UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2002
|_| 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, CA 95037
(Address of principal executive offices, including zip code)
(408) 852-8000
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK,
NO PAR VALUE
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No __
The number of shares of the Registrant's Common stock outstanding as of November
4, 2002 was 4,806,044.
CASTELLE
FORM 10-Q
TABLE OF CONTENTS
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements: 2
Condensed Consolidated Balance Sheets 2
Condensed Consolidated Statements of Operations 3
Condensed Consolidated Statements of Cash Flows 4
Notes to Condensed Consolidated Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 11
Item 3. Quantitative and Qualitative Disclosure About Market Risk 24
Item 4. Controls and Procedures 24
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 25
Item 2. Changes in Securities and Use of Proceeds 25
Item 3. Defaults Upon Senior Securities 25
Item 4. Submission of Matters to a Vote of Security Holders 25
Item 5. Other Information 25
Item 6. Exhibits and Reports on Form 8-K 25
Signatures 25
1
PART I - FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
CASTELLE
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(Unaudited)
September 30, 2002 December 31, 2001
---------------------- ---------------------
Assets:
Current assets:
Cash and cash equivalents $ 4,838 $ 4,568
Accounts receivable, net of allowances for doubtful
accounts of $186 in 2002 and $206 in 2001 611 680
Inventories, net 993 926
Prepaid expenses and other current assets 174 130
---------------------- ---------------------
Total current assets 6,616 6,304
Property, plant & equipment, net 473 598
Other assets, net 108 108
---------------------- ---------------------
Total assets $ 7,197 $ 7,010
====================== =====================
Liabilities and Shareholders' Equity:
Current liabilities:
Long-term debt, current portion $ 19 $ 18
Accounts payable 223 280
Accrued liabilities 2,378 2,446
---------------------- ---------------------
Total current liabilities 2,620 2,744
Long-term debt, net of current portion 50 64
---------------------- ---------------------
Total liabilities 2,670 2,808
Shareholders' equity:
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 4,755 and 4,745, respectively 28,980 28,977
Deferred compensation (1) (1)
Accumulated deficit (24,452) (24,774)
---------------------- ---------------------
Total shareholders' equity 4,527 4,202
---------------------- ---------------------
Total liabilities and shareholders' equity $ 7,197 $ 7,010
====================== =====================
See accompanying notes to condensed consolidated financial statements.
2
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(Unaudited)
Three months ended Nine months ended
................................ ...............................
September 30, September 28, September 30, September 28,
2002 2001 2002 2001
--------------- --------------- --------------- ---------------
Net sales $ 2,543 $ 2,500 $ 7,172 $ 7,106
Cost of sales 735 770 2,181 2,310
--------------- --------------- --------------- ---------------
Gross profit 1,808 1,730 4,991 4,796
--------------- --------------- --------------- ---------------
Operating expenses:
Research and development 312 470 1,074 1,336
Sales and marketing 799 860 2,342 2,912
General and administrative 475 353 1,329 1,052
Restructuring charges (benefits) - 5 (40) 243
--------------- --------------- --------------- ---------------
Total operating expenses 1,586 1,688 4,705 5,543
--------------- --------------- --------------- ---------------
Income (loss) from operations 222 42 286 (747)
Interest income, net 13 19 35 77
Other income (expense), net (7) (8) 1 47
--------------- --------------- --------------- ---------------
Income (loss) before provision for income taxes 228 53 322 (623)
Provision for income taxes -- -- -- --
--------------- --------------- --------------- ---------------
Net income (loss) $ 228 $ 53 $ 322 $ (623)
=============== =============== =============== ===============
Income (loss) per share:
Net income (loss) per common share - basic $ 0.05 $ 0.01 $ 0.07 $ (0.13)
Shares used in per share calculation - basic 4,755 4,745 4,750 4,743
Net income (loss) per common share - diluted $ 0.05 $ 0.01 $ 0.07 $ (0.13)
Shares used in per share calculation - diluted 4,787 4,782 4,778 4,743
See accompanying notes to condensed consolidated financial statements.
3
CASTELLE
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
Nine months ended
......................................
September 30, 2002 September 28, 2001
----------------- ------------------
Cash flows from operating activities:
Net income (loss) $ 322 $ (623)
Adjustment to reconcile net income (loss) to net cash
provided by operating activities:
Loss on disposal of fixed assets 1 9
Depreciation and amortization 158 208
Provision for doubtful accounts and sales returns (66) 93
Provision for excess and obsolete inventory (49) 120
Compensation expense related to grant of stock options -- 5
Changes in assets and liabilities:
Accounts receivable 135 1,324
Inventories (18) (17)
Prepaid expenses and other current assets (44) 48
Other assets -- (567)
Accounts payable (57) (437)
Accrued liabilities (68) 12
----------------- ------------------
Net cash provided by operating activities 314 175
----------------- ------------------
Cash flows from investing activities:
Return of restricted cash -- 125
Purchase of property and equipment (34) (77)
----------------- ------------------
Net cash (used for) provided by investing activities (34) 48
----------------- ------------------
Cash flows from financing activities:
Repayment of long-term debt (13) (11)
Proceeds from issuances of common stock 3 --
----------------- ------------------
Net cash used in financing activities (10) (11)
----------------- ------------------
Net increase in cash and cash equivalents 270 212
Cash and cash equivalents at beginning of period 4,568 3,893
----------------- ------------------
Cash and cash equivalents at end of period $ 4,838 $ 4,105
================= ==================
See accompanying notes to condensed consolidated financial statements.
4
CASTELLE
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation and Significant Accounting Policies:
The accompanying unaudited condensed consolidated financial statements
include the accounts of Castelle and its wholly-owned subsidiaries in the
United Kingdom and The Netherlands, and have been prepared in accordance
with accounting principles generally accepted in the United States of
America. All intercompany balances and transactions have been eliminated.
In the opinion of management, all adjustments (consisting only of normal
recurring accruals) considered necessary for a fair presentation of the
Company's financial position, results of operations and cash flows at the
dates and for the periods indicated have been included. Because all of the
disclosures required by accounting principles generally accepted in the
United States of America are not included in the accompanying unaudited
condensed consolidated financial statements and related notes, they should
be read in conjunction with the audited consolidated financial statements
and related notes included in the Company's Form 10-K and Form 10-K/A for
the fiscal year ended December 31, 2001. The December 31, 2001 condensed
balance sheet data was derived from our audited financial statements and
does not include all of the disclosures required by accounting principles
generally accepted in the United States of America. The statements of
operations for the periods presented are not necessarily indicative of
results that we expect for any future period, nor for the entire year.
Certain prior year amounts have been reclassified to conform with the
current presentation.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
The Company believes that its existing cash balances, anticipated cash
flows from operations and available lines of credit will be sufficient to
meet its 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 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. 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 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.
5
On March 12, 2002, the Company received a notice from the NASDAQ Stock
Market that its common stock had failed to maintain the minimum bid price
of $1.00 per share required for continued listing on the Nasdaq SmallCap
Market. The notice stated that if the Company's common stock failed to meet
the $1.00 bid price per share for a minimum of ten consecutive trading days
prior to September 9, 2002, the Company's common stock would be delisted
from the Nasdaq SmallCap Market. On September 10, 2002, the Company
received a letter from NASDAQ stating that its common stock had failed to
meet the minimum bid price requirement for ten consecutive trading days
during the preceding 180 calendar day period. This letter also stated that
if the Company did not appeal the decision of the staff, then NASDAQ would
delist the Company's common stock from the SmallCap Market on September 18,
2002, before the trading day commenced. In response to this notice, on
September 16, 2002, the Company requested a hearing to appeal the decision
of the staff. NASDAQ delayed delisting the Company's common stock from the
SmallCap Market until a hearing could be conducted and a decision rendered.
A hearing was held on October 17, 2002. The Company is awaiting written
determination from NASDAQ regarding this matter.
Revenue Recognition
Castelle recognizes revenue based on the provisions of Staff Account
ing Bulletin ("SAB") No. 101 "Revenue Recognition in Financial
Statements" and Statement of Financial Accounting Standards ("SFAS") No.
48 "Revenue Recognition When Right of Return Exists."
Product revenue is recognized upon shipment if persuasive evidence of an
arrangement exists, the fee is fixed and determinable, collection of the
resulting receivables is probable and product returns are reasonably
estimable. Shipment generally occurs when product is delivered to a common
carrier.
The Company enters into agreements with certain of its distributors which
permit limited stock rotation rights. These stock rotation rights allow the
distributor to return products for credit but require the distributor to
purchase additional products of equal value. Customers who purchase
products directly from Castelle also have limited return rights, which
expire 30 days from the date of product shipment. Revenues subject to stock
rotation rights are reduced by management's estimates of anticipated
exchanges. Castelle establishes its returns allowance for distributors and
direct customers based on historic return rates.
Pursuant to the Company's distributor agreements, the Company also protects
its distributors' exposure related to the impact of price reductions. Price
adjustments are recorded at the time price deductions are communicated to
the Company's distributors.
The Company recognizes revenue from support or maintenance contracts,
including extended warranty and support programs, ratably over the period
of the contract.
Castelle recognizes royalties on the sale of LANpress products by a
Japanese distributor. Royalties are not recognized as revenue until the
products are sold by the distributor.
Provisions for estimated warranty costs are recorded at the time products
are shipped.
6
2. Accounting Changes
Effective January 1, 2002, Castelle redefined its fiscal quarter and year
end for financial reporting purposes to conform with calendar month ends,
i.e., ending on March 31, June 30, September 30 and December 31.
Previously, Castelle set its fiscal quarter as ending on the Friday of the
thirteenth week into the quarter. This change had no significant impact on
the Company's financial position, results of operations or cash flows for
the 2002 periods presented herein.
Effective January 1, 2002, Castelle implemented Emerging Issues Task Force
No. 01-9, "Accounting for Consideration Given by a Vendor to a Customer
(Including a Reseller of the Vendor's Products)" ("EITF 01-9"), which
presumes consideration from a vendor to a customer or reseller of the
vendor's products to be a reduction of the selling prices of the vendor's
products which, therefore, should be characterized as a reduction of
revenue when recognized in the vendor's income statement and could lead to
negative revenue under certain circumstances. Revenue reduction is required
unless consideration relates to a separate identifiable benefit and the
benefit's fair value can be established. Since Castelle was unable to
clearly separate the benefits received from certain marketing development
funds it paid to its resellers, these costs have been reclassified as a
reduction of sales, and the financial statements for prior periods
presented for comparative purposes have been reclassified to comply with
the new accounting standard. The effect of the implementation of this new
accounting standard was a reduction of sales of $47,000 and $207,000 in the
three and nine months ended September 30, 2002, respectively, with an
equivalent reduction in operating expenses. This compares to a reduction in
sales of $59,000 and $172,000 in the three and nine months ended September
29, 2001, respectively, with an equivalent reduction in operating expenses.
The new accounting standard has no impact on the Company's operating
margin, net income or earnings per share. The table below reflects the
impact of this new accounting standard on fiscal 2001 revenues.
2001 SALES - RESTATED FOR EITF 01-9
(in thousands, unaudited)
QUARTER ENDED
Mar 30 Jun 29 Sep 28 Dec 31 TOTAL YEAR
------------- ------------ ------------ ------------ ----------------
Sales:
Original $2,349 $2,370 $2,559 $2,342 $9,620
Restated $2,293 $2,313 $2,500 $2,248 $9,354
Difference ($56) ($57) ($59) ($94) ($266)
3. Income (Loss) Per Share
Basic net income (loss) per share is computed by dividing net income (loss)
available to common shareholders by the weighted average number of common
shares outstanding for that period. Diluted net income per share reflects
the potential dilution from the exercise or conversion of other securities
into common stock that were outstanding during the period. Diluted net loss
per share excludes potentially dilutive shares if their effect is
anti-dilutive. Shares that are potentially dilutive to the Company's basic
income per share consist of incremental shares of common stock issuable
upon exercise of stock options and warrants.
7
Basic and diluted earnings per share are calculated as follows for the
third quarter and first nine months of 2002 and 2001, respectively:
(in thousands, except per share amounts)
.......................................................
(Unaudited)
.......................................................
Three months ended Nine months ended
.......................... ............................
September September September September
30, 2002 28, 2001 30, 2002 28, 2001
-------------------------- ----------------------------
Basic:
Weighted average common shares outstanding 4,755 4,745 4,750 4,743
=========================== ============= ==============
Net income (loss) $ 228 $ 53 $ 322 $ (623)
=========================== ============= ==============
Net income (loss) per common share - basic $ 0.05 $0.01 $ 0.07 $(0.13)
=========================== ============= ==============
Diluted:
Weighted average common shares outstanding 4,755 4,745 4,750 4,743
Common equivalent shares from stock options 32 37 28 --
--------------------------- ------------- --------------
Shares used in per share calculation - diluted 4,787 4,782 4,778 4,743
=========================== ============= ==============
Net income (loss) $ 228 $ 53 $ 322 $ (623)
=========================== ============= ==============
Net income (loss) per common share - diluted $ 0.05 $0.01 $0.07 $(0.13)
=========================== ============= ==============
The calculation of diluted shares outstanding for the nine months ended
September 28, 2001 excludes options to purchase 848,980 shares of the
Company's common stock, as their effect was antidilutive in the period.
4. Inventories:
Inventories are stated at the lower of standard cost (which approximates
cost on a first-in, first-out basis) or market and net of reserves for
excess and obsolete inventory. Inventory details are as follows (in
thousands):
(Unaudited)
September 30, 2002 December 31, 2001
-----------------------------------------------
Raw material $ 462 $ 283
Work in process 163 182
Finished goods 368 461
-----------------------------------------------
Total inventories $ 993 $ 926
===============================================
5. Segment Disclosure and Geographic Information:
The Company has determined that it operates in one segment. Revenues by
geographic area are determined by the location of the customer and are
summarized as follows (in thousands):
8
(Unaudited)
.......................................................
Three months ended Nine months ended
.......................... ............................
September September September September
30, 2002 28, 2001 30, 2002 28, 2001
-------------------------- ----------------------------
Americas $2,098 $ 2,070 $ 5,917 $ 5,708
Europe 181 232 585 709
Pacific Rim 264 198 670 689
--------------------------- ------------- --------------
Total Revenues $2,543 $ 2,500 $ 7,172 $ 7,106
=========================== ============= ==============
6. Comprehensive Income:
Under Statement of Financial Accounting Standards ("SFAS") No. 130,
"Reporting Comprehensive Income," disclosure of comprehensive income and
its components is required in financial statements. 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.
7. Restructuring:
In April 2001, we terminated 17 regular, temporary and contractor
positions, which constituted approximately 25% of our workforce. This
action resulted in a severance charge of $243,000 in the first nine months
of fiscal 2001. In the second quarter of fiscal 2002, a non-recurring
benefit of $40,000 arising from the reversal of previously recorded
restructuring charges was included in the results of operations, following
the completion of the Company's 2001 restructuring programs for less than
previously anticipated.
8. Commitments and Contingencies:
The Company was initially contacted by a third party in fiscal 1999
claiming that the Company needs to obtain licenses of certain patents held
by that party for certain of the Company's fax server products. The Company
is continuing to assess the validity and strength of the claims, believes
it has adequate legal defenses and that the ultimate outcome of any
possible action will not have a material effect on the Company's financial
position, results of operations or cash flows although there can be no
assurance as to the outcome of any possible litigation.
From time to time, the Company may have certain contingent liabilities that
arise in the ordinary course of its business activities. The Company
accrues contingent liabilities when it is probable that future expenditures
will be made and such expenditures can be reasonably estimated. No estimate
of the amount of any potential loss upon resolution of these matters can be
made at this time. However, depending on the amount and timing of such
resolution, an unfavorable resolution of some or all of these matters could
materially affect the Company's financial position.
9
9. Stock Buyback:
On October 16, 2002, the Company's Board of Directors authorized the
Company, from time to time, to repurchase at market prices, up to $1.5
million of its common stock for cash in open market, negotiated or block
transactions. The timing of such transactions will depend on market
conditions, other corporate strategies and will be at the discretion of the
management of the Company. No time limit was set for the completion of this
program; however, the Company expects to execute its buyback program over
the next twelve months. Castelle currently has 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.
10. New Accounting Pronouncements:
In April 2002, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment
of FASB Statement No. 13, and Technical Corrections". SFAS No. 145 rescinds
Statement 4, which required all gains and losses from extinguishment of
debt to be aggregated and, if material, classified as an extraordinary
item, net of related income tax effect. As a result, the criteria in APB
Opinion 30 will now be used to classify those gains and losses. SFAS 145
also amends Statement 13 to require that certain lease modifications that
have economic effects similar to sale-leaseback transactions be accounted
for in the same manner as sale-leaseback transactions. The Company does not
believe that the adoption of this statement will have a material impact on
its results of operations, financial position or cash flows.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 requires that a
liability for a cost associated with an exit or disposal activity be
recognized when the liability is incurred. SFAS No. 146 eliminates the
definition and requirement for recognition of exit costs in Emerging Issues
Task Force Issue No. 94-3 where a liability for an exit cost was recognized
at the date of an entity's commitment to an exit plan. This statement is
effective for exit or disposal activities initiated after December 31,
2002. The Company does not believe that the adoption of this statement will
have a material impact on its results of operations, financial position or
cash flows.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This document contains forward-looking statements that involve risks and
uncertainties. The Company's operating results may vary significantly from
quarter to quarter due to a variety of factors, including changes in the
Company's product and customer mix, constraints in the Company's manufacturing
and assembling operations, shortages or increases in the prices of raw materials
and components, changes in pricing policy by the Company or its competitors, a
slowdown in the growth of the networking market, seasonality, timing of
expenditures and economic conditions in the United States, Europe and Asia.
Words such as "believes," "anticipates," "expects," "intends" and similar
expressions are intended to identify forward-looking statements, but are not the
exclusive means of identifying such statements. Unless the context otherwise
requires, references in this Form 10-Q to "we," "us," or the "Company" refer to
Castelle. Readers are cautioned that the forward-looking statements reflect
management's analysis only as of the date hereof, and the Company assumes no
obligation to update these statements. Actual events or results may differ
materially from the results discussed in the forward-looking statements. Factors
that might cause such a difference include, but are not limited to the risks and
uncertainties discussed herein, as well as other risks set forth under the
caption "Risk Factors" in the Company's Annual Report on Form 10-K and Form
10-K/A for the fiscal year ended December 31, 2001.
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 beginning of this Form 10-Q.
The following discussion should be read in conjunction with the Financial
Statements and the Notes thereto included in Item 1 of this Quarterly Report on
Form 10-Q and in the Company's Form 10-K and Form 10-K/A for the fiscal year
ended December 31, 2001.
Critical Accounting Policies
Castelle's financial statements and accompanying notes are prepared in
accordance with generally accepted accounting principles in the United States of
America. Preparing financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets, liabilities, sales,
and expenses. These estimates and assumptions are affected by management's
application of accounting policies. Critical accounting policies for Castelle
include revenue recognition; credit, collection and allowances for doubtful
accounts; inventories and related provisions for obsolete and excess inventory,
which are discussed in more detail in Item 7, "Management's Discussion and
Analysis of Financial Conditions and Results of Operations," and Note 2 of
"Notes to Consolidated Financial Statements" in the Company's Annual Report on
Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2001.
11
Consolidated Statements of Operations - As a Percentage of Net Sales
(Unaudited)
Three months ended Nine months ended
................................ ................................
September 30, September 28, September 30, September 28,
2002 2001 2002 2001
---------------- -------------- ---------------- --------------
Net sales 100% 100% 100% 100%
Cost of sales 29% 31% 30% 33%
---------------- -------------- ---------------- --------------
Gross profit 71% 69% 70% 67%
---------------- -------------- ---------------- --------------
Operating expenses:
Research and development 12% 19% 15% 19%
Sales and marketing 31% 34% 33% 41%
General and administrative 19% 14% 19% 15%
Restructuring charges -- * (1%) 3%
---------------- -------------- ---------------- --------------
Total operating expenses 62% 67% 66% 78%
---------------- -------------- ---------------- --------------
Income (loss) from operations 9% 2% 4% (11%)
Interest income, net * * * 1%
Other income, net * * * 1%
---------------- -------------- ---------------- --------------
Income (loss) before provision for
income taxes 9% 2% 4% (9%)
Provision for income taxes -- -- -- --
---------------- -------------- ---------------- --------------
Net income (loss) 9% 2% 4% (9%)
================ ============== ================ ==============
* Less than 1%
Results of Operations
Net Sales
Net sales for the third quarter of fiscal 2002 were $2.54 million, a
slight increase as compared to $2.50 million for the same period in fiscal
2001. This also compared to $2.26 million in the second quarter of fiscal
2002, an increase of 12%.
Net sales for first the nine months of fiscal 2002 were $7.17 million,
as compared to $7.11 million for the same period in fiscal 2001.
Domestic sales in the third quarter of fiscal 2002 were $2.10 million,
or 83% of total net sales, as compared to $2.07 million, or 83% of total
net sales, in the same period in fiscal 2001. For the first nine months of
fiscal 2002, domestic sales were $5.92 million, or 83% of total net sales,
as compared to $5.71 million, or 80% of total net sales, in fiscal 2001.
The increases in domestic sales for the three- and nine-month periods in
fiscal 2002 were primarily due to higher sales of our FaxPress fax server
products.
International sales in the third quarter of fiscal 2002 were $445,000,
or 17% of total net sales, as compared to $430,000, or 17% of net sales, in
the same period in fiscal 2001.
12
International sales for the first nine months of fiscal 2002 and 2001 were
$1.26 million and $1.40 million, representing 17% and 20%, respectively, of
total net sales. The decline in international sales in the first nine
months of fiscal 2002 were the result of reduced demand for our print
server products in the Asia Pacific region.
Cost of Sales; Gross Profit
Gross profit increased to $1.81 million, or 71% of net sales, for the
third quarter of fiscal 2002, as compared to $1.73 million, or 69% of net
sales, for the same period in fiscal 2001. This also compared to $1.59
million, or 70% of net sales, for the second quarter of fiscal 2002. The
improvement in gross profit percentage was primarily due to the mix of
products sold and continued product cost reductions.
Gross profits for the first nine months of fiscal 2002 and 2001 were
$4.99 million, or 70% of net sales and $4.80 million, or 67% of net sales,
respectively. The increase in gross profit for the first nine months of
fiscal 2002 was primarily due to higher sales of our fax server products,
which carry higher gross margins.
The reduction in gross profit as a percentage of sales resulting from
the implementation of EITF No. 01-9 was insignificant for the three and
nine-month periods ended September 30, 2002 and September 28, 2001.
Research & Development
Research and product development expenses were $312,000, or 12% of net
sales, for the third quarter of fiscal 2002, as compared to $470,000, or
19% of net sales, for the same period in fiscal 2001. The decrease in
research and development expenses was chiefly due to a $83,000 reduction in
outside consulting expenses and a $50,000 reduction in other allocated
support costs. Research and product development expenses for the first nine
months of fiscal 2002 were $1.07 million, or 15% of net sales, as compared
to $1.34 million, or 19% of net sales, for the same period in fiscal 2001.
This reduction of $262,000 for the nine-month period was primarily due to
decreases in outside consulting expenses of $153,000 and other allocated
support costs of $166,000, offset in part by higher compensation costs of
$74,000.
Sales & Marketing
Sales and marketing expenses were $799,000, or 31% of net sales, for
the third quarter of fiscal 2002, as compared to $860,000, or 34% of net
sales, for the same period in fiscal 2001. The reduction of $61,000 was
primarily attributable to reduced payroll and related costs. For the first
nine months of fiscal 2002, sales and marketing expenses were $2.34
million, or 33% of net sales, as compared to $2.91 million, or 41% of net
sales, for the same period in fiscal 2001. This reduction of sales and
marketing spending by $570,000 was primarily due to lower compensation and
other payroll related expenses of $321,000, and reduced promotional
expenses of $206,000.
General & Administrative
General and administrative expenses were $475,000, or 19% of net sales,
for the third quarter of fiscal 2002, as compared to $353,000, or 14% of
net sales, for the same period in fiscal 2001. The increase of $122,000 in
general and administrative expenses in the third quarter of fiscal 2002 was
principally due to an increase of $91,000 in outside consulting expenses.
13
General and administrative expenses for the first nine months of fiscal
2002 were $1.33 million, or 19% of net sales, as compared to $1.05 million,
or 15% of net sales for the same period in fiscal 2001. The increase in
general and administrative expenses of $277,000 was primarily due to the
combination of higher outside consulting expenses of $147,000, legal and
accounting expenses of $87,000 and the absence of benefit obtained from the
collection of previously written-off bad debts in the first nine months of
fiscal 2001 of $95,000. The higher expenses for the first nine months of
2002 were offset partially by lower compensation expenses of $46,000.
Restructuring
In April 2001, we terminated 17 regular, temporary and contractor
positions, which constituted approximately 25% of our workforce. This
action resulted in a severance charge of $243,000 in the first nine months
of fiscal 2001. In the second quarter of fiscal 2002, a non-recurring
benefit of $40,000 arising from the reversal of previously recorded
restructuring charges was included in the results of operations, following
the completion of the Company's 2001 restructuring programs for less than
previously anticipated.
Liquidity and Capital Resources
As of September 30, 2002, we had approximately $4.84 million of cash
and cash equivalents, as compared to $4.57 million at December 31, 2001. The
increase in cash and cash equivalents of $270,000 was primarily due to an
increase in cash provided by operating activities.
The Company leases its corporate headquarters in Morgan Hill,
California. The lease on the Morgan Hill facility has an initial term of five
years, expiring in December 2005, with one conditional three-year option, which
if exercised, would extend the lease to December 2008 commencing with rent at
95% of fair market value. As of September 30, 2002, the future minimum payments
under the lease were approximately $854,000.
In December 2000, as a source of capital asset financing, we entered
into a loan and security agreement with a finance company for an amount of
$75,000. This loan is subject to interest of 12.8% per annum and is repayable by
December 2006. As of September 30, 2002, the future minimum payments were
$72,000.
In April 2001, as a source of capital asset financing, we entered into
a loan and security agreement with a finance company for an amount of $25,000.
This loan is subject to interest of 12.5% per annum and is repayable by April
2004. As of September 30, 2002, the future minimum payments were $15,000.
In addition to the commitments shown above, we have a $3.0 million
collateralized revolving line of credit with a bank, which expires in March
2003, pursuant to which we may borrow 100% against pledges of cash at the bank's
prime rate. Borrowings under this line of credit agreement are collateralized by
all of our assets. areas of September 30, 2002, we were in compliance with the
terms of the agreement and had no borrowings under the line of credit.
As of September 30, 2002, net accounts receivable were $611,000, down
from $680,000 at December 31, 2001. The decrease in net accounts receivable was
largely attributable to improved collection of outstanding balances in the first
nine months of fiscal 2002.
14
Net inventory as of September 30, 2002 was $993,000, an increase from
the $926,000 at December 31, 2001. The higher inventory was primarily due to a
purchase of a component used in our fax server products from a supplier that has
discontinued the product. The supplier has announced a replacement product,
which we expect to begin to use after depleting existing inventory..
Although we believe that our existing capital resources, anticipated
cash flows from operations and available lines of credit will be sufficient to
meet our capital requirements for at least the next 12 months, we may be
required to seek additional equity or debt financing. The timing and amount of
such additional 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 the pace of technological change in the networking industry. There
can be no assurance that such additional financing will be available on
satisfactory terms when needed, if at all.
We believe that, for the periods presented, inflation has not had a
material effect on our operations.
New Accounting Pronouncements:
In April 2002, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of
FASB Statement No. 13, and Technical Corrections". SFAS No. 145 rescinds
Statement 4, which required all gains and losses from extinguishment of debt to
be aggregated and, if material, classified as an extraordinary item, net of
related income tax effect. As a result, the criteria in APB Opinion 30 will now
be used to classify those gains and losses. SFAS 145 also amends Statement 13 to
require that certain lease modifications that have economic effects similar to
sale-leaseback transactions be accounted for in the same manner as
sale-leaseback transactions. The Company does not believe that the adoption of
this statement will have a material impact on its results of operations,
financial position or cash flows.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 requires that a
liability for a cost associated with an exit or disposal activity be recognized
when the liability is incurred. SFAS No. 146 eliminates the definition and
requirement for recognition of exit costs in Emerging Issues Task Force Issue
No. 94-3 where a liability for an exit cost was recognized at the date of an
entity's commitment to an exit plan. This statement is effective for exit or
disposal activities initiated after December 31, 2002. The Company does not
believe that the adoption of this statement will have a material impact on its
results of operations, financial position or cash flows.
15
RISK FACTORS
The risks and uncertainties described below are not the only ones
facing the Company. Additional risks and uncertainties not presently known to
the Company or that the Company currently deems immaterial also may impair the
Company's business operations. If any of the following risks or such other risks
actually occur, our business could be adversely affected.
Fluctuations in Operating Results
The Company's operating results may vary significantly from quarter to
quarter due to a variety of factors, some of which are outside the control of
the Company, including changes in the Company's product and customer mix,
constraints in the Company's manufacturing and assembling operations, shortages
or increases in the prices of raw materials and components, changes in pricing
policy by the Company or its competitors, a slowdown in the growth of the
networking market, seasonality, timing of expenditures and economic conditions
in the United States, Europe and Asia. The Company's sales will often reflect
orders shipped in the same quarter in which they are received. The Company's
backlog at any given time is not necessarily indicative of actual sales for any
succeeding period. In addition, significant portions of the Company's expenses
are relatively fixed in nature, and planned expenditures are based primarily on
sales forecasts. Therefore, if the Company inaccurately forecasts demand for its
products, the impact on net income may be magnified by the Company's inability
to adjust spending quickly enough to compensate for the net sales shortfall.
Other factors contributing to fluctuations in the Company's quarterly
operating results include changes in the demand for the Company's products,
customer order deferrals in anticipation of new versions of the Company's
products, the introduction of new products and product enhancements by the
Company or its competitors, the effects of filling the distribution channels
following such introductions, potential delays in the availability of announced
or anticipated products, the mix of product revenue, the commencement or
conclusion of significant development projects, changes in foreign currency
exchange rates, the timing of acquisitions and associated costs, and the timing
of significant marketing and sales promotions. Based on the foregoing, the
Company believes that quarterly operating results are likely to vary
significantly in the future and that period-to-period comparisons of its results
of operations are not necessarily meaningful and should not be viewed upon as
indications of future performance.
Small Decreases in the Company's Operating Results Could Adversely Impact the
Company's Liquidity
The Company's working capital is limited and its cash flow from
operations is small. There can be no assurance that cash flow from operations
will be positive in future quarters. If the Company operates at a loss for any
reason, its liquidity will be diminished. In addition, the Company recently
initiated a stock repurchase program in which the Company could use up to $1.5
million of its cash reserves to repurchase shares on the open market. Such stock
repurchases will reduce the Company's working capital, leaving the Company more
vulnerable to unexpected challenges and less able to take advantage of potential
business opportunities.
History of Losses; Accumulated Deficit
The Company has experienced significant operating losses and, as of
September 30, 2002, had an accumulated deficit of $24.45 million. The
development and marketing by the
16
Company of its current and new products will
continue to require substantial expenditures. There can be no assurance that
growth in net sales or profitability will be achieved or sustained in future
years.
Nasdaq SmallCap Listing; Risk associated with Limited Market
The Company's common stock has been listed on the Nasdaq SmallCap
Market since April 1999. In order to maintain its listing on the Nasdaq SmallCap
Market, the Company must maintain total assets, capital and public float at
specified levels and generally must maintain a minimum bid price of $1.00 per
share. If the Company fails to maintain the standards necessary to be quoted on
the Nasdaq SmallCap Market, the Company's common stock could become subject to
delisting. On March 12, 2002, the Company received a notice from the Nasdaq
Stock Market that its common stock had failed to maintain the minimum bid price
of $1.00 per share required for continued listing on the Nasdaq SmallCap Market.
The notice stated that if the Company's common stock failed to meet the $1.00
bid price per share for a minimum of ten consecutive trading days prior to
September 9, 2002, the Company's common stock would be delisted from the Nasdaq
SmallCap Market. On September 10, 2002, the Company received a letter from
NASDAQ stating that its common stock had failed to meet the minimum bid price
requirement for ten consecutive trading days during the preceding 180 calendar
day period. This letter also stated that if the Company did not appeal the
decision of the staff, then NASDAQ would delist the Company's common stock from
the SmallCap Market on September 18, 2002, before the trading day commenced. In
response to this notice, on September 16, 2002, the Company requested a hearing
to appeal the decision of the staff. NASDAQ delayed delisting the Company's
common stock from the SmallCap Market until a hearing could be conducted and a
decision rendered. A hearing was held on October 17, 2002. The Company is
awaiting a written notification from NASDAQ regarding this matter. If the common
stock is delisted, shareholders will find it more difficult to dispose of shares
or to obtain accurate quotations as to the price of the common stock. It might
also contribute to volatility in the market price of the Company's common stock
and could adversely affect the Company's ability to raise additional equity or
debt financing on acceptable terms or at all.
Rapid Technological Change; Risks Associated with New Products
The market for the Company's products is affected by rapidly changing
networking technology, evolving industry standards, increasing Internet usage
and the emergence of other new communication technologies. The Company believes
that its future success will depend upon its ability to enhance its existing
products and to identify, develop, manufacture and introduce new products which
conform to or support emerging network telecommunications standards, are
compatible with a growing array of computer and peripheral devices, support
popular computer and network operating systems and applications, meet a wide
range of evolving user needs and achieve market acceptance. There can be no
assurance that the Company will be successful in these efforts. The Company has
incurred, and the Company expects to continue to incur, substantial expenses
associated with the introduction and promotion of new products. There can be no
assurance that the research and development expenses incurred will not exceed
cost estimates or that new products will achieve market acceptance and generate
sales sufficient to offset development and promotion costs. In order to develop
new products successfully, the Company is dependent upon timely access to
information about new technological developments and standards. There can be no
assurance that the Company will have such access or that it will be able to
develop new products successfully and respond effectively to technological
change or new product announcements by others. Furthermore, the Company expects
that printer and other
17
peripheral manufacturers will add features to their
products that make them more network accessible, which may reduce demand for the
Company's print servers. There can be no assurance that products or technologies
developed by others will not render the Company's products non-competitive or
obsolete. The fax-on-demand market in general has been negatively affected by
the growth of the Internet. Although the Company has new Web/fax/email products
in development, there can be no assurance these products will compete
successfully. Complex products such as those offered by the Company may contain
undetected or unresolved hardware defects or software errors when they are first
introduced or as new versions are released. Changes in the Company's or its
suppliers' manufacturing processes or the inadvertent use of defective
components by the Company or its suppliers could adversely affect the Company's
ability to achieve acceptable manufacturing yields and product reliability. The
Company has in the past discovered hardware defects and software errors in
certain of its new products and enhancements after their introduction. There can
be no assurance that despite testing by the Company and by third-party test
sites, errors will not be found in future releases of the Company's products,
which would result in adverse product reviews and negatively affect market
acceptance of these products.
The introduction of new or enhanced products requires the Company to
manage the transition, both internally and for customers, from the older
products to the new or enhanced products or versions. The Company 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. The
Company has from time to time experienced delays in the shipment of new
products. There can be no assurance that future product transitions will be
managed successfully by the Company.
Key Personnel
Due to the Company's size, it is unusually dependent upon the continued
contributions of a small number of key management, marketing, product
development and operational personnel. Any vacancy in a key position could harm
the Company's operations and financial results. Replacing a current key employee
or adding a new key employee could be costly and have a significant impact on
working capital. The Company has particularly limited resources to use to
compensate its employees. For example, the Company currently has very few stock
options available under its stock option plan to grant to its employees.
Competition for employees in the technology sector is intense, and there can be
no assurance that the Company will be able to attract and retain enough
qualified employees. The Company does not carry key person life insurance with
respect to any of its personnel.
Competition and Price Erosion
The network enhancement products and computer software markets are
highly competitive, and the Company believes 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. The Company competes principally in the market for network fax servers
and network print servers and fax-on-demand software. Increased competition,
direct and indirect, could adversely affect the Company's business and operating
results through pricing pressure, loss of market share and other factors. In
particular, the Company expects that, over time, average selling prices for its
print server products will continue to decline, as the market for these products
becomes increasingly competitive. Any material reduction in the average selling
prices of the Company's products would adversely affect gross margins.
18
There can be no assurance the Company will be able to maintain the current
average selling prices of its products or the related gross margins.
The principal competitive factors affecting the market for the
Company's 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 the Company's existing
and potential competitors, most notably the Hewlett-Packard Company
("Hewlett-Packard") and Intel Corporation ("Intel"), have substantially greater
financial, engineering, manufacturing and marketing resources than the Company.
The Company also experiences competition from a number of other software,
hardware and service companies. In addition to its current competitors, the
Company may face substantial competition from new entrants into the network
enhancement market, including established and emerging computer, computer
peripherals, communications and software companies. In the fax server market the
Company competes with companies such as Captaris Inc., Omtool, Ltd. and Computer
Associates International, Inc. There can be no assurance that competitors will
not introduce products incorporating technology more advanced than the
technology used by the Company in its products. In addition, certain competing
methods of communication such as the Internet or electronic mail could adversely
affect the market for fax products. Certain of the Company's existing and
potential competitors in the print server market are manufacturers of printers
and other peripherals, and these competitors may develop closed systems
accessible only through their own proprietary servers. There can be no assurance
that the Company will be able to compete successfully or that competition will
not have a material adverse effect on the Company's business, operating results
and financial condition.
International Sales
Sales to customers located outside Canada and the United States
accounted for approximately 20%, 25% and 31% of the Company's net sales in
fiscal 2001, 2000 and 1999, respectively, and 17% for the nine months ended
September 30, 2002. The Company sells its products in approximately 40 foreign
countries through approximately 50 international distributors. Macnica, the
Company's principal Japanese distributor, accounted for approximately 46%, 60%
and 60% of the Company's international sales in fiscal 2001, 2000 and 1999,
respectively, and 10%, 15% and 18% of the Company's total net sales in fiscal
2001, 2000 and 1999, respectively. Sales to Macnica accounted for approximately
5% of the Company's total net sales in the nine months ended September 30, 2002.
The Company expects that international sales will continue to represent a
significant portion of the Company's product revenues and that the Company 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 the Company will not experience
difficulties resulting from changes in foreign laws relating to the export of
its products in the future. In addition, because the Company primarily invoices
its foreign sales in U.S. dollars, fluctuations in exchange rates could affect
demand for the Company's products by causing its prices to be out of line with
products priced in the local currency. Additionally, any such difficulties would
have a material adverse effect on the Company's international sales and a
resulting material adverse effect on the Company's business, operating results
and financial condition. In fiscal 2001, the Company downsized its operations in
the United Kingdom and entered into an agreement with a distributor to service
the region. In addition, the Company entered into a separate agreement in fiscal
2001 with a Japanese distributor to sell the Company's LANpress products in
Japan, from which the Company is entitled to receive a royalty on sales of these
products. The Company may
19
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 the Company will be able to maintain the
historical level of international sales in the future. Any fluctuations in
international sales will greatly affect the Company's operating results and
financial condition.
Lack of Product Revenue Diversification
The Company derives substantially all of its sales from its fax and
print server products. The Company's fax server products accounted for 91% of
its total sales in fiscal 2001 and 94% of its total sales for the nine months
ended September 30, 2002. The Company is leveraging its expertise in these areas
to develop new messaging features and products to support greater integration
into corporate network environments and with Internet communications. The
Company expects that its current products will continue to account for a
majority of the Company's sales in the near future. A decline in demand for
these products as a result of competition, technological change or other
factors, or a delay in the development and market acceptance of new features and
products, would have a material adverse effect on the Company's business,
operating results and financial condition.
Product Transition; Risk of Product Returns and Inventory Obsolescence
From time to time, the Company 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 such
inventory becomes obsolete. The Company has 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 the Company's allowance for such returns in the future
and will not have a material adverse effect on the Company's business, operating
results and financial condition.
Concentration of Distributors; Distribution Risks
The Company sells its products primarily through a two-tier domestic
and international distribution network. The Company's distributors sell
Castelle's products to VARs, e-commerce vendors and other resellers. The
Company's distributors typically represent other products that are complementary
to, or compete with, those of the Company. In particular, certain of the
Company's competitors, including Hewlett-Packard and Intel, sell a substantially
higher dollar volume of products through several of the Company's large U.S.
distributors, and as a result, the Company believes such distributors give
higher priority to products offered by such competitors. The Company's
distributors are not contractually committed to future purchases of the
Company's products and could discontinue carrying the Company's products at any
time for any reason. 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 has a stock rotation policy with certain of its
distributors that allows them to return marketable inventory against offsetting
orders. Should the Company reduce its prices, the Company credits certain of its
distributors for the difference between the purchase price of products remaining
in their inventory and the Company's reduced price for such products. In
addition, due to industry conditions or the actions of competitors, inventory
levels of the Company's products held by distributors could become excessive,
resulting in product returns
20
and inventory write-downs. Although the Company
provides an allowance for anticipated returns and for price protection, and
believes its existing policy results in the establishment of an adequate
allowance , there can be no assurance that in the future returns and price
protection will not have a material adverse effect on the Company's business,
operating results and financial condition.
Dependence on Third-Party Suppliers and Subcontractors
The Company's products incorporate or require components or
sub-assemblies procured from third-party suppliers. Certain of these components
or sub-assemblies are available only from a single source, and others are
available only from limited sources. Certain key components of the Company's
products, including a modem chip set from Conexant Systems, Inc. and a
microprocessor from Motorola, Inc., are currently available from single sources.
Other product components are currently available from only a limited number of
sources. In addition, the Company subcontracts a substantial portion of its
manufacturing to third parties, and there can be no assurance that these
subcontractors will be able to support the manufacturing requirements of the
Company. Other than an agreement with Sercomm Corporation to manufacture certain
print server products, the Company does not have material long-term supply
contracts with third parties or any other sole or limited source vendors and
subcontractors. The Company purchases components or sub-assemblies on a purchase
order basis. The Company's ability to obtain these components and sub-assemblies
is dependent upon its ability to accurately forecast customer demand for its
products and to anticipate shortages of critical components or sub-assemblies
created by competing demands upon suppliers. If the Company were unable to
obtain a sufficient supply of high-quality components or sub-assemblies from its
current sources, the Company could experience delays in obtaining such
components or sub-assemblies from other sources. Resulting delays or reductions
in product shipments could adversely affect the Company's business, operating
results and financial condition and damage customer relationships. Furthermore,
a significant increase in the price of one or more of these components or
sub-assemblies or the Company's inability to lower component or sub-assembly
prices in response to competitive price reductions could adversely affect the
Company's business, operating results and financial condition.
The Company augments its product offerings by obtaining access to
third-party products and technologies in areas outside of its core competencies
or where the Company believes internal development of products and technologies
is not cost-effective. The Company's third-party supplier of certain print
server products is SerComm. There can be no assurance that these products will
produce gross margins comparable to those of the Company's internally generated
products or that the parties with which the Company contracts will continue to
provide the quantities and quality of products needed by the Company or that
they will upgrade their respective products on a timely basis. The termination
of the Company's relationships with third-party product suppliers and with
SerComm, in particular, could result in delays or reductions in product
shipments, which could have a material adverse effect on the Company's business,
operating results and financial condition.
Government Regulation
Certain aspects of the telecommunications industry in which the Company
competes 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
where telecommunications standards differ from those in the United States of
America,
21
or the inability to obtain regulatory approvals within a reasonable
period of time, could have a material, adverse effect on the Company's business,
operating results and financial condition. The Company's 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 the Company's business, operating results and
financial condition.
Dependence on Proprietary Rights; Uncertainty of Obtaining Licenses
The Company's success depends to a certain extent upon its
technological expertise and proprietary software technology. The Company relies
upon a combination of contractual rights and copyright, trademark and trade
secret laws to establish and protect its technologies. Despite the precautions
taken by the Company, it may be possible for unauthorized third parties to copy
the Company's products or to reverse engineer or obtain and use information that
the Company regards as proprietary. In addition, the laws of some foreign
countries in which the Company produces or sells its products either do not
protect the Company's proprietary rights or offer only limited protection. Given
the rapid evolution of technology and uncertainties in intellectual property law
in the United States of America and internationally, there can be no assurance
that the Company's 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 to the Company and divert
the efforts of the Company's technical and management personnel, whether or not
such litigation is determined in favor of the Company. In the event of an
adverse result in any such litigation, the Company could be required to expend
significant resources to develop non-infringing technology or to obtain licenses
to the technology that is the subject of the litigation. There can be no
assurance that the Company would be successful in such development or that any
such licenses would be available. The Company also relies on technology licenses
from third parties. There can be no assurance that these licenses will continue
to be available to the Company upon reasonable terms, if at all. Any impairment
or termination of the Company's relationship with third-party licensors could
have a material adverse effect on the Company's business, operating results and
financial condition. There can be no assurance that the Company's precautions
will be adequate to deter misappropriation or infringement of its proprietary
technologies. Furthermore, while the Company has obtained federal registration
for many of its trademarks in the United States of America, certain of its
trademarks have not been registered in the United States of America or foreign
jurisdictions. There can be no assurance that the Company's use of such
registered trademarks will not be contested by third parties in the future.
The Company has received, and may receive in the future, communications
asserting that its products infringe the proprietary rights of third parties or
seeking indemnification against such infringement. There can be no assurance
that third parties will not assert infringement claims against the Company with
respect to current or future products or that any such assertion may not require
the Company to enter into royalty arrangements or result in costly litigation.
As the number of software products in the industry increases and the
functionality of these products further overlap, the Company believes that
software developers may become increasingly subject to infringement claims. Any
such claims, with or without merit, can be time consuming and expensive to
defend. There can be no assurance that any such intellectual property litigation
that may be brought in the future will not have a material adverse effect on the
Company's business, operating results and financial condition. As a result of
such claims or litigation, it may become necessary or desirable in the future
for the Company to obtain licenses relating to one or more of
22
its products or relating to current or future technologies, and there can be no
assurance that it would be able to do so on commercially reasonable terms.
Possible Volatility of the Company's Common Stock Price
The price of the Company's common stock has fluctuated widely in the
past. Sales of substantial amounts of the Company's common stock, or the
perception that such sales could occur, could adversely affect prevailing market
prices for the Company's common stock. The management of the Company believes
that such past fluctuations may have been caused by the factors identified above
as well as announcements of new products, quarterly fluctuations in the results
of operations, the announcement of a stock buyback program, and other factors,
including changes in the condition of the personal computer industry in general.
These fluctuations, as well as general economic, political and market
conditions, such as recessions or international currency fluctuations, may
adversely affect the market price of the Company's common stock. Stock markets
have experienced extreme price volatility in recent years. This volatility has
had a substantial effect on the market prices of securities issued by the
Company and other technology companies, often for reasons unrelated to the
operating performance of the specific companies. The Company anticipates that
prices for Castelle common stock may continue to be volatile. Such future stock
price volatility for Castelle common stock may provoke the initiation of
securities litigation, which may divert substantial management resources and
have an adverse effect on the Company's business, operating results and
financial condition.
Future Capital Requirements
The development and marketing of the Company's products requires
significant amounts of capital. The Company believes that its existing cash
balances, anticipated cash flows from operations and available lines of credit
will be sufficient to meet its anticipated capital requirements for the next 12
months. However, a decline in future orders and revenues might require us to
seek additional capital to meet our working capital needs during or beyond the
next twelve months if we are unable to reduce expenses to the degree necessary
to avoid incurring losses. If we have a need for additional capital resources,
we may be required to sell additional equity or debt securities, secure
additional lines of credit or obtain other third party financing. The timing and
amount of such additional 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 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. 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.
Voting Control by Officers, Directors and Affiliates
As of October 24, 2002, to the Company's knowledge and based on public
filings, the Company's officers and directors and their affiliates beneficially
owned approximately 29% of the outstanding shares of the Company's common stock.
Accordingly, together they had the ability to significantly influence the
election of the Company's 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 of the Company.
23
Certain Charter Provisions
The Company's Board of Directors has authority to issue up to 2,000,000
shares of preferred stock and to fix the rights, preferences, privileges and
restrictions, including voting rights, of these shares without any further vote
or action by the shareholders. The rights of the holders of the Company's 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 the
outstanding voting stock of the Company, thereby delaying, deferring or
preventing a change in control of the Company. 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 value of the Company's common stock.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We had no holdings of derivative financial or commodity instruments at
September 30, 2002. However, we are exposed to financial market risks, including
changes in interest rates and foreign currency exchange rates. While most of our
sales are transacted in U.S dollars, some revenues and capital spending are
transacted in Pounds Sterling. These amounts are not currently material to our
financial statements, and therefore we believe that fluctuations in 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 account and related interest income would not be significantly impacted
by changes in interest rates due mainly to the highly liquid nature of this
investment.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Regulations under the Securities Exchange Act of 1934 require public
companies, including our company, to maintain "disclosure controls and
procedures," which are defined to mean a company's controls and other procedures
that are designed to ensure that information required to be disclosed in the
reports that it files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported, within the time periods specified
in the Securities and Exchange Commission's rules and forms. Our chief executive
officer and our chief financial officer, based upon their evaluation of our
disclosure controls and procedures within 90 days before the filing date of this
report, concluded that as of their evaluation date, our disclosure controls and
procedures were effective for this purpose.
Changes in Internal Controls
There were no significant changes in our internal controls or to our
knowledge, in other factors that could significantly affect these controls
subsequent to the date of their evaluation, which occurred as of the evaluation
date referenced in the above paragraph.
24
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Reports on Form 8-K
On September 16, 2002 the Company filed a Form 8-K
reporting, under Item 5, Other Events, the receipt of a
letter from NASDAQ informing the Company that it was not in
compliance with certain listing standards. On the same day,
the Company notified NASDAQ of its intention to appeal the
NASDAQ staff determination and requested a hearing.
25
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
CASTELLE
By: /s/ Scott C. McDonald Date: November 6, 2002
Scott C. McDonald
Chief Executive Officer and President
(principal executive officer)
By: /s/ Paul Cheng Date: November 6, 2002
Paul Cheng
Vice President of Finance and Administration
Chief Financial Officer
(principal financial officer and principal accounting officer)
Secretary
26
CERTIFICATION PURSUANT TO
SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
I, SCOTT C. MCDONALD, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Castelle;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have: a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function): a) all significant deficiencies in
the design or operation of internal controls which could adversely
affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: November 6, 2002 By: /s/ Scott C. McDonald
Scott C. McDonald
Chief Executive Officer and President
CERTIFICATION PURSUANT TO
SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
I, PAUL CHENG, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Castelle;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have: a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function): a) all significant deficiencies in
the design or operation of internal controls which could adversely
affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: November 6, 2002 By: /s/ Paul Cheng
Paul Cheng
Chief Financial Officer