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 JULY 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 September 2, 2004 Registrant had outstanding 25,439,181 shares of
common stock, par value $0.001 per share.
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
FORM 10-Q
QUARTER ENDED JULY 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
July 31, 2004........................................................ 2
Condensed Consolidated Statements of Operations for the three and
nine months ended July 31, 2003 and 2004............................. 3
Condensed Consolidated Statements of Cash Flows for the nine months
ended July 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............. 37
Item 4. Controls and Procedures................................................ 37
PART II OTHER INFORMATION
Item 1. Legal Proceedings...................................................... 38
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds............ 38
Item 3. Defaults Upon Senior Securities........................................ 39
Item 4. Submission of Matters to a Vote of Security Holders.................... 39
Item 5. Other Information...................................................... 39
Item 6. Exhibits and Reports .................................................. 39
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, JULY 31,
2003 2004
----------- ---------
ASSETS
Current assets:
Cash and cash equivalents ................................................... $ 14,707 $ 18,829
Short-term investments ...................................................... 16,670 10,653
----------- ---------
Total cash, cash equivalents and short-term investments ................... 31,377 29,482
Accounts receivable, net of allowance for doubtful
accounts of $164 and $130, respectively ................................... 2,994 1,980
Inventories, net ............................................................ 1,633 1,611
Prepaids and other current assets ........................................... 1,274 636
----------- ---------
Total current assets ...................................................... 37,278 33,709
Property and equipment, net .................................................... 3,299 2,715
Other assets ................................................................... 288 282
----------- ---------
Total assets .............................................................. $ 40,865 $ 36,706
=========== =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ............................................................ $ 1,953 $ 2,193
Accrued expenses ............................................................ 2,470 1,632
Accrued warranty costs ...................................................... 802 588
Deferred revenue ............................................................ 382 384
----------- ---------
Total current liabilities ................................................. 5,607 4,797
Commitments and contingencies
Stockholders' equity:
Common stock, $.001 par value, 175,000,000 shares authorized,
24,368,144 and 25,433,598 shares issued and outstanding, respectively ..... 24 25
Additional paid-in capital .................................................. 182,831 183,258
Deferred stock-based compensation ........................................... (126) (11)
Accumulated deficit ......................................................... (147,471) (151,363)
----------- ---------
Total stockholders' equity ................................................ 35,258 31,909
----------- ---------
Total liabilities and stockholders' equity ................................ $ 40,865 $ 36,706
=========== =========
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 NINE MONTHS ENDED
JULY 31, JULY 31,
--------------------------- ---------------------------
2003 2004 2003 2004
------------ ------------ ------------ ------------
Revenue:
Product ............................. $ 3,741 $ 2,920 $ 21,444 $ 12,551
Royalty and other ................... 1,876 1,957 2,424 6,876
------------ ------------ ------------ ------------
Total revenue ..................... 5,617 4,877 23,868 19,427
Cost of revenue:
Product ............................. 2,547 1,305 14,018 5,934
Royalty and other ................... 91 41 237 158
------------ ------------ ------------ ------------
Total cost of revenue ............. 2,638 1,346 14,255 6,092
------------ ------------ ------------ ------------
Gross profit ........................... 2,979 3,531 9,613 13,335
------------ ------------ ------------ ------------
Operating expenses:
Sales and marketing ................. 1,018 1,019 3,033 3,403
Research and development ............ 2,925 3,892 9,063 9,993
General and administrative .......... 1,136 1,158 4,283 3,858
NexQL research and development ...... - - - 721
Business restructuring .............. (201) (73) (341) (187)
Non-controlling interest ............ - (215) - (215)
Amortization of intangibles ......... - - 173 -
------------ ------------ ------------ ------------
Total operating expenses .......... 4,878 5,781 16,211 17,573
------------ ------------ ------------ ------------
Loss from operations ................... (1,899) (2,250) (6,598) (4,238)
Other income, net ................... 164 120 468 346
------------ ------------ ------------ ------------
Net loss ............................... $ (1,735) $ (2,130) $ (6,130) $ (3,892)
============ ============ ============ ============
Basic and diluted net loss per share ... $ (0.07) $ (0.08) $ (0.25) $ (0.16)
============ ============ ============ ============
Shares used in computing basic and
diluted net loss per share .......... 24,190,122 25,318,050 24,478,962 25,061,443
============ ============ ============ ============
See accompanying notes to unaudited condensed consolidated financial statements.
3
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
NINE MONTHS ENDED
JULY 31,
-------------------
2003 2004
-------- --------
Cash flows from operating activities:
Net loss ..................................................... $ (6,130) $ (3,892)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation ............................................... 2,775 1,897
Business restructuring expenses ............................ - (187)
Amortization of intangibles ................................ 173 -
Loss on disposal of fixed assets ........................... 61 99
Impairment charge on investment in privately-held company .. - 721
Stock-based compensation ................................... 955 114
Provision for doubtful accounts receivable ................. - 35
Provision for excess and obsolete inventory ................ - (93)
Changes in assets and liabilities:
Accounts receivable ........................................ 2,993 979
Inventories ................................................ 558 115
Prepaids and other current assets .......................... 37 638
Accounts payable ........................................... (2,248) 1,046
Accrued expenses and other ................................. (1,391) (855)
-------- --------
Net cash provided by (used in) operating activities ..... (2,217) 617
-------- --------
Cash flows from investing activities:
Purchase of property and equipment ........................... (614) (1,413)
Purchase of held-to-maturity investments ..................... (12,545) (9,065)
Maturity of held-to-maturity investments ..................... 15,787 15,082
Investment in privately-held company ......................... - (721)
Payment of note receivable from stockholders ................. 126 -
-------- --------
Net cash provided by investing activities ............... 2,754 3,883
-------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock ....................... 399 460
Retirement of common stock ................................... - (32)
Change in book overdraft ..................................... - (806)
Purchase of common stock under open market stock purchase
program ................................................. (1,983) -
-------- --------
Net cash used in financing activities ................... (1,584) (378)
-------- --------
Net increase (decrease) in cash and cash equivalents ............ (1,047) 4,122
Cash and cash equivalents, beginning of period .................. 14,723 14,707
-------- --------
Cash and cash equivalents, end of period ........................ $ 13,676 $ 18,829
======== ========
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 July 31, 2004, its results of
operations for the three and nine month periods ended July 31, 2003 and 2004 and
its cash flows for the nine months ended July 31, 2003 and 2004. Certain
reclassifications have been made to prior year amounts in order to conform to
the current year presentation. The Company adopted new accounting guidance that
required consolidation of the balance sheet of NexQL Corporation ("NexQL"), a
variable interest entity ("VIE"), beginning April 30, 2004 and the statements of
operations and cash flows beginning May 1, 2004. See Footnote 4 for further
discussion of the impact of consolidating NexQL. The results of operations for
the three and nine months ended July 31, 2004 are not necessarily indicative of
results that may be expected for any other interim period or for the full year.
The Company defines its operations as two distinct businesses: sales of
enterprise data routing solutions for open storage area networks; and NexQL, a
pre-revenue development stage enterprise in the data management industry.
The accompanying financial data as of July 31, 2004 and for the three and
nine month periods ended July 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.
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 or when title transfers. 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 can differ, but typically
consist of upfront non-refundable fees including payments relating to past and
future sales of licensee products. 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.
License arrangements can also include a royalty stream that is recognized
quarterly based on reports from the licensee. Revenue from royalty payments from
HP is recognized monthly based on reports from HP and quarterly from other IP
licensees. Service revenue is recognized ratably over the service period.
Stock-Based Compensation
As of July 31, 2004, the Company has one employee stock-based 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 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.
5
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 NINE MONTHS ENDED
JULY 31, JULY 31,
------------------ ------------------
2003 2004 2003 2004
-------- -------- -------- --------
Cost of revenue .................... $ 3 $ 1 $ 23 $ 3
Sales and marketing ................ 5 - 115 -
Research and development ........... 65 7 237 43
General and administrative ......... 124 11 580 68
-------- -------- -------- --------
Total stock-based compensation .. $ 197 $ 19 $ 955 $ 114
======== ======== ======== ========
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 Statement No. 123, "Accounting for Stock-Based
Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," to employee stock-based compensation
(in thousands, except share data):
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
----------------------- -----------------------
2003 2004 2003 2004
---------- ---------- ---------- ----------
Net loss, as reported ........................ $ (1,735) $ (2,130) $ (6,130) $ (3,892)
Stock-based employee compensation
expense included in reported net loss .... 197 19 955 114
Stock-based employee compensation
expense determined under fair value based
method for all awards .................... (3,406) (862) (11,385) (6,124)
---------- ---------- ---------- ----------
Pro forma net loss ........................... $ (4,944) $ (2,973) $ (16,560) $ (9,902)
========== ========== ========== ==========
Net loss per share:
Basic and diluted - as reported .......... $ (0.07) $ (0.08) $ (0.25) $ (0.16)
Basic and diluted - pro forma ............ $ (0.20) $ (0.12) $ (0.68) $ (0.40)
6
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
2. INVENTORIES
Inventories, net consist of the following (in thousands):
OCTOBER 31, JULY 31,
2003 2004
----------- -------
Raw materials ............................. $ 1,219 $ 1,427
Work-in-process ........................... - 19
Finished goods ............................ 862 520
----------- -------
2,081 1,966
Less: Allowance for excess and obsolete
inventory ......................... (448) (355)
----------- -------
$ 1,633 $ 1,611
=========== =======
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, product sales returns and other allowances. The Company has not
experienced material credit losses in any of the periods presented.
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. Additionally, 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.
The percentage of sales to significant customers was as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
------------------- -------------------
2003 2004 2003 2004
-------- -------- -------- --------
HP ...................... 63.5% 59.7% 61.2% 50.1%
StorageTek .............. 15.4% 15.9% 22.6% 23.7%
EMC ..................... - 14.8% - 16.9%
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. NEXQL
During the first fiscal quarter of 2004, the Company entered into a
strategic relationship with NexQL, a privately held development stage enterprise
in the data management industry. Pursuant to certain agreements with NexQL, the
7
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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.
During the nine months ended July 31, 2004, the Company had invested $1.0
million in NexQL and loaned approximately $0.3 million to NexQL. 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.
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 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.
Management believes that recognition of additional liabilities as a result
of consolidating NexQL does not result in any incremental increase in the level
of claims on the general assets of the Company and its other subsidiaries,
rather, the additional liabilities represent claims against the additional
assets recognized by the Company as a result of the consolidation. Conversely,
the additional assets recognized as a result of consolidating NexQL do not
represent additional assets of the Company that could be used to satisfy claims
by the creditors of the Company and its other subsidiaries.
Under FIN 46R transition rules, the operating results of NexQL continued to
be accounted for on the equity method for the six months ended April 30, 2004.
The Company consolidated the statements of operations and cash flows of NexQL
beginning May 1, 2004, the beginning of the current quarter.
Crossroads did not record any amounts as revenue related to NexQL for the
nine months ended July 31, 2004. Net operating expenses and net loss
attributable to NexQL for the three and nine months ended July 31, 2004 were
approximately $0.6 million and $1.4 million, respectively. Overall results were
significantly impacted as a result of our investment in NexQL and adoption of
FIN 46R.
5. 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.
8
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Components of business restructuring expenses and the remaining
restructuring accruals as of July 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
--------
Cash activity ............................ (81)
Non-cash activity ........................ (62)
--------
Balance as of April 30, 2004 ................ $ 688
========
Cash activity ............................ (81)
Non-cash activity ........................ (73)
--------
Balance as of July 31, 2004 ................. $ 534
========
The entire accrual amount relates to remaining payments to be made for lease
abandonment losses. In March 2003, the Company entered into 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
$0.4 million during the nine months ended July 31, 2004, principally for rent
payments to be received over the next nine to twelve months of the remaining
sublease terms. The Company assesses recoverability of these sublease payments
on a quarterly basis.
The Company has substantially completed its 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.
6. 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,
2005. As of October 31, 2003 and July 31, 2004, there were no borrowings
outstanding under this revolving line of credit.
7. 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 million line of credit. Future minimum
lease payments under all non-cancelable operating leases as of July 31, 2004
were approximately $3.0 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.
9
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 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. The Company warrants products for a period from 12 to 39 months
following the sale of its products.
Activity in the accrued warranty costs during the nine months ended July 31,
2003 and 2004 was as follows (in thousands):
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END OF
OF PERIOD EXPENSES DEDUCTIONS PERIOD
---------- ---------- ---------- ----------
Nine months ended July 31, 2003
Warranty reserve ................. $ 615 $ 290 $ (103) $ 802
========== ========== ========== ==========
Nine months ended July 31, 2004
Warranty reserve ................. $ 802 $ (77) $ (137) $ 588
========== ========== ========== ==========
LEGAL PROCEEDINGS
Intellectual Property Litigation
On October 17, 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. Dot Hill recently filed a third-party complaint
against FalconStor, Inc. (FalconStor), seeking indemnification for certain of
Dot Hill's products at issue in the litigation. In response, FalconStor has also
denied infringement and alleged the `972 and `035 Patents are invalid and
unenforceable. On August 18, 2004, FalconStor and Crossroads settled their
claims against one another. The settlement included an upfront license fee from
FalconStor to Crossroads and a cross-license of patents between the parties. In
the continuing litigation against Dot Hill, Crossroads plans to vigorously
defend its patents against all 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
10
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
represent purchasers of the Company's common stock during various periods
ranging from January 25, 2000 through August 24, 2000. On February 24, 2003, the
Court entered a final judgment in the defendants' favor. Plaintiff's appealed to
the United States Court of Appeals for the Fifth Circuit. On April 14, 2004, the
Fifth Circuit issued an opinion, which affirmed in part and vacated in part the
district court's ruling. The remaining claims were remanded to the district
court. On May 12, 2004, the Fifth Circuit denied plaintiff's request for panel
rehearing. The Company continues to deny the remaining 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.
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.
Also see Footnote 10 "Subsequent Events" for information regarding severance
benefits to be paid to the Company's chief financial officer.
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,
including the amount and type of consideration. Depending upon the structure of
the purchase, one condition could be the need to obtain Crossroads' stockholder
approval. The exclusive right to purchase NexQL will lapse at various times
after NexQL completes certain milestones.
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 was 5,243,492 and 4,955,596 as of July 31, 2003 and
2004, respectively.
11
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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
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 were extended to July 1,
2004 and the note is currently past due. The balance of approximately $74,000
was reserved in the second fiscal quarter through a charge to general and
administrative expense, as collection of the note was uncertain. As of July 31,
2004 the collectibility of the note remains uncertain.
10. SUBSEQUENT EVENTS
In August 2004, FalconStor and Crossroads agreed to settle their claims
against one another. The settlement included an upfront license fee of $1.3
million from FalconStor to Crossroads and a cross-license of patents between the
parties. In late August, 2004, the settlement agreement became finalized when
the court entered an order dismissing the claims of FalconStor and Crossroads
against each other and amended the complaint filed by Crossroads in its
underlying action against Dot Hill Systems Corporation removing certain products
that contain FalconStor's technology from the action.
NexQL entered into a Master Reseller Agreement on July 30, 2004 with a
reseller in Europe. Subject to the terms of the agreement, NexQL has assigned
specific customer accounts exclusively to the reseller for an initial fee. In
August, NexQL received an initial order from the reseller and has collected
$950,000. Generally, NexQL will recognize revenue when persuasive evidence of an
arrangement exists, delivery has occurred, the fee is fixed or determinable and
collection is probable. Securities and Exchange Commission Staff Accounting
Bulletin No. 104-"Revenue Recognition" requires us to estimate returns and
warranty expenses prior to recognizing revenue. Since NexQL has no history
selling their products, at this time we are not able to estimate returns and
warranty expense. Revenue from sales of products prior to the time we are able
to estimate returns and warranty expense will be deferred.
On August 27, 2004, the vice president and chief financial officer of
Crossroads resigned from her position. In accordance with the severance
agreement, Crossroads will pay one year of salary, continue health benefits for
one year, accelerate the vesting of options to purchase approximately 40,625
shares of Crossroads common stock, and issue 28,882 shares of Crossroads common
stock for no additional consideration which otherwise would have been issued in
December 2004.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. All statements
other than historical or current facts, including, without limitation,
statements about our business strategy, plans and objectives of management and
our future prospects, are forward-looking statements. Although we believe that
the expectations reflected in such forward-looking statements are reasonable,
such forward-looking statements are subject to risks and uncertainties that
could cause actual results to differ materially from these expectations. Such
risks and uncertainties include, without limitation, the following:
- our operating results are difficult to predict and are likely to vary
significantly from quarter to quarter in the future;
- we are unable to determine at this time if we will be required in
accordance with FIN 46R to consolidate our financial results with NexQL
Corporation in future quarters and, if so, what the impact on our
financial statements would be;
- we could be materially harmed in the event of a general economic
slowdown resulting in a reduction in information technology spending;
- we could be materially harmed if demand for our products is less than we
anticipate;
- we could be materially harmed if the market for our current and future
products fails to develop as we currently anticipate; and
- other risks indicated below under the caption "Additional Factors That
May Affect Future Results".
These risks and uncertainties are beyond our control and, in many cases, we
cannot predict the risks and uncertainties that could cause our actual results
to differ materially from those indicated by the forward-looking statements.
When used in this document, the words "believes," "plans," "expects,"
"anticipates," "intends," "continue," "may," "will," "could," "should,"
"future," "potential," "estimate," or the negative of such terms and similar
expressions as they relate to us or our management are intended to identify
forward-looking statements.
The following discussion should be read in conjunction with, and is
qualified in its entirety by, the condensed consolidated financial statements
and notes thereto included above in Item 1 of this Quarterly Report and the
condensed consolidated financial statements and notes thereto and Management's
Discussion and Analysis of Financial Condition and Results of Operations in our
Form 10-K filed with the SEC on January 22, 2004. Historical results and
percentage relationships among any amounts in the financial statements are not
necessarily indicative of trends in operating results for any future periods.
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.
13
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 the nine months ended July 31, 2004, we realized a 39%
year over year increase in gross margin to $13.3 million on revenue of $19.4
million compared to gross margin of $9.6 million on revenue of $23.9 million
during the comparable period in fiscal 2003.
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 plan to accomplish this by developing
new 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 elements of our business strategy in 2004 are:
- 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 investing in new technologies; and
- protect our intellectual property.
During the nine months ended July 31, 2004, we made progress on achieving
these objectives as follows:
- Strategic Relationships.
- In December 2003, we announced a strategic relationship with
NexQL, a development stage company, for the joint
development of advanced data management solutions that are
expected to outperform other solutions by orders of
magnitude at a fraction of the cost. NexQL is currently in
the process of developing and testing their product solution
as well as commencing initial customer and reseller
relationships. 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.
- In March 2004, we announced a strategic relationship with
LeftHand Networks, the leading provider of complete,
integrated IP SAN solutions. We believe that partnering with
LeftHand Networks will enable us to bring a robust network
storage solution to the marketplace. This relationship
enables the joint development of technology leveraging our
core competencies in data routing and network storage
connectivity with LeftHand Networks' expertise in
distributed storage utilization.
- Building on Core Technologies.
- Our customers are asking for features such as better
performance, guaranteed back up completion, enhanced
recovery execution, maximized resource utilization and ease
of use. To meet these needs, we are now offering a suite of
software, promoted as "Intelligence at the Edge," that
focuses on the expansion of our existing technology to bring
multiple networking functionality and capabilities to backup
storage solutions.
- In April 2004, we announced the availability of the
Crossroads 6240 Storage Router. The Crossroads 6240 Storage
router, along with our current suite of products, serves as
a platform for delivering "Intelligence At The Edge," by
improving the understanding, utilization and management of
high-performance tape library resources.
14
- 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 nine months ended
July 31, 2004, as EMC became our third largest customer, comprising 17%
of our total revenue. We have also started new channel programs during
fiscal 2004 and are expanding our reach into Europe, North America and
South America through new sales partnerships.
- Intellectual Property Value. We have entered into various agreements
with Adaptec, ADIC, XIOtech, Hitachi and others to license our
technology. We have also strengthened our patent portfolio as we now
have 25 issued patents and 52 pending patents worldwide. We plan to
vigorously defend our patents against these counterclaims.
- 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. In the continuing litigation against Dot Hill,
Crossroads plans to vigorously defend its patents against all
counterclaims.
- Dot Hill subsequently filed a third-party complaint against
FalconStor, Inc. (FalconStor), seeking indemnification for
certain of Dot Hill's products at issue in the litigation. In
response to Dot Hill's complaint, FalconStor also denied
infringement and alleged the `972 and `035 Patents are invalid
and unenforceable. On August 18, 2004, FalconStor and Crossroads
settled their claims against one another. The settlement
included an upfront license fee of $1.3 million from FalconStor
to Crossroads and a cross-license of patents between the
parties.
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 and consolidation, 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 and consolidation;
- warranty obligations;
- excess and obsolete inventories;
- allowance for doubtful accounts;
- facility lease abandonment losses; and
- litigation.
15
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. 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, we record revenue from upfront
nonrefundable IP license fees. License arrangements can also include a royalty
stream that is recognized quarterly based on reports from the licensee. Revenue
from royalty payments from HP is recognized monthly based on reports from HP and
quarterly from other IP licensees. Service revenue is recognized ratably over
the 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 July 31, 2004 is zero.
Investment in privately-held company and consolidation. We assess 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 we determine that the carrying value of an investment may not be
recoverable, an impairment charge is recorded.
As of July 31, 2004, we had a minority equity interest in NexQL of
approximately 17% and we held two of NexQL's board of director seats. Currently,
NexQL has a negative equity position. If we are required to consolidate our
financial results with NexQL in the future, any additional losses will impact
our consolidated statement of operations. The factors used to determine how we
will account for our interest in NexQL in the future makes it difficult for us
to assess the impact of NexQL on our financial results in future periods.
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.
16
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 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:
- 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 pending or
threatened 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 July 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 pending or threatened litigation could result in revisions to our
estimates of the potential liability and could materially impact our results of
operations and financial position.
17
RESULTS OF OPERATIONS
Our net loss for the three and nine months ended July 31, 2004 was $2.1
million and $3.9 million, respectively. Our net loss for three and nine months
ended July 31, 2003 was $1.7 million and $6.1 million, respectively. Our
investment in NexQL had a significant impact on our current net loss. Net
operating expenses and net loss attributable to NexQL for the three and nine
months ended July 31, 2004 were approximately $0.6 million and $1.4 million,
respectively.
The following table sets forth, for the periods indicated, a year-over-year
comparison of the key components of our revenue, costs of revenue and gross
profit:
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
----------------------- -----------------------
2003 2004 2003 2004
---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS) (DOLLARS IN THOUSANDS)
TOTAL REVENUE .................. $ 5,617 $ 4,877 $ 23,868 $ 19,427
Product ..................... $ 3,741 $ 2,920 $ 21,444 $ 12,551
Royalty and other ........... $ 1,876 $ 1,957 $ 2,424 $ 6,876
TOTAL COST OF REVENUE .......... $ 2,638 $ 1,346 $ 14,255 $ 6,092
Product ..................... $ 2,547 $ 1,305 $ 14,018 $ 5,934
Royalty and other ........... $ 91 $ 41 $ 237 $ 158
TOTAL GROSS PROFIT ............. $ 2,979 $ 3,531 $ 9,613 $ 13,335
Product ..................... $ 1,194 $ 1,615 $ 7,426 $ 6,617
Royalty and other ........... $ 1,785 $ 1,916 $ 2,187 $ 6,718
TOTAL GROSS PROFIT PERCENTAGE .. 53% 72% 40% 69%
Product ..................... 32% 55% 35% 53%
Royalty and other ........... 95% 98% 90% 98%
TOTAL REVENUE
Total revenue is broken out between product revenue and royalty revenue.
Last year, we transitioned our embedded router business with HP to a royalty
model whereby they would manufacture the products and pay us a specified royalty
on each unit shipped. 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.
A significant portion of our revenue is concentrated among a relatively
small number of OEM customers. For the three months ended July 31, 2004, three
customers each represented greater than ten percent of our total revenues for
combined totals of 90% of our total revenues. 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. Therefore, the loss of, or a decrease in
the level of sales to, any one of these customers, could seriously harm our
financial condition and results of operations.
Product Revenue
Product revenue consists of sales of our storage router and ServerAttach
lines of products. Our product revenue is primarily generated from our OEM
partners. Product revenue decreased 22% and 41% for the three and nine months
ended July 31, 2004, respectively, as compared to the comparable periods in
fiscal 2003. Product revenue decreased in both comparative periods primarily due
to weakened demand from our OEM partners and seasonality, with our third quarter
traditionally being our weakest quarter. The decrease in product revenue for the
nine months was also the result of our successful transition to a royalty model
for embedded products with HP.
18
Royalty and Other Revenue
Royalty and other revenue consists of 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 or future sales of licensee products.
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. License arrangements can also include a
royalty stream that is recognized quarterly based on reports from the licensee.
Revenue from royalty payments from HP is recognized monthly based on reports
from HP and quarterly from other IP licensees. Service revenue is recognized
ratably over the service period.
Royalty and other revenue for the nine months ended July 31, 2004 increased
as compared to the comparable periods in fiscal 2004 primarily due to our
transition to a royalty based model with HP in the third fiscal quarter of 2003.
During the three months ended July 31, 2004, as compared to the comparable
period in fiscal 2003, royalty and other revenue increased due to greater demand
for our royalty products.
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.
Gross Profit
Gross profit is total revenue less total cost of revenue. Total gross profit
increased 19% for the three months ended July 31, 2004 and 39% for the nine
months ended July 31, 2004 as compared to the comparable periods last year. The
increases in total gross profit and gross profit percentage reflect lower cost
of product revenue associated with the royalty model with HP, IP license revenue
and, to a lesser extent, sales of higher margin products.
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 49% from
the three months ended July 31, 2003 to the three months ended July 31, 2004.
Cost of product revenue decreased 58% for the nine months ended July 31, 2003 to
the nine months ended July 31, 2004.
The decrease in cost of product revenue was expected 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. In addition,
product costs relative to product revenue decreased primarily due to lower
manufacturing costs and higher margin product mix. The decrease in cost of
product revenue was impacted during the three months ended July 31, 2004 due to
decreases of $0.1 million and $0.2 million in both the reserve for excess and
obsolete inventories and warranty, respectively. The cost of product revenue may
fluctuate based on the introduction of new products and changes in product mix
and other fluctuations in the components of cost of product revenue.
We expect to introduce new products in the latter part of calendar year
2004. As new or enhanced products are introduced, we must successfully manage
the transition from older products to avoid excessive levels of older product
inventories, and ensure that sufficient supplies of new products can be
delivered to meet customer demands. Our revenue and gross profit margin will be
adversely affected if we fail to successfully manage the introductions of these
new products.
OPERATING EXPENSES
Sales and Marketing Expenses
Sales and marketing expenses consist primarily of salaries, commissions,
travel, tradeshow and advertising programs, other promotional activities and
stock-based compensation expenses. The following table sets forth, for the
periods indicated, a year-over-year comparison of the key components of our
sales and marketing expenses:
19
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
---------------------- ----------------------
2003 2004 2003 2004
---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS) (DOLLARS IN THOUSANDS)
TOTAL SALES AND MARKETING .... $ 1,018 $ 1,019 $ 3,033 $ 3,403
Stock-based compensation .. $ 5 $ - $ 115 $ -
Sales and marketing expenses increased during the nine months ended July 31,
2004, as compared to the same period in fiscal 2003, primarily due to additional
compensation expense. We began the expansion of our sales and marketing teams
during the third fiscal quarter of 2003. Consequently, expenses for the three
months ended July 31, 2003 and 2004 were comparatively flat, while expenses for
the nine months ended July 31, 2004 were higher on a comparative basis than the
nine months ended July 31, 2003. We anticipate that sales and marketing expenses
may increase as we plan to launch new products during the last half of the
calendar year.
As a result of consolidation of NexQL's results, we also absorbed
approximately $66,000 of NexQL sales and marketing expenses, primarily for
compensation and tradeshow related costs. If NexQL's results continue to be
consolidated, we anticipate that sales and marketing expenses related to NexQL
would increase in the future with further product introduction and development.
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. The following sets forth, for the periods indicated, a year-over-year
comparison of the key components of our research and development expenses:
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
---------------------- ----------------------
2003 2004 2003 2004
---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS) (DOLLARS IN THOUSANDS)
TOTAL RESEARCH AND DEVELOPMENT .. $ 2,925 $ 3,892 $ 9,063 $ 9,993
Stock-based compensation ..... $ 65 $ 7 $ 237 $ 43
In general, research and development expenses have increased for both the
three and nine months ended July 31, 2004, as compared to the same periods in
fiscal 2003, due to increased spending on prototypes and outside services for
the development of new products. We anticipate that research and development
expenses may increase as we plan to continue the development of our technologies
and expand our product offerings.
As a result of consolidation of NexQL's results, we also absorbed
approximately $0.7 million of NexQL research and development expenses, primarily
for compensation and prototype related costs. If NexQL's results continue to be
consolidated, we anticipate that research and development costs related to NexQL
would increase as they continue to progress through various product development
stages.
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. The following table sets forth, for the
periods indicated, a year-over-year comparison of the key components of our
general and administrative expenses:
20
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
---------------------- ----------------------
2003 2004 2003 2004
---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS) (DOLLARS IN THOUSANDS)
TOTAL GENERAL AND ADMINISTRATIVE .. $ 1,136 $ 1,158 $ 4,283 $ 3,858
Stock-based compensation ....... $ 124 $ 11 $ 580 $ 68
The decrease in general and administrative expenses for the nine months
ended July 31, 2004, as compared to the same period in fiscal 2003, was
primarily due to decreases in insurance, depreciation and stock-based
compensation expense. We anticipate that general and administrative expenses may
begin to increase throughout the remainder of fiscal 2004 due to additional
costs associated with the Sarbanes-Oxley Act of 2002 and other related
legislative and regulatory changes as well as due to severance related expenses
related to the resignation of the chief financial officer.
As a result of consolidation of NexQL's results, we also absorbed
approximately $81,000 of NexQL general and administrative expenses, primarily
for compensation, legal and insurance related costs. If NexQL's results continue
to be consolidated, we anticipate that general and administrative costs related
to NexQL would increase as the development company continues to mature.
NexQL
During the first fiscal quarter of 2004, we entered into a strategic
relationship with NexQL, a privately-held development stage company. Pursuant to
certain agreements with NexQL, through July 31, 2004 we have invested $1.0
million to purchase NexQL common stock and may provide NexQL with up to an
additional $1.5 million under a loan facility, over a discretionary time period.
Through July 31, 2004 we have loaned NexQL approximately $0.3 million. We also
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,
including the amount and type of consideration. Depending upon the structure of
the purchase, one condition could be the need for us to obtain stockholder
approval. The exclusive right to purchase NexQL will lapse at various times
after NexQL completes certain milestones.
In connection with the adoption of the Revised Interpretations of FIN 46
(FIN 46R), we concluded that NexQL is a VIE and that we are the primary
beneficiary. Under FIN 46R transition rules, the operating results of NexQL
continued to be accounted for on the equity method for the six months ended
April 30, 2004. The Company consolidated the statements of operations and cash
flows of NexQL beginning May 1, 2004, the beginning of the current quarter.
Crossroads did not record any amounts as revenue related to NexQL for the
nine months ended July 31, 2004. Net operating expenses and net loss
attributable to NexQL for the three and nine months ended July 31, 2004 were
approximately $0.6 million and $1.4 million, respectively. Our overall results
were significantly impacted as a result of our investment in NexQL and adoption
of FIN 46R. Generally, NexQL will recognize revenue when persuasive evidence of
an arrangement exists, delivery has occurred, the fee is fixed or determinable
and collection is probable. Securities and Exchange Commission Staff Accounting
Bulletin No. 104-"Revenue Recognition" requires us to estimate returns and
warranty expenses prior to recognizing revenue. Since NexQL has no history
selling their products, at this time we are not able to estimate returns and
warranty expense. Revenue from sales of products prior to the time we are able
to estimate returns and warranty expense will be deferred.
We monitored our investment in NexQL for impairment during the first two
quarters of fiscal 2004 and made appropriate reductions in its carrying value
and recorded an impairment charge based on the financial condition and near-term
prospects of NexQL. These impairment charges are included in the caption, NexQL
research and development, in the consolidated statement of operations. The
impairment charge, including our percentage of losses on our investment in
NexQL, was approximately $0.7 million for the nine months ended July 31, 2004.
Our 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. If we are required to consolidate in accordance with FIN 46R in
21
the future, any additional losses from NexQL will impact our consolidated
statement of operations, which could cause substantial fluctuations in our
financial results.
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.
Components of business restructuring expenses and the remaining
restructuring accruals as of July 31, 2004 are as follows (in thousands):
FACILITY LEASE
ABANDONMENT
--------------
Balance as of October 31, 2003.............. $ 964
Cash activity............................ (243)
Non-cash activity........................ (187)
---------
Balance as of July 31, 2004................. $ 534
=========
In March 2003, we entered into 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 2006.
In total, we reduced our restructuring accrual by approximately $0.4 million
during the nine months ended July 31, 2004, principally for rent payments to be
received over the next nine to twelve months of both sublease terms. We assess
recoverability of these sublease payments on a quarterly basis.
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.
22
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, JULY 31,
2003 2004
----------- --------
Cash and cash equivalents ................ $ 14,707 $ 18,829
Short-term investments ................... $ 16,670 $ 10,653
Working capital .......................... $ 31,671 $ 28,912
Current ratio ............................ 6.6:1 7:1
Days sales outstanding ................... 30 36
Our principal sources of liquidity at July 31, 2004 consisted of $18.8
million in cash and cash equivalents and $10.7 million in short-term
investments.
In June 2004, we renewed 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 2005. As of July 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 nine months ended July 31,
2004 was approximately $0.6 million. The overall increase in cash provided by
operating activities during fiscal 2004, as compared to fiscal 2003, is a result
of a lower net loss due to higher gross margin and continued control over
operating expenditures.
Cash provided by investing activities was approximately $3.9 million during
the nine months ended July 31, 2004, primarily due to the timing of short-term
investment transactions and 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 requires investment in high quality
short-term securities. The cash impact of investing approximately $1.0 million
in NexQL is also reflected in our investing activities. Capital expenditures
were approximately $1.4 million and reflect our investments in computer
equipment, software, test equipment, software development tools and leasehold
improvements, all of which were required to support the ongoing research and
development in our technologies and expansion of our product offerings. We
anticipate additional capital expenditures during the remainder of fiscal 2004,
primarily to support our ongoing product development efforts.
During the first fiscal quarter of 2004, we entered into a strategic
relationship with NexQL for the joint development of advanced data management
solutions. Based on certain agreements with NexQL, to date we have provided
NexQL with $1.0 million in equity investment and $0.3 million in a loan facility
and we have agreed to provide NexQL with up to an additional $1.2 million in a
loan facility.
Cash utilized by financing activities was approximately $0.4 million for the
nine months ended July 31, 2004 as a result of a decrease in our book overdrafts
of approximately $0.8 million, due to the timing of vendor payments.
We have funded our operations to date primarily through product sales, sales
of preferred stock and our initial public offering, resulting in aggregate gross
proceeds to us of $98.2 million.
At July 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,
acquisition of companies, products or technologies, the timing of introductions
of new products and enhancements to
23
existing products, the amount of cash used to fund our stock repurchase program,
and market acceptance of our products. Moreover, we may enter into additional
strategic arrangements or acquisitions in the future that could require us to
seek equity or debt financing. In particular, we have the exclusive right, but
not an obligation, to purchase NexQL. In the event that we elected to exercise
this option by purchasing NexQL for cash, we may utilize a substantial portion
of our available cash and short-term investments, and therefore may need to
obtain additional funding. We cannot assure 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 based on shares of our common stock outstanding
at the commencement of the repurchase program. There were no stock repurchases
under our open market stock repurchase program in fiscal 2004.
Under future repurchase programs approved by the board of directors, the
stock would 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.
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 July 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 ...... $ 3,484 $ 2,117 $ 1,367 $ - $ -
NexQL loan facility* .. 1,148 1,148 - - -
Subleases ............. (451) (267) (184) - -
------- --------- --------- --------- ---------
Total, net ............ $ 4,181 $ 2,998 $ 1,183 $ - $ -
======= ========= ========= ========= =========
* Pursuant to our agreements with NexQL, we may provide up to $1.5 million of
the loan facility over a discretionary time period.
24
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.
The Company has a minority equity interest in NexQL. In connection with the
adoption of the Revised Interpretations of FIN 46 (FIN 46R), the Company
concluded that NexQL is a VIE and that the Company is the primary beneficiary.
Under FIN 46R transition rules, the operating results of NexQL continued to be
accounted for on the equity method for the six months ended April 30, 2004. The
Company consolidated the statements of operations and cash flows of NexQL
beginning May 1, 2004, the beginning of the current quarter.
25
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. This document is
qualified in its entirety by these risk factors.
If any of the following risks actually occur, they could materially harm our
business, financial condition or results of operations. In that case, the market
price of our common stock could decline.
WE HAVE INCURRED SIGNIFICANT LOSSES AND NEGATIVE CASH FLOW, WE EXPECT FUTURE
LOSSES AND WE MAY NEVER BE PROFITABLE OR MAINTAIN A CONSISTENT POSITIVE CASH
FLOW 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 July 31, 2004,
we had an accumulated deficit of $151.4 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 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 typical reduction in demand for our products during our fiscal
third quarter;
26
- if we are required to consolidate NexQL's financial results with
ours;
- 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
- 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:
- delays in our initial shipment of new products;
- the difficulty of 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.
27
We have also recently entered into a strategic relationship with NexQL 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 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 February 24, 2003, the Court entered a final
judgment in the defendant's favor. Plaintiff's appealed to the United States
Court of Appeals for the Fifth Circuit. On April 14, 2004, the Fifth Circuit
issued an opinion, which affirmed in part and vacated in part the district
court's ruling. The remaining claims were remanded to the district court. On May
12, 2004, the Fifth Circuit denied plaintiff's request for panel rehearing. We
continue to deny the remaining allegations in the complaint and intend to defend
ourselves vigorously. 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, if any,
that we might incur in connection with this lawsuit.
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;
28
- 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.
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 product lines, including the storage routers and the
ServerAttach line of products. We have received revenue from the sale of our
storage routers and ServerAttach lines 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), HP and StorageTek. 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. Although we added EMC to our list of significant OEM customers
for the nine months ended July 31, 2004, our operating results now and 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
29
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.
DEMAND FOR OUR CURRENT 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 current 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.
30
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 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.
31
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, 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 OUR PRODUCTS DECREASE OVER TIME, AND IF WE CANNOT INCREASE OUR
SALES VOLUMES AND DEVELOP NEW, HIGHER MARGIN PRODUCTS, 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
32
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 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.
OUR CHIEF FINANCIAL OFFICER RECENTLY RESIGNED AND IF WE ARE UNABLE TO REPLACE
HER QUICKLY, OUR BUSINESS MAY SUFFER.
On August 27, 2004 we announced that our chief financial officer, Andrea
Wenholz, has resigned from Crossroads effective September 15, 2004. We have a
limited number of financial personnel and therefore the loss of our chief
financial officer is critical. While Ms. Wenholz has agreed to assist us during
a transition period, if we are unable to successfully identify and hire a
qualified chief financial officer, our disclosure controls and procedures could
be materially weakened. In addition, we may be deemed to have a material
weakness in our internal control over financial reporting and our business may
suffer.
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
33
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:
- 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, 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 RELATIONSHIP WITH NEXQL SUBJECTS US TO NUMEROUS RISKS AND UNCERTAINTIES.
We are a party to several agreements with NexQL. As of July 31, 2004, we had
a minority equity interest in NexQL of approximately 17% and we held two of
NexQL's four board of director seats. Our relationship with NexQL subjects us to
numerous risks and uncertainties, including:
34
- we have invested $1.0 million and have committed to lend $1.5 million to
NexQL and we may lose all of our investment;
- we are required to consolidate NexQL's financial statements with our own
and therefore our operating results are less predictable and subject to
significant fluctuation beyond our control, and may be adversely
affected by the results of NexQL;
- our relationship with NexQL has and will continue to require our
management to devote substantial time and resources to NexQL's business
which may adversely affect our business;
- we have the right to acquire NexQL, and if we exercise this right, the
consideration will be either cash, stock or a mixture of both, the
impact of either of which would be costly and dilutive to our
stockholders and, as with any acquisition, would entail significant
risks, which risks would be even more acute because NexQL is an early
stage company in the process of developing its initial product;
- in the event we were to acquire NexQL, whether either all or in part
with cash, we would likely be required to seek additional financing that
may not be available to us on acceptable terms, or at all; and
- NexQL's business is substantially different from our business and
therefore in the event we elect to acquire NexQL, there would the
associated risks of managing a new segment.
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 COMMON STOCK IS CURRENTLY TRADING ABOVE $1.00 PER SHARE. HOWEVER, IF THE
CLOSING BID PRICE OF OUR COMMON STOCK WERE TO FALL BELOW $1.00 PER SHARE FOR
MORE THAN 30 CONSECUTIVE TRADING DAYS, OUR STOCK COULD BE AT RISK OF BEING
DELISTED FROM THE NASDAQ NATIONAL MARKET.
In the event that the closing bid price of our stock were to fall below
$1.00 for 30 consecutive trading days, we would be in danger of having our stock
delisted from the NASDAQ National Market. Delisting could make our stock more
difficult to trade, reduce the trading volume of our stock and further depress
our stock price. In addition, delisting or the threat of delisting could impair
our ability to raise funds in the capital markets, which could materially impact
our business, results of operations and financial condition.
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
35
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.
36
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 July 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 July 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.
37
CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Securities Class Action Litigation. 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
February 24, 2003, the Court entered a final judgment in the defendant's favor.
Plaintiff's appealed to the United States Court of Appeals for the Fifth
Circuit. On April 14, 2004, the Fifth Circuit issued an opinion, which affirmed
in part and vacated in part the district court's ruling. The remaining claims
were remanded to the district court. On May 12, 2004, the Fifth Circuit denied
plaintiff's request for panel rehearing. We continue to deny the remaining
allegations in the complaint and intend to defend ourselves vigorously. 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, if any, that the Company might
incur in connection with this lawsuit.
Intellectual Property Litigation. On October 17, 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. Dot Hill
recently filed a third-party complaint against FalconStor, Inc. (FalconStor),
seeking indemnification for certain of Dot Hill's products at issue in the
litigation. In response, FalconStor has also denied infringement and alleged the
`972 and `035 Patents are invalid and unenforceable. On August 18, 2004,
FalconStor and Crossroads settled their claims against one another. The
settlement included an upfront license fee from FalconStor to Crossroads and a
cross-license of patents between the parties. In the continuing litigation
against Dot Hill, Crossroads plans to vigorously defend its patents against all
counterclaims.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
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 July 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.
During the quarter ended July 31, 2004, Crossroads repurchased the following
shares of our common stock:
MAXIMUM NUMBER (OR
TOTAL NUMBER OF APPROXIMATE DOLLAR
SHARES PURCHASED AS VALUE) OF SHARES
PART OF PUBLICLY THAT MAY YET BE
TOTAL NUMBER OF AVERAGE PRICE PAID ANNOUNCED PLANS OR PURCHASED UNDER THE
PERIOD SHARES PURCHASED PER SHARE PROGRAMS PLANS OR PROGRAMS
- ---------------------------- ---------------- ------------------ ------------------- -------------------
MONTH #1 (MAY 1 TO MAY 31) -- -- N/A N/A
MONTH #2 (JUNE 1 TO JUNE 30) 20,023 (1) $1.58 N/A N/A
MONTH #3 (JULY 1 TO JULY 31) -- -- N/A N/A
TOTAL 20,023 $1.58 N/A N/A
38
(1) In connection with the issuance of an aggregate of 74,542 shares of our
common stock to Rob Sims, our President and Chief Executive Officer, and Andrea
Wenholz, our Vice President and Chief Financial Officer, pursuant to our 2003
Stock Bonus Plan, our board approved the repurchase of 12,078 shares of our
common stock issued to Mr. Sims and 7,945 shares of our common stock issued to
Ms. Wenholz with the proceeds of the repurchase to be held for payment of all
federal taxes required to be withheld by us and federal taxes required to be
paid by Mr. Sims and Ms. Wenholz in connection with the stock bonus plan stock
issuances.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
On August 27, 2004, the vice president and chief financial officer of Crossroads
resigned from her position. In accordance with the severance agreement,
Crossroads will pay one year of salary, continue health benefits for one year,
accelerate the vesting of options to purchase shares of Crossroads' common
stock, and issue 28,882 shares of Crossroads' common stock for no additional
consideration.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
10.1 Letter Agreement dated June 14, 2004 by and between Registrant and
Rob Sims.
10.2 Letter Agreement dated June 14, 2004 by and between Registrant and
Andrea Wenholz.
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.
39
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
CROSSROADS SYSTEMS, INC.
September 2, 2004 /s/ Rob Sims
----------------- ----------------------------------------------
(Date) Rob Sims
Chief Executive Officer
(Principal Executive Officer)
September 2, 2004 /s/ Andrea Wenholz
----------------- ----------------------------------------------
(Date) Andrea Wenholz
Chief Financial Officer
(Principal Financial and Accounting Officer)
40
EXHIBIT INDEX
EXHIBIT
10.1 Letter Agreement dated June 14, 2004 by and between Registrant and Rob
Sims.
10.2 Letter Agreement dated June 14, 2004 by and between Registrant and
Andrea Wenholz.
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.
41