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 July 2, 1999 |_| 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) 3255-3 Scott Boulevard, Santa Clara, California 95054 (Address of principal executive offices, including zip code) (408) 496-0474 (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 August 10, 1999 was 4,687,935. CASTELLE FORM 10-Q TABLE OF CONTENTS PAGE PART I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements: Consolidated Balance Sheets 2 Consolidated Statements of Operations 3 Consolidated Statements of Cash Flows 4 Notes to Consolidated Financial Statements 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8 PART II. OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders 14 Item 6. Exhibits and Reports on Form 8-K 14 Signatures 15 Exhibit 27.1 - Financial Data Schedule E-1 Exhibit 99.1 - Press Release dated August 12, 1999 E-2 1 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CASTELLE AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) July 2, 1999 December 31, 1998 (unaudited) (audited) ---------------------- --------------------- Assets: Current assets: Cash and cash equivalents $3,968 $3,924 Restricted cash 125 125 Accounts receivable, net of allowances of $304 in 1999 and $720 in 1998 2,241 3,472 Inventory 2,178 3,739 Prepaid expense and other current assets 305 398 ---------------------- --------------------- Total current assets 8,817 11,658 Property, plant & equipment, net 521 666 Other assets 150 170 ---------------------- --------------------- $ 9,488 $12,494 ====================== ===================== Liabilities & Shareholders' Equity: Current liabilities: Current portion of notes payable $ 96 $ 96 Accounts payable 1,744 2,084 Accrued liabilities 2,929 2,715 ---------------------- --------------------- Total current liabilities 4,769 4,895 Notes payable 50 98 ---------------------- --------------------- Total liabilities 4,819 4,993 ---------------------- --------------------- Shareholders' equity: Common stock, no par value; authorized: 25,000 shares; Issued and outstanding: 4,685 and 4,337, respectively 28,994 29,255 Note receivable for purchase of common stock -- (274) Deferred compensation (94) (120) Accumulated deficit (24,231) (21,360) ---------------------- --------------------- Total shareholders' equity 4,669 7,501 ---------------------- --------------------- $ 9,488 $12,494 ====================== ===================== See accompanying notes to condensed consolidated financial statements. 2 CASTELLE AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) (unaudited) Three months ended Six months ended ................................ ................................ July 2, 1999 July 3, 1998 July 2, 1999 July 3, 1998 --------------- --------------- --------------- --------------- Net sales $ 3,738 $ 6,097 $ 8,206 $ 12,698 Cost of sales 1,753 2,967 4,602 6,068 --------------- --------------- --------------- --------------- Gross profit 1,985 3,130 3,604 6,630 --------------- --------------- --------------- --------------- Operating expenses: Research and development 948 747 1,632 1,397 Sales and marketing 2,005 1,898 3,859 4,030 General and administrative 494 476 953 955 Amortization of intangible assets -- 40 40 40 Acquisition of in-process research and development -- 1,124 -- 1,124 --------------- --------------- --------------- --------------- Total operating expenses 3,447 4,285 6,484 7,546 --------------- --------------- --------------- --------------- Loss from operations (1,462) (1,155) (2,880) (916) Interest income, net 25 62 55 120 Other income (expense), net (23) 10 (46) 17 --------------- --------------- --------------- --------------- Loss before benefit from income taxes (1,460) (1,083) (2,871) (779) Benefit from income taxes -- (158) -- (37) --------------- --------------- --------------- --------------- Net loss $(1,460) $ (925) $(2,871) $ (742) =============== =============== =============== =============== Net Loss per share: Net loss per common share - basic and diluted $(0.31) $(0.20) $(0.64) $(0.16) Shares used in per share calculation - basic and diluted 4,663 4,603 4,499 4,549 See accompanying notes to condensed consolidated financialstatements. 3 CASTELLE AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited) Six months ended ...................................... July 2, 1999 July 3, 1998 ------------------ ------------------ Cash flows from operating activities: Net loss $ (2,871) $ (742) Adjustment to reconcile net loss to net cash provided by operating activities: Loss on disposal of fixed assets 37 -- Depreciation and amortization 302 323 Provision for doubtful accounts and sales returns (1,149) (204) Provision for excess and obsolete inventory 1,146 74 Acquisition of in-process research and development -- 1,124 Changes in assets and liabilities: Accounts receivable 2,380 (843) Inventory 415 1,281 Prepaid expenses and other current assets 93 (98) Accounts payable (340) 317 Accrued liabilities 214 (111) ------------------ ------------------ Net cash provided by operating activities 227 1,121 ------------------ ------------------ Cash flows from investing activities: Purchase of property and equipment (115) (133) Acquisition of Object-Fax product line -- (784) Increase in other assets (33) (82) ------------------ ------------------ Net cash (used in) investing activities (148) (999) ------------------ ------------------ Cash flows from financing activities: Proceeds from notes payable -- 142 Repayment of notes payable (48) (42) Proceeds from collection of note receivable for stock 11 -- Proceeds from issuance of common stock and warrants, net of repurchases 2 9 ------------------ ------------------ Net cash provided by (used in) financing activities (35) 109 ------------------ ------------------ Net increase in cash and cash equivalents 44 231 Cash and cash equivalents at beginning of period 3,924 6,204 ------------------ ------------------ Cash and cash equivalents at end of period $ 3,968 $ 6,435 ================== ================== Supplemental Information: Noncash financing activities: Issuance of common stock for acquisition of Object-Fax product line $ -- $ 500 See accompanying notes to condensed consolidated financial statements. 4 CASTELLE AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) 1. Basis of Presentation: The accompanying unaudited 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 generally accepted accounting principles. All intercompany balances and transactions have been eliminated. In the opinion of management, all adjustments (consisting 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 result of operations for the interim period presented is not necessarily indicative of the results for the year ending December 31, 1999. Because all of the disclosures required by generally accepted accounting principles are not included in the accompanying consolidated financial statements and related notes, they should be read in conjunction with the audited consolidated financial statements and related notes included in the Company's Form 10-K for the fiscal year-ended December 31, 1998. 2. Net Loss Per Share Basic net loss per share is computed by dividing net loss available to common shareholders by the weighted average number of common shares outstanding for that 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. Shares that are potentially dilutive consist of incremental common shares issuable upon exercise of stock options and warrants. Basic and diluted earnings per share are calculated as follows for the second quarter and first six months ending of 1999 and 1998: (in thousands, except per share amounts) ............................................................ Three months ended Six months ended ............................. ............................. July 2, July 3, July 2, July 3, 1999 1998 1999 1998 -------------- -------------- -------------- -------------- Basic: Weighted average common shares outstanding 4,663 4,603 4,499 4,549 ============== ============== ============== ============== Net loss $(1,460) $(925) $(2,871) $(742) ============== ============== ============== ============== Net loss per common share - basic $ (0.31) $ (0.20) $ (0.64) $ (0.16) ============== ============== ============== ============== Diluted: Weighted average common shares outstanding 4,663 4,603 4,499 4,549 Common equivalent shares from stock options -- -- -- -- -------------- -------------- -------------- -------------- Shares used in per share calculation - diluted 4,663 4,603 4,499 4,549 ============== ============== ============== ============== Net loss $(1,460) $(925) $(2,871) $(742) ============== ============== ============== ============== Net loss per common share - diluted $ (0.31) $ (0.20) $ (0.64) $ (0.16) ============== ============== ============== ============== The calculation of diluted shares outstanding for the three months ended July 2, 1999 and July 3, 1998 excludes 27,201 and 53,818 stock options, respectively, as their effect was antidilutive in the period. The calculation of diluted shares outstanding for the six months ended July 2, 1999 and July 3, 1998 excludes 21,967 and 45,391 stock options, respectively, as their effect was antidilutive in the period. 5 3. Inventory: Inventory is 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): July 2, December 31, 1999 1998 --------------- ---------------- Raw material $ 121 $ 1,282 Work in process 117 130 Finished goods 1,940 2,327 --------------- ---------------- $ 2,178 $ 3,739 =============== ================ 4. Revenue Recognition: Product revenue is recognized upon shipment if a signed contract exists, the fee is fixed and determinable, collection of the resulting receivables is probable and product returns are reasonably estimable. 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 purchase of additional products of equal value. Revenues subject to stock rotation rights are reduced by management's estimates of anticipated exchanges. Provisions for estimated warranty costs and anticipated retroactive price adjustments are recorded at the time products are shipped. The Company recognizes revenue from the sale of extended warranty contracts ratably over the period of the contracts. 5. Segments Disclosure: The Company has adopted SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information," which is effective for fiscal years beginning after December 31, 1997. SFAS No. 131 supersedes SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise." SFAS No. 131 changes current practice under SFAS No. 14 by establishing a new framework on which to base segment reporting and introduces requirements for interim reporting of segment information. The Company has determined that it uses one measurement of profitability of its business for internal reporting. 6. Comprehensive Income: Castelle has adopted the provisions of Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income," effective January 1, 1998. This statement requires the disclosure of comprehensive income and its components in a full set of general-purpose 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, therefore, no separate statement of comprehensive income has been presented. 6 7. New accounting pronouncements: In June of 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measures those instruments at fair value. There is no effect of this change on the Company's operations. In December 1998, the Accounting Standards Executive Committee ("AcSEC") released Statement of Position 98-9 ("SOP 98-9"), Modification of SOP 97-2, "Software Revenue Recognition," with Respect to Certain Transactions. SOP 98-9 amends SOP 97-2 to require that an entity recognize revenue for multiple element arrangements by means of the "residual method" when (1) there is vendor-specific objective evidence ("VSOE") of the fair values of all the undelivered elements that are not accounted for by means of long-term contract accounting, (2) VSOE of fair value does not exist for one or more of the delivered elements, and (3) all revenue recognition criteria of SOP 97-2 (other than the requirement for VSOE of the fair value of each delivered element) are satisfied. The provisions of SOP 98-9 that extend the deferral of certain paragraphs of SOP 97-2 became effective December 15, 1998. These paragraphs of SOP 97-2 and SOP 98-9 will be effective for transactions that are entered into in fiscal years beginning after March 15, 1999. Retroactive application is prohibited. This pronouncement will not have an impact on the Company's current revenue recognition policies. 7 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis contains forward-looking statements that involve risks and uncertainties. Such forward-looking statements may be deemed to the adequacy of anticipated sources of cash to fund the Company's future capital requirements through March 31, 2000, and the costs of the Company's Year 2000 compliance efforts and dates by which the Company believes it will complete such efforts. 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. 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 for the fiscal year ended December 31, 1998. 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 for the fiscal year ended December 31, 1998. Consolidated Statements of Operations - As a Percentage of Net Sales Three months ended Six months ended ................................. ................................. July 2, 1999 July 3, 1998 July 2, 1999 July 3, 1998 --------------- ---------------- --------------- ---------------- Net sales 100% 100% 100% 100% Cost of sales 47% 49% 56% 48% --------------- ---------------- --------------- ---------------- Gross profit 53% 51% 44% 52% --------------- ---------------- --------------- ---------------- Operating expenses: Research and development 25% 12% 20% 11% Sales and marketing 54% 31% 47% 32% General and administrative 13% 8% 12% 7% Amortization of intangible assets -- 1% * * Acquisition of in-process research and development -- 18% -- 9% --------------- ---------------- --------------- ---------------- Total operating expenses 92% 70% 79% 59% --------------- ---------------- --------------- ---------------- Loss from operations (39%) (19%) (35%) (7%) Interest income, net * 1% * 1% Other income (expense), net * * * * --------------- ---------------- --------------- ---------------- Loss before benefit from income taxes (39%) (18%) (35%) (6%) Benefit from income taxes -- (3%) -- * --------------- ---------------- --------------- ---------------- Net loss (39%) (15%) (35%) (6%) =============== ================ =============== ================ * Less than 1% 8 Results of Operations Net Sales Net sales for the second quarter of 1999 decreased to $3.7 million from $6.1 for the same period in 1998. The reduction in net sales was primarily the result of a $1.7 million (75%) decrease in print server product sales, as well as, $0.7 million (18%) decrease in sales of the Company's fax server products to distributors to maintain manageable inventory levels in the channel. Net sales were $8.2 million and $12.7 million for the first six months of 1999 and 1998, respectively. The lower net sales were the result of a 64% reduction in print server, primarily due to reduced demand for the Company's print server products in Asia and a 21% reduction in fax server products, primarily due to decreased sales of the Company's fax server products to distributors to maintain manageable inventory levels in the channel. International sales in the second quarter of 1999 decreased to $1.0 million from $2.2 million for the same period in 1998, representing 28% and 36%, respectively, of total net sales. This 52% decline in international sales was mainly the result of reduced demand for the Company's print server products in Asia. International sales were $2.7 million and $5.0 million for the first six months of 1999 and 1998, respectively, representing 33% and 39%, respectively, of total net sales. The decrease in international sales was the result of lower demand for the Company's print server products in Asia. Gross Profit Gross profit of 53% for the second quarter of fiscal 1999 increased compared to gross profit of 51% for the same period in 1998. The increase in fiscal 1999 gross profit is primarily attributable to a higher percentage of fax server products being sold that yield higher margins. Gross profit for the first six months of 1999 and 1998 were 44% and 52%, respectively. The reduction in gross profit is primarily attributable to an additional $1,148,000 excess inventory provision recorded in the first six months of 1999. This provision is primarily associated with excess print server products targeted for the Asian market and fax server products expected to be replaced by newly introduced FaxPress models. Research & Development Research and product development expenses increased to $948,000 or 25% of net sales for the second quarter of 1999 as compared to $747,000 or 12% of net sales for the same period in 1998. Research and product development expenses for the first six months increased 17% to $1.6 million or 20% of net sales in 1999 as compared to $1.4 million or 11% of net sales for the same period in 1998. The increase is due to the increased personnel-related expenses. 9 Sales & Marketing Sales and marketing expenses were $2.0 million or 54% of net sales for the second quarter of 1999, as compared to $1.9 million or 31% of net sales for the same period in 1998. The increase of sales and marketing expenses is associated with higher advertising expenses in the distribution channel during the second quarter of 1999. Sales and marketing expenses decreased to $3.9 million or 47% of net sales for the first six months of 1999 from $4.0 million or 32% of net sales for the same period in 1998. This slight decrease is attributable to lower personnel-related expenses. General & Administrative General and administrative expenses were $494,000 or 13% of net sales for the second quarter of 1999, as compared to $476,000 or 8% of net sales for the same period in 1998. General and administrative expenses for the first six months slightly decreased to $953,000 or 12% of net sales in 1998, as compared to $955,000 or 7% of net sales for the same period in 1998. Amortization of intangible assets & Acquisition of in-process research and development The intangible assets were fully amortized in the first quarter of 1999. The expense was $40,000 or 1% of net sales for the same period in 1998. It reflects the amortization of intangible assets for the acquisition of the Object-Fax NT product line in April 1998. In April 1998, the Company completed its acquisition of the Object-Fax NT product line, a facsimile software application designed for LAN's, WAN's and Internet-based networks, from Tolvusamskipti HF, an Icelandic corporation. The purchase, valued at approximately $1.4 million, included the exchange of $300,000 in cash, 100,000 shares of Castelle common stock, and the right to receive either additional cash or the number of shares of Castelle common stock on the date six months after the acquisition necessary to make the fair market value of the common stock and additional cash received in the transaction not less than $500,000. Since the value of the Castelle common stock received in the transaction was less than $500,000 on the date six months after the acquisition, an additional 339,560 shares of Castelle common stock were issued to Tolvusamskipti HF on April 9, 1999. A portion of the purchase price was allocated to in-process research and development, and, accordingly, the Company recorded a one-time charge against earnings in the second quarter of 1998 of $1.1 million. Further, the Company recorded intangible assets of $160,000, which are being amortized over 12 months, resulting in a $40,000 charge in the second quarter of 1998. Interest & Other income (expense), net Interest and other income (expense), net, comprised income of $2,000 for the second quarter of 1999, as compared to income of $72,000 or 1% of net sales for the same period in 1998. This reduction in income is the result of lower interest earned on the Company's investments and an exchange loss from the UK subsidiary. Interest income and other income (expenses) for the first six months of 1999 income decreased to $9,000, as compared to $137,000 or 1% of net sales for the same period in 1998. This reduction in income is the result of lower interest earned on the Company's investments, an exchange loss from the UK subsidiary and a loss on disposal of fixed assets. 10 Liquidity and Capital Resources Since its inception in 1987, Castelle has funded its operations primarily through the sale of capital stock and bank debt. As of July 2, 1999, the Company had approximately $4.0 million of cash and cash equivalents, up from $3.9 million at December 31, 1998. Working capital decreased to $4.1 million at July 2, 1999 from $6.8 million at December 31, 1998. The decrease in working capital is primarily due to the Company's net loss for the first six months of 1999. In April 1998, the Company completed its acquisition of the Object-Fax NT product line, a facsimile software application designed for LAN's, WAN's and Internet-based networks, from Tolvusamskipti HF, an Icelandic corporation, in exchange for $300,000 in cash, 100,000 shares of Castelle common stock and the right to receive either additional cash or the number of shares of Castelle common stock on the date six months after the acquisition necessary to make the fair market value of the common stock and additional cash received in the transaction not less than $500,000. Since the value of the Castelle common stock received in the transaction was less than $500,000 on the date six months after the acquisition, an additional 339,560 shares of Castelle common stock were issued to Tolvusamskipti HF on April 9, 1999. The Company has a $3.0 million secured revolving line of credit with a bank, which expires in March 17, 2000 and at July 2, 1999 had no borrowings under the line of credit. In December 1997, the Company entered into a loan and security agreement with a finance company for an amount of $288,000. The amounts borrowed are subject to interest of 10.11%, are repayable by December 2000, and are partially collateralized by a certificate of deposit of $125,000, which is classified as restricted cash on the Company's balance sheet. As of July 2, 1999, the outstanding balance of the loan under the agreement was $146,000. As of July 2, 1999, net accounts receivable were $2.2 million, down from $3.5 million at December 31, 1998. The decrease in net accounts receivable is attributed to a decrease in net sales and the improved collection of outstanding balances in the second quarter of 1999, which resulted in an improvement in days sales outstanding from 87 at the end of 1998 to 55 days at July 2, 1999. Net inventory as of July 2, 1999 was $2.2 million, down from $3.7 million at December 31, 1998. The decrease was primarily attributable to an additional $1,148,000 inventory provision recorded in the first six months of 1999. This provision is mainly associated with excess print server products targeted for the Asian market and fax server products expected to be replaced by newly introduced FaxPress models. The Company had not made any material capital commitments during the first six months ended July 2, 1999. Although the Company believes that its existing capital resources, anticipated cash flows from operations and available lines of credit will be sufficient to meet its capital requirements at least through the next 12 months, the Company may be required to seek additional equity or debt 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 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. Management believes that, for the periods presented, inflation has not had a material effect on the Company's operations. 11 Year 2000 Compliance The Company has completed a comprehensive review of its business applications, computer systems and infrastructure and products. In addition, Castelle is in the process of conducting a comprehensive review of its key business partners to identify those that could be adversely affected by the Year 2000 issue and is developing and implementing a plan to resolve issues identified. The Year 2000 issue refers to the inability of many computer systems to process accurately dates later than December 31, 1999. Date codes in many programs are abbreviated to allow only two digits for the year, e.g. "98" for the year 1998. Unless these programs are modified to handle the century date change, they will likely interpret the year "00", that is, the year 2000, as the year 1900. The Year 2000 issue creates risk for the Company from unforeseen problems in its own computer systems as well as in computer systems of third parties with whom the Company does business worldwide, including banks and credit processing entities, factories, customers and others. Business Applications, Computer Systems and Infrastructure Castelle has completed a comprehensive review and inventory of its business applications and computer systems, including servers and network infrastructure, to insure that they are Year 2000 compliant. To date, the Company has installed and/or upgraded all computer network file servers and infrastructure (hubs, switches, modems and access devices) to hardware and software that is certified to be Year 2000 compliant by its vendors. In addition, Castelle's main business application from Computer Associates International, Inc. (Computer Associates) has been upgraded to a Year 2000 compliant version as certified by Computer Associates. The Company has substantially completed an upgrade of all desktop (including laptop) computers to Microsoft NT software certified by Microsoft Corporation as Year 2000 compliant. All of the Company's engineering, manufacturing, final test, and repair computer systems have been upgraded and tested for Y2k compliance. The Company presently believes that the Year 2000 issue will not pose significant operational problems for the Company due to planned modifications to existing software, and conversions to new software which have been implemented or are being implemented by the Company during the year. Key business partners The Company is in the process of conducting a comprehensive review of its key business partners, including customers, suppliers and vendors, to identify those critical to the success of the Company's operations that may have Year 2000 issues which could adversely affect the operations of the Company. The Company anticipates that its review will be completed by November 19, 1999. The Company presently believes that the Year 2000 issue will not pose significant operational problems for the Company due to planned modifications by our key business partners to their existing systems and conversions to new software which have been implemented or are being implemented by the Company's key business partners over the next year. However, if such modifications and conversions are not completed in a timely manner, the Year 2000 issue may have a material adverse impact on the operations of the Company. The Company cannot give assurance the third parties with whom it does business will address any Year 2000 issues in their own systems on a timely basis. Costs The total cost associated with required modifications to become Year 2000 compliant is not expected to be material to the Company's financial position. At the present time, all costs associated with the installation and upgrading of equipment and software have been related to routine upgrades of the Company's business systems, which to date have been approximately $105,000. The Company estimates the remaining cost associated with the installation and upgrading of the equipment will be approximately $15,000. However, the Company cannot give any assurance that significant costs associated with unforeseen circumstances will not significantly affect the future results of the Company. 12 Products The Company has completed a comprehensive review of its products, both firmware and software, to insure that they are Year 2000 compliant. This was done to insure that the Company's products are free of any Year 2000 issues discussed above. The Company believes that the more recent versions of its products are Year 2000 compliant, meaning the products will perform functions correctly when processing dates later than December 31, 1999. In order to avoid difficulties, users will need to install the Y2K compliant versions of the Company's software or apply appropriate patches to prior versions of software. Full details on Year 2000 compliance of the Company's various product lines and software version releases are available on the Company's Web site. Necessary patches are available on the web site to allow customers to install these versions. The Company's products work in conjunction with network operating systems such as Novell NetWare and Microsoft Windows 95/98/NT, and while these products appear to be Year 2000 compliant, the Company cannot accept responsibility for Year 2000 compliance of any network operating system or any other third party software with which Castelle software interfaces . If modifications or upgrades to these systems are not completed in a timely fashion, the Year 2000 issue may have a material adverse impact on the Company's business, operating results and financial condition. Contingency Plans The Company has developed contingency plans in the event that the Company's systems or products prove to not be Year 2000 compliant. The Company has contingency plans in place for all specific client, server, hardware, and general network infrastructure Year 2000 issues. Company has currently reviewed its key business activities and developed plans to support ongoing business operations in the event of a disruption. Based on its assessment to date, the Company presently believes that the Year 2000 Issue will not pose significant operational problems for the Company. Although the Company has detailed contingency plans, ongoing evaluating and testing of the Company's network infrastructure will continue up to and past the year 2000 to ensure a smooth transition to the new millennium. Other Matters The listing of the Company's Common Stock was transferred to The Nasdaq SmallCap Market on April 14, 1999. As a condition to the qualifications exception to the Company pursuant to the Nasdaq Listing Qualification Panel decision dated April 12, 1999, the Company was required to evidence a minimum closing bid price of $1.00 per share on or before July 14, 1999. Thereafter, the Company was required to evidence a minimum closing bid price of at least $1.00 per share for a minimum of ten consecutive trading days. The Company evidenced a minimum closing bid price of $1.00 per share prior to July 14, 1999 and continued to evidence a minimum closing bid price of at least $1.00 for 17 consecutive trading days. Because the Company complied with the terms of its exception, on June 21, 1999, the trading symbol of the Company's securities returned to "CSTL". 13 PART II - OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company held its Annual Meeting of Shareholders on May 25, 1999 (the "Annual Meeting"). At the Annual Meeting, the Company's shareholders elected four directors nominated by the Board of Directors by the votes indicated: Nominee Votes in Favor Votes Withheld ----------------- ----------------- ----------------- Donald L. Rich 2,680,003 27,740 Peter R. Tierney 2,680,003 27,740 Scott C. McDonald 2,680,003 27,740 Robert Hambrecht 2,670,003 37,740 The proposal to ratify the selection of PricewaterhouseCoopers LLP as the Company's independent auditors for the fiscal year ending December 31, 1999 was approved. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: 27.1 Financial Data Schedule 99.1 Press Release dated August 12, 1999 (b) Reports on Form 8-K None 14 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/ Donald L. Rich Date: August 12, 1999 Donald L. Rich President, Chief Executive Officer and Director By: /s/ Laurie Gee Date: August 12, 1999 Laurie Gee Vice President of Finance and Administration (Principal Financial and Accounting Officer) 15