- -------- --------
Total cost of sales 2,485 726 3,211 2,836 704 3,540
-------- -------- -------- -------- -------- --------
Gross Profit 7,729 (760) 6,969 6,923 (743) 6,180
-------- -------- -------- -------- -------- --------
Operating expenses:
Research and development 1,590 -- 1,590 1,383 (4) 1,379
Sales and marketing 3,131 (733) 2,398 3,016 (715) 2,301
General and administrative 1,902 -- 1,902 1,943 -- 1,943
Restructuring charges -- -- -- (40) -- (40)
-------- -------- -------- -------- -------- --------
Total operating expenses 6,623 (733) 5,890 6,302 (719) 5,583
-------- -------- -------- -------- -------- --------
Operating income 1,106 (27) 1,079 621 (24) 597
-------- -------- -------- -------- -------- --------
Other income (expense), net (10) -- (10) 44 -- 44
-------- -------- -------- -------- -------- --------
Income before provision for
(benefit from) income taxes 1,096 (27) 1,069 665 (24) 641
Provision for (benefit
from) income taxes (537) -- (537) 6 -- 6
-------- -------- -------- -------- -------- --------
Net income $ 1,633 (27) $ 1,606 $ 659 (24) $ 635
======== ======== ======== ======== ======== ========
Net income per common
share:
Basic $ 0.50 ($0.01) $ 0.49 $ 0.15 ($0.01) $ 0.14
======== ======== ======== ======== ======== ========
Diluted $ 0.39 ($0.01) $ 0.38 $ 0.14 $ 0.00 $ 0.14
======== ======== ======== ======== ======== ========
F-16
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Castelle
Summary of Adjustments to Consolidated Balance Sheets
(amounts in thousands)
December 31, December 31,
2003 December 31, 2002 December 31,
as previously Restatement 2003 as previously Restatement 2002
reported adjustments as restated reported adjustments as restated
------------- ----------- ----------- ------------- ----------- -------------
Balance sheet accounts:
Current liabilities:
Accrued liabilities $ 1,759 ($22) $ 1,737 $ 1,696 (15) $ 1,681
Deferred revenue 909 46 955 592 12 604
Total current liabilities 2,998 24 3,022 2,668 (3) 2,665
Total liabilities 3,027 24 3,051 2,712 (3) 2,709
-------- -------- -------- -------- -------- --------
Accumulated deficit (22,482) (24) (22,506) (24,115) 3 (24,112)
Total shareholders' equity 4,776 (24) $ 4,752 $ 2,923 3 $ 2,926
Total liabilities and
shareholders' equity $ 7,803 -- $ 7,803 $ 5,635 -- $ 5,635
======== ======== ======== ======== ======== ========
4. Balance Sheet Detail (in thousands)
Accounts Receivable, net:
December 31,
---------------------------
2004 2003
----------- -----------
Accounts receivable $ 1,295 $ 1,354
Less: allowance for sales returns (408) (442)
Less: allowance for doubtful accounts (30) (39)
----------- -----------
Total accounts receivable, net $ 857 $ 873
=========== ===========
Inventories:
December 31,
---------------------------
2004 2003
----------- -----------
Raw materials $ 1,202 $ 610
Work in process 118 --
Finished goods 465 567
----------- -----------
Total inventories $ 1,785 $ 1,177
=========== ===========
F-17
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Property and equipment:
December 31,
---------------------------
2004 2003
---------- ----------
Production, test and demonstration equipment $ 422 $ 420
Computer equipment 1,151 1,175
Office equipment 105 100
Leasehold improvements 446 442
---------- ----------
2,124 2,137
Less accumulated depreciation and amortization (1,921) (1,761)
---------- ----------
Total property and equipment $ 203 $ 376
========== ==========
The Company recorded depreciation and amortization related to
property and equipment of $206,000, $213,000 and $206,000 in 2004,
2003 and 2002, respectively.
As of December 31, 2004 and 2003, the Company had $75,000 and
$100,000, respectively, of equipment under capital leases.
Accumulated amortization associated with these capital leases was
$61,000 and $65,000 at December 31, 2004 and 2003, respectively.
Accrued liabilities:
December 31,
---------------------------
2004 2003
---------- ----------
(Restated)
Accrued compensation $ 429 $ 462
Accrued sales and marketing 123 378
Accrued professional fees 73 136
Other accruals 448 761
---------- ----------
Total accrued liabilities $ 1,073 $ 1,737
========== ==========
F-18
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
5. Commitments and Contingencies
Lease Commitments
The Company has entered into a noncancelable operating lease that expires
in 2009 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 was extended for a term of five years commencing on June 1, 2004
and expiring on May 31, 2009, with one conditional three-year renewal
option, which if exercised, would extend the lease to May 31, 2012
commencing with rent at ninety-five percent of fair market value. Future
minimum payments under noncancelable operating leases are as follows (in
thousands):
Year Ending December 31,
2005 $ 207
2006 207
2007 207
2008 207
2009 87
---------
$ 915
=========
Rent expense, including the facility lease and equipment rental, was
$162,000 $288,000, and $298,000, for 2004, 2003 and 2002, 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, 2004, the Company had a loan and security agreement of $32,000, which
is subject to an interest rate of 12.8%. As of December 31, 2004, future
minimum lease payments are as follows (in thousands):
Year Ending December 31,
2005 18
2006 14
---------
Total minimum lease payments 32
Less amount representing interest (3)
---------
Present value of capital lease obligations 29
Less current portion (15)
---------
Long-term portion of capital lease obligations $ 14
=========
Product Warranties and Guarantor Arrangements
We offer warranties on certain products and record a liability for the
estimated future costs associated with warranty claims, which is based
upon historical experience and our estimate of the level of future costs.
Warranty costs are reflected in the Statement of Earnings as a Cost of
Sales. If actual warranty costs are different from our estimated costs, or
if the warranty claims were to be significantly higher than our historical
experience, then revisions to the estimated warranty liability may be
required and the warranty expense could change from current levels. A
F-19
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
reconciliation of the changes in our warranty liability during the periods
presented is as follows (in thousands):
December 31, December 31,
2004 2003
Warranty accrual at the beginning of the year $ 24 $ 34
Accruals for warranties issued during the year 2 15
Settlements made in kind during the year (13) (25)
-----------------------------
Warranty accrual at the end of the year $ 13 $ 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.
6. Bank Borrowings
On August 2, 2004, we secured from Silicon Valley Bank a new revolving
line of credit to replace the previous credit facility. The new revolving
line of credit provides for borrowings of up to $4.0 million and has a
one-year term. Borrowings under this line of credit agreement are
collateralized by all of our assets and bear interest at the bank's prime
rate plus 0.50%. Under the new facility we are required to maintain
certain minimum cash and investment balances with the bank and meet
certain other financial covenants. As of December 31, 2004, we have not
drawn down on the line of credit and were in compliance with the terms of
the agreement.
7. 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
F-20
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
the Company. No time limit was set for the completion of this program. At
the time of the approval by the Board of Directors, the Company had
approximately 4.8 million shares of common stock outstanding. During the
fourth quarter of 2002, the Company repurchased from open market and
negotiated transactions a total of approximately 1.62 million shares for
approximately $1.8 million, at an average per share price of $1.10. During
the first quarter of 2003, the Company repurchased from open market
transactions a total of 46,500 shares for $48,000, at an average per share
price of $1.04. The Company has not repurchased any of its common stock
since then. 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, 2004, 400,205 options have been granted under the
2002 Plan, while 903,000 options are outstanding under the prior plans.
The following table summarizes option activity under the Company's stock
option plans (in thousands):
F-21
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Outstanding Options
Weighted
Average
Available Number Exercise
for Grant Outstanding Price
---------- ----------- ----------
Balances, January 1, 2002 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
Options granted (96) 96 $ 3.45
Options cancelled 10 (19) $ 1.92
Options exercised -- (374) $ 1.10
---------- ---------- ----------
Balances, December 31, 2004 460 1,293 $ 1.61
========== ========== ==========
At December 31, 2004, 2003 and 2002, 993,000, 1,078,000, and 1,087,000
options, respectively, were exercisable at a weighted average exercise
price of $1.34, $1.15 and, $1.10, respectively.
F-22
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
Options to purchase common stock outstanding and currently exercisable by
exercise price at December 31, 2004, 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 4.3 $0.34 10 $0.34
$0.51-$0.75 226 4.1 $0.70 164 $0.70
$0.76-$1.00 436 3.2 $0.91 425 $0.91
$1.01-$1.25 88 3.6 $1.12 88 $1.12
$1.26-$1.50 67 2.0 $1.33 66 $1.33
$1.51-$1.75 40 0.7 $1.60 40 $1.61
$1.76-$2.00 30 5.2 $1.94 30 $1.94
$2.00-$2.50 37 4.9 $2.38 20 $2.38
$2.51-$3.00 172 5.8 $2.77 100 $2.78
$3.01-$5.00 187 6.4 $3.45 50 $3.86
------- -------
1,293 4.2 $1.61 993 $1.34
======= =======
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes model with the following assumptions for 2004,
2003 and 2002:
2004 2003 2002
----------- ----------- -----------
Risk-free interest rate 3.68%-4.73% 3.32%-4.48% 3.86%-5.43%
Expected life 4.7 years 4.1 years 6.9 years
Expected dividends - - -
Volatility 192% 201% 146%
The weighted average fair value of options granted in 2004, 2003 and 2002
was $3.45, $2.95, and $0.71 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.
There were no grants to non-employees in 2002, 2003, or 2004. 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
in 2002 and nothing in 2003 or 2004.
Options to purchase 27,000, 27,000, and 33,000 shares of common stock were
held by non-employees at December 31, 2004, 2003 and 2002, respectively,
of which 27,000, 27,000, and
F-23
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
33,000 were exercisable for aggregate total exercise proceeds of $44,000,
$44,000, and $50,000, respectively.
8. Income Taxes
The provision (benefit) for income taxes is as follows (amounts in
thousands).
Year Ended December 31,
2004 2003 2002
----------- ----------- -----------
Current
Federal $ (70) $ 5 --
State 1 1 6
----------- ----------- -----------
Total Current $ (69) $ 6 $ 6
Deferred
Federal $ (849) $ (464) --
State (149) (79) --
----------- ----------- -----------
Total Deferred $ (998) $ (543) --
----------- ----------- -----------
Total provision (benefit) for income taxes $ (1,067) $ (537) $ 6
=========== =========== ===========
The Company's tax provision (benefit) differs from the provision computed
using statutory income tax rates as follows (in thousands):
2004 2003 2002
----------- ----------- -----------
Federal tax provision at statutory rate $ 353 $ 386 $ 248
Permanent difference due to
non-deductible expenses 10 12 7
State tax provision, net of federal benefit 39 1 6
Utilization of net operating loss carryovers (33) (187) (122)
Change in valuation allowance (1,436) (689) (65)
General business credits -- (60) (68)
----------- ----------- -----------
$ (1,067) $ (537) $ 6
=========== =========== ===========
F-24
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
The components of the net deferred tax assets are as follows (in
thousands):
December 31,
------------------------
2004 2003
---------- ----------
Inventory allowances and adjustments $ 72 $ 77
Accounts receivable allowances 12 16
Other liabilities and allowances 369 526
Net operating loss carryforwards 4,538 4,584
Tax credit carryforwards 1,633 1,615
Depreciation and amortization 478 396
Valuation allowance (5,579) (6,688)
---------- ----------
Total net deferred tax assets $ 1,523 $ 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 2004 and 2003, the
Company recorded tax benefits of $1,067,000 and $537,000, respectively.
This portion of the valuation allowance was reversed because the Company
determined that it was more likely than not that certain future tax
benefits will be realized as a result of projected future income.
At December 31, 2004, the Company had net operating loss carryforwards of
approximately $12,955,000 and $2,296,000 available to offset future
federal and California taxable income, respectively. These loss
carryforwards will expire in varying amounts beginning in 2005 through
2021. In addition, at December 31, 2004, the Company had federal and
California Research and Development credit carryforwards of approximately
$1,152,000 and $728,000, respectively. The federal Research and
Development credits expire in varying amounts beginning in 2007. The
California Research and Development credits carry-forward indefinitely.
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 before provision for income taxes for all periods
presented was derived substantially from domestic operations.
9. 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 2004, 2003 and 2002, the Company made no
contributions to the plan.
10. Major Customers and Geographic Information
Revenues by geographic area are determined by the location of the customer
and are summarized as follows (in thousands):
F-25
Year Ended December 31,
---------------------------------------------
2004 2003 2002
----------- ----------- -----------
(Restated) (Restated)
United States $ 8,574 $ 8,222 $ 7,660
Europe 785 704 826
Pacific Rim 804 883 887
Rest of Americas, excluding United States 294 371 347
----------- ----------- -----------
Total revenues $ 10,457 $ 10,180 $ 9,720
=========== =========== ===========
Customers that individually accounted for greater than 10% of net sales
are as follows (in thousands):
Year Ended December 31,
--------------------------------------------------------------------------------
2004 2003 2002
Customer Amount Percentage Amount Percentage Amount Percentage
-------- --------- ---------- -------- ---------- -------- ----------
A $ 2,186 21% $ 2,200 22% $ 2,657 27%
B $ 2,451 23% $ 2,899 28% $ 2,257 23%
11. Restructuring
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.
12. 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-26
Castelle
Supplemental Financial Information
--------------------------------------------------------------------------------
Supplemental Data (unaudited)
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.
Quarterly Results of Operations (unaudited)
The following table sets forth certain consolidated quarterly financial
data for the eight quarters ended December 31, 2004. 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.
The consolidated quarterly financial data presented below reflects the
restatement of the periods through September 30, 2004 to reflect the
adjustment for certain errors noted by the Company during the fourth
quarter of fiscal 2004. For a description of the restatement items and the
effect on annual periods for fiscal 2003 and 2002, see Note 3 to the
Company's consolidated financial statements.
Year 2004, Quarter Ended
------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
------ ------ ------ ------
(in thousands, except per share data)
(Restated) (Restated) (Restated)
Net sales (1) $2,539 $2,691 $2,685 $2,542
Gross profit (2) 1,702 1,883 1,804 1,686
Operating income (3) 228 272 236 330
Net income (4) 129 146 130 1,714(5)
Net income per share, basic (4) 0.04 0.04 0.04 0.46(5)
Net income per share, diluted (4) 0.03 0.03 0.03 0.39(5)
(1) Net sales in the 2004 quarters ended March 31, June 30 and September
30 have been restated to reduce service revenues by $19,000, $26,000
and $13,000, respectively, as compared to previously reported net
sales in relation to the extended support contract adjustments.
(2) Gross profit and operating expenses for the quarters ended March 31,
June 30 and September 30, 2004 have been restated to reduce such
balances by equal amounts of $198,000, $216,000 and $207,000,
respectively, as compared to previously reported amounts, as a
result of the reclassification of cost of service revenues from
operating expenses to cost of sales.
F-27
Castelle
Supplemental Financial Information
--------------------------------------------------------------------------------
(3) Operating income for the quarters ended March 31, June 30, and
September 30, 2004 has been increased by an additional $1,000 in
each of the three quarters, as compared to previously reported
amounts to correct the overstatement of the Company's paid-time-off
accrual.
(4) The restatement adjustments referred to above reduced previously
reported net income by $18,000, $25,000 and $12,000 in 2004 for the
quarters ended March 31, June 30 and September 30, respectively.
Both basic and diluted net income per share as restated decreased by
$0.01 for the quarter ended June 30 as compared to the amounts
previously reported. Basic and diluted net income per share as
restated did not change from the amounts previously reported in 2004
for the quarters ended March 31 and September 30.
(5) Includes a non-cash tax benefit of $1.4 million, or $0.37 per basic
share, and $0.31 per diluted share, resulting from the release of a
portion of our tax valuation allowance.
Year 2003, Quarter Ended
----------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
------ ------ ------ ------
(in thousands, except per share data)
(Restated) (Restated) (Restated) (Restated)
Net sales(1) $2,495 $2,501 $2,561 $2,623
Gross profit(2) 1,626 1,752 1,814 1,777
Operating income(3) 252 232 238 357
Net income(4) 239 220 238 909(5)
Net income per share, basic(4) 0.07 0.07 0.07 0.27(5)
Net income per share, diluted(4) 0.06 0.05 0.05 0.21(5)
(1) Net sales in the 2003 quarters ended March 31, June 30, September 30
and December 31 have been restated to reflect the reduction of
service revenues by $5,000, $10,000, $5,000 and $14,000,
respectively, as compared to previously reported amounts in relation
to the extended support contract adjustments.
(2) Gross profit and operating expenses for the quarters ended March 31,
June 30, September 30 and December 31, 2003 have been restated to
reduce such balances by equal amounts of $172,000, $177,000,
$193,000 and $187,000, respectively, as compared to previously
reported amounts, as a result of the reclassification of cost of
service revenues from operating expenses to cost of sales.
(3) Operating income has been increased by $1,000 in the quarter ended
March 31, 2003 and $2,000 in each of the remaining quarters of 2003,
as compared to previously reported amounts, to correct the
overstatement of the Company's paid-time-off accrual.
(4) The restatement adjustments referred to above reduced previously
reported net income by $4,000, $8,000, $3,000 and $12,000 for the
quarters ended March 31, June 30, September 30 and December 31,
respectively. Basic net income per share as restated decreased by
$0.01 for the quarter ended March 31 and did not change for the
quarters ended June 30, September 30 or December 31, as compared to
the amounts previously reported. Diluted net income per share as
restated decreased by $0.01 for the quarters ended June 30 and
September 30 and did not change for the quarters ended March 31 or
December 31, as compared to amounts previously reported.
F-28
Castelle
Supplemental Financial Information
--------------------------------------------------------------------------------
(5) 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.
F-29
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, 2002:
Deducted from asset accounts:
Allowance for doubtful accounts $ 96 $ (21) $ (5) $ 70
Allowance for sales returns and stock rotation $ 630 $ 660 $ (656) $ 634
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
Allowance for sales returns and stock rotation $ 634 $ 524 $ (716) $ 442
Valuation allowance for deferred tax asset $ 7,689 $ -- $ (1,001) $ 6,688
Year Ended December 31, 2004:
Deducted from asset accounts:
Allowance for doubtful accounts $ 39 $ (1) $ (8) $ 30
Allowance for sales returns and stock rotation $ 442 $ 886 $ (921) $ 407
Valuation allowance for deferred tax asset $ 6,688 $ -- $ (1,109) $ 5,579
F-30
Castelle
--------------------------------------------------------------------------------
Exhibit
Number Description
--------- ------------------------------------------------------------------
10.11 Summary of Severance Agreement with Named Executive Officers
23.1 Consent of Independent Registered Public Accounting Firm - Grant
Thornton LLP
23.2 Consent of Independent Registered Public Accounting Firm -
PricewaterhouseCoopers LLP
31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 - Chief Executive Officer
31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 - Chief Financial Officer
32.1 Certification Pursuant to 8 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - Chief
Executive Officer
32.2 Certification Pursuant to 8 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - Chief
Financial Officer
F-31