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 June 30, 2006 | ||
o | 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 Incorporation or Organization) | (IRS Employer Identification No.) | |
855 Jarvis Drive, Suite 100, Morgan Hill, California 95037 (Address of Principal Executive Offices, Including Zip Code) |
(408) 852-8000 (Registrant’s Telephone Number, Including Area Code) |
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x Noo |
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):. |
Large Accelerated Filero | Accelerated Filero | Non-Accelerated Filer x |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o Nox |
The number of shares of registrant’s common stock outstanding as of July 31, 2006 was 4,026,146. |
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CASTELLE |
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PART I - FINANCIAL INFORMATION CASTELLE |
June 30, 2006 | December 31, 2005 | ||||||
---|---|---|---|---|---|---|---|
Assets: | |||||||
Current assets: | |||||||
Cash and cash equivalents | $ | 7,002 | $ | 6,766 | |||
Accounts receivable, net of allowance for doubtful accounts of | |||||||
$31 and $27, respectively | 1,008 | 1,137 | |||||
Inventories | 1,219 | 1,156 | |||||
Prepaid expenses and other current assets | 160 | 135 | |||||
Deferred income taxes | 212 | 212 | |||||
Total current assets | 9,601 | 9,406 | |||||
Property and equipment, net | 255 | 200 | |||||
Other non-current assets | 130 | 140 | |||||
Deferred income taxes, non-current | 928 | 928 | |||||
Total assets | $ | 10,914 | $ | 10,674 | |||
Liabilities and Shareholders’ Equity: | |||||||
Current liabilities: | |||||||
Short-term debt | $ | 6 | $ | 14 | |||
Accounts payable | 252 | 286 | |||||
Accrued liabilities | 545 | 824 | |||||
Deferred revenue | 1,669 | 1,498 | |||||
Total current liabilities | 2,472 | 2,622 | |||||
Shareholders’ equity: | |||||||
Common stock, no par value: | |||||||
Authorized: 25,000 shares | |||||||
Issued and outstanding: 4,026 and 3,986, respectively | 28,078 | 27,860 | |||||
Accumulated deficit | (19,636 | ) | (19,808 | ) | |||
Total shareholders’ equity | 8,442 | 8,052 | |||||
Total liabilities and shareholders’ equity | $ | 10,914 | $ | 10,674 | |||
See accompanying notes to condensed consolidated financial statements. |
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CASTELLE |
Three months ended | Six months ended | ||||||||||||
---|---|---|---|---|---|---|---|---|---|---|---|---|---|
June 30, 2006 | June 30, 2005 | June 30, 2006 | June 30, 2005 | ||||||||||
Net Sales: | |||||||||||||
Products | $ | 1,607 | $ | 2,116 | $ | 3,794 | $ | 4,009 | |||||
Services | 805 | 730 | 1,607 | 1,431 | |||||||||
Total net sales | 2,412 | 2,846 | 5,401 | 5,440 | |||||||||
Cost of sales: | |||||||||||||
Products | 643 | 674 | 1,434 | 1,216 | |||||||||
Services | 276 | 258 | 552 | 528 | |||||||||
Total cost of sales | 919 | 932 | 1,986 | 1,744 | |||||||||
Gross profit | 1,493 | 1,914 | 3,415 | 3,696 | |||||||||
Operating expenses: | |||||||||||||
Research and development | 431 | 418 | 916 | 857 | |||||||||
Sales and marketing | 719 | 618 | 1,393 | 1,216 | |||||||||
General and administrative | 439 | 582 | 1,055 | 1,217 | |||||||||
Total operating expenses | 1,589 | 1,618 | 3,364 | 3,290 | |||||||||
Operating income/(loss) | (96 | ) | 296 | 51 | 406 | ||||||||
Interest income, net | 80 | 35 | 149 | 60 | |||||||||
Other expense, net | (18 | ) | (15 | ) | (28 | ) | (15 | ) | |||||
Income/(loss) before provision for income taxes | (34 | ) | 316 | 172 | 451 | ||||||||
Provision for income taxes | — | — | — | — | |||||||||
Net income/(loss) | $ | (34 | ) | $ | 316 | $ | 172 | $ | 451 | ||||
Net Income per share: | |||||||||||||
Net income/(loss) per common share - basic | $ | (0.01 | ) | $ | 0.08 | $ | 0.04 | $ | 0.12 | ||||
Net income/(loss) per common share - diluted | $ | (0.01 | ) | $ | 0.07 | $ | 0.04 | $ | 0.10 | ||||
Shares used in per share calculation - basic | 4,023 | 3,871 | 4,012 | 3,843 | |||||||||
Shares used in per share calculation - diluted | 4,023 | 4,460 | 4,477 | 4,463 |
See accompanying notes to condensed consolidated financial statements. |
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CASTELLE |
Six months ended | |||||||
---|---|---|---|---|---|---|---|
June 30, 2006 | June 30, 2005 | ||||||
Cash flows from operating activities: | |||||||
Net income | $ | 172 | $ | 451 | |||
Adjustment to reconcile net income to net cash | |||||||
provided by operating activities: | |||||||
Share-based compensation | 178 | — | |||||
Depreciation and amortization | 62 | 95 | |||||
Provision for doubtful accounts | 2 | 10 | |||||
Provision for excess and obsolete inventory | 15 | (474 | ) | ||||
Allowance for sales returns and stock rotation | (122 | ) | (55 | ) | |||
Changes in assets and liabilities: | |||||||
Accounts receivable | 248 | 179 | |||||
Inventories | (77 | ) | 706 | ||||
Prepaid expenses and other current assets | (24 | ) | (44 | ) | |||
Accounts payable | (34 | ) | (234 | ) | |||
Accrued liabilities | (279 | ) | 25 | ||||
Deferred revenue | 171 | 81 | |||||
Net cash provided by operating activities | 312 | 740 | |||||
Cash flows from investing activities: | |||||||
Acquisition of equipment | (108 | ) | (95 | ) | |||
Net cash used in investing activities | (108 | ) | (95 | ) | |||
Cash flows from financing activities: | |||||||
Repayment of long-term debt | (8 | ) | (9 | ) | |||
Proceeds from exercise of stock options | 40 | 115 | |||||
Net cash provided by financing activities | 32 | 106 | |||||
Net increase in cash and cash equivalents | 236 | 751 | |||||
Cash and cash equivalents at beginning of period | 6,766 | 5,599 | |||||
Cash and cash equivalents at end of period | $ | 7,002 | $ | 6,350 | |||
See accompanying notes to condensed consolidated financial statements. |
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CASTELLE |
1. | Basis of Presentation: |
The accompanying unaudited condensed consolidated financial statements include the accounts of Castelle and its wholly-owned subsidiary in the United Kingdom (collectively, the “Company”). These financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. Because all of the disclosures required by accounting principles generally accepted in the United States of America are not included in the accompanying condensed consolidated financial statements and related notes, they should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. All intercompany balances and transactions have been eliminated. In the Company’s opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the Company’s financial position, results of operations, and cash flows at the dates and for the periods indicated have been included. The condensed consolidated balance sheet data as of December 31, 2005 was derived from the Company’s audited financial statements and does not include all of the disclosures required by accounting principles generally accepted in the United States of America. The results of operations for the periods presented are not necessarily indicative of results that the Company expects for any future period, or for the entire year. | |
The preparation of financial statements in conformity with generally accepted accounting principles requires the Company 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. | |
2. | Net Income/(Loss) Per Share: |
Basic net income/(loss) per share is computed by dividing net income by the weighted average number of common shares outstanding for such period. Diluted net income/(loss) per share reflects the potential dilution from the exercise or conversion of other securities into common stock that were outstanding during the period. Diluted net income/(loss) per share excludes shares that are potentially dilutive if their effect is anti-dilutive. Dilutive potential shares consist of incremental common shares issuable upon exercise of stock options. |
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Basic and diluted net income/(loss) per share are calculated as follows for the three and six months ended June 30, 2006 and 2005 (unaudited, in thousands, except per share amounts): | |
Three months ended | Six months ended | |||||||||||||
---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
June 30, 2006 | June 30, 2005 | June 30, 2006 | June 30, 2005 | |||||||||||
Basic: | ||||||||||||||
Weighted average common shares outstanding | 4,023 | 3,871 | 4,012 | 3,843 | ||||||||||
Net income/(loss) | $ | (34 | ) | $ | 316 | $ | 172 | $ | 451 | |||||
Net income/(loss) per common share – basic | $ | (0.01 | ) | $ | 0.08 | $ | 0.04 | $ | 0.12 | |||||
Diluted: | ||||||||||||||
Weighted average common shares outstanding | 4,023 | 3,871 | 4,012 | 3,843 | ||||||||||
Common equivalent shares from stock options | — | 589 | 465 | 617 | ||||||||||
Shares used in per share calculation – diluted | 4,023 | 4,460 | 4,477 | 4,463 | ||||||||||
Net income/(loss) | $ | (34 | ) | $ | 316 | $ | 172 | $ | 451 | |||||
Net income/(loss) per common share – diluted | $ | (0.01 | ) | $ | 0.07 | $ | 0.04 | $ | 0.10 | |||||
The calculation of diluted shares outstanding for the three months ended June 30, 2006 and 2005 excluded 455,000 shares and 123,000 shares, respectively, of common stock issuable upon exercise of outstanding stock options as their effect was anti-dilutive in the period. The calculation of diluted shares outstanding for the six months ended June 30, 2006 and 2005 excluded 397,000 shares and 123,000 shares, respectively, of common stock issuable upon exercise of outstanding stock options as their effect was anti-dilutive in the period. | |
3. | Share-Based Compensation |
The Company grants stock options to employees, non-employee directors and consultants under its 2002 Equity Incentive Plan (the “2002 Plan”). Prior to January 1, 2006, the Company accounted for these share-based awards under the intrinsic value method of Accounting Principles Board (“APB”) No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). This method under APB No. 25 resulted in no expense being recorded for stock option grants. Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standard No. 123 (Revised 2004) “Share-Based Payment”, (“SFAS No. 123R”), which replaces SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No 123”) and supersedes APB No. 25. SFAS No. 123R requires that compensation cost relating to share-based payment transactions be recognized in the Company’s financial statements. That cost is measured based upon the fair value of the option issued. SFAS No. 123R applies to all of the Company’s outstanding unvested share-based payment awards as of January 1, 2006 and all prospective awards using the modified prospective transition method without restatement of prior periods. Accordingly, the Company’s share-based compensation cost is measured at the grant date, based on the fair value of the award, and is either recognized as an expense over the requisite service period using the graded, or accelerated, attribution method, or capitalized as inventory. | |
The fair value of each of the Company’s option awards is estimated on the date of grant using the Black-Scholes-Merton option-pricing model. Expected stock price volatility is based on historical volatility of the Company’s common stock over the estimated expected life of the options. The expected life of options granted is based on historical experience and on the terms and conditions of the options. Separate groups of option awardees that have similar historical exercise behavior are considered separately for valuation purposes. The ranges given below result from certain groups of option awardees exhibiting different behavior. Additionally, the Company uses historical data to estimate employee forfeitures. Our estimated cumulative forfeiture rates over the vesting period of |
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the options granted were calculated at 2% for directors and 20% for employees. The risk-free rates are based on the U.S. Treasury yield curve in effect at the time of grant. | |
As of June 30, 2006, the Company had 850,000 shares of common stock reserved for issuance under the 2002 Plan, of which 638,000 shares were subject to outstanding options and 212,000 shares were available for future grants of stock awards. There were 648,000 shares subject to options outstanding under prior plans. | |
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 under these plans generally lapses, at a rate of one-quarter of the shares subject to the options 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. | |
The fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton model with the following assumptions for options granted during the six months ended June 30, 2006: | |
June 30, 2006 | |||||
---|---|---|---|---|---|
Risk-free interest rate | 5.13% - 5.10% | ||||
Expected life | 3 - 5 years | ||||
Expected dividends | — | ||||
Volatility | 50% - 59% |
A summary of option activity during the six months ended June 30, 2006 is presented below (unaudited): | |
Options | Shares (in thousands) | Weighted Average Exercise Price | Weighted Average Remaining Contractual Life (in years) | Aggregate Intrinsic Value (in thousands) | |||||||||||
---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
Outstanding at Dec. 31, 2005 | 1,300 | $ | 1.94 | ||||||||||||
Granted | 28 | $ | 3.10 | ||||||||||||
Exercised | (40 | ) | $ | 0.99 | |||||||||||
Forfeited | (2 | ) | $ | 2.55 | |||||||||||
Expired | (1 | ) | $ | 3.30 | |||||||||||
Outstanding at June 30, 2006 | 1,285 | $ | 2.00 | 4.0 | $ | 1,466 | |||||||||
Exercisable at June 30, 2006 | 1,007 | $ | 1.70 | 3.4 | $ | 1,448 | |||||||||
The weighted-average grant-date fair value of options granted during the six months ended June 30, 2006 and 2005 was $1.56 and $2.58, respectively. The total intrinsic value of all options (which is the amount by which the stock price exceeded the exercise price of the options at the date of exercise) |
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exercised during the six months ended June 30, 2006 and 2005 was $85,000 and $215,000, respectively. | |
As of June 30, 2006, there was $276,000 of total unrecognized compensation cost related to unvested stock options that is expected to be recognized over a weighted-average vesting period of 0.9 years. | |
Share-Based Compensation Expense: Total compensation costs recognized in the Company’s financial statements relating to its stock option plans in the three and six months ended June 30, 2006 were $83,000 and $165,000, respectively, and included the following financial statement line items (unaudited, in thousands): | |
Three months ended June 30, 2006 | Six months ended June 30, 2006 | ||||||
---|---|---|---|---|---|---|---|
Share-based compensation expense by caption: | |||||||
Cost of services sales | $ | 6 | $ | 16 | |||
Research and development | 28 | 58 | |||||
Sales and marketing | 8 | 17 | |||||
General and administrative | 41 | 74 | |||||
Total share-based compensation: | $ | 83 | $ | 165 | |||
Share-based compensation expense of $13,000 and $6,000 was capitalized and included in inventory on the Company’s condensed consolidated balance sheet as of June 30, 2006 and March 31, 2006, respectively. No tax benefits were recorded with respect to share-based compensation expense recorded during the six and three months ended June 30, 2006. | |
For the three and six-month periods ended June 30, 2006, the Company recorded $83,000 and $165,000 of expense associated with share-based payments, respectively, which would not have been recorded prior to the adoption of SFAS No. 123R. As a result of the adoption of SFAS No. 123R, loss from continuing operations increased by $83,000 for the three months ended June 30, 2006, and income from continuing operations was reduced by $165,000 for the six months ended June 30, 2006. Basic and diluted net income/loss per share for the three and six-months ended June 30, 2006 was $.02 and $.04 lower, respectively as a result of the adoption of SFAS No. 123R. There was no impact on cash flows as a result of the adoption of SFAS No. 123R. |
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Through 2005, the Company accounted for its stock option plans using the intrinsic value method. Had the fair value method prescribed by SFAS 123 been used to account for share-based compensation for the six and three months ended June 30, 2005, net income and net income per share would have been reduced to the following pro forma amounts (unaudited, in thousands, except per share amounts): | |
Three months ended June 30, 2005 | Six months ended June 30, 2005 | ||||||
---|---|---|---|---|---|---|---|
Net income – as reported | $ | 316 | $ | 451 | |||
Fair value of stock-based compensation | (99 | ) | (297 | ) | |||
Net income – pro forma | $ | 217 | $ | 154 | |||
Net income per share – basic – as reported | $ | 0.08 | $ | 0.12 | |||
Net income per share – diluted – as reported | $ | 0.07 | $ | 0.10 | |||
Net income per share – basic – pro forma | $ | 0.06 | $ | 0.04 | |||
Net income per share – diluted – pro forma | $ | 0.05 | $ | 0.03 | |||
4. | Inventories: |
Inventories are stated at the lower of standard cost (which approximates cost on a first-in, first-out basis) or market. Inventory details are as follows (unaudited, in thousands): | |
June 30, 2006 | December 31, 2005 | ||||||||
---|---|---|---|---|---|---|---|---|---|
Raw material | $ | 757 | $ | 745 | |||||
Work in process | 19 | 55 | |||||||
Finished goods | 443 | 356 | |||||||
Total inventory | $ | 1,219 | $ | 1,156 | |||||
After the announcement by the Company’s component suppliers that new components are available to replace certain of their end-of-life components currently used in the Company’s FaxPress products, the Company purchased approximately two years worth of these end-of-life components in an effort to guarantee a smooth supply of its FaxPress Products to its customers while it continues to develop new replacement products. As of June 30, 2006, the Company had approximately $306,000 worth of end-of-life components as compared to $390,000 at December 31, 2005. The Company believes 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. | |
Inventories are reduced for excess and obsolete products. These write-downs are based on management’s review of inventories on hand on a quarterly basis, compared to management’s assumptions about future demand, market conditions and anticipated timing of the release of product upgrades or next generation products. If actual market conditions for future demand are less favorable than those projected by the Company or if product upgrades or next generation products are released earlier than anticipated, additional inventory write-downs may be required. Obsolete products removed from gross inventory are physically scrapped. |
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5. | Segment Information: |
The Company has determined that it operates in one segment. Sales by geographic area are determined by the location of the customer and are summarized as follows (unaudited, in thousands): | |
Three months ended | Six months ended | |||||||||||||
June 30, 2006 | June 30, 2005 | June 30, 2006 | June 30, 2005 | |||||||||||
United States | $ | 2,091 | $ | 2,170 | $ | 4,657 | $ | 4,360 | ||||||
Europe | 98 | 119 | 311 | 212 | ||||||||||
Pacific Rim | 176 | 290 | 316 | 531 | ||||||||||
Rest of Americas, excluding United States | 47 | 267 | 117 | 337 | ||||||||||
Total Sales | $ | 2,412 | $ | 2,846 | $ | 5,401 | $ | 5,440 | ||||||
As a result of errors noted in previous disclosures, the Company has reclassified its sales by geographic area as reported in its Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2006. This reclassification is between geographic areas and does not change the amount of total sales, net income, cash flows, or earnings per share. The as-reported and corrected sales by geographic area for the three months ended March 31, 2006 are summarized as follows (unaudited, in thousands): | |
Three months ended March 31, 2006 | ||||||||
As-Reported | Corrected | |||||||
Sales: | ||||||||
United States | $ | 2,224 | $ | 2,566 | ||||
Europe | 626 | 213 | ||||||
Pacific Rim | 69 | 140 | ||||||
Rest of Americas, excluding United States | 70 | 70 | ||||||
Total sales | $ | 2,989 | $ | 2,989 | ||||
Customers that individually accounted for greater than 10% of net sales are as follows (unaudited, dollar amounts in thousands): | |
Three months ended | Six months ended | ||||||||||||||||||||||||
June 30, 2006 | June 30, 2005 | June 30, 2006 | June 30, 2005 | ||||||||||||||||||||||
Customer | Amount | Percentage | Amount | Percentage | Amount | Percentage | Amount | Percentage | |||||||||||||||||
A | $ | 480 | 16 | % | $ | 415 | 15 | % | $ | 1,114 | 21 | % | $ | 870 | 16 | % | |||||||||
B | $ | 568 | 19 | % | $ | 773 | 27 | % | $ | 1,423 | 26 | % | $ | 1,475 | 27 | % | |||||||||
C | * | * | $ | 256 | 9 | % | * | * | $ | 520 | 10 | % |
* This customer accounted for less than 10% in 2006. |
6. | Commitments and Contingencies: |
Contingencies | |
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 |
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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. | |
Lease Commitments | |
The following represents combined aggregate maturities for all of the Company’s financing and commitments under operating and capital leases as of June 30, 2006 (unaudited, in thousands): | |
Operating Leases | Capital Lease Obligations | Total Commitments | |||||||||
Six months ending December 31, 2006 | $ | 104 | $ | 6 | $ | 110 | |||||
Year ending December 31, 2007 | 207 | — | 207 | ||||||||
Year ending December 31, 2008 | 207 | — | 207 | ||||||||
Year ending December 31, 2009 | 86 | — | 86 | ||||||||
Total Commitments | $ | 604 | $ | 6 | $ | 610 | |||||
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. | |
The Company leases certain of its equipment under various operating and capital leases that expire at various dates through 2006. The lease agreements frequently include renewal and escalation clauses and purchase provisions and require the Company to pay taxes, insurance and maintenance costs. As of June 30, 2006, the Company had $6,000 outstanding under a loan and security agreement, which was subject to an interest rate of 12.8%. | |
The Company renewed its line of credit with Silicon Valley Bank in July 2006, which now matures on July 30, 2007. The revolving line of credit provides for borrowings of up to $6.0 million. Borrowings under this line of credit agreement are collateralized by all of the Company’s assets and bear interest at the bank’s prime rate plus 0.50%. The Company is required to maintain certain minimum cash and investment balances with the bank and to meet certain other financial covenants. As of June 30, 2006, the Company has not drawn down on the line of credit and was in compliance with debt covenants and all other terms of the agreement. | |
Product Warranties and Guarantor Arrangements | |
The Company offers warranties on certain products and records a liability for the estimated future costs associated with warranty claims, which is based upon historical experience and the Company’s estimate of the level of future costs. Warranty costs are reflected in the Statement of Operations as a Cost of Sales. A reconciliation of the changes in the Company’s warranty liability is as follows (unaudited, in thousands): | |
Three months ended | Six months ended | |||||||||||||
June 30, 2006 | June 30, 2005 | June 30, 2006 | June 30, 2005 | |||||||||||
Balance at beginning of period | $ | 24 | $ | 18 | $ | 21 | $ | 13 | ||||||
Accruals for warranties issued during the period | — | — | 4 | 5 | ||||||||||
Actual warranty expense | (3 | ) | — | (4 | ) | — | ||||||||
Balance at end of period | $ | 21 | $ | 18 | $ | 21 | $ | 18 | ||||||
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As permitted under California law, and under the provisions of the Company’s articles of incorporation and by-laws, the Company is obligated to indemnify 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 our exposure and enables it to recover a portion of any future amounts paid. As a result of the Company’s insurance policy coverage, it believes that the estimated fair value of these indemnification agreements is insignificant. | |
The Company enters into standard indemnification agreements with its customers 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 claims or costs to defend lawsuits or settle claims related to these indemnification agreements. | |
7. | Recent Accounting Pronouncements: |
In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation Number 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken in a tax return. The Company must determine whether it is “more-likely-than-not” that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. Once it is determined that a position meets the more-likely-than-not recognition threshold, the position is measured to determine the amount of benefit to recognize in the financial statements. FIN 48 applies to all tax positions related to income taxes subject to FASB Statement No. 109, “Accounting for Income Taxes.” The interpretation clearly scopes out income tax positions related to FASB Statement No. 5, “Accounting for Contingencies.” The Company will adopt the provisions of this statement beginning in the first quarter of 2007. The cumulative effect of applying the provisions of FIN 48, if any, will be reported as an adjustment to the opening balance of retained earnings on January 1, 2007. Management is in the process of determining the impact, if any, of the adoption of FIN 48; however, the Company does not currently anticipate that the adoption of this Interpretation will have a material effect on its financial position or results of operations. |
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This document contains forward-looking statements that involve risks and uncertainties. Our operating results may vary significantly from quarter to quarter due to a variety of factors, including changes in our product and customer mix, constraints in our manufacturing and assembling operations, shortages or increases in the prices of raw materials and components, fluctuations in distribution partner inventory levels, changes in pricing policy by us or our 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 we assume 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 Item 1A of Part II of this Form 10-Q below and in our Annual Report on Form 10-K for the year ended December 31, 2005. |
ITEM 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that are subject to many risks and uncertainties that could cause actual results to differ significantly from expectations. For more information on forward-looking statements, refer to the “Special Note on Forward-Looking Statements” prior to this section. The following discussion should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and the Notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and the audited Consolidated Financial Statements and the Notes thereto included in our Form 10-K for the year ended December 31, 2005. |
Critical Accounting Policies |
Our financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition; distributor programs and incentives; credit, collection and allowances for doubtful accounts; inventories and related allowance for obsolete and excess inventory; and income taxes, which are discussed in more detail under the caption “Critical Accounting Policies” in our 2005 Annual Report on Form 10-K. |
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Consolidated Statements of Operations – As a Percentage of Net Sales (unaudited) |
Three months ended | Six months ended | ||||||||||||
June 30, 2006 | June 30, 2005 | June 30, 2006 | June 30, 2005 | ||||||||||
Net Sales: | |||||||||||||
Products | 67 | % | 74 | % | 70 | % | 74 | % | |||||
Services | 33 | % | 26 | % | 30 | % | 26 | % | |||||
Net sales | 100 | % | 100 | % | 100 | % | 100 | % | |||||
Cost of sales: | |||||||||||||
Products | 27 | % | 24 | % | 27 | % | 22 | % | |||||
Services | 11 | % | 9 | % | 10 | % | 10 | % | |||||
Cost of sales | 38 | % | 33 | % | 37 | % | 32 | % | |||||
Gross profit | 62 | % | 67 | % | 63 | % | 68 | % | |||||
Operating expenses: | |||||||||||||
Research and development | 18 | % | 15 | % | 17 | % | 16 | % | |||||
Sales and marketing | 30 | % | 22 | % | 26 | % | 22 | % | |||||
General and administrative | 18 | % | 20 | % | 19 | % | 23 | % | |||||
Total operating expenses | 66 | % | 57 | % | 62 | % | 61 | % | |||||
Operating income/(loss) | (4 | )% | 10 | % | 1 | % | 7 | % | |||||
Interest income, net | 3 | % | 1 | % | 3 | % | 1 | % | |||||
Other expense, net | (1 | )% | * | (1 | )% | * | |||||||
Income/(loss) before provision for income taxes | (1 | )% | 11 | % | 3 | % | 8 | % | |||||
Provision for income taxes | — | — | — | — | |||||||||
Net income/(loss) | (1 | )% | 11 | % | 3 | % | 8 | % | |||||
* Less than 1% |
Results of Operations |
Net Sales | |
Three months ended | Six months ended | |||||||||||||
June 30, 2006 | June 30, 2005 | June 30, 2006 | June 30, 2005 | |||||||||||
(unaudited, in thousands) | ||||||||||||||
Net Sales | ||||||||||||||
Products | $ | 1,607 | $ | 2,116 | $ | 3,794 | $ | 4,009 | ||||||
Services | 805 | 730 | 1,607 | 1,431 | ||||||||||
Total net sales | $ | 2,412 | $ | 2,846 | $ | 5,401 | $ | 5,440 | ||||||
Net sales for the second quarter of 2006 decreased 15% to $2.4 million from $2.8 million for the same period in 2005. Net sales of $5.4 million for the first six months of 2006 were relatively unchanged as compared to the same period in 2005. |
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Product sales for the second quarter of 2006 decreased 24% to $1.6 million from $2.1 million for the same period in 2005, mostly attributable to lower shipments of our products to our distribution partners due their periodic adjustments of inventory levels. Product sales of $3.8 million for the first six months of 2006 represent a 5% decrease from $4.0 million for the first six months of 2005. | |
Service sales are comprised primarily of extended warranty and support programs as well as 60-days of maintenance bundled with initial product sales. Sales related to these arrangements are recognized ratably over the period of the arrangement. Service sales for the second quarter of 2006 increased 10% to $805,000 from $730,000 for the same period in 2005. For the first six months of 2006, service sales increased 12% to $1.6 million from $1.4 million for the same period in 2005. The increase in service sales was primarily due to increased sales of extended warranty contracts due to an increase in our installed customer base. | |
Sales by geographic area for the three and six months ended June 30, 2006 and 2005 are summarized as follows (unaudited, in thousands): | |
Three months ended | Six months ended | |||||||||||||
June 30, 2006 | June 30, 2005 | June 30, 2006 | June 30, 2005 | |||||||||||
United States | $ | 2,091 | $ | 2,170 | $ | 4,657 | $ | 4,360 | ||||||
Europe | 98 | 119 | 311 | 212 | ||||||||||
Pacific Rim | 176 | 290 | 316 | 531 | ||||||||||
Rest of Americas, excluding United States | 47 | 267 | 117 | 337 | ||||||||||
Total Sales | $ | 2,412 | $ | 2,846 | $ | 5,401 | $ | 5,440 | ||||||
Sales in the United States for the second quarter of 2006 were $2.1 million, as compared to $2.2 million for the same period in 2005, representing 87% and 76% of total net sales in the second quarter of 2006 and 2005, respectively. United States sales for the first six months of 2006 were $4.7 million, as compared to $4.4 million for the same period in 2005, representing 86% and 80% of total net sales for the first six months of 2006 and 2005, respectively. The increase in sales is mostly attributable to higher sales from services, offset in part by lower product shipments to the distribution channels. | |
International sales (excluding sales to the rest of the Americas) for the second quarter of 2006 were $274,000 as compared to $409,000 for the same period in 2005, representing 11% and 14% of net sales for the second quarter of 2006 and 2005, respectively. International sales were $627,000 for the first six months of 2006, as compared to $743,000 for the same period in 2005, representing 12% and 14% of total net sales for the first six months of 2006 and 2005, respectively. The decrease in international sales is primarily due to lower demand of the FaxPress and FaxPress Premier fax server products from Japan and Hong Kong during the six month period ended June 30, 2006. | |
Sales to the rest of the Americas (excluding the United States) for the second quarter of 2006 were $47,000 as compared to $267,000 for the same period in 2005, representing 2% and 9% of total net sales for the second quarter of 2006 and 2005, respectively. Sales in the second quarter of 2005 included a shipment of FaxPress Premier server products to a certain customer in Latin America of $203,000. For the six months ended June 30, 2006 and 2005 sales to the rest of the Americas were $117,000 and $337,000, respectively, representing 2% and 6% of net sales for the first six months of 2006 and 2005, respectively. |
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Cost of Sales; Gross Profit | |
Three months ended | Six months ended | ||||||||||||
June 30, 2006 | June 30, 2005 | June 30, 2006 | June 30, 2005 | ||||||||||
(unaudited, dollar amounts in thousands) | |||||||||||||
Cost of sales: | |||||||||||||
Products | $ | 643 | $ | 674 | $ | 1,434 | $ | 1,216 | |||||
Services | 276 | 258 | 552 | 528 | |||||||||
Total cost of sales | 919 | 932 | 1,986 | 1,744 | |||||||||
Gross profit | 1,493 | 1,914 | 3,415 | 3,696 | |||||||||
Gross profit % | 62 | % | 67 | % | 63 | % | 68 | % |
Gross profit for the second quarter of 2006 and 2005 was $1.5 million and $1.9 million, respectively, or 62% and 67% of net sales for the second quarter of 2006 and 2005, respectively. Gross profit for the first six months of 2006 and 2005 was $3.4 million and $3.7 million, respectively, or 63% and 68% of net sales for the first six months of 2006 and 2005, respectively. The decrease in gross profit margins in the three and six month ended June 30, 2006 as compared to the same periods in 2005 was primarily due to more FaxPress Premier fax servers shipped at higher cost of sales than FaxPress fax server products, and share-based compensation expenses of $16,000 included in the first six months of 2006. | |
Research & Development | |
Research and product development expenses for the second quarter of 2006 were $431,000, or 18% of net sales, as compared to $418,000, or 15% of net sales, for the same period in 2005. For the first six months of 2006, research and development expenses were $916,000, as compared to $857,000 for the same period of 2005, or 17% of net sales for both periods. The increase in research and product development expenses of $13,000 over the three month period, and $59,000 over the six month period, was primarily due to share-based compensation expenses, which were not present in the same periods in 2005. | |
Sales & Marketing | |
Sales and marketing expenses for the second quarter of 2006 were $719,000, or 30% of net sales, as compared to $618,000, or 22% of net sales, for the same period in 2005. Sales and marketing expenses were $1.4 million for the first six months of 2006, and $1.2 million for the same period of 2005, representing 26% and 22%, respectively, of net sales for these period. The increase of $101,000 in sales and marketing expenses for the second quarter of 2006 compared to the same period in 2005 is primarily due to higher product advertising expenses of $23,000, an increase in trade show related expenditures of $50,000, and sales commissions of $27,000. We expect trade show related expenses to be more in line with historical spending levels. The increase of $176,000 over the six month period is mainly due to share-based compensation expenses of $17,000, along with higher sales commission expenses of $72,000, an increase in product advertising expenses of $42,000, and an increase in trade show related expenses of $53,000. | |
General & Administrative | |
General and administrative expenses were $439,000 for the second quarter of 2006 as compared to $582,000 for the same period in 2005, representing 18% and 20% of net sales of the second quarter of 2006 and 2005, respectively. For the first six months of 2006, general and administrative expenses were $1.1 million, or 20% of net sales, as compared to $1.2 million, or 23% |
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of net sales, for the first six months of 2005. The decrease of $143,000 for the second quarter is primarily due to $74,000 in accounting and legal fees related to the restatement of our historical financial statements in 2004 incurred in the year ago quarter, along with lower compensation expenses of $76,000 in the second quarter of 2006 primarily because of lower incentive payments due to performance goals that were not met, partially offset by share-based compensation expense of $41,000 incurred in the second quarter of 2006. The decrease of $162,000 for the six months ended June 30, 2006 is primarily due to $177,000 in accounting and legal fees incurred during the first six months of 2005 related to the restatement of our historical financial statements along with lower employee compensation expenses of $67,000 because of lower incentive payments due to performance goals that were not met, partially offset by share-based compensation expenses of $74,000 during the first six months of 2006. General and administrative expenses are expected to increase in fiscal 2006 as we begin to prepare for Sarbanes-Oxley internal control compliance. | |
Provision for Income Tax | |
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 establish a valuation allowance to the extent that all or some portion of the deferred tax assets will not be recoverable against future taxable income. | |
Significant management judgment is required in determining the provision for income taxes, and, in particular, any valuation allowance recorded against our deferred tax assets. During 2005, we again reviewed the need for a valuation allowance against our deferred tax assets. As a result of this review, we determined that, based on 2005 financial results and projected future taxable income, an increase in the valuation allowance was necessary. We recorded a tax provision in 2005 of $395,000 resulting from federal and state provision and an increase in the valuation allowance. Due to our continued operating profitability over 18 straight quarters and a determination that it is more likely than not that certain future tax benefits will be realized, a total of $1.1 million of our deferred tax assets has been recognized and was included on our consolidated balance sheet as of December 31, 2005. Based in large part on our projected future taxable income, we did not record income tax provision in the first quarter of 2006. We will record a tax provision in future periods when all available non-operating losses and tax credit carryforwards are fully utilized or the remaining deferred tax assets are deemed to be unrealizable. | |
As of December 31, 2005, we had approximately $12.2 million and $1.8 million of net operating loss (“NOL”) carryforwards available to offset future federal and California taxable income, respectively. In addition, at December 31, 2005, we had federal and California credit carryforwards of approximately $1.3 million and $835,000, respectively. We do not expect to utilize significant amounts of cash for income tax payments until the NOLs have been utilized. |
Liquidity and Capital Resources |
June 30, 2006 | December 31, 2005 | ||||||
(unaudited, in thousands) | |||||||
Cash and cash equivalents | $ | 7,002 | $ | 6,766 | |||
Working capital | $ | 7,129 | $ | 6,784 | |||
Working capital ratio | 3.9 | 3.6 |
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Since the initial public offering of our 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 June 30, 2006, we had $7.0 million of cash and cash equivalents, an increase of $236,000 from December 31, 2005. The increase in cash and cash equivalents was primarily attributable to cash provided by operating activities of $312,000, offset by $108,000 in cash used in investing activities. | |
Our operating activities generated cash of $312,000 in the first six months of 2006 primarily due to net income of $172,000 and improved cash collections from outstanding accounts receivables of $128,000. Net cash used in investing activities of $108,000 over the six month period ended June 30, 2006 was primarily used for the purchase of computer hardware and software which is in line with historical requirements. Net cash provided by financing activities in the first six months of 2006 of $32,000 is primarily due to proceeds from the exercise of stock options. | |
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 worth of 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 June 30, 2006, 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 2006 or 2005. However, we may continue to execute our buyback program as we deem necessary. | |
We renewed our line of credit with Silicon Valley Bank in July 2006, which now matures on July 30, 2007. The revolving line of credit provides for borrowings of up to $6.0 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%. We are required to maintain certain minimum cash and investment balances with the bank and meet certain other financial covenants. As of June 30, 2006, we have not drawn down on the line of credit and were in compliance with debt covenants and all other 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 June 30, 2006, we had $6,000 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 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 June 30, 2006, future minimum payments under the lease were $604,000. |
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The following represents combined aggregate maturities for all our financing and commitments as of June 30, 2006 (unaudited, in thousands): | |
Payments Due by Period | |||||||||||||||
Contractual Obligations | Total | 1 Year | 2 - 3 Years | 4 - 5 Years | More than 5 Years | ||||||||||
Capital (Finance) Lease Obligations | $ | 6 | $ | 6 | — | — | — | ||||||||
Operating Lease Obligations | $ | 604 | $ | 207 | $ | 397 | — | — | |||||||
Total contractual cash obligations | $ | 610 | $ | 213 | $ | 397 | — | — | |||||||
In addition, because we are dependent on a small number of distributors for a significant portion of the revenues from 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. In both the first six months of 2006 and 2005, our two largest distributors collectively represented approximately 45% of our net sales. | |
We believe that, for the periods presented, inflation has not had a material effect on our operations. |
Recent Accounting Pronouncements: |
20 |
21 |
Nominee | For | Withheld | ||||||
Donald L. Rich | 3,454,683 | 154,665 | ||||||
Scott C. McDonald | 3,604,648 | 4,700 | ||||||
Peter R. Tierney | 3,155,569 | 48,196 | ||||||
Robert H. Hambrecht | 3,561,152 | 48,196 | ||||||
Robert O. Smith | 3,604,648 | 4,700 |
Proposal 2: To ratify the appointment of Grant Thornton LLP as our independent registered public accounting firm for the 2006 fiscal year: | |
For | Against | Abstain | ||||||
3,607,183 | 1,030 | 1,135 |
22 |
Exhibit No. | Description | |
10.1 | Third Amendment to Loan and Security Agreement, dated as of July 18, 2006, by and between Registrant and Silicon Valley Bank Loan Agreement | |
31.1 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, executed by Scott C. McDonald, Chief Executive Officer and President of Castelle | |
31.2 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, executed by Paul Cheng, Chief Financial Officer of Castelle | |
32.1* | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, executed by Scott C. McDonald, Chief Executive Officer and President of Castelle | |
32.2* | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, executed by Paul Cheng, Chief Financial Officer of Castelle | |
* This exhibit is being furnished rather than filed, and shall not be deemed incorporated by reference into any filing, in accordance with Item 601 of Regulation S-K. |
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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 Scott C. McDonald Chief Executive Officer and President (Principal Executive Officer) | Date: August 14, 2006 |
By: | /s/ Paul Cheng Paul Cheng Vice President of Finance and Administration Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) | Date: August 14, 2006 |
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EXHIBIT INDEX |
* This exhibit is being furnished rather than filed, and shall not be deemed incorporated by reference into any filing, in accordance with Item 601 of Regulation S-K. |
25 |