UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JANUARY 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 000-30362
CROSSROADS SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 74-2846643
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
8300 NORTH MOPAC EXPRESSWAY
AUSTIN, TEXAS 78759
(Address of Registrant's principal executive offices, including zip code.)
(512) 349-0300
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 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. [X] Yes [ ] No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act.) [ ] Yes [X] No
As of March 8, 2004 Registrant had outstanding 25,161,843 shares of common
stock, par value $0.001 per share.
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
FORM 10-Q
QUARTER ENDED JANUARY 31, 2004
TABLE OF CONTENTS
PAGE
----
PART I FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets as of October 31, 2003 and
January 31, 2004................................................... 2
Condensed Consolidated Statements of Operations for the three months
ended January 31, 2003 and 2004.................................... 3
Condensed Consolidated Statements of Cash Flows for the three months
ended January 31, 2003 and 2004...................................... 4
Notes to Condensed Consolidated Financial Statements................. 5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.............................................. 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk........... 32
Item 4. Controls and Procedures.............................................. 32
PART II OTHER INFORMATION
Item 1. Legal Proceedings.................................................... 33
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities.................................................. 33
Item 3. Defaults Upon Senior Securities...................................... 33
Item 4. Submission of Matters to a Vote of Security Holders.................. 33
Item 5. Other Information.................................................... 33
Item 6. Exhibits and Reports on Form 8-K..................................... 33
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE DATA)
OCTOBER 31, JANUARY 31,
2003 2004
----------------- ----------------
ASSETS
Current assets:
Cash and cash equivalents ............................................... $ 14,707 $ 20,735
Short-term investments .................................................. 16,670 10,715
---------- ---------
Total cash, cash equivalents and short-term investments ............ 31,377 31,450
Accounts receivable, net of allowance for doubtful
accounts of $164 and $194, respectively ............................ 2,994 3,084
Inventories, net ........................................................ 1,633 1,511
Prepaids and other current assets ....................................... 1,274 1,041
---------- ---------
Total current assets ............................................... 37,278 37,086
Property and equipment, net ................................................... 3,299 2,805
Other assets .................................................................. 288 287
---------- ---------
Total assets ....................................................... $ 40,865 $ 40,178
========== =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ........................................................ $ 1,953 $ 2,317
Accrued expenses ........................................................ 2,470 2,119
Accrued warranty costs .................................................. 802 779
Deferred revenue ........................................................ 382 324
---------- ---------
Total current liabilities .......................................... 5,607 5,539
Commitments and contingencies
Stockholders' equity:
Common stock, $.001 par value, 175,000,000 shares authorized,
24,368,144 and 25,147,288 shares issued and outstanding, respectively 24 25
Additional paid-in capital ............................................... 182,831 183,180
Deferred stock-based compensation ........................................ (126) (65)
Accumulated deficit ...................................................... (147,471) (148,501)
---------- ---------
Total stockholders' equity .......................................... 35,258 34,639
---------- ---------
Total liabilities and stockholders' equity .......................... $ 40,865 $ 40,178
========== =========
See accompanying notes to unaudited condensed consolidated financial statements.
2
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
THREE MONTHS ENDED
JANUARY 31,
-------------------------------------
2003 2004
---------------- ----------------
Revenue:
Product................................................ $ 9,561 $ 4,941
Royalty and other ..................................... 111 2,184
----------- -----------
Total revenue ............................ 9,672 7,125
Cost of revenue:
Product ............................................... 6,331 2,479
Royalty and other ..................................... 98 36
----------- -----------
Total cost of revenue .................... 6,429 2,515
----------- -----------
Gross profit ................................................ 3,243 4,610
----------- -----------
Operating expenses:
Sales and marketing ................................... 1,025 1,140
Research and development .............................. 3,139 3,021
General and administrative ............................ 1,644 1,382
NexQL research and development ........................ - 270
Business restructuring ................................ - (52)
Amortization of intangibles ........................... 173 -
----------- -----------
Total operating expenses ................. 5,981 5,761
----------- -----------
Loss from operations ........................................ (2,738) (1,151)
Other income, net ..................................... 161 121
----------- -----------
Net loss .................................................... $ (2,577) $ (1,030)
=========== ===========
Basic and diluted net loss per share ........................ $ (0.10) $ (0.04)
=========== ===========
Shares used in computing basic and
diluted net loss per share ............................ 25,087,407 24,699,222
=========== ===========
See accompanying notes to unaudited condensed consolidated financial statements.
3
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
THREE MONTHS ENDED
JANUARY 31,
--------------------------------------
2003 2004
---------------- -----------------
Cash flows from operating activities:
Net loss ......................................................... $ (2,577) $ (1,030)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation ................................................. 1,031 711
Business restructuring expenses .............................. - (52)
Amortization of intangibles .................................. 173 -
Impairment charge on investment in privately-held company .... - 270
Stock-based compensation ..................................... 492 60
Provision for doubtful accounts receivable ................... (48) 30
Provision for excess and obsolete inventory .................. 100 59
Changes in assets and liabilities:
Accounts receivable .......................................... 406 (120)
Inventories .................................................. 62 63
Prepaids and other assets .................................... (572) 233
Accounts payable ............................................. (201) 762
Accrued expenses and other ................................... 251 (379)
-------- --------
Net cash provided by (used in) operating activities ..... (883) 607
-------- --------
Cash flows from investing activities:
Purchase of property and equipment ............................... (291) (217)
Purchase of held-to-maturity investments ......................... (3,025) (3,002)
Maturity of held-to-maturity investments ......................... 7,010 8,957
Investment in privately-held company ............................. - (270)
Payment of note receivable from stockholders ..................... 126 -
-------- --------
Net cash provided by investing activities ............... 3,820 5,468
-------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock ........................... 44 350
Change in book overdraft ......................................... - (397)
Repurchase and retirement of common stock ........................ (1,107) -
-------- --------
Net cash used in financing activities ................... (1,063) (47)
-------- --------
Net increase in cash and cash equivalents .............................. 1,874 6,028
Cash and cash equivalents, beginning of period ......................... 14,723 14,707
-------- --------
Cash and cash equivalents, end of period ............................... $ 16,597 $ 20,735
======== ========
See accompanying notes to unaudited condensed consolidated financial statements.
4
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
In the opinion of management, the accompanying Condensed Consolidated
Financial Statements of Crossroads Systems, Inc. (collectively with its
wholly-owned subsidiaries, Crossroads or the Company) include all adjustments,
consisting only of normal recurring items, necessary to present fairly its
financial position as of October 31, 2003 and January 31, 2004, and its results
of operations and cash flows for the three month periods ended January 31, 2003
and 2004. Certain reclassifications have been made to prior year amounts in
order to conform to the current year presentation. The results of operations for
the three months ended January 31, 2004 are not necessarily indicative of
results that may be expected for any other interim period or for the full year.
The accompanying financial data as of January 31, 2004 and for the three
month periods ended January 31, 2003 and 2004, have been prepared by the
Company, without audit, pursuant to the rules and regulations of the Securities
and Exchange Commission (the SEC). Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to the
SEC's rules and regulations. These unaudited financial statements should be read
in conjunction with the audited financial statements and related notes for the
year ended October 31, 2003, included in our Annual Report on Form 10-K.
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
As defined by Statement of Financial Accounting Standards (SFAS) No. 131,
"Disclosures about Segments of an Enterprise and Related Information," the
Company operates in one disclosable segment, using one measurement of
profitability for its business.
Revenue Recognition
Product revenue is recognized when persuasive evidence of an arrangement
exists, delivery has occurred, the price is fixed or determinable,
collectibility is probable and the risk of loss has passed to the customer.
Revenue from product sales to customers that do not have rights of return,
including product sales to Original Equipment Manufacturers (OEMs) and certain
distributors, Value Added Resellers (VARs) and system integrators, are
recognized upon shipment. Sales and cost of sales related to customers that have
rights of return are deferred and subsequently recognized upon sell-through to
end-users.
Royalty and other revenue includes, revenue from the licensing of
intellectual property (IP), royalty payments from Hewlett-Packard (HP) and sales
of service contracts. IP licensing arrangements consist of upfront nonrefundable
fees including payments relating to past sales of licensee products or payments
related to a paid-up license in which the licensee makes a single payment for a
lifetime patent license. Once a license agreement is signed, delivery of the
license has occurred and there are no remaining obligations outstanding, the
Company records revenue from upfront nonrefundable IP license arrangements.
Royalty revenue is recognized monthly based on shipment reports received from
HP's contract manufacturer and service revenue is recognized over the service
period.
NexQL Research and Development
During the three months ended January 31, 2004, the Company entered into a
strategic relationship with NexQL Corporation, a privately-held development
stage company. Pursuant to certain strategic agreements with NexQL, the Company
may provide NexQL with up to $1.5 million under a loan facility, over a
discretionary time period, and will make an equity investment of $1.0 million.
As of January 31, 2004, the Company had invested $150,000, provided
approximately $60,000 of funding under the loan facility and incurred
approximately $60,000 in legal fees related to the transactions. The Company
monitors its investment in NexQL for impairment and makes an appropriate
reduction in its carrying value and records an impairment charge based on the
financial condition and near-term prospects of NexQL. This impairment charge is
included in the caption NexQL research and development in the consolidated
statement of operations. The investment in NexQL has inherent risk as the
markets for the technologies or products of NexQL are in the early stages of
development and may never materialize. The Company's impairment
5
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
charge on its investment in NexQL was its entire investment of approximately
$270,000 for the three months ended January 31, 2004.
Stock-based Compensation
As of January 31, 2004, the Company has one stock-based employee
compensation plan, which is described more fully in Note 9 of our Annual Report
on Form 10-K. Stock-based compensation is recognized using the intrinsic value
method prescribed in Accounting Principles Board (APB) Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations.
Accordingly, compensation cost for stock options is measured as the excess, if
any, of the fair value of the Company's stock at the date of grant over the
amount an employee must pay to acquire the stock amortized over the vesting
period.
The Company allocates stock-based compensation to specific line items within
the condensed consolidated statements of operations based on the classification
of the employees who receive the benefit. Stock-based compensation was recorded
as follows (in thousands):
THREE MONTHS ENDED
JANUARY 31,
------------------------------
2003 2004
------------- ------------
Cost of revenue .................................... $ 12 $ 1
Sales and marketing ................................ 77 0
Research and development ........................... 94 21
General and administrative ......................... 309 38
------- -------
Total stock-based compensation ............... $ 492 $ 60
======= =======
The following table illustrates the effect on net loss and loss per share if
the Company had applied the fair value recognition provisions of Financial
Accounting Standards Board (FASB) Statement No. 123, "Accounting for Stock-Based
Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," to stock-based employee compensation
(in thousands, except share data):
THREE MONTHS ENDED
JANUARY 31,
----------------------------------
2003 2004
--------------- ---------------
Net loss, as reported ............................................ $ (2,577) $ (1,030)
Stock-based employee compensation expense
included in reported net loss .............................. 492 60
Stock-based employee compensation expense
determined under fair value based method for all awards..... (4,048) (3,614)
-------- --------
Pro forma net loss ............................................... $ (6,133) $ (4,584)
======== ========
Net loss per share:
Basic and diluted - as reported ............................ $ (0.10) $ (0.04)
Basic and diluted - pro forma .............................. $ (0.24) $ (0.19)
Warranty Costs
The Company provides for the estimated cost to repair or replace products
under warranty and technical support costs when the related product revenue is
recognized. The Company warrants products for a period from 12 to 39 months
following the sale of its products. A reserve for warranty costs is recorded
based upon the historical level of warranty claims and management's estimate of
future costs.
6
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Recent Accounting Pronouncements
In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,
which addresses consolidation by business enterprises of variable interest
entities (VIEs) either: (1) that do not have sufficient equity investment at
risk to permit the entity to finance its activities without additional
subordinated financial support, or (2) in which the equity investors lack an
essential characteristic of a controlling financial interest. In December 2003,
the FASB completed deliberations of proposed modifications to FIN 46 (Revised
Interpretations) resulting in multiple effective dates based on the nature as
well as the creation date of the VIE. VIEs created after January 31, 2003, but
prior to January 1, 2004, may be accounted for either based on the original
interpretation or the Revised Interpretations. However, the Revised
Interpretations must be applied no later than the second quarter of fiscal year
2004. VIEs created after January 1, 2004 must be accounted for under the Revised
Interpretations. There has been no material impact to the Company's financial
statements from potential VIEs entered into after January 31, 2003 and the
Company does not expect there to be a material impact to our financial
statements from the adoption of the deferred provisions in the second quarter of
fiscal year 2004.
In December 2003, the SEC issued Staff Accounting Bulletin No. 104 (SAB
104), Revenue Recognition, which codifies, revises and rescinds certain sections
of SAB 101, Revenue Recognition, in order to make this interpretive guidance
consistent with current authoritative accounting and auditing guidance and SEC
rules and regulations. The changes noted in SAB 104 did not have a material
effect on the Company's condensed consolidated results of operations, financial
position or cash flows.
7
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
2. INVENTORIES
Inventories, net consist of the following (in thousands):
OCTOBER 31, JANUARY 31,
2003 2004
----------------- -----------------
Raw materials ............................................... $ 1,219 $ 1,117
Work-in-process ............................................. - 103
Finished goods .............................................. 862 795
------- -------
2,081 2,015
Less: Allowance for excess and obsolete inventory .... (448) (504)
------- -------
$ 1,633 $ 1,511
======= =======
3. CONCENTRATIONS
Financial instruments that potentially expose the Company to concentrations
of credit risk consist primarily of cash and cash equivalents, short-term
investments and accounts receivable. The Company invests only in high credit
quality short-term debt instruments.
The Company's sales are primarily concentrated in the United States and are
primarily derived from sales to OEMs in the computer storage and server
industry. Revenue is concentrated with several major customers. The loss of a
major customer, a change of suppliers or a significant technological change in
the industry could affect operating results adversely. The Company performs
credit evaluations of its customers and generally does not require collateral on
accounts receivable balances and provides allowances for potential credit losses
and product sales returns. The Company has established reserves for credit
losses and sales returns and other allowances. The Company has not experienced
material credit losses in any of the periods presented.
The Company's business is concentrated in the storage area networking
industry, which has been impacted by unfavorable economic conditions.
Accordingly, the Company's future success depends upon the buying patterns of
customers in the storage area networking industry, their response to current and
future IT investment trends and the continued demand by such customers for the
Company's products. The Company's continued success will depend upon its ability
to enhance its existing products and to develop and introduce, on a timely
basis, new cost-effective products and features that keep pace with
technological developments and emerging industry standards. The Company's
supplier arrangement for the production of certain vital components of its
storage routers is concentrated with a small number of key suppliers.
Additionally, the Company relies on a limited number of contract
manufacturers to provide manufacturing services for its products. The inability
of any contract manufacturer or supplier to fulfill supply requirements could
materially impact future operating results.
The percentage of sales to significant customers was as follows:
THREE MONTHS
JANUARY 31,
---------------------------
2003 2004
------------- ------------
HP ................ 63.2% 46.3%
StorageTek ........ 20.8% 31.1%
EMC ............... - 14.7%
8
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The level of sales to any customer may vary from quarter to quarter.
However, the Company expects that significant customer concentration,
particularly to our three major customers, will continue for the foreseeable
future. The loss of any one of these customers, or a decrease in the level of
sales to any one of these customers, could have a material adverse impact on the
Company's financial condition or results of operations.
4. BUSINESS RESTRUCTURING EXPENSES AND ASSET IMPAIRMENT
In May 2002, the Company completed a restructuring plan that reduced its
workforce by approximately 25%, or 40 people (primarily in the sales, marketing
and general and administrative areas), to scale down its infrastructure and to
consolidate operations.
Components of business restructuring expenses and the remaining
restructuring accruals as of January 31, 2004 are as follows (in thousands):
FACILITY LEASE
ABANDONMENT
-----------------
Balance as of October 31, 2003 .......... $ 964
Cash activity ..................... (81)
Non-cash activity ................. (52)
-----
Balance as of January 31, 2004 .......... $ 831
=====
The entire accrual amount relates to remaining payments to be made for lease
abandonment losses. In March 2003, the Company signed an agreement to sublease a
portion of its abandoned facilities. The anticipated rent payments from this
sublease are approximately $0.5 million through January 2006. A second agreement
to sublease a portion of its abandoned properties was signed in May 2003. The
anticipated rent payments from the second sublease are approximately $0.1
million through January 2006.
In total, the Company has reduced its restructuring accrual by approximately
$52,000 during the three months ended January 31, 2004, principally for rent
payments to be received over the next twelve months of both sublease terms. The
Company will assess recoverability of these sublease payments on a quarterly
basis.
As of January 31, 2004, remaining cash expenditures resulting from the
restructuring are estimated to be approximately $0.8 million and relate to
facility lease abandonment losses only. The Company has substantially completed
their restructuring efforts initiated in conjunction with the restructuring
announcement made during fiscal 2002; however, there can be no assurance that
future restructuring efforts will not be necessary.
5. LINE OF CREDIT
The Company carries a line of credit with its bank. The committed revolving
line provides for an advance of up to $3.0 million with a borrowing base of 80%
of eligible accounts receivable. The line of credit will mature on June 14,
2004. As of January 31, 2004, there were no borrowings outstanding under this
revolving line of credit.
6. COMMITMENTS AND CONTINGENCIES
OPERATING LEASES
The Company leases office space and equipment under long-term operating
lease agreements that expire on various dates through April 15, 2006. In
conjunction with entering into a lease agreement for its headquarters, the
Company signed an unconditional, irrevocable letter of credit with a bank for
$100,000, which is secured by the $3.0
9
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
million line of credit. Future minimum lease payments under all non-cancelable
operating leases as of January 31, 2004 were approximately $4.0 million. In
addition to base rent on its facilities lease, many of the operating lease
agreements require that the Company pay a proportional share of the respective
facilities' operating expenses.
GUARANTEES AND PRODUCT WARRANTIES
FIN 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others," requires that upon
issuance of a guarantee, the guarantor must disclose and recognize a liability
for the fair value of the obligation it assumes under that guarantee. The
initial recognition and measurement requirement of FIN 45 is effective for
guarantees issued or modified after December 31, 2002. As of January 31, 2004,
the Company's guarantees that were issued or modified after December 31, 2002,
were not material.
The disclosure requirements of FIN 45 are applicable to the Company's
product warranty liability and certain guarantees issued before December 31,
2002. The Company's guarantees issued before December 31, 2002, which would have
been disclosed in accordance with the disclosure requirements of FIN 45, were
not material.
It is the Company's policy to repair or replace products that have been
authorized for repair or replacement by the Company's customers. The Company
maintains a reserve for the estimated costs of such repairs or replacements and
adjusts the reserve based on historical sales volumes as well as actual costs
incurred.
Activity in the reserve for product returns during the three months ended
January 31, 2004 was as follows (in thousands):
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END OF
OF PERIOD EXPENSES DEDUCTIONS PERIOD
-------------- ------------- ------------- -------------
Three months ended January 31, 2003
Warranty reserve .......................... $ 615 $ 179 $ (7) $ 787
===== ===== ===== =====
Three months ended January 31, 2004
Warranty reserve .......................... $ 802 $ - $ (23) $ 779
===== ===== ===== =====
LEGAL PROCEEDINGS
Intellectual Property Litigation
On November 4, 2003, the Company filed a lawsuit against Dot Hill Systems,
Inc. (Dot Hill) alleging that Dot Hill has infringed two of the Company's
patents, U.S. Patent No. 5,941,972 (the '972 patent) and U.S. Patent No.
6,425,035 (the '035 Patent), with some of Dot Hill's products. Subsequently, Dot
Hill filed an answer denying infringement and alleging the '972 and '035 Patents
are invalid and unenforceable. Crossroads plans to vigorously defend its patents
against these counterclaims.
Securities Class Action Litigation
The Company and several of its officers and directors were named as
defendants in several class action lawsuits filed in the United States District
Court for the Western District of Texas. The plaintiffs in the actions purport
to represent purchasers of the Company's common stock during various periods
ranging from January 25, 2000 through August 24, 2000. On November 22, 2002, the
court granted the Company's motion for summary judgment. On February 26, 2003,
the plaintiffs filed a notice of appeal. On December 3, 2003, the parties
conducted oral argument on plaintiffs' appeal before the United States Circuit
Court for the Fifth Circuit. The Fifth Circuit has not yet issued its ruling on
plaintiffs' appeal. The plaintiffs are seeking unspecified amounts of
compensatory damages, interest and costs, including legal fees. The Company
denies the allegations in the complaint and intends to defend itself vigorously.
It is not possible at this time to predict whether the Company will incur any
liability or to estimate the damages, or the range of damages, if any, that the
Company might incur in connection with this lawsuit.
10
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Other
From time to time, the Company may be involved in litigation relating to
claims arising out of its ordinary course of business. Management believes that,
other than the matters described above, there are no claims or actions pending
or threatened against the Company, the ultimate disposition of which would have
a material impact on the Company's financial position, results of operations or
cash flows.
EMPLOYMENT CONTRACTS
The Company has entered into Employment Agreements with its President and
Chief Executive Officer and its Vice President and Chief Financial Officer. Both
executives are employed on an "at will" basis and may be terminated at any time,
with or without cause.
The Company has also entered into Severance Benefit Plans with some
executive officers. Pursuant to the terms of these plans, to the extent these
executive officers are terminated prior to a change of control involving the
Company (i) they will receive a cash payment equal to one month of salary for
each quarter of service they have provided to the Company, up to a maximum of
twelve months salary and (ii) the vesting of all options held by such executive
officer will accelerate by a period of one year.
NEXQL COMMITMENT
The Company entered into certain strategic agreements to provide a total of
up to $2.5 million in debt and equity financing to NexQL, a development stage
company. Under the terms of these agreements, the Company has an exclusive
right, but not an obligation, to purchase NexQL. If the Company chooses to
exercise this right, the purchase would be subject to various conditions.
Depending upon the structure of the purchase, one condition might be the need to
obtain stockholder approval. The exclusive right to purchase NexQL will lapse at
various times after NexQL completes certain milestones.
7. STOCKHOLDERS' EQUITY
DEFERRED STOCK-BASED COMPENSATION
Deferred compensation represents, for accounting purposes, the difference
between the deemed fair value of the common stock underlying these options and
their exercise price on the date of grant. The difference has been recorded as
deferred stock-based compensation and is being amortized over the vesting period
of the applicable options, typically four years.
8. NET LOSS PER SHARE
In accordance with SFAS No. 128, "Earnings Per Share," basic and diluted net
loss per share is computed by dividing the loss to common stockholders by the
weighted average number of common shares outstanding for the period, less shares
subject to repurchase. Diluted loss per share is equivalent to basic loss per
share because all common stock equivalents are antidilutive for all periods
presented.
Common stock equivalents consist of outstanding stock options. The total
number of outstanding stock options excluded from the calculations of diluted
net loss per common share were 6,146,772 and 4,905,571 as of January 31, 2003
and 2004, respectively.
9. RELATED PARTY TRANSACTIONS
In July 2000, the Company loaned an employee of the Company $50,000 for
personal reasons, not equity related, in exchange for a full recourse promissory
note due in full, with accrued interest, in 2 years or upon the date in which
11
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
the employee ceases to remain in service. The note accrues interest at 10.5% per
year, compounded semi-annually. The principal and accrued interest was due in
one lump sum on July 1, 2002. The terms on this note have been extended to July
1, 2004 and the balance is approximately $72,000 as of January 31, 2004.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This report contains forward-looking statements, within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934, that involve risks and uncertainties, such as statements
concerning: growth and future operating results; developments in our markets and
strategic focus; new products and product enhancements; potential acquisitions
and the integration of acquired businesses, products and technologies; strategic
relationships; and future economic, business and regulatory conditions. Such
forward-looking statements are generally accompanied by words such as "plan,"
"estimate," "expect," "believe," "should," "would," "could," "anticipate," "may"
or other words that convey uncertainty of future events or outcomes. These
forward-looking statements and other statements made elsewhere in this report
are made in reliance on the Private Securities Litigation Reform Act of 1995.
OVERVIEW
We are a leading provider of enterprise data routing solutions for open
system storage area networks (SANs), based on our market share of storage
routers shipped. Our storage routers serve as the interconnect between SANs and
the other devices in a computer network and allow organizations to more
effectively and efficiently store, manage and ensure the integrity and
availability of their data. Specifically, when used in SANs, our storage
routers:
- improve data transfer speeds within a network;
- reduce the time required to back up and restore data;
- improve utilization of storage resources; and
- preserve and enhance existing server and storage system investments.
Last year, we transitioned our embedded router business with our largest
customer to a royalty model. This transition has resulted in higher gross margin
on lower revenue. During our first fiscal quarter of 2004, we realized a 42%
year over year increase in gross margin to $4.6 million on revenue of $7.1
million dollars compared to lower gross margin of $3.2 million on higher revenue
of $9.7 million during the comparable period last year.
Our primary objective throughout 2004 is to transition from being primarily
a storage connectivity company to a business that provides more complete,
intelligent solutions for the end user. We will accomplish this by investing in
technology, products and solutions that will leverage our storage routing
expertise to solve a wide range of customer problems. We will continue to
provide first-in-class connectivity, while offering value-added software that
will help customers better utilize resources, lower overall costs and achieve
higher performance levels.
The key, measurable elements of our business strategy in 2004 are as
follows:
- grow our current market position by solving today's customer storage
issues;
- build on our core storage networking technologies to offer intelligent
networking solutions;
- expand our reach into other storage markets;
- increase our market leadership by investment in technology; and
- protect our intellectual property.
During the three months ended January 31, 2004, we made progress on
achieving these objectives as follows:
- New Partnerships. In December 2003, we announced a strategic
relationship with NexQL Corporation, a development stage company, for
the joint development of advanced data management solutions that are
13
expected to outperform other solutions by orders of magnitude at a
fraction of the cost. We believe our strategic relationship with NexQL
will allow us to capitalize on adjacent markets and offer multiple
opportunities for the combination of Crossroads and NexQL technologies.
- Building on Core Technologies. Our customers are asking for features
such as better performance, guaranteed completion, enhanced recovery
execution, maximized resource utilization and ease of use. To meet
these needs, we are developing a suite of software that focuses on the
expansion of our existing technology to bring multiple networking
functionality and capabilities to backup storage solutions.
- Customer Base Expansion. We delivered our latest generation products to
our existing customers as well as expanded our storage routing customer
base. Our customer base further expanded during the three months ended
January 31, 2004, as EMC became our third largest customer, comprising
14.7% of our total revenue. We have also started new channel programs
in the fiscal second quarter and are expanding our reach into Europe,
North America and South America through new sales partnerships.
- Intellectual Property Value. To date, we have entered into various
agreements with Adaptec, ADIC, XIOtech and Hitachi to license our
technology. We have also strengthened our patent portfolio as we now
have 19 issued patents and 49 pending patents worldwide. In November
2003, we filed a lawsuit against Dot Hill Systems, Inc. alleging that
Dot Hill has infringed two of our patents, U.S. Patent No. 5,941,972
(the '972 patent) and U.S. Patent No. 6,425,035 (the '035 Patent), with
some of Dot Hill's products. Subsequently, Dot Hill filed an answer
denying infringement and alleging the '972 and '035 Patents are invalid
and unenforceable. We plan to vigorously defend our patents against
these counterclaims.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's Discussion and Analysis of Financial Condition and Results of
Operations is based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires management
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenue and expenses, and related disclosure of contingent assets
and liabilities. On an ongoing basis, we evaluate our estimates, including those
related to revenue recognition, deferred taxes, investment in privately-held
company, warranty obligations, excess and obsolete inventories, allowance for
doubtful accounts, facility lease abandonment losses associated with our
restructuring and litigation. We base our estimates on historical experience and
on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.
We believe the following critical accounting policies, among others, affect
our more significant judgments and estimates used in the preparation of our
consolidated financial statements:
- Revenue recognition;
- Deferred taxes;
- Investment in privately-held company;
- Warranty obligations;
- Excess and obsolete inventories;
- Allowance for doubtful accounts;
- Facility lease abandonment losses; and
- Litigation.
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Revenue recognition. With respect to sales of our products to OEMs, we
recognize product revenue when persuasive evidence of an arrangement exists,
delivery has occurred, the price is fixed or determinable, collectibility is
probable and risk of loss has passed to the OEM. Product sales to distributors,
VARs and system integrators who do not have return rights are recognized upon
shipment. To the extent that we sell products to distributors, VARs and system
integrators that have rights of return, we defer revenue and the related cost of
revenue associated with such sales and recognize these amounts when that
customer sells our products to its customers. Management's judgments and
estimates must be made and used in connection with the revenue recognized in any
given accounting period. Material differences may result in the amount and
timing of our revenue, in any given accounting period, if our management alters
the method by which they derive such judgments or estimates.
Royalty and other revenue includes licensing of intellectual property (IP),
royalty payments and sales of service contracts. IP licensing arrangements
typically consist of upfront nonrefundable fees, including payments related to
past sales of licensed products or payments related to a paid-up license in
which the licensee makes a single payment for a lifetime patent license. Once a
license agreement is signed, delivery of the license has occurred and there are
no remaining obligations outstanding, the Company records revenue from upfront
nonrefundable IP license fees. Service revenue is recognized over the applicable
service period.
Deferred taxes. In preparing our financial statements, we are required to
estimate our income tax obligations. This process involves estimating our actual
tax exposure together with assessing temporary differences resulting from
differing treatment of items for tax and accounting purposes. These differences
result in deferred tax assets and liabilities, which are included within our
balance sheet. We must then assess the likelihood that our deferred tax assets
will be recovered from future taxable income and, to the extent we believe that
recovery is not likely, we must establish a valuation allowance. If we change
this valuation allowance in a period, we must include an expense or benefit
within the tax provision in our statement of operations.
Judgment is required in determining our deferred tax assets and liabilities
and our valuation allowance recorded against our net deferred tax assets. In
assessing the potential realization of deferred tax assets, we consider whether
it is more likely than not that some portion or all of the deferred tax assets
will be realized. The ultimate realization of deferred tax assets is dependent
upon us attaining future taxable income during the period in which our deferred
tax assets are recoverable. Due to uncertainty surrounding our ability to
generate taxable income in the future, we have determined that it is more likely
than not that we will not be able to utilize any of the benefits of our deferred
tax assets, including net operating loss carry forwards, before they expire.
Therefore, we have provided a 100% valuation allowance on our deferred tax
assets, and our net deferred tax assets as of January 31, 2004 is zero.
Investment in privately-held company. The Company assesses the impairment of
investments whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Factors considered important which could
trigger an impairment review include: (i) inherent risk of investment due to
stage of development, (ii) underperformance relative to projected future
operating results, and (iii) changes in the strategy of business. When the
Company determines that the carrying value of an investment may not be
recoverable, an impairment charge is recorded.
Warranty obligations. We provide for the estimated cost of product
warranties at the time revenue is recognized. These estimates are developed
based on historical information. While we engage in extensive product quality
programs and processes, including actively monitoring and evaluating the quality
of our component suppliers, our warranty obligation is affected by product
failure rates, material usage and service delivery costs incurred in correcting
a product failure. Should actual product failure rates, material usage or
service delivery costs differ from our estimates, revisions to the estimated
warranty liability would be required.
Excess and obsolete inventory. We write-down our inventory for estimated
obsolescence or unmarketable inventory based on the difference between the cost
of inventory and the estimated market value derived by assumptions about future
demand and market conditions. If actual demand and/or market conditions are less
favorable than those projected by management, additional inventory write-downs
may be required.
Allowance for doubtful accounts. We continuously assess the collectibility
of outstanding customer invoices and in doing such, we maintain an allowance for
estimated losses resulting from the non-collection of customer receivables. In
estimating this allowance, we consider factors such as:
15
- historical collection experience;
- a customer's current credit-worthiness;
- customer concentrations;
- age of the receivable balance, both individually and in the
aggregate; and
- general economic conditions that may affect a customer's ability to
pay.
Actual customer collections could differ from our estimates. For example, if
the financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required.
Facility lease abandonment losses. We vacated excess leased facilities as a
result of the restructuring plan we completed during fiscal 2002. We estimated
costs of vacating these leased facilities, including estimated costs to
sublease, based on market information and trend analysis. Any sublease payments
received by us are recorded as a reduction to this accrual based on the
specified sublease terms. Actual results may differ from these estimates in the
near term, and such differences could be material to our financial statements.
Litigation. We evaluate contingent liabilities, including threatened or
pending litigation in accordance with SFAS No. 5, "Accounting for Contingencies"
and record accruals when the outcome of these matters is deemed probable and the
liability is reasonably estimable. We make these assessments based upon the
facts and circumstances, and in some instances based in part upon the advice of
outside legal counsel. As of January 31, 2004, we have not accrued any material
costs associated with any pending or threatened litigation as no amounts have
been deemed probable or reasonably estimable. However, any changes in the
threatened or pending litigation could result in revisions to our estimates of
the potential liability and could materially impact our results of operations
and financial position.
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RESULTS OF OPERATIONS
The following table sets forth our condensed, consolidated financial data
for the periods indicated in thousands and expressed as a percentage of our
total revenue.
THREE MONTHS ENDED
JANUARY 31,
-------------------------------------------------------
2003 2004
------------------------- -------------------------
(DOLLARS IN THOUSANDS)
Revenue:
Product revenue ............................... $ 9,561 98.9 % $ 4,941 69.3 %
Royalty and other revenue ..................... 111 1.1 2,184 30.7
----------- ----- --------- -----
Total revenue ............................ 9,672 100.0 7,125 100.0
Cost of revenue:
Product ....................................... 6,331 65.5 2,479 34.8
Royalty and other ............................. 98 1.0 36 0.5
----------- ----- --------- -----
Total cost of revenue .................... 6,429 66.5 2,515 35.3
----------- ----- --------- -----
Gross profit ........................................ 3,243 33.5 4,610 64.7
Operating expenses:
Sales and marketing ........................... 1,025 10.6 1,140 16.0
Research and development ...................... 3,139 32.4 3,021 42.4
General and administrative .................... 1,644 17.0 1,382 19.4
NexQL research and development ................ - - 270 3.8
Business restructuring ........................ - - (52) (0.7)
Amortization of intangibles ................... 173 1.8 - -
----------- ----- --------- -----
Total operating expenses ................. 5,981 61.8 5,761 80.9
----------- ----- --------- -----
Loss from operations ................................ (2,738) (28.3) (1,151) (16.2)
----------- ----- --------- -----
Other income, net ............................. 161 1.7 121 1.7
----------- ----- --------- -----
Net loss ............................................ $ (2,577) (26.6%) $ (1,030) (14.5)%
=========== ===== ========= =====
PRODUCT REVENUE
Product revenue consists of sales of our storage router and ServerAttach
line of products. Product revenue decreased 48.3% from $9.6 million for the
three months ended January 31, 2003 to $4.9 million for the three months ended
January 31, 2004.
The decrease in product revenue was primarily the result of our successful
transition to a royalty model for embedded products with HP. Under this model,
our product revenue declined, as expected, because we have outsourced the
manufacturing of our embedded routers to HP and the royalty revenue we receive
is now classified under royalty and other revenue.
Our storage router sales are primarily through our OEM partners. However, we
believe that an opportunity exists with our ServerAttach technology in both the
channel and with our new OEM relationship with EMC. ServerAttach technology
allows customers to connect their SCSI server resources into the SAN. The
result, in many cases, is improved application performance and better
utilization of available central processing unit capabilities. Our ServerAttach
technology helps customers get more out of their existing resources rather than
spending resources on costly server replacement strategies or disruptive fiber
channel upgrades. Our sales organization has been deployed to educate the direct
end user of the features and cost savings that our ServerAttach technology has
to offer.
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On a product basis, sales have shifted to our next generation products and
to our ServerAttach family of products. A significant portion of our revenue is
still concentrated among a relatively small number of OEM customers.
Fluctuations in revenue have resulted from, among other things, product and
customer transitions, OEM qualification and testing, reduced IT spending rates
by our customers and potential customers and our transition to the royalty model
with HP which is described further in "Royalty and Other Revenue" below. We
expect that a significant portion of our future revenue will continue to come
from sales of products to a relatively small number of customers.
ROYALTY AND OTHER REVENUE
Royalty and other revenue includes revenue from the licensing of IP, royalty
payments from HP and sales of service contracts. IP licensing arrangements
typically consist of upfront nonrefundable fees. These fees are collected as
consideration for either past sales of licensed products or a perpetual patent
license. When a license agreement is signed, delivery of the license has
occurred and there are no remaining obligations outstanding, we record revenue
from upfront nonrefundable IP licensing arrangements. Royalty revenue is
recognized monthly based on shipment reports received from HP's contract
manufacturer and service revenue is recognized over the service period.
Royalty and other revenue increased from $0.1 million for the three months
ended January 31, 2003 to $2.2 million for the three months ended January 31,
2004. The increase in royalty and other revenue was due to the transition to a
royalty model with HP.
Given the nature of patent license agreements, the timing of license revenue
is difficult to forecast and therefore is expected to cause fluctuations in
royalty and other revenue. Our potential to generate patent license revenue in
the future will be largely dependent upon our ability to identify and pursue
additional, potential licensees.
COST OF REVENUE
Product
Cost of product revenue consists primarily of contract manufacturing costs,
material costs, manufacturing overhead, third party software licenses, warranty
costs and stock-based compensation. Cost of product revenue decreased 60.8% from
$6.3 million for the three months ended January 31, 2003 to $2.5 million for the
three months ended January 31, 2004.
The decrease in cost of product revenue was expected as a result of the
manufacturing cost savings with the transition to the royalty model with HP.
Under this model, HP manufactures our embedded products, which has resulted in
lower manufacturing costs to us. We expect to continue to see the benefits from
the royalty model; however, the cost of product revenue may fluctuate based on
the introduction of new products and changes in product mix.
GROSS PROFIT
Gross profit increased 42.2% from $3.2 million for the three months ended
January 31, 2003 to $4.6 million for the three months ended January 31, 2004.
Gross profit margin increased from 34% for the three months ended January 31,
2003 to 65% for the three months ended January 31, 2004.
This increase reflects the positive effect of the royalty model with HP and
increased sales of higher margin products. In addition, both our manufacturing
and engineering teams continued to drive down manufacturing costs. A greater
proportion of product revenue for the three months ended January 31, 2004 was
comprised of sales of our next generation products.
SALES AND MARKETING EXPENSES
Sales and marketing expenses consist primarily of salaries, commissions,
travel, advertising programs, other promotional activities and stock-based
compensation expenses. Sales and marketing expenses increased 11.2% from $1.0
million for the three months ended January 31, 2003 to $1.1 million for the
three months ended January 31, 2004. Sales and marketing personnel totaled 14
and 21 at January 31, 2003 and 2004, respectively.
18
The increase in sales and marketing expenses was primarily due to additional
compensation expense of approximately $0.2 million as we increased our sales
force over the second half of fiscal 2003 and that expense continued during the
three months ended January 31, 2004. We anticipate that sales and marketing
expenses may continue to increase as we further broaden our sales and marketing
efforts.
RESEARCH AND DEVELOPMENT EXPENSES
Research and development expenses consist primarily of salaries and other
personnel-related costs, product development costs and stock-based compensation
expenses. Research and development expenses decreased 3.8% from $3.1 million for
the three months ended January 31, 2003 to $3.0 million for the three months
ended January 31, 2004. Research and development personnel totaled 67 and 68 at
January 31, 2003 and 2004, respectively.
The decrease in research and development expenses was primarily due to a
reduction of depreciation expense and continued control over costs in general.
We anticipate that research and development expenses may increase due to
increased costs relating to the continued development of our technologies and
the expansion of our product offerings.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses consist primarily of salaries and other
personnel-related costs, costs of our administrative, executive and information
technology departments, as well as legal and accounting, insurance and
stock-based compensation expenses. General and administrative expenses decreased
15.9% from $1.6 million for the three months ended January 31, 2003 to $1.4
million for the three months ended January 31, 2004. Stock-based compensation
expense for general and administrative expenses was $0.3 million and $38,000 for
the three months ended January 31, 2003 and 2004, respectively. General and
administrative personnel totaled 19 at January 31, 2003 and 2004.
The decrease in general and administrative expenses was primarily due to
decreased stock-based compensation expense of approximately $0.3 million, which
was partially offset by increased franchise tax expense.
We anticipate that general and administrative expenses may begin to increase
throughout fiscal 2004 due to additional costs associated with the
Sarbanes-Oxley Act of 2002 and other related legislative and regulatory changes.
NEXQL RESEARCH AND DEVELOPMENT EXPENSES
During the three months ended January 31, 2004, we entered into a strategic
relationship with NexQL Corporation, a privately-held development stage
company. Pursuant to certain strategic agreements with NexQL, we may provide
NexQL with up to $1.5 million under a loan facility, over a discretionary time
period, and will make an equity investment of $1.0 million. As of January 31,
2004, we had invested $150,000, provided approximately $60,000 of funding under
the loan facility and incurred approximately $60,000 in legal fees related to
the transactions. We have an exclusive right, but not an obligation, to purchase
NexQL. If we choose to exercise this right, the purchase would be subject to
various conditions. Depending upon the structure of the purchase, one condition
might be the need to obtain stockholder approval. The exclusive right to
purchase NexQL will lapse at various times after NexQL completes certain
milestones. We will monitor our investment in NexQL for impairment and make
appropriate reductions in the carrying value and record an impairment charge
based on the financial condition and near-term prospects of NexQL. This
impairment charge is included in the caption NexQL research and development in
the condensed consolidated statement of operations. The investment in NexQL has
inherent risk as the markets for the technologies or products of NexQL are in
the early stages of development and may never materialize. The impairment charge
on our investment in NexQL was the entire investment of approximately $270,000
for the three months ended January 31, 2004.
BUSINESS RESTRUCTURING EXPENSES AND ASSET IMPAIRMENT
In May 2002, we completed a restructuring plan that reduced our workforce by
approximately 25%, or 40 people (primarily in the sales, marketing and general
and administrative areas), to scale down our infrastructure and to consolidate
our operations.
19
Components of business restructuring expenses, asset impairments and the
remaining restructuring accruals as of January 31, 2004 are as follows (in
thousands):
FACILITY LEASE
ABANDONMENT
-----------------
Balance as of October 31, 2003 ............ $ 964
Cash activity ....................... (81)
Non-cash activity ................... (52)
---------
Balance as of January 31, 2004 ............ $ 831
=========
In March 2003, we signed an agreement to sublease a portion of our abandoned
facilities. The anticipated rent payments from this sublease are approximately
$0.5 million through January 2006. In addition, we signed another agreement to
sublease a portion of our abandoned facilities during the third fiscal quarter
of 2003. The anticipated rent payments from this sublease are approximately $0.1
million through January 31, 2006.
In total, we reduced our restructuring accrual by approximately $52,000
during the three months ended January 31, 2004, principally for rent payments to
be received over the next twelve months of both sublease terms. We will assess
recoverability of these sublease payments on a quarterly basis.
As of January 31, 2004, remaining cash expenditures resulting from the
restructuring are estimated to be $0.8 million and relate to facility lease
abandonment losses only. We have substantially completed our restructuring
efforts initiated in conjunction with the restructuring announcement made during
fiscal 2002; however, there can be no assurance that future restructuring
efforts will not be necessary.
LIQUIDITY AND CAPITAL RESOURCES
The following table presents selected financial statistics and information
related to our liquidity and capital resources (dollars in thousands):
OCTOBER 31, JANUARY 31,
2003 2004
----------------- ----------------
Cash and cash equivalents ......... $ 14,707 $ 20,735
Short-term investments ............ 16,670 10,715
Working capital ................... 31,671 31,547
Current ratio ..................... 6.6:1 6.7:1
Days sales outstanding ............ 30 40
Our principal sources of liquidity at January 31, 2004 consisted of $20.7
million in cash and cash equivalents and $10.7 million in short-term
investments.
In June 2003, we renegotiated our line of credit with Silicon Valley Bank.
The committed revolving line is an advance of up to $3.0 million with a
borrowing base of 80% of eligible accounts receivable. The line of credit
contains provisions that prohibit the payment of cash dividends and require the
maintenance of specified levels of tangible net worth and certain financial
performance covenants measured on a monthly basis. The line of credit matures in
June 2004. As of January 31, 2004, there were no borrowings outstanding under
the revolving line of credit and no term loans outstanding.
Cash provided by operating activities for the three months ended January 31,
2004 was approximately $607,000 primarily due to higher gross margin as a result
of our transition to a royalty model with HP and changes in our
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product mix. Our gross margin as well as our continued control over operating
expenditures resulted in lower net loss for the three months ended January 31,
2004.
Cash provided by investing activities was approximately $5.5 million during
the three months ended January 31, 2004 primarily due to the timing of
short-term investment transactions and reflects the maturity of held-to-maturity
investments, net of purchases. Our investment policy, related to debt
instruments, places greater emphasis on the safeguarding of cash and only allows
us to invest in high quality short-term investments. Capital expenditures were
approximately $0.2 million and reflect our investments in computer equipment and
software, test equipment, software development tools and leasehold improvements,
all of which were required to support our ongoing research and development in
our technologies and expanding our product offerings. We anticipate moderate
additional capital expenditures during fiscal 2004, primarily to support our
ongoing product development efforts.
Cash utilized by financing activities was approximately $47,000 for the
three months ended January 31, 2004. We did not repurchase any common stock
through our stock repurchase program during the three months ended January 31,
2004.
We have funded our operations to date primarily through product sales, sales
of preferred stock and our initial public offering. Our initial public offering
resulted in aggregate gross proceeds to us of $98.2 million.
At January 31, 2004, we had no long-term debt. We believe our existing cash
balances and our credit facilities will be sufficient to meet our capital
requirements beyond the next 12 months. However, we could be required or could
elect to seek additional funding prior to that time. Our future capital
requirements will depend on many factors, including the rate of revenue growth,
the timing and extent of spending to support product development efforts, the
timing of introductions of new products and enhancements to existing products,
the amount of cash used to fund our stock repurchase program, and market
acceptance of our products. This quarter, we entered into a strategic
relationship with NexQL Corporation for the joint development of advanced data
management solutions. During the term of this and other strategic agreements, we
will provide funding up to $2.5 million to NexQL. Additionally, we may enter
into additional strategic arrangements or acquisitions in the future that could
require us to seek additional equity or debt financing. We cannot assure you
that additional equity or debt financing, if required, will be available to us
on acceptable terms, or at all.
STOCK REPURCHASE PROGRAM
In September 2001, our board of directors authorized a stock repurchase
program pursuant to which we were authorized to repurchase up to $5.0 million of
our common stock in the open market. From September 2001 to April 2002, we
repurchased 661,300 shares of our common stock at an aggregate purchase price of
$2.1 million. In May 2002, our board of directors authorized the extension of
our stock repurchase program and authorized the repurchase up to an additional
$5.0 million worth of our common stock, for an aggregate amount of up to $7.1
million. From May 2002 through October 31, 2002, we repurchased 1,714,465 shares
of our common stock at an aggregate purchase price of $1.7 million. In October
2002, our board of directors authorized the further extension of our stock
repurchase program through the end of 2003. From November 2002 to October 31,
2003, we repurchased 1,772,300 shares of our common stock at an aggregate
purchase price of $2.0 million. As of October 31, 2003, we had repurchased an
aggregate of 4,148,065 shares of our common stock for an aggregate purchase
price of $5.7 million under our stock repurchase program representing a total of
approximately 15% of the Company. We did not repurchase any shares of our common
stock during the three months ended January 31, 2004.
Under the repurchase program, the stock will be purchased in the open
market or privately negotiated transactions from time to time in compliance with
the SEC's Rule 10b-18, subject to market conditions, applicable legal
requirements and other factors. The timing and amounts of any purchases will be
as determined by our management from time to time or may be suspended at any
time without prior notice, depending on market conditions and other factors they
deem relevant. The timing and size of any future stock repurchases are subject
to market conditions, stock prices, cash position and other cash requirements.
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CONTRACTUAL CASH OBLIGATIONS AND COMMITMENTS
We lease office space and equipment under long-term operating lease
agreements that expire on various dates through April 15, 2006. In April 2000,
we relocated our headquarters in accordance with an agreement to lease
approximately 63,500 square feet of administrative office space in Austin,
Texas. The term of the lease agreement is approximately six years, from April 1,
2000 through April 15, 2006, and represents a lease commitment of approximately
$1.8 million per year through the lease term. In conjunction with entering into
the lease agreement, we signed an unconditional, irrevocable letter of credit
with a bank for $100,000, which is secured by a $3.0 million line of credit.
The following summarizes our contractual cash obligations as of January 31,
2004 (in thousands):
PAYMENTS DUE BY PERIOD
--------------------------------------------------------------------
LESS THAN MORE THAN
TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS
------- --------- --------- --------- ---------
Operating leases ................ $ 4,594 $ 2,213 $ 1,924 $ 457 $ -
NexQL investment ................ $ 850 $ 850 $ - $ - $ -
NexQL loan facility* ............ $ 1,440 $ 1,440 $ - $ - $ -
Subleases ....................... (567) (220) (347) - -
------- ------- ------- ----- -----
Operating leases, net ........... $ 6,317 $ 4,283 $ 1,577 $ 457 $ -
======= ======= ======= ===== =====
* Pursuant to strategic agreements with NexQL, the Company may provide up to
$1.5 million of the loan facility, over a discretionary time period.
RECENT ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,
which addresses consolidation by business enterprises of variable interest
entities (VIEs) either: (1) that do not have sufficient equity investment at
risk to permit the entity to finance its activities without additional
subordinated financial support, or (2) in which the equity investors lack an
essential characteristic of a controlling financial interest. In December 2003,
the FASB completed deliberations of proposed modifications to FIN 46 (Revised
Interpretations) resulting in multiple effective dates based on the nature as
well as the creation date of the VIE. VIEs created after January 31, 2003, but
prior to January 1, 2004, may be accounted for either based on the original
interpretation or the Revised Interpretations. However, the Revised
Interpretations must be applied no later than the second quarter of fiscal year
2004. VIEs created after January 1, 2004 must be accounted for under the Revised
Interpretations. There has been no material impact to our financial statements
from potential VIEs entered into after January 31, 2003 and we do not expect
there to be a material impact to our financial statements from the adoption of
the deferred provisions in the second quarter of fiscal year 2004.
In December 2003, the SEC issued Staff Accounting Bulletin No. 104 (SAB
104), Revenue Recognition, which codifies, revises and rescinds certain sections
of SAB 101, Revenue Recognition, in order to make this interpretive guidance
consistent with current authoritative accounting and auditing guidance and SEC
rules and regulations. The changes noted in SAB 104 did not have a material
effect on our condensed consolidated results of operations, financial position
or cash flows.
22
ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS
In addition to the other information in this Form 10-Q, the following
factors should be considered in evaluating Crossroads and our business. These
factors include, but are not limited to the factors listed below. Additional
risks and uncertainties that we are unaware of or that we currently deem
immaterial also may become important factors that affect us.
WE HAVE INCURRED SIGNIFICANT LOSSES AND NEGATIVE CASH FLOW, WE EXPECT FUTURE
LOSSES AND WE MAY NEVER MAINTAIN CONSISTENT PROFITABILITY OR A CASH FLOW
POSITIVE POSITION.
We have incurred significant losses in every fiscal quarter since fiscal
1996 and expect to continue to incur losses in the future. As of January 31,
2004, we had an accumulated deficit of $148.5 million. We cannot be certain that
we will be able to generate sufficient revenue to achieve profitability or
become consistently cash flow positive. Although we restructured our
organization in 2002, which significantly reduced our expense structure, we
still expect to incur significant sales and marketing, research and development
and general and administrative expenses and, as a result, we expect to continue
to incur losses. We were cash flow positive for the three months ended January
31, 2004, but may not be cash flow positive in the second fiscal quarter of
2004. We expect fluctuations in our cash flow position to continue in future
quarters throughout fiscal 2004.
WE HAVE EXPERIENCED AND EXPECT TO CONTINUE TO EXPERIENCE SIGNIFICANT
PERIOD-TO-PERIOD FLUCTUATIONS IN OUR REVENUE AND OPERATING RESULTS, WHICH MAY
RESULT IN VOLATILITY IN OUR STOCK PRICE.
We have experienced and expect to continue to experience significant
period-to-period fluctuations in our revenue and operating results due to a
number of factors, and any such variations and factors may cause our stock price
to fluctuate. Accordingly, you should not rely on the results of any past
quarterly or annual periods as an indication of our future performance. It is
likely that in some future period our operating results will be below the
expectations of public market analysts or investors. If this occurs, our stock
price may drop, perhaps significantly.
A number of factors, some of which are beyond our control, may particularly
contribute to fluctuations in our revenue and operating results, including:
- changes in general economic conditions and specific economic
conditions in the computer, storage, and networking industries;
- timing and amount of intellectual property licenses;
- the timing of orders from, and product integration by, our
customers, particularly our original equipment manufacturer (OEM)
customers, and the tendency of these customers to change their
order requirements frequently with little or no advance notice to
us;
- the rate of adoption of storage area networks (SANs) as an
alternative to existing data storage and management systems;
- the ongoing need for storage routing products in storage area
network architectures;
- the deferrals of customer orders in anticipation of new products,
services or product enhancements from us or our competitors or
from other providers of storage area network products;
- the rate at which new markets emerge for products we are
currently developing;
- the deferrals of customer orders based on budgetary restrictions;
- the successful launch and customer acceptance of our new
products;
- disruptions or downturns in general economic activity resulting
from terrorist activity and armed conflict;
- increases in prices of components used in the manufacture of our
products; and
23
- variations in the mix of our products sold and the mix of
distribution channels through which they are sold.
In addition, potential and existing OEM customers often place initial orders
for our products for purposes of qualification and testing. As a result, we may
report an increase in sales or a commencement of sales of a product in a quarter
that will not be followed by similar sales in subsequent quarters as OEMs
conduct qualification and testing. This order pattern could lead to fluctuations
in quarterly revenue and gross profits.
GLOBAL ECONOMIC CONDITIONS MAY CONTINUE TO NEGATIVELY IMPACT US AND THE PRICE OF
OUR COMMON STOCK.
The macroeconomic environment and capital spending on information technology
in the past two fiscal years resulted in continued uncertainty in our revenue
expectations. The operating results of our business depend on the overall demand
for storage area network products. Because our sales are primarily to major
corporate customers whose businesses fluctuate with general economic and
business conditions, continued soft demand for storage area network products
caused by budgetary constraints has resulted in decreased revenue. We may be
especially prone to this as a result of the relatively high percentage of
revenue we have historically derived from the high-tech industry, which has been
more adversely impacted by the economic environment. In particular, continuing
economic uncertainty has resulted in a general reduction in information
technology spending. This reduction in information technology spending has led
to a decline in our growth rates compared to historical trends. Customers may
continue to defer or reconsider purchasing products if they continue to
experience a lack of growth in their business or if the general economy fails to
significantly improve, resulting in a continued decrease in our product revenue.
THE STORAGE TECHNOLOGY MARKET IS CHARACTERIZED BY RAPID TECHNOLOGICAL EVOLUTION,
AND OUR SUCCESS DEPENDS ON OUR ABILITY TO DEVELOP NEW PRODUCTS.
The market for our products is characterized by rapidly changing technology
and evolving industry standards and is highly competitive with respect to timely
innovation. The introduction of new products embodying new or alternative
technology or the emergence of new industry standards could render our existing
products obsolete or unmarketable. Our future success will depend in part on our
ability to anticipate changes in technology, to gain access to such technology
for incorporation into our products and to develop new and enhanced products on
a timely and cost-effective basis. Risks inherent in the development and
introduction of new products include:
- delay in our initial shipment of new products;
- the difficulty in forecasting customer demand accurately;
- our inability to expand production capacity fast enough to meet
customer demand;
- the possibility that new products may erode demand for our
current products;
- the possibility that we release new products with undetected
errors;
- competitors' responses to our introduction of new products; and
- the desire by customers to evaluate new products for longer
periods of time before making a purchase decision.
We have also recently entered into a strategic relationship with NexQL
Corporation for the joint development of advanced data management solutions.
This relationship may not result in additional products that obtain market
acceptance.
In addition, we must be able to maintain the compatibility of our products
with future device technologies, and we must rely on producers of new device
technologies to achieve and sustain market acceptance of those technologies.
Development schedules for high-technology products are subject to uncertainty,
and we may not meet our product
24
development schedules. If we are unable, for technological or other reasons, to
develop products in a timely manner or if the products or product enhancements
that we develop do not achieve market acceptance, our business will be harmed.
FAILURE TO MANAGE OUR BUSINESS EFFECTIVELY COULD SERIOUSLY HARM OUR BUSINESS,
FINANCIAL CONDITION, AND PROSPECTS.
Our ability to successfully implement our business plan, develop and offer
products, and manage our business in a rapidly evolving market requires a
comprehensive and effective planning and management process. We continue to
change the scope of our operations, including managing our headcount
appropriately. Changes in our business, headcount, organizational structure and
relationships with customers and other third parties has placed, and will
continue to place, a significant strain on our management systems and resources.
Our failure to continue to improve upon our operational, managerial and
financial controls, reporting systems, and internal control procedures, and our
failure to continue to train and manage our work force, could seriously harm our
business and financial results.
AN ADVERSE DECISION IN THE VARIOUS SECURITIES CLASS ACTION LAWSUITS FILED
AGAINST US MAY HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS AND FINANCIAL
PERFORMANCE.
We and several of our officers and directors, were named as defendants in
several class action lawsuits filed in the United States District Court for the
Western District of Texas. The plaintiffs in the actions purport to represent
purchasers of our common stock during various periods ranging from January 25,
2000 through August 24, 2000. On November 22, 2002, the court granted our motion
for summary judgment, concluding that the plaintiffs failed to demonstrate an
essential element to their claim of securities fraud. On February 26, 2003, the
plaintiffs filed a notice of appeal to the Fifth Circuit Court of Appeals. On
December 3, 2003, the parties conducted oral argument on plaintiffs' appeal
before the United States Circuit Court for the Fifth Circuit. The Fifth Circuit
has not yet issued its ruling on plaintiffs' appeal. The plaintiffs are seeking
unspecified amounts of compensatory damages, interest and costs, including legal
fees. It is not possible at this time to predict whether we will incur any
liability or to estimate the damages, or the range of damages, that we might
incur in connection with such actions. An adverse judgment may have a material
adverse effect on our business and financial performance.
OUR BUSINESS IS DEPENDENT ON THE STORAGE AREA NETWORK MARKET, WHICH IS
UNPREDICTABLE, AND IF THIS MARKET DOES NOT DEVELOP AND EXPAND AS WE ANTICIPATE,
OUR BUSINESS WILL SUFFER.
Substantially all of our products are used exclusively in SANs and,
therefore, our business is dependent on the SAN market. Accordingly, the
widespread adoption of SANs for use in organizations' computing systems is
critical to our future success. Most of the organizations that would be likely
to purchase our products have invested substantial resources in their existing
computing and data storage systems and, as a result, may be reluctant or slow to
adopt a new approach like SANs, particularly in the current economic
environment. SANs are often implemented in connection with the deployment of new
storage systems and servers. Therefore, our future success is also substantially
dependent on the market for new storage systems and servers. Furthermore, the
ability of the different components used in a SAN to function effectively, or
interoperate, with each other when placed in a computing system has not yet been
achieved on a widespread basis. Until greater interoperability is achieved,
customers may be reluctant to deploy SANs. Our success in generating revenue in
the emerging SAN market will depend on, among other things, our ability to:
- educate potential OEM customers, distributors, system
integrators, storage service providers and end-user organizations
about the benefits of SANs and storage router technology,
including, in particular, the ability to use storage routers with
SANs to improve system back up and recovery processes;
- maintain and enhance our relationships with OEM customers,
distributors, system integrators, storage system providers and
end-user organizations;
- predict and base our products on standards which ultimately
become industry standards; and
- achieve interoperability between our products and other SAN
components from diverse vendors.
25
WE HAVE LIMITED PRODUCT OFFERINGS AND OUR SUCCESS DEPENDS ON OUR ABILITY TO
DEVELOP IN A TIMELY MANNER NEW AND ENHANCED PRODUCTS THAT ACHIEVE MARKET
ACCEPTANCE.
We currently have a limited number of products that we sell in commercial
quantities. Our future growth and competitiveness will depend greatly on the
market acceptance of our newly introduced product lines, including the 6000 and
10000 storage routers as well as the ServerAttach line of products, all of which
we released in 2002. We have received revenue from the sale of our 6000, 10000
and ServerAttach line of products; however, the market acceptance of our
ServerAttach line of products sold through the channel remains uncertain. If the
ServerAttach line of products does not achieve sufficient market acceptance, our
future growth prospects could be seriously harmed. Moreover, even if we are able
to develop and commercially introduce new products and enhancements, these new
products or enhancements may not achieve market acceptance.
Factors that may affect the market acceptance of our products, some of which
are beyond our control, include the following:
- growth of the SAN market;
- changing requirements of customers within the SAN market;
- performance, quality, price and total cost of ownership of our
products;
- availability, performance, quality and price of competing
products and technologies;
- our customer service and support capabilities and responsiveness;
and
- successful development of our relationships with existing and
potential OEM, distributor, system integrator and storage system
provider customers.
WE DEPEND ON A LIMITED NUMBER OF CUSTOMERS FOR THE VAST MAJORITY OF OUR REVENUE.
THE LOSS OF OR SIGNIFICANT REDUCTION IN ORDERS FROM ANY KEY CUSTOMERS WOULD
SIGNIFICANTLY REDUCE OUR REVENUE AND WOULD SUBSTANTIALLY HARM OUR FUTURE RESULTS
OF OPERATIONS.
In fiscal 2001, 2002, and 2003, 51%, 75% and 75% of our total revenue,
respectively, was derived from two OEM customers (information for 2001 and 2002
assumes the subsequent merger of HP and Compaq). In fiscal 2003, HP and
StorageTek represented 54% and 21% of our total revenue, respectively. In May
2002, the merger of HP and Compaq significantly increased our customer
concentration as both HP and Compaq had been significant customers to that
point. Even though we were able to add EMC to our list of significant OEM
customers for the three months ended January 31, 2004, our operating results in
the foreseeable future will continue to depend on sales to a relatively small
number of OEM customers. Therefore, the loss of any of our key OEM customers, or
a significant reduction in sales to any one of them, would significantly reduce
our revenue.
OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.
Prior to offering our products for sale, our OEM customers require that each
of our products undergo an extensive qualification process, which involves
interoperability testing of our product in the OEM's system as well as rigorous
reliability testing. This qualification process may continue for a year or
longer. However, qualification of a product by an OEM does not assure any sales
of the product to the OEM. Despite this uncertainty, we devote substantial
resources, including sales, marketing and management efforts, toward qualifying
our products with OEMs in anticipation of future sales opportunities. If we are
unsuccessful or delayed in qualifying any products with an OEM, such failure or
delay would preclude or delay sales of that product to the OEM, which may impede
our ability to grow our business.
26
DEMAND FOR OUR PRODUCTS DEPENDS SIGNIFICANTLY UPON THE NEED TO INTERCONNECT
SMALL COMPUTER SYSTEM INTERFACE (SCSI) TAPE STORAGE SYSTEMS WITH FIBRE CHANNEL
SANs, AND WE EXPECT TO FACE COMPETITION FROM MANUFACTURERS OF TAPE STORAGE
SYSTEMS THAT INCORPORATE FIBRE CHANNEL INTERFACES INTO THEIR PRODUCTS.
In traditional computer networks, system back up is accomplished by
transferring data from applications and databases over the servers used in the
network to tape drives or other media where the data is safely stored. Tape
storage devices generally rely on a SCSI connection to interface with the
network in receiving and transmitting data. Our routers enable these SCSI-based
storage devices to interface with the Fibre Channel-based components of the SAN.
Because our routers allow communication between SCSI storage devices and a Fibre
Channel SAN, organizations are able to affect their back up processes over the
SAN rather than through the computer network, enabling the servers of the
network to remain available for other computing purposes. We currently derive
the majority of our revenue from sales of storage routers that are used to
connect SCSI-based tape storage systems with SANs. The introduction of tape
storage systems that incorporate Fibre Channel interfaces would enable tape
storage devices to communicate directly with SANs, without using storage
routers. We are aware that a number of manufacturers of storage systems,
including several of our current customers, are developing tape storage systems
with embedded Fibre Channel interfaces, with products expected to be introduced
to market in the near future. If these or other manufacturers are successful in
introducing Fibre Channel-based storage systems, demand for our storage router
products would be materially reduced and our revenue would decline.
OUR RESEARCH AND DEVELOPMENT EFFORTS ARE FOCUSED ON UTILIZING EMERGING
TECHNOLOGIES AND STANDARDS AND ANY DELAY OR ABANDONMENT OF EFFORTS TO DEVELOP
THESE TECHNOLOGIES OR STANDARDS, BY INDUSTRY PARTICIPANTS, OR FAILURE OF THESE
TECHNOLOGIES OR STANDARDS TO ACHIEVE MARKET ACCEPTANCE, COULD COMPROMISE OUR
COMPETITIVE POSITION.
Our products are intended to complement other SAN products to improve the
performance of computer networks by addressing the input/output bottlenecks that
have emerged between the storage systems and the servers within a computing
system. We have devoted and expect to continue to devote significant resources
to developing products based on emerging technologies and standards that reduce
input/output bottlenecks, such as internet SCSI (iSCSI). A number of large
companies in the computer hardware and software industries are actively involved
in the development of new technologies and standards that we expect to
incorporate in our new products. Should any of these companies delay or abandon
their efforts to develop commercially available products based on these new
technologies and standards, our research and development efforts with respect to
such technologies and standards likely would have no appreciable value. In
addition, if we do not correctly anticipate new technologies and standards, or
if our products based on these new technologies and standards fail to achieve
market acceptance, our competitors may be better able to address market demand
than would we. Furthermore, if markets for these new technologies and standards
develop later than we anticipate, or do not develop at all, demand for our
products that are currently in development would suffer, resulting in less
revenue for these products than we currently anticipate.
UNCERTAINTIES INVOLVING SALES AND DEMAND FORECASTS FOR OUR PRODUCTS COULD
NEGATIVELY AFFECT OUR BUSINESS.
We have limited ability to forecast the demand for our products. In
preparing sales and demand forecasts, we rely largely on input from our
distribution partners. If our distribution partners are unable to accurately
forecast demand, or we fail to effectively communicate with our distribution
partners about end-user demand or other time sensitive information, sales and
demand forecasts may not reflect the most accurate, up-to-date information.
Because we make business decisions based on our sales and demand forecasts, if
these forecasts are inaccurate, our business and financial results could be
negatively impacted. Furthermore, we may not be able to identify these forecast
differences until late in our fiscal quarter. Consequently, we may not be able
to make adjustments to our business model without negatively impacting our
business and results of operations.
WE ARE SUBJECT TO INCREASED INVENTORY RISKS AND COSTS BECAUSE WE MANUFACTURE
PRODUCTS IN ADVANCE OF BINDING COMMITMENTS FROM OUR CUSTOMERS TO PURCHASE OUR
PRODUCTS.
In order to assure availability of our products for some of our largest OEM
customers, we manufacture products in advance of purchase orders from these
customers based on forecasts provided by them. However, these forecasts do not
represent binding purchase commitments and we do not recognize revenue for such
products until the product is shipped and risk of loss has passed to the OEM. As
a result, we incur inventory and manufacturing costs in advance
27
of anticipated revenue. Because demand for our products may not materialize,
this product delivery method subjects us to increased risks of high inventory
carrying costs and increased obsolescence and may increase our operating costs.
THE LOSS OF OUR PRIMARY CONTRACT MANUFACTURERS, OR THE FAILURE TO FORECAST
DEMAND ACCURATELY FOR OUR PRODUCTS OR TO MANAGE OUR RELATIONSHIP WITH OUR
PRIMARY CONTRACT MANUFACTURERS SUCCESSFULLY, WOULD NEGATIVELY IMPACT OUR ABILITY
TO MANUFACTURE AND SELL OUR PRODUCTS.
We rely on a limited number of contract manufacturers, primarily Solectron
and Celestica, to assemble the printed circuit board for our current shipping
programs, including our 6000 and 10000 and ServerAttach line of products. We
generally place orders for products with Solectron and Celestica approximately
four months prior to the anticipated delivery date, with order volumes based on
forecasts of demand from our customers. Accordingly, if we inaccurately forecast
demand for our products, we may be unable to obtain adequate manufacturing
capacity from Solectron or Celestica to meet our customers' delivery
requirements, or we may accumulate excess inventories. We have on occasion in
the past been unable to adequately respond to unexpected increases in customer
purchase orders, and therefore were unable to benefit from this incremental
demand. Solectron and Celestica have not provided assurance to us that adequate
capacity will be available to us within the time required to meet additional
demand for our products.
OUR PLANS TO INTRODUCE NEW PRODUCTS AND PRODUCT ENHANCEMENTS TO MARKET REQUIRE
COORDINATION ACROSS OUR SUPPLIERS AND MANUFACTURERS, WHICH EXPOSES US TO RISKS
OF DELAY OR POOR EXECUTION FROM A VARIETY OF SOURCES.
We have recently introduced new products and product enhancements, which
requires that we coordinate our efforts with those of our component suppliers
and our contract manufacturers to rapidly achieve volume production. In
addition, we transitioned the manufacturing of our embedded router products to
HP. If we should fail to effectively manage our relationships with our component
suppliers, our contract manufacturers and other manufacturers of our products or
if any of our suppliers or our manufacturers experience delays, disruptions,
capacity constraints or quality control problems in their manufacturing
operations, our ability to ship products to our customers could be delayed, and
our competitive position and reputation could be harmed. Qualifying a new
component supplier or contract manufacturer and commencing volume production can
be expensive and time consuming. If we are required to change or choose to
change suppliers, we may lose revenue and damage our customer relationships.
WE DEPEND ON SOLE SOURCE AND LIMITED SOURCE SUPPLIERS FOR CERTAIN KEY
COMPONENTS, AND IF WE ARE UNABLE TO BUY THESE COMPONENTS ON A TIMELY BASIS, OUR
DELAYED ABILITY TO DELIVER OUR PRODUCTS TO OUR CUSTOMERS MAY RESULT IN REDUCED
REVENUE AND LOST SALES.
We currently purchase Fibre Channel application specific integrated circuits
and other key components for our products from sole or limited sources. To date,
most of our component purchases have been made in relatively small volumes. As a
result, if our suppliers receive excess demand for their products, we likely
will receive a low priority for order fulfillment, as large volume customers
will use our suppliers' available capacity. If we are delayed in acquiring
components for our products, the manufacture and shipment of our products will
also be delayed, which will reduce our revenue and may result in lost sales. We
generally use a rolling nine-month forecast of our future product sales to
determine our component requirements. Lead times for ordering materials and
components vary significantly and depend on factors such as specific supplier
requirements, contract terms and current market demand for such components. If
we overestimate our component requirements, we may have excess inventory which
would increase our costs. If we underestimate our component requirements, we may
have inadequate inventory that would delay our manufacturing and render us
unable to deliver products to customers on a scheduled delivery date. We also
may experience shortages of certain components from time to time, which also
could delay our manufacturing. Manufacturing delays could negatively impact our
ability to sell our products and damage our customer relationships.
COMPETITION WITHIN OUR MARKETS MAY REDUCE SALES OF OUR PRODUCTS AND REDUCE OUR
MARKET SHARE.
The market for SAN products generally, and storage routers in particular, is
increasingly competitive. We anticipate that the market for our products will
continually evolve and will be subject to rapid technological change. We
currently face direct competition primarily from ADIC, ATTO and Chaparral
Network Storage. In addition,
28
other OEM customers could develop products or technologies internally, or by
entering into strategic relationships with or acquiring other existing SAN
product providers that would replace their need for our products and would
become a source of competition. We may face competition in the future from OEMs,
including our customers and potential customers, local area network router
manufacturers, storage system industry suppliers, including manufacturers and
vendors of other SAN products or entire SAN systems, and innovative start-up
companies. For example, manufacturers of Fibre Channel switches or directors
could seek to include router functionality within their SAN products that would
obviate the need for our storage routers. As the market for SAN products grows,
we also may face competition from traditional networking companies and other
manufacturers of networking products. These networking companies may enter the
storage router market by introducing their own products or by entering into
strategic relationships with or acquiring other existing SAN product providers.
This could introduce additional competition in our markets, especially, if one
of our OEMs begins to manufacture our higher end storage routers. While we do
not currently face significant direct competition for our ServerAttach products,
we anticipate we will see increased competition as this market develops.
WE ARE A RELATIVELY SMALL COMPANY WITH LIMITED RESOURCES COMPARED TO SOME OF OUR
CURRENT AND POTENTIAL COMPETITORS.
Some of our current and potential competitors have longer operating
histories, significantly greater resources, broader name recognition and a
larger installed base of customers than Crossroads. As a result, these
competitors may have greater credibility with our existing and potential
customers. They also may be able to adopt more aggressive pricing policies and
devote greater resources to the development, promotion and sale of their
products than we can to ours, which would allow them to respond more quickly
than us to new or emerging technologies or changes in customer requirements. In
addition, some of our current and potential competitors have already established
supplier or joint development relationships with decision makers at our current
or potential customers. These competitors may be able to leverage their existing
relationships to discourage these customers from purchasing products from us or
to persuade them to replace our products with their products. Increased
competition could decrease our prices, reduce our sales, lower our margin, or
decrease our market share. These and other competitive pressures may prevent us
from competing successfully against current or future competitors, and may
materially harm our business.
WE HAVE LICENSED OUR STORAGE ROUTER TECHNOLOGY TO A KEY CUSTOMER, WHICH MAY
ENABLE THIS CUSTOMER TO COMPETE WITH US.
In November 2002, we amended our existing licensing agreement with HP.
Pursuant to this amendment we have outsourced the manufacturing of our embedded
routers to HP. As a result, we do not incur the inventory and overhead costs of
the hardware, and we will receive a royalty from HP for licensing our
technology, which will result in less aggregate revenue for us. However, even
though total revenue from the sale of our embedded routers will be less in the
future, our arrangement will have a positive impact on gross margin. We believe
this agreement will allow us to leverage the strengths of both companies,
including HP's economies of scale in manufacturing and systems integration
expertise and our software, value-added applications and intellectual property.
We have been working under this new agreement since the fiscal second quarter of
2003. HP has vastly greater resources and distribution capabilities than we do,
and therefore, it could establish market acceptance in a relatively short time
frame for any competitive products that it may introduce using our licensed
technologies, which, in turn, would reduce demand for our products from HP and
could reduce demand for our products from other customers.
UNIT PRICES OF SOME OF OUR PRODUCTS HAVE DECREASED OVER TIME, AND IF WE CANNOT
INCREASE OUR SALES VOLUMES, OUR REVENUE WILL DECLINE.
As storage networking continues to mature as an industry, we have seen a
trend towards simplification of devices. The impact of this trend on our
business has been the push for, and subsequent ramp of embedded routers being
shipped with tape libraries. These embedded routers are lower cost than the
stand-alone box routers and this lower cost is passed on to our OEM customers.
As our mix shifts from box routers to embedded routers, we will see a reduction
in average price per unit and revenue will decline if volume does not increase.
To date, some of our agreements with OEM customers, including our largest
customer, provide for quarterly reductions in pricing on a product-by-product
basis, with the actual discount determined according to the volume potential
expected from the customer, the OEM's customer base, the credibility the OEM may
bring to our solution, additional technology the
29
OEM may help us incorporate with our product, and other Crossroads products the
OEM supports. Notwithstanding, the decreases in our average selling prices of
our older generation products generally have been partially offset by higher
average selling prices for our newer products, as well as sales to distributors
and system integrators where price decreases are not generally required.
Nonetheless, we could experience declines in our average unit selling prices for
our products in the future, especially if our newer products do not receive
broad market acceptance. In addition, declines in our average selling prices may
be more pronounced should we encounter significant pricing pressures from
increased competition within the storage router market.
OUR PRODUCTS ARE COMPLEX AND MAY CONTAIN UNDETECTED SOFTWARE OR HARDWARE ERRORS
THAT COULD LEAD TO AN INCREASE IN OUR COSTS OR A REDUCTION IN OUR REVENUE.
Networking products such as ours may contain undetected software or hardware
errors when first introduced or as new versions are released. Our products are
complex and errors have been found in the past and may be found from time to
time in the future. In addition, our products include components from a number
of third-party vendors. We rely on the quality testing of these vendors to
ensure the adequate operation of their products. Because our products are
manufactured with a number of components supplied by various third-party
sources, should problems occur in the operation or performance of our products,
it may be difficult to identify the source. In addition, our products are
deployed within SANs from a variety of vendors. Therefore, the occurrence of
hardware and software errors, whether caused by our or another vendor's SAN
products, could adversely affect sales of our products. Furthermore, defects may
not be discovered until our products are already deployed in the SAN. These
errors also could cause us to incur significant warranty, diagnostic and repair
costs, divert the attention of our engineering personnel from our product
development efforts and cause significant customer relations and business
reputation problems.
WE DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A RAPIDLY
CHANGING MARKET, AND IF WE ARE UNABLE TO RETAIN OUR CURRENT PERSONNEL AND HIRE
ADDITIONAL PERSONNEL, OUR ABILITY TO SELL OUR PRODUCTS COULD BE HARMED.
We believe our future success will depend in large part upon our ability to
attract and retain highly skilled managerial, engineering and sales and
marketing personnel. Moreover, we maintain a relatively small staff of executive
management. The loss of the services of any of our key employees or key
management would harm our business. Additionally, our inability to attract or
retain qualified personnel in the future or any delays in hiring required
personnel, particularly engineers and sales personnel, could delay the
development and introduction of, and negatively impact our ability to sell, our
products.
WE MAY BE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, WHICH WOULD NEGATIVELY
AFFECT OUR ABILITY TO COMPETE.
Our products rely on our proprietary technology, and we expect that future
technological advancements made by us will be critical to sustain market
acceptance of our products. Therefore, we believe that the protection of our
intellectual property rights is and will continue to be important to the success
of our business. We rely on a combination of patent, copyright, trademark and
trade secret laws and restrictions on disclosure to protect our intellectual
property rights. We also enter into confidentiality or license agreements with
our employees, consultants and business partners, and control access to and
distribution of our software, documentation and other proprietary information.
Despite these efforts, unauthorized parties may attempt to copy or otherwise
obtain and use our products or technology. Monitoring unauthorized use of our
products is difficult, and we cannot be certain that the steps we have taken
will prevent unauthorized use of our technology, particularly in foreign
countries where applicable laws may not protect our proprietary rights as fully
as in the United States.
OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED
IN COSTLY AND LENGTHY LITIGATION WHICH COULD SERIOUSLY HARM OUR BUSINESS.
In recent years, there has been significant litigation in the United States
involving patents, trademarks and other intellectual property rights. Legal
proceedings could subject us to significant liability for damages or invalidate
our intellectual property rights. Any litigation, regardless of its outcome,
would likely be time consuming and expensive to resolve and would divert
management's time and attention. Any potential intellectual property litigation
against us could force us to take specific actions, including:
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- cease selling our products that use the challenged intellectual
property;
- obtain from the owner of the infringed intellectual property
right a license to sell or use the relevant technology or
trademark, which license may not be available on reasonable
terms, or at all; or
- redesign those products that use infringing intellectual property
or cease to use an infringing trademark.
As we have discussed elsewhere in this report, we have engaged in lengthy
and costly litigation regarding various patents. While we have prevailed to date
in these cases, we cannot assure you that we would prevail in any future effort
to enforce our rights in our patents.
ANY ACQUISITIONS WE MAKE COULD DISRUPT OUR BUSINESS AND HARM OUR FINANCIAL
CONDITION.
As part of our growth strategy, we intend to review opportunities to acquire
other businesses or technologies that would complement our current products,
expand the breadth of our markets or enhance our technical capabilities. For
example, we recently entered into certain strategic agreements with NexQL
Corporation, a development stage company. Under the terms of these agreements,
we have an exclusive right, but not an obligation, to purchase NexQL. Any
acquisitions, including any potential acquisition of NexQL, would entail a
number of risks that could materially and adversely affect our business and
operating results, including:
- problems integrating the acquired operations, technologies or
products with our existing business and products;
- diversion of management's time and attention from our core
business;
- difficulties in retaining business relationships with suppliers
and customers of the acquired company;
- risks associated with entering markets in which we lack prior
experience; and
- potential loss of key employees of the acquired company.
OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKET.
Our products comprise only a part of a SAN. All components of a SAN must
uniformly comply with the same industry standards in order to operate
efficiently together. We depend on companies that provide other components of
the SAN to support prevailing industry standards. Many of these companies are
significantly larger and more influential in effecting industry standards than
we are. Some industry standards may not be widely adopted or implemented
uniformly, and competing standards may emerge that may be preferred by OEM
customers or end users. If larger companies do not support the same industry
standards that we do, or if competing standards emerge, our products may not
achieve market acceptance, which would adversely affect our business.
PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW, COULD PREVENT, DELAY OR
IMPEDE A CHANGE IN CONTROL OF US AND MAY REDUCE THE MARKET PRICE OF OUR COMMON
STOCK.
Provisions of our certificate of incorporation and bylaws could have the
effect of discouraging, delaying or preventing a merger or acquisition that a
stockholder may consider favorable. We also are subject to the anti-takeover
laws of the State of Delaware that may discourage, delay or prevent someone from
acquiring or merging with us, which may adversely affect the market price of our
common stock. Further, in August 2002, our Board of Directors approved, adopted
and entered into a Stockholder Rights Plan which also may have the effect of
discouraging, delaying or preventing an acquisition which stockholders otherwise
may desire to support.
OUR STOCK PRICE IS VOLATILE.
The market price of our common stock has been volatile in the past and may
be volatile in the future. For example, since November 1, 2002, the intra-day
market price of our common stock as quoted on The NASDAQ
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Stock Market fluctuated between $0.50 and $3.81. The market price of our common
stock may be significantly affected by the following factors:
- actual or anticipated fluctuations in our operating results;
- changes in financial estimates by securities analysts or our
failure to perform in line with such estimates;
- changes in market valuations of other technology companies,
particularly those that sell products used in SANs;
- announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint ventures
or capital commitments;
- sale of or distribution by Austin Ventures of our common stock to
their limited partners or substantial sales by other significant
stockholders;
- introduction of technologies or product enhancements that reduce
the need for storage routers;
- the loss of one or more key OEM customers; and
- departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For a description of the Company's market risks, see "Item 7 - Management's
Discussion and Analysis of Financial Condition and Results of Operations" in the
Company's Annual Report on Form 10-K for the fiscal year ended October 31, 2003.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures.
We carried out an evaluation, under the supervision and with the
participation of our management, including the Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures pursuant to Rule 13a-15 of the Securities
Exchange Act of 1934 (the "Exchange Act"). Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that as of January 31,
2004, the end of the period covered by this report, our disclosure controls and
procedures were effective at the reasonable assurance level in timely alerting
them to material information relating to Crossroads (including its consolidated
subsidiaries) required to be included in our Exchange Act filings.
(b) Changes in internal control over financial reporting.
During the quarter ended January 31, 2004, there have been no significant
changes in our internal control over financial reporting that materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
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CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES
The Securities and Exchange Commission on October 19, 1999 declared
effective our registration statement on Form S-1 (File No. 333-85505) relating
to the initial public offering of our common stock. As of January 31, 2004, we
have used all of the net offering proceeds for the purchase of temporary
investments, consisting of cash, cash equivalents, and short-term investments.
We currently intend to use the net proceeds of the offering for working capital
and general corporate purposes, including financing accounts receivable and
capital expenditures made in the ordinary course of business. We also may apply
a portion of the proceeds of the offering to acquire businesses, products and
technologies, or enter into joint venture arrangements such as our joint
development agreement with NexQL, that are complementary to our business and
product offerings. We also may apply a portion of the proceeds to the payment of
cash dividends or for additional stock repurchases or other similar
transactions.
We did not repurchase any shares of our common stock during the first
quarter of fiscal 2004.
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
(a) Exhibits
31.1 Certification of Rob Sims, President and Chief Executive Officer
of the Company, as adopted pursuant to Section 302 of
Sarbanes-Oxley Act of 2002.
31.2 Certification of Andrea Wenholz, Vice President and Chief
Financial Officer of the Company, as adopted pursuant to Section
302 of Sarbanes-Oxley Act of 2002.
32.1 Certification of Rob Sims, President and Chief Executive Officer
of the Company, as adopted pursuant to Section 906 of
Sarbanes-Oxley Act of 2002.
32.2 Certification of Andrea Wenholz, Vice President and Chief
Financial Officer of the Company, as adopted pursuant to Section
906 of Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
During the fiscal quarter ended January 31, 2004, Crossroads filed the
following current report on Form 8-K. Information regarding each item
reported on is listed below.
33
DATE FILED OR
FURNISHED ITEM NO. DESCRIPTION
- ---------------- -------- --------------------------------------------------------------------------
December 2, 2003 Item 12 On December 2, 2003, we announced our results of operations for our fiscal
year ended October 31, 2003.*
- ----------
* This furnished Form 8-K is not to be deemed filed or incorporated by reference
into any filing.
34
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) 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.
CROSSROADS SYSTEMS, INC.
March 8, 2004 /s/ Rob Sims
------------- --------------------------------------------
(Date) Rob Sims
Chief Executive Officer
(Principal Executive Officer)
March 8, 2004 /s/ Andrea Wenholz
------------- --------------------------------------------
(Date) Andrea Wenholz
Chief Financial Officer
(Principal Financial and Accounting Officer)
35
EXHIBIT INDEX
EXHIBIT
- -------
31.1 Certification of Rob Sims, President and Chief Executive Officer of the Company, as adopted
pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
31.2 Certification of Andrea Wenholz, Vice President and Chief Financial Officer of the Company, as
adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
32.1 Certification of Rob Sims, President and Chief Executive Officer of the Company, as adopted
pursuant to Section 906 of Sarbanes-Oxley Act of 2002.
32.2 Certification of Andrea Wenholz, Vice President and Chief Financial Officer of the Company, as
adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.