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 October 27, 2001.
[ ] 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 0-26761
NETSILICON, INC.
(Exact name of registrant as specified in its charter)
MASSACHUSETTS 04-2826579
(State of incorporation) (I.R.S. Employer Identification No.)
411 WAVERLEY OAKS RD., BLDG. 227, WALTHAM, MASSACHUSETTS 02452
(Address of principal executive office)
(781) 647-1234
(Telephone number)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ----
Indicate the number of shares outstanding of each of the issuer's classes of
Common Stock, as of the latest practicable date.
7,093,700 shares of Voting Common Stock, $0.01 par value, as of December 6,
2001; 6,972,700 shares of Non-Voting Common Stock, $0.01 par value, as of
December 6, 2001.
NETSILICON, INC.
TABLE OF CONTENTS
PAGE
----
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
Condensed Consolidated Balance Sheets
October 27, 2001 and January 31, 2001.......................... 1
Condensed Consolidated Statements of Operations
Three Months and Nine Months Ended October 27, 2001 and
October 28, 2000............................................... 2
Condensed Consolidated Statements of Cash Flows
Nine Months Ended October 27, 2001 and October 28, 2000........ 3
Notes to Condensed Consolidated Financial Statements........... 4
ITEM 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations....................................... 8
ITEM 3. Quantitative and Qualitative Disclosure About Market Risk......... 24
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings................................................. 25
ITEM 2. Changes in Securities and Use of Proceeds......................... 25
ITEM 3. Defaults Upon Senior Securities................................... 26
ITEM 4. Submission of Matters to a Vote of Security Holders............... 26
ITEM 5. Other Information................................................. 26
ITEM 6. Exhibits and Reports on Form 8-K.................................. 26
Signatures.................................................................. 27
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
NETSILICON, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
OCTOBER 27, 2001 JANUARY 31, 2001
---------------- ----------------
(Unaudited)
ASSETS
CURRENT ASSETS
Cash and equivalents $ 8,423,000 $ 5,999,200
Short-term investments 2,350,600 6,794,400
Accounts receivable, net 3,355,200 4,660,300
Inventory, net 4,470,000 6,707,000
Prepaid expenses and other current assets 1,283,100 1,628,600
------------- ------------
TOTAL CURRENT ASSETS 19,881,900 25,789,500
PROPERTY AND EQUIPMENT, NET 2,072,400 2,335,200
INTANGIBLE ASSETS, NET 1,512,200 1,351,800
OTHER ASSETS 2,618,700 1,924,600
------------- ------------
TOTAL ASSETS $ 26,085,200 $ 31,401,100
============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable $ 2,612,600 $ 2,787,100
Deferred revenue 418,700 343,000
Other current liabilities 4,285,200 3,557,700
------------ ------------
TOTAL CURRENT LIABILITIES 7,316,500 6,687,800
------------ ------------
STOCKHOLDERS' EQUITY
Preferred stock, $0.01 par value; 5,000,000 authorized;
none issued -- --
Common stock, $0.01 par value; 35,000,000 authorized;
issued and outstanding:
Voting (7,093,700 and 6,810,100 shares) 70,900 68,100
Non- Voting (6,972,700 shares) 69,700 69,700
Additional paid-in capital 29,575,400 28,187,400
Accumulated other comprehensive income 9,200 26,500
Accumulated deficit (10,956,500) (3,638,400)
------------ ------------
TOTAL STOCKHOLDERS' EQUITY 18,768,700 24,713,300
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 26,085,200 $ 31,401,100
============ ============
See accompanying notes to condensed consolidated financial statements.
1
NETSILICON, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
------------------------------------ -------------------------------------
OCTOBER 27, 2001 OCTOBER 28, 2000 OCTOBER 27, 2001 OCTOBER 28, 2000
---------------- ---------------- ---------------- ----------------
NET SALES $ 7,171,000 $ 10,687,700 $ 21,200,700 $ 29,554,600
COST OF SALES 3,305,500 4,429,300 9,686,000 12,069,700
------------ ------------ ------------ ------------
GROSS MARGIN 3,865,500 6,258,400 11,514,700 17,484,900
------------ ------------ ------------ ------------
OPERATING EXPENSES
Selling and marketing 2,290,700 2,819,200 7,659,700 8,151,300
Engineering, research and development 1,833,900 1,900,100 5,665,900 4,693,500
General and administrative 2,642,200 1,085,300 5,346,300 3,124,800
Amortization of intangibles 168,600 -- 473,400 --
------------ ------------ ------------ ------------
TOTAL OPERATING EXPENSES 6,935,400 5,804,600 19,145,300 15,969,600
------------ ------------ ------------ ------------
OPERATING INCOME (LOSS) (3,069,900) 453,800 (7,630,600) 1,515,300
Interest income, net 79,700 218,200 351,600 683,100
------------ ------------ ------------ ------------
INCOME (LOSS) BEFORE TAXES
ON INCOME (2,990,200) 672,000 (7,279,000) 2,198,400
Taxes on income (benefit) (26,100) -- 39,100 --
------------ ------------ ------------ ------------
NET INCOME (LOSS) $ (2,964,100) $ 672,000 $ (7,318,100) $ 2,198,400
============ ============ ============ ===========
NET INCOME (LOSS) PER COMMON SHARE
Basic $ (0.21) $ 0.05 $ (0.52) $ 0.16
Diluted $ (0.21) $ 0.04 $ (0.52) $ 0.14
SHARES USED IN PER SHARE CALCULATION
Basic 14,054,789 13,719,643 14,020,395 13,636,354
Diluted 14,054,789 15,814,393 14,020,395 15,911,922
See accompanying notes to condensed consolidated financial statements.
2
NETSILICON, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
NINE MONTHS ENDED
------------------------------------
OCTOBER 27, 2001 OCTOBER 28, 2000
---------------- ----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(7,318,100) $ 2,198,400
Adjustments to reconcile net income (loss) to
net cash used in operating activities:
Depreciation and amortization 1,731,000 1,179,000
Other asset impairment charges 58,000 --
Changes in operating assets and liabilities, net of
effects of acquisition:
Accounts receivable 2,323,000 (3,189,900)
Inventories 2,291,600 (2,281,700)
Other current assets (481,100) (40,200)
Accounts payable (743,500) 1,545,000
Other current liabilities 472,500 (257,400)
Deferred revenue 75,700 268,300
----------- -----------
NET CASH USED IN OPERATING ACTIVITIES (1,590,900) (578,500)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of short-term investments 4,433,300 170,000
Purchases of property and equipment (671,500) (1,669,300)
Cash acquired (paid) in acquisition (net of cash paid and direct
acquisition costs of $347,800 in 2001) 413,600 (439,700)
Software development costs (63,000) (426,900)
Other assets (213,000) (308,700)
----------- -----------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 3,899,400 (2,674,600)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of notes receivable to officer -- (871,200)
Repayments of short-term debt -- (779,700)
Payments of capital lease obligation (10,900) (189,000)
Proceeds from issuance of stock 133,000 --
Proceeds from exercise of stock options -- 1,087,700
----------- -----------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 122,100 (752,200)
----------- -----------
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND
EQUIVALENTS (6,800) --
------------ -----------
INCREASE (DECREASE) IN CASH AND EQUIVALENTS 2,423,800 (4,005,300)
CASH AND EQUIVALENTS - BEGINNING OF PERIOD 5,999,200 11,096,500
----------- -----------
CASH AND EQUIVALENTS - END OF PERIOD $ 8,423,000 $ 7,091,200
=========== ===========
See accompanying notes to condensed consolidated financial statements.
3
NETSILICON, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of presentation:
In the opinion of management, the accompanying condensed
consolidated financial statements include all adjustments
necessary for a fair presentation of NetSilicon, Inc.'s (the
"Company") financial position, results of operations and cash
flows for this interim period. This quarterly information
should be read in conjunction with the audited financial
statements and accompanying notes included in the Company's
2001 Form 10-K as filed with the Securities and Exchange
Commission ("SEC") on May 1, 2001.
The financial statements are prepared in conformity with
generally accepted accounting principles, which require
management to make estimates that affect the reported amounts
of assets, liabilities, revenues and expenses, and the
disclosure of contingent assets and liabilities. Actual
results could differ from these estimates.
Certain prior period amounts have been reclassified to conform
to the current period presentation. These reclassifications
had no effect on net income (loss) or stockholders' equity.
Operating results for the interim period are not necessarily
indicative of results that may be expected for the entire
fiscal year.
2. Inventories:
Inventories are stated at the lower of cost (first-in,
first-out) or market. Cost is computed using standard costs,
which approximate actual cost on a first-in, first-out basis.
Inventories consist of:
October 27, 2001 January 31, 2001
---------------- -----------------
Raw material $4,318,300 $6,543,000
Work in process 18,600 118,100
Finished Goods 133,100 45,900
----------- ----------
Total Inventory $4,470,000 $6,707,000
=========== ==========
3. Earnings per share calculation:
Basic earnings per share is computed based on the weighted
average number of shares outstanding during the period.
Diluted earnings per share is computed based on the weighted
average number of shares outstanding during the period
increased by the effect of dilutive potential common shares
which consist of shares issuable under stock benefit plans and
warrants.
4
The following is a reconciliation of the numerator and
denominators of the basic and diluted per share computations:
Three months ended Nine months ended
--------------------------- ----------------------------
October 27, October 28, October 27, October 28,
2001 2000 2001 2000
------------ ----------- ------------ -------------
Net income (loss) available to
common shareholders, basic and
diluted $(2,964,100) $ 672,000 $ (7,318,100) $ 2,198,400
============ =========== ============ ===========
Weighted-average number of
common shares used in basic
earnings per share 14,054,789 13,719,643 14,020,395 13,636,354
Effect of dilutive securities -
stock options -- 2,094,750 -- 2,275,568
------------ ----------- ------------ -----------
Weighted-average number of
common shares and dilutive
potential common stock used in
dilutive earnings per share 14,054,789 15,814,393 14,020,395 15,911,922
============ =========== ============ ===========
The shares issuable upon exercise of options and warrants
represent the shares issuable at exercise net of the shares
assumed to have been purchased, at the average market price
for the period, with the assumed exercise proceeds.
Accordingly, options and warrants with exercise prices in
excess of the average market price for the period are excluded
because their effect would be anti-dilutive. The Company had a
net loss for the three and nine months ended October 27, 2001.
The effect of dilutive securities including stock options and
warrants to acquire common stock are not included in the
calculation of earnings (loss) per share for the periods ended
October 27, 2001 because their effect would be anti-dilutive.
4. Acquisition:
On February 16, 2001, the Company purchased all of the equity
securities of Dimatech Corporation ("Dimatech") pursuant to a
Stock Purchase Agreement, dated as of February 16, 2001, by
and among Dimatech, Hiroyuki Kataoka and the Company. Prior to
the acquisition, Dimatech was a major distributor of the
Company's products in Japan and Asia and Hiroyuki Kataoka was
the President and owner of Dimatech. Dimatech, under a new
name, continues to operate in Japan and Asia as a distributor
of the Company's products and provides technical support and
other services to customers in the region. Hiroyuki Kataoka
has joined NetSilicon as Vice President of Intelligent Device
Markets for Japan.
The purchase price was allocated to the tangible and
intangible assets acquired and liabilities assumed on the
basis of their respective estimated fair values on the
acquisition date. The following represents a preliminary
allocation of the purchase price:
Cash..................................... $ 761,400
Accounts receivable...................... 1,017,900
Other tangible assets.................... 161,900
Customer list............................ 351,400
Workforce................................ 148,000
Goodwill................................. 134,400
----------
Total purchase price..................... $2,575,000
==========
5
The purchase price consisted of 241,667 shares of the common
stock of the Company, valued at $1,239,100, assumed
liabilities of $969,400, $250,000 in cash and $116,500 of
acquisition related costs, including legal and accounting
fees.
5. Comprehensive Income (Loss):
Comprehensive income (loss) is defined as a change in equity
of a company during a period from transactions and other
events and circumstances excluding transactions resulting from
investments by owners and distributions to owners. The
difference between net income (loss) and comprehensive income
(loss) for NetSilicon results from foreign currency
translation adjustments and unrealized gains and losses on
available-for-sale securities, net of taxes. Comprehensive
income (loss) consisted of the following:
Three Months Ended Nine Months Ended
--------------------------- --------------------------
October 27, October 28, October 27, October 28,
2001 2000 2001 2000
------------ ----------- ------------ ------------
Net Income (Loss)........... $(2,964,100) $672,000 $(7,318,100) $2,198,400
------------ -------- ----------- ----------
Foreign currency
translation adjustments..... 61,400 -- (6,800) --
Unrealized gain (loss)
on investments.............. 16,300 11,100 (10,500) 34,400
----------- -------- ----------- ----------
Other comprehensive income
(loss)...................... 77,700 11,100 (17,300) 34,400
------------ -------- ----------- ----------
Total comprehensive income
(loss)...................... $(2,886,400) $683,100 $(7,335,400) $2,232,800
=========== ======== =========== ==========
6. Contingencies:
On or about August 9, 2001, a purported securities class
action lawsuit captioned "Ellis Investments, Ltd. v.
NetSilicon, Inc., et al." (01-CV-7281) was filed in the United
States District Court for the Southern District of New York.
Later in August, 2001, two additional, nearly identical
complaints were filed in the same Court in lawsuits captioned
"Michael Rasner v. NetSilicon, Inc., et al." (01-CV-7651) and
"Walter Weitz v. NetSilicon, Inc. et al." (01-CV-8217). The
suits name as defendants the Company, certain of its officers
and directors, and certain underwriters involved in the
Company's initial public offering ("IPO"). The Ellis
Investments suit also names Osicom Technologies, Inc. as a
defendant. The complaints in these actions are allegedly
brought on behalf of purchasers of the Company's common stock
during the period from September 15, 1999 to December 6, 2000,
and assert, among other things, that the Company's IPO
prospectus and registration statement violated federal
securities laws because they contained material
misrepresentations and/or omissions regarding the conduct of
the Company's IPO underwriters in allocating shares in the
Company's IPO to the underwriters' customers. The actions seek
rescission or rescissory and other damages, fees and costs
associated with the litigation, and interest. The Company
understands that various plaintiffs have filed substantially
similar lawsuits against over a hundred other publicly traded
companies in connection with the underwriting of their initial
public offerings. The Company and its officers and directors
believe that the allegations in the complaints are without
merit and intend to contest them vigorously. An unfavorable
resolution of the actions could have a material adverse effect
on the business, results of operations or financial condition
of the Company.
Contingent on the Company's merger with Digi International,
the Company has agreed to forgive the payment obligations of
two promissory notes in the aggregate principal amount of
$871,200 plus interest made by its Chairman of the Board and
Chief Executive Officer ("Chairman and CEO") and provide
additional payments as necessary to cover any taxes owed by
the Chairman and CEO as a result of the forgiveness and the
additional payment. Also contingent on the merger, the
Chairman and CEO will receive a one-time payment of $740,000.
6
7. Subsequent Events:
Proposed Merger with Digi International - On November 5, 2001,
the Company and Digi International Inc. ("Digi"), announced
the signing of an Agreement and Plan of Merger dated October
30, 2001 (the "Agreement") pursuant to which the Company will
effectively become a wholly-owned subsidiary of Digi. Under
the terms of the Agreement, each outstanding share of the
Company's common stock would be converted into the right to
receive either cash, Digi common stock or a combination of
cash and Digi common stock at the election of the holder. The
Agreement provides that each holder of the Company's common
stock may elect to receive 0.6500 of a share of Digi common
stock for each share of the Company's common stock, or cash in
the amount of 0.6500 multiplied by the average per-share
closing price of Digi common stock during the period of ten
trading days ending on the third trading day before the date
of closing, or a combination of both stock and cash, provided
that the maximum amount of cash to be paid by Digi will be $15
million. The merger is expected to close in the first calendar
quarter of 2002 and is subject to approval by the shareholders
of the Company and Digi and by regulators. The details of the
proposed transaction are discussed in the Company's Form 8-K
filed with the Securities and Exchange Commission on October
30, 2001.
Websprocket, LLC Legal Claims - On November 2, 2001, the
Company and Websprocket, LLC entered into a Settlement
Agreement and Mutual Release settling all claims between the
companies, including all claims and counterclaims asserted in
the litigation captioned Websprocket, LLC v. NetSilicon, Inc.,
Civil Action No. C-00-20915 RMV pending in the United States
District Court for the Northern District of California. On
November 13, 2001, the court approved and entered a
Stipulation of Dismissal With Prejudice, in which the Company
and Websprocket, LLC dismissed all claims in the litigation
and waived all rights to appeal. The Company has paid
Websprocket, LLC approximately $162,000 as part of the
settlement agreement.
8. Recent Accounting Pronouncements:
In June 2001, the Financial Accounting Standards Board
finalized FASB Statement No. 141, "Business Combinations
("SFAS 141"), and No. 142, Goodwill and Other Intangible
Assets ("SFAS 142"). SFAS 141 requires the use of the
purchased method of accounting and prohibits the use of the
pooling-of-interests method of accounting for business
combinations initiated after June 30, 2001. SFAS 141 also
requires that the Company recognize acquired intangible assets
apart from goodwill if the acquired intangible assets meet
certain criteria. SFAS 141 applies to all business
combinations initiated after June 30, 2001 and for purchase
business combinations completed on or after July 1, 2001. Upon
adoption of SFAS 142, it requires that the Company reclassify
the carrying amounts of intangible assets and goodwill based
on the criteria in SFAS 141.
SFAS 142 requires, among other things, that companies no
longer amortize goodwill, but instead test goodwill for
impairment at least annually. In addition, SFAS 142 requires
that the Company identify reporting units for the purposes of
assessing potential future impairments of goodwill, reassess
the useful lives of other existing recognized intangible
assets, and cease amortization of intangible assets with an
indefinite useful life. An intangible asset with an indefinite
useful life should be tested for impairment in accordance with
the guidance in SFAS 142. SFAS 142 is required to be applied
in fiscal years beginning after December 15, 2001 to all
goodwill and other intangible assets recognized at that date,
regardless of when those assets were initially recognized.
SFAS 142 requires the Company to complete a transitional
goodwill impairment test six months from the date of adoption.
The Company is also required to reassess the useful lives of
other intangible assets within the first interim quarter after
adoption of SFAS 142.
The Company's previous business combinations were accounted
for using the purchase method. As of October 27, 2001, the net
carrying amount of intangible assets is $1.5 million.
Amortization expense during the nine month period ended
October 27, 2001 was $473,000. Currently, the Company is
assessing but has not yet determined how the adoption of SFAS
141 and SFAS 142 will impact its financial position and
results of operations.
7
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Some of the information in this discussion and analysis
contains forward-looking statements within the meaning of the
federal securities laws. These statements include, among
others, statements regarding our financial performance,
expected future revenue, product development plans, projected
capital expenditures, liquidity and business strategy.
Forward-looking statements typically are identified by use of
terms such as may, will, expect, anticipate, estimate and
similar words, although some forward-looking statements are
expressed differently. You should be aware that our actual
results could differ materially from those contained in the
forward-looking statements due to a number of factors,
including delays in product introductions, interruptions in
supply and competitive product introductions. You should also
consider carefully the "Business" and "Risk Factors" sections
contained in the Company's 2001 Form 10-K as filed with the
SEC and the "Risk Factors" section contained herein, which
address additional factors that could cause our actual results
to differ from those set forth in the forward-looking
statements.
You should read this discussion together with the unaudited
financial statements and other information included in this
document.
OVERVIEW
We develop and market embedded Ethernet networking solutions,
which combine advanced microprocessors and software, to
manufacturers building intelligent, network-enabled devices.
We commenced our operations in 1984 as Digital Products, Inc.
From our inception, we have developed and marketed networking
products for embedded systems that enable the connection of
electronic devices to networks.
In September 1996, Sorrento Networks Corporation, formerly
Osicom Technologies, Inc. ("Sorrento"), acquired all of our
outstanding capital stock from our stockholders. We were a
wholly-owned subsidiary of Sorrento from the date of the
acquisition through our initial public offering in September
of 1999.
RESULTS OF OPERATIONS
The following table sets forth information derived from our
Statements of Operations expressed as a percentage of net
sales for the three and nine month periods ended October 27,
2001 and October 28, 2000.
Three Months Ended Nine Months Ended
----------------------------- ----------------------------
October 27, October 28, October 27, October 28,
2001 2000 2001 2000
------------ ----------- ------------ -----------
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales 46.1 41.4 45.7 40.8
----- ----- ----- -----
Gross margin 53.9 58.6 54.3 59.2
----- ----- ----- -----
Operating expenses:
Selling and marketing 31.9 26.4 36.1 27.6
Engineering, research
and development 25.6 17.8 26.7 15.9
General and administrative 36.8 10.2 25.2 10.6
Amortization of intangibles 2.4 -- 2.2 --
----- ----- ----- -----
Total operating expenses 96.7 54.4 90.2 54.1
----- ----- ----- -----
8
Operating income (loss) (42.8) 4.2 (35.9) 5.1
Interest income, net 1.1 2.0 1.7 2.3
----- ----- ----- -----
Income (loss) before taxes
on income (41.7) 6.2 (34.2) 7.4
Taxes on income (benefit) (0.4) -- 0.2 --
----- ----- ----- -----
Net income (loss) (41.3)% 6.2% (34.4)% 7.4%
===== ===== ===== =====
Three and Nine Months Ended October 27, 2001 compared to Three
and Nine Months Ended October 28, 2000:
NET SALES. Net sales were $7.2 million for the three months
ended October 27, 2001 compared to $10.7 million for the three
months ended October 28, 2000, representing a decrease of
32.9%. Net sales decreased to $21.2 million for the nine
months ended October 27, 2001 from $29.6 million for the nine
months ended October 28, 2000, a decrease of 28.3%.
The decrease in net sales in the three and nine month periods
was due primarily to an economic slowdown that has affected
our imaging customers. Revenue from our imaging customers was
$5.7 million and $16.9 million for the three and nine month
periods, respectively, ended October 27, 2001 compared to $8.5
million and $24.1 million for the three and nine month
periods, respectively, ended October 28, 2000. Backlog for our
products and service was approximately $3.3 and $4.8 million
at October 27, 2001 and October 28, 2000, respectively, all of
which was scheduled to be shipped within 12 months.
Our embedded networking semiconductor and controller products
accounted for 88.5% and 89.0% of total net sales for the nine
months ended October 27, 2001 and October 28, 2000,
respectively. Software development tools and development
boards accounted for 4.5% of total net sales for the nine
months ended October 27, 2001 and 5.4% of total net sales for
the prior year nine month period. Royalty, maintenance and
service revenue was 7.0% and 5.6% of total net sales for the
nine months ended October 27, 2001 and October 28, 2000,
respectively.
During the nine months ended October 27, 2001, international
sales accounted for 53.6% of net sales compared to 55.0% of
net sales for the nine month period ended October 28, 2000.
COST OF SALES; GROSS MARGIN. Costs of goods sold consists
principally of the cost of raw material components and
subcontractor labor assembly from outside manufacturers and
suppliers. Cost of sales also includes amortization of
software development costs. Gross margin decreased to $3.9
million, or 53.9% of net sales, for the three months ended
October 27, 2001 from $6.3 million, or 58.6% of net sales, for
the three months ended October 28, 2000, representing a
decrease of 38.2%. Gross margin decreased 34.1% to $11.5
million, or 54.3% of net sales, for the nine months ended
October 27, 2001 from $17.5 million, or 59.2% of net sales,
for the nine months ended October 28, 2000.
The decrease in gross margin percent for the three and nine
month periods ended October 27, 2001 from the prior year
periods was due primarily to (i) a decrease in high-margin
sales of development kits; (ii) a decrease in royalty revenue;
and (iii) the overall decrease in sales which were offset in
part by increased sales of high-margin software products and
decreases in overhead spending, including freight costs.
9
SELLING AND MARKETING EXPENSES. Selling and marketing expenses
consist mainly of employee-related expenses, commissions to
sales representatives, trade shows, publicity and travel
expenses. Selling and marketing expenses decreased from $2.8
million, or 26.4% of net sales, for the three months ended
October 28, 2000 to $2.3 million, or 31.9% of net sales, for
the three months ended October 27, 2001, representing a
decrease of 18.7%. Selling and marketing expenses were $7.7
million, or 36.1% of net sales, for the nine month period
ended October 27, 2001 compared to $8.2 million, or 27.6% of
net sales, for the nine month period ended October 28, 2000.
The decrease in selling and marketing expenses for the three
and nine months ended October 27, 2001 compared to the three
and nine months ended October 28, 2000 was the result of (i) a
decrease in commission to sales representatives due to the
decrease in revenue; (ii) the absence of commission payable to
Dimatech Corporation, our former distributor in Japan that we
acquired in February 2001; and (iii) decreases in several
discretionary costs due to our cost reduction initiatives.
These decreased costs were offset in part by (i) additional
payroll costs related to the expansion of our direct sales and
marketing teams, including those costs related to our
acquisition of Dimatech Corporation and certain assets of
Pacific Softworks, Inc. and (ii) payroll recruiting and other
costs associated with investments made to expand our customer
support department.
ENGINEERING, RESEARCH AND DEVELOPMENT. Engineering, research
and development expenses consist primarily of salaries and the
related costs of employees engaged in research, design and
development activities. Engineering, research and development
expenses decreased to $1.8 million, or 25.6% of net sales, for
the three months ended October 27, 2001 from $1.9 million, or
17.8% of net sales, for the three months ended October 28,
2000, representing a decrease of 3.5%. Engineering, research
and development expenses increased 20.7% to $5.7 million, or
26.7% of net sales, for the nine months ended October 27, 2001
from $4.7 million, or 15.9% of net sales, for the nine months
ended October 28, 2000.
The decrease in engineering, research and development expenses
for the three month period ended October 27, 2001 from the
prior year period is attributable to decreases in several
discretionary costs due to our cost reduction initiatives. The
increase in engineering, research and development expenses for
the nine month period ended October 27, 2001 from the prior
year period is due to the addition of approximately 10
engineers acquired in connection with our purchase of certain
assets of Pacific Softworks in August 2000.
GENERAL AND ADMINISTRATIVE EXPENSES. General and
administrative expenses consist mainly of salaries,
employee-related expenses, legal expenses, audit fees and
reserves for accounts receivable allowances. General and
administrative expenses increased to $2.6 million, or 36.8% of
net sales, for the three months ended October 27, 2001 from
$1.1 million, or 10.2% of net sales, for the three months
ended October 28, 2000, an increase of 143.5%. General and
administrative expenses increased 71.1% to $5.3 million, or
25.2% of net sales, for the nine months ended October 27, 2001
from $3.1 million, or 10.6% of net sales, for the nine months
ended October 28, 2000.
The increase in general and administrative expenses is
attributable to increased legal costs related to the proposed
merger with Digi International and the Websprocket, LLC and
IPO class action lawsuits. The increase in general and
administrative expenses is also due to an increase in rent
expense related to our new facilities in California and Japan
and vacated space at our headquarters in Massachusetts,
increases in accounting and insurance costs, and increases in
employee-related expenses including severance costs for
terminated employees. These increases were offset in part by
decreases in several discretionary costs due to our cost
reduction initiatives.
10
AMORTIZATION OF INTANGIBLES. Amortization of intangible assets
consists of the amortization of intangible assets acquired in
connection with the purchase of certain assets of Pacific
Softworks, Inc. in August 2000 and our acquisition of Dimatech
Corporation in February 2001. Amortization of intangibles
increased to $169,000, or 2.4% of net sales, and $473,000, or
2.2% of net sales, for the three and nine months ended October
27, 2001, respectively, from $0 for the three and nine months
ended October 28, 2000.
INTEREST INCOME, NET. Interest income includes interest earned
on cash and short-term investment balances. Net interest
income was $80,000, or 1.1% of net sales, and $218,000, or
2.0% of net sales, for the three months ended October 27, 2001
and October 28, 2000, respectively. Net interest income was
$352,000, or 1.7% of net sales, and $683,000, or 2.3% of net
sales, for the nine months ended October 27, 2001 and October
28, 2000, respectively. The decrease in interest income is due
to a decrease in cash and short-term investments.
Provision for income taxes. The tax benefit for the three
months ended October 27, 2001 totaled $26,000, or 0.4% of net
sales, and the income tax provision for the nine months ended
October 27, 2001 totaled $39,000, or 0.2% of net sales, and
both related to foreign taxes for our Japanese subsidiary.
There was no net provision for U.S. income taxes for the three
and nine months ended October 28, 2000 due to the utilization
of available net operating loss carryforwards.
Liquidity and Capital Resources
Prior to our public offering in September 1999, we financed
our operations through advances from Sorrento and borrowings
under our short-term bank line of credit. The Company received
proceeds, net of offering costs, of approximately $22.2
million as a result of the initial public offering and sale of
our stock. At October 27, 2001, we had working capital of
$12.6 million, cash and cash equivalents of $8.4 million and
short-term investments of $2.4 million.
Our operating activities used cash of $1.6 million and
$579,000 for the nine months ended October 27, 2001 and
October 28, 2000, respectively. Cash used by operating
activities in the nine month period ended October 27, 2001 was
attributable to the net loss and a decrease in accounts
payable, offset in part by decreases in accounts receivable
and inventory and the non-cash impact of depreciation and
amortization. The decrease in accounts receivable is due to
the decrease in sales and strong collection efforts and the
decrease in inventory is attributable to a decrease in
purchasing activity and the consumption of electronic
components that were previously purchased in large volumes to
decrease the risk to our operations of the sharp fluctuations
in market supply of the components. Cash used during the nine
months ended October 28, 2000 was attributable to an increase
in accounts receivable and inventory, offset in part by net
income, an increase in accounts payable and the non-cash
impact of depreciation and amortization.
Our sales and marketing expenses, engineering, research and
development expenses and general and administrative expenses
each may increase in the fiscal year ending January 31, 2002
and thereafter compared to the amounts of such expenses in the
fiscal year ending January 31, 2001. Due in part to an
economic slowdown affecting our imaging customers, we
anticipate a decline in imaging revenue growth in fiscal year
2002, from fiscal year 2001, which will adversely effect our
results of operations and financial condition and may result
in operating losses for all or part of fiscal year 2002. There
can be no assurance that our available cash and cash flow from
operations will be sufficient to fund such additional
expenses.
11
Our standard payment terms are net 30 days. While we actively
pursue collection within that time, receivables have
frequently taken longer to collect in part because we sell
products to large companies in Asia.
Our investing activities provided cash of $3.9 million and
used cash of $2.7 million during the nine months ended October
27, 2001 and October 28, 2000, respectively. Cash provided by
investing activities during the nine months ended October 27,
2001 related primarily to proceeds of $4.4 million from
short-term investments and net cash acquired in the
acquisition of Dimatech Corporation of $414,000, offset in
part by purchases of property and equipment of $672,000. Cash
used in investing activities during the nine months ended
October 28, 2000 related primarily to purchases of $1.7
million of property and equipment, software development costs
of $427,000, and cash payments of $440,000 related to our
acquisition of certain assets of Pacific Softworks.
On August 31, 2000, we issued 90,000 shares of common stock,
valued at $2.3 million and incurred $570,000 of
acquisition-related costs in connection with the acquisition
of the strategic network technology assets of Pacific
Softworks, Inc. The total purchase price was $2.8 million and
was allocated to the tangible and intangible assets acquired.
On February 16, 2001, we issued 241,667 shares of common stock
valued at $1.2 million, paid cash of $250,000, incurred
$116,500 of acquisition-related costs and assumed $969,400 of
liabilities in connection with the acquisition of Dimatech
Corporation. The total purchase price was $2.6 million and was
allocated to the tangible and intangible assets acquired.
Cash provided by financing activities was $122,000 and cash
used by financing activities was $752,000 during the nine
months ended October 27, 2001 and October 28, 2000,
respectively. Cash provided by financing during the period
ended October 27, 2001 related to proceeds from the issuance
of stock. Cash used in financing activities in the period
ended October 27, 2000 was attributable to repayments of short
term debt of $780,000 and loans to an officer of the Company
in the amount of $871,000, offset in part by proceeds from the
exercise of stock options of $1.1 million.
We anticipate that our available cash resources will be
sufficient to meet our presently anticipated capital
requirements through the next 12 months. Nonetheless, we may
elect to sell additional equity securities or obtain
additional credit. Our future capital requirements may vary
materially from those now planned and will depend on many
factors, including, but not limited to, the levels at which we
maintain inventory and accounts receivable; the market
acceptance of our products; the levels of promotion and
advertising required to launch products or enter markets and
attain a competitive position in the marketplace; volume
pricing concessions; our business, product, capital
expenditure and research and development plans and technology
roadmap; capital improvements to new and existing facilities;
technological advances; the response of competitors to our
products; and our relationships with suppliers and customers.
In addition, we may require an increase in the level of
working capital to accommodate planned growth, hiring and
infrastructure needs. Additional capital may be required for
consummation of any acquisitions of businesses, products or
technologies. We may need to raise additional funds through
public or private financings or borrowings if existing
resources and cash generated from operations are insufficient
to fund our future activities. No assurance can be given that
additional financing will be available or that, if available,
such financing can be obtained on terms favorable to our
shareholders and us. If additional funds are raised through
the issuance of equity securities, the percentage ownership of
then current stockholders of us will be reduced and such
equity securities may have rights, preferences or privileges
senior to those of holders of our common stock. If adequate
funds are not available to satisfy short- or long-term capital
requirements, we may be required to limit our operations
significantly.
12
Impact of Recent Accounting Pronouncements:
In June 2001, the Financial Accounting Standards Board
finalized FASB Statement No. 141, "Business Combinations
("SFAS 141"), and No. 142, Goodwill and Other Intangible
Assets ("SFAS 142"). SFAS 141 requires the use of the
purchased method of accounting and prohibits the use of the
pooling-of-interests method of accounting for business
combinations initiated after June 30, 2001. SFAS 141 also
requires that the Company recognize acquired intangible assets
apart from goodwill if the acquired intangible assets meet
certain criteria. SFAS 141 applies to all business
combinations initiated after June 30, 2001 and for purchase
business combinations completed on or after July 1, 2001. Upon
adoption of SFAS 142, it requires that the Company reclassify
the carrying amounts of intangible assets and goodwill based
on the criteria in SFAS 141.
SFAS 142 requires, among other things, that companies no
longer amortize goodwill, but instead test goodwill for
impairment at least annually. In addition, SFAS 142 requires
that the Company identify reporting units for the purposes of
assessing potential future impairments of goodwill, reassess
the useful lives of other existing recognized intangible
assets, and cease amortization of intangible assets with an
indefinite useful life. An intangible asset with an indefinite
useful life should be tested for impairment in accordance with
the guidance in SFAS 142. SFAS 142 is required to be applied
in fiscal years beginning after December 15, 2001 to all
goodwill and other intangible assets recognized at that date,
regardless of when those assets were initially recognized.
SFAS 142 requires the Company to complete a transitional
goodwill impairment test six months from the date of adoption.
The Company is also required to reassess the useful lives of
other intangible assets within the first interim quarter after
adoption of SFAS 142.
The Company's previous business combinations were accounted
for using the purchase method. As of October 27, 2001, the net
carrying amount of intangible assets is $1.5 million.
Amortization expense during the nine month period ended
October 27, 2001 was $473,000. Currently, the Company is
assessing but has not yet determined how the adoption of SFAS
141 and SFAS 142 will impact its financial position and
results of operations.
RISK FACTORS
YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISKS BEFORE
INVESTING IN OUR COMMON STOCK. THESE ARE NOT THE ONLY RISKS
FACING OUR COMPANY. ADDITIONAL RISKS MAY ALSO IMPAIR OUR
BUSINESS OPERATIONS. IF ANY OF THE FOLLOWING RISKS COME TO
FRUITION, OUR BUSINESS, RESULTS OF OPERATIONS OR FINANCIAL
CONDITION COULD BE MATERIALLY ADVERSELY AFFECTED. IN THAT
CASE, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE, AND
YOU MAY LOSE ALL OR PART OF YOUR INVESTMENT. YOU SHOULD ALSO
REFER TO THE OTHER INFORMATION SET FORTH IN THIS DOCUMENT,
INCLUDING OUR FINANCIAL STATEMENTS AND THE ACCOMPANYING NOTES.
WE HAVE A HISTORY OF LOSSES AND AN ACCUMULATED DEFICIT THAT
MAKE FUTURE OPERATING RESULTS AND PROFITABILITY DIFFICULT TO
PREDICT.
We incurred net losses from continuing operations for the
fiscal years ended January 31, 1997, 1998, 1999 and 2001. At
January 31, 2001, we had an accumulated deficit of $3.6
million. There can be no assurance that we will be able to
achieve profitability on a quarterly or annual basis in the
future. In addition, revenue growth is not necessarily
indicative of future operating results and there can be no
assurance that we will be able to sustain revenue growth. We
continue to invest significant financial resources in product
13
development, marketing and sales, and a failure of such
expenditures to result in significant increases in revenue
could have a material adverse effect on us. Due to the limited
history and undetermined market acceptance of our new
products, the rapidly evolving nature of our business and
markets, potential changes in product standards that
significantly influence many of the markets for our products,
the high level of competition in the industries in which we
operate and the other factors described elsewhere in these
Risk Factors, there can be no assurance that our investment in
these areas will result in increases in revenue or that any
revenue growth that is achieved can be sustained. Our history
of losses, coupled with the factors described below, make
future operating results difficult to predict. We and our
future prospects must be considered in light of the risks,
costs and difficulties frequently encountered by emerging
companies. As a result, there can be no assurance that we will
be profitable in any future period.
THE UNPREDICTABILITY OF OUR QUARTERLY RESULTS MAY ADVERSELY
AFFECT THE TRADING PRICE OF OUR COMMON STOCK.
Our net sales and operating results have in the past and may
in the future fluctuate substantially from quarter to quarter
and from year to year. These results have varied significantly
due to a number of factors, including:
- market acceptance of and demand for our products
and those of our customers;
- unanticipated delays or problems in the
introduction of our products;
- the timing of large customer orders;
- the timing and success of our customers'
development cycles;
- our ability to introduce new products in
accordance with customer design requirements and
design cycles;
- new product announcements or product introductions
by us and our competitors;
- availability and cost of manufacturing sources
for our products;
- the volume of orders that are received and can be
filled in a quarter;
- the rescheduling or cancellation of orders by
customers;
- changes in product mix;
- timing of "design wins" with our customers and
related revenue; and
- changes in currency exchange rates.
Our operating results could also be harmed by:
- the growth rate of markets into which we sell
our products;
- changes in the mix of sales to customers and
sales representatives;
- costs associated with protecting our
intellectual property; and
14
- changes in product costs and pricing by us
and our competitors.
We budget expenses based in part on future revenue
projections. We may be unable to adjust spending in a timely
manner in response to any unanticipated declines in revenues.
As a result of these and other factors, investors should not
rely solely upon period-to-period comparisons of our operating
results as an indication of future performance. It is likely
that in some future period our operating results or business
outlook will be below the expectations of securities analysts
or investors, which would likely result in a significant
reduction in the market price of the shares of our common
stock.
OUR FAILURE TO INCREASE SALES TO MANUFACTURERS OF INTELLIGENT,
NETWORK-ENABLED DEVICES AND OTHER EMBEDDED SYSTEMS WILL
ADVERSELY AFFECT OUR FINANCIAL RESULTS.
Our financial performance and future growth is dependent upon
our ability to sell our products to manufacturers of
intelligent, network-enabled devices and other embedded
systems in various markets, including markets in which
networking solutions for embedded systems have not
historically been sold, such as the industrial automation
equipment, data acquisition and test equipment, Internet
devices and security equipment markets. A substantial portion
of our recent development efforts have been directed toward
the development of new products for markets that are new and
rapidly evolving. There can be no assurance that:
- the additional intelligent device markets
targeted by us for our products and services
will develop;
- developers within each market targeted by us
will choose our products and services to meet
their needs;
- we will successfully develop products to meet the
industry-specific requirements of developers in
our targeted markets or that design wins will
result in significant sales; or
- developers in our targeted markets will gain
market acceptance for their devices which
incorporate our products.
We have limited experience in designing our products to meet
the requirements of developers in these industries. Moreover,
our products and services have, to date, achieved limited
acceptance in these industries.
WE ARE DEPENDENT ON THE IMAGING MARKET FOR A LARGE PORTION OF
OUR REVENUES.
The imaging market has historically accounted for
substantially all of our revenues. In the fiscal years ended
January 31, 2001, 2000 and 1999, 79%, 95% and 95%,
respectively, of our revenues were generated from customers in
the imaging market. Our success has been and continues to be
dependent on the continued success of the imaging market. Many
of our customers face competition from larger, more
established companies which may exert competitive or other
pressures on them. Any decline in sales to the imaging market
would have a material adverse effect on our business, results
of operations and financial condition.
Due in part to an economic slowdown affecting our imaging
customers, we anticipate a decline in imaging revenue growth
in fiscal year 2002, from fiscal year 2001, which will
adversely affect our results of operations and financial
condition.
15
The imaging market is characterized by declining prices of
existing products and a transition from higher priced network
interface cards to semiconductor devices. Therefore, continual
improvements in manufacturing efficiencies and the
introduction of new products and enhancements to existing
products are required for us to maintain our gross margins. In
response to customer demands or competitive pressures, or to
pursue new product or market opportunities, we may take
certain pricing or marketing actions, such as price reductions
or volume discounts. These actions could have a material
adverse effect on us.
A significant amount of our customers in the imaging market
are headquartered in Japan. Our customers are subject to
declines in their local economies, which have affected them
from time to time in the past and may affect them in the
future. The success of our customers affects their purchases
from us.
OUR HIGHLY CONCENTRATED CUSTOMER BASE INCREASES THE POTENTIAL
ADVERSE EFFECT ON US FROM THE LOSS OF ONE OR MORE CUSTOMERS.
Our products have historically been sold into the imaging
markets for use in products such as printers, scanners, fax
machines, copiers and multi-function peripherals. This market
is highly concentrated. Accordingly, our sales are derived
from a limited number of customers, with our top five OEM
customers accounting for 55%, 72% and 52% of total revenues
for the fiscal years ended 2001, 2000 and 1999, respectively.
In particular, sales to Dimatech, which we acquired in
February 2001, and Ricoh accounted for 23% and 20% of total
revenues, respectively, for the fiscal year ended January 31,
2001. We expect that a small number of customers will continue
to account for a substantial portion of our total revenues for
the foreseeable future. All of our sales are made on the basis
of purchase orders rather than under long-term agreements, and
therefore, any customer could cease purchasing our products at
any time without penalty. The decision of any key customer to
cease using our products or a material decline in the number
of units purchased by a significant customer would have a
material adverse effect on us.
THE LONG AND VARIABLE SALES CYCLE FOR OUR PRODUCTS MAKES IT
MORE DIFFICULT FOR US TO PREDICT OUR OPERATING RESULTS AND
MANAGE OUR BUSINESS.
The sale of our products typically involves a significant
technical evaluation and commitment of capital and other
resources by potential customers, as well as delays frequently
associated with customers' internal procedures to deploy new
technologies within their products and to test and accept new
technologies. For these and other reasons, the sales cycle
associated with our products is typically lengthy, lasting
nine months or longer, and is subject to a number of
significant risks, including customers' internal acceptance
reviews, that are beyond our control. Because of the lengthy
sales cycle and the large size of customer orders, if orders
forecasted for a specific customer for a particular quarter
are not realized in that quarter, our operating results for
that quarter could be materially adversely affected.
OUR RELATIVELY LOW LEVEL OF BACKLOG INCREASES THE POTENTIAL
VARIABILITY OF OUR QUARTERLY OPERATING RESULTS.
Our backlog at the beginning of each quarter typically is not
sufficient to achieve expected sales for the quarter. To
achieve our sales objectives, we are dependent upon obtaining
orders during each quarter for shipment during that quarter.
Furthermore, our agreements with our customers typically
permit them to change delivery schedules.
16
Non-imaging customers may cancel orders within specified time
frames (typically 30 days or more prior to the scheduled
shipment date under our policies) without significant penalty.
Our customers have in the past built, and may in the future
build, significant inventory in order to facilitate more rapid
deployment of anticipated major products or for other reasons.
Decisions by such customers to reduce their inventory levels
have led and could lead to reductions in their purchases from
us. These reductions, in turn, have caused and could cause
adverse fluctuations in our operating results.
OUR DEPENDENCE ON NEW PRODUCT DEVELOPMENT AND THE RAPID
TECHNOLOGICAL CHANGE THAT CHARACTERIZES OUR INDUSTRY MAKE US
SUSCEPTIBLE TO LOSS OF MARKET SHARE RESULTING FROM
COMPETITORS' PRODUCT INTRODUCTIONS AND SIMILAR RISKS.
The semiconductor and networking industries are characterized
by rapidly changing technologies, evolving industry standards,
frequent new product introductions, short product life cycles
and rapidly changing customer requirements. The introduction
of products embodying new technologies and the emergence of
new industry standards can render existing products obsolete
and unmarketable. Our future success will depend on our
ability to enhance our existing products, to introduce new
products to meet changing customer requirements and emerging
technologies, and to demonstrate the performance advantages
and cost-effectiveness of our products over competing
products. Any failure by us to modify our products to support
new local-area network, or LAN, wide-area network, or WAN, and
Internet technologies, or alternative technologies, or any
failure to achieve widespread customer acceptance of such
modified products could have a material adverse effect on us.
We have in the past and may in the future experience delays in
developing and marketing product enhancements or new products
that respond to technological change, evolving industry
standards and changing customer requirements. There can be no
assurance that we will not experience difficulties that could
delay or prevent the successful development, introduction and
marketing of these products or product enhancements, or that
our new products and product enhancements will adequately meet
the requirements of the marketplace and achieve any
significant or sustainable degree of market acceptance in
existing or additional markets. Failure by us, for
technological or other reasons, to develop and introduce new
products and product enhancements in a timely and
cost-effective manner would have a material adverse effect on
us. In addition, the future introductions or announcements of
products by us or one of our competitors embodying new
technologies or changes in industry standards or customer
requirements could render our then-existing products obsolete
or unmarketable. There can be no assurance that the
introduction or announcement of new product offerings by us or
one or more of our competitors will not cause customers to
defer the purchase of our existing products. Such deferment of
purchases could have a material adverse effect on us.
OUR FAILURE TO EFFECTIVELY MANAGE PRODUCT TRANSITIONS COULD
HAVE A MATERIAL ADVERSE EFFECT ON US.
From time to time, we or our competitors may announce new
products, capabilities or technologies that may replace or
shorten the life cycles of our existing products.
Announcements of currently planned or other new products may
cause customers to defer or stop purchasing our products until
new products become available. Furthermore, the introduction
of new or enhanced products requires us to manage the
transition from older product inventories and ensure that
adequate supplies of new products can be delivered to meet
customer demand. Our failure to effectively manage transitions
from older products could have a material adverse effect on
our business, results of operations and financial condition.
17
OUR FAILURE TO COMPETE SUCCESSFULLY IN OUR HIGHLY COMPETITIVE
MARKET COULD RESULT IN REDUCED PRICES AND LOSS OF MARKET
SHARE.
The markets in which we operate are intensely competitive and
characterized by rapidly changing technology, evolving
industry standards, declining average selling prices and
frequent new product introductions. A number of companies
offer products that compete with one or more elements of our
products. We believe that the competitive factors affecting
the market for our products include product performance, price
and quality, product functionality and features, the
availability of products for existing and future platforms,
the ease of integration with other hardware and software
components of the customer's products, and the quality of
support services, product documentation and training. The
relative importance of each of these factors depends upon the
specific customer involved. There can be no assurance that we
will be able to compete successfully against current and
future competitors, or that competitive factors faced by us
will not have a material adverse effect on us.
We primarily compete with the internal development departments
of large manufacturing companies that have developed their own
networking solutions, as well as established developers of
embedded systems software and chips such as Axis
Communications, Echelon, Emulex, Hitachi, Intel, Milan
Technology, a division of Digi International, Motorola,
Peerless Systems, Samsung and Wind River. In addition, we are
aware of certain companies which have recently introduced
products that address the markets targeted by us. We have
experienced and expect to continue to experience increased
competition from current and potential competitors, many of
which have substantially greater financial, technical, sales,
marketing and other resources, as well as greater name
recognition and larger customer bases than ours. In
particular, established companies in the networking or
semiconductor industries may seek to expand their product
offerings by designing and selling products using competitive
technology that could render our products obsolete or have a
material adverse effect on our sales. Increased competition
may result in further price reductions, reduced gross margins
and loss of market share.
WE DEPEND ON THIRD-PARTY SOFTWARE THAT WE USE UNDER LICENSES
THAT MAY EXPIRE.
We rely on certain software that we license from third
parties, including software that is integrated with internally
developed software and used in our products to perform key
functions. These software license agreements are with Express
Logic, Inc., Allegro Software Development Corporation and Wind
River, each of which terminates only if we default under the
respective agreement; with Novell, Inc., which is renewable
annually at the option of both parties; with InterNiche
Technologies, Inc., which renews until terminated by either
party; and with Peerless Systems Corporation, which expires in
2004 and is subject to year-to-year renewals thereafter at the
option of both parties. These third-party software licenses
may not continue to be available to us on commercially
reasonable terms, and the related software may not continue to
be appropriately supported, maintained or enhanced by the
licensors. The loss of licenses to use, or the inability of
licensors to support, maintain, and enhance any of such
software, could result in increased costs, delays or
reductions in product shipments until equivalent software is
developed or licensed, if at all, and integrated.
WE DEPEND ON MANUFACTURING, ASSEMBLING AND PRODUCT TESTING
RELATIONSHIPS AND ON LIMITED SOURCE SUPPLIERS, AND ANY
DISRUPTIONS IN THESE RELATIONSHIPS MAY CAUSE DAMAGE TO OUR
CUSTOMER RELATIONSHIPS.
18
We do not have our own semiconductor fabrication assembly or
testing operations or contract manufacturing capabilities.
Instead, we rely upon independent contractors to manufacture
our components, subassemblies, systems and products.
Currently, all of our semiconductor devices are being
manufactured, assembled and tested by Atmel Corporation in the
United States and Europe, and we expect that we will continue
to rely upon Atmel, or a similar manufacturer, to manufacture,
assemble and test a significant portion of our semiconductor
devices in the future. In the past, we experienced a delay in
the introduction of one of our products due to a problem with
Atmel's design tools. While we are in the process of
qualifying other suppliers, any qualification and
pre-production periods could be lengthy and may cause delays
in providing products to customers in the event that the sole
source supplier of the semiconductor devices fails to meet our
requirements. For example, Atmel uses its manufacturing
facilities for its own products as well as those it
manufactures on a contract basis. There is no assurance that
Atmel will have adequate capacity to meet the needs of its
contract manufacturing customers. In addition, semiconductor
manufacturers generally experience periodic constraints on
their manufacturing capacity.
We also rely upon limited-source suppliers for a number of
other components used in our products. There can be no
assurance that these independent contractors and suppliers
will be able to meet our future requirements for manufactured
products, components and subassemblies in a timely fashion. We
generally purchase limited-source components under purchase
orders and have no guaranteed supply arrangements with these
suppliers. In addition, the availability of many of these
components to us is dependent in part on our ability to
provide our suppliers with accurate forecasts of our future
requirements. Any extended interruption in the supply of any
of the key components currently obtained from limited sources
would disrupt our operations and have a material adverse
effect on our business, results of operations and financial
condition.
Delays or lost sales have been and could be caused by other
factors beyond our control, including late deliveries by
vendors of components, changes in implementation priorities or
slower than anticipated growth in the market for networking
solutions for embedded systems. Operating results in the past
have also been adversely affected by delays in receipt of
significant purchase orders from customers. In addition, we
have experienced delays as a result of the need to modify our
products to comply with unique customer specifications. In
general, the timing and magnitude of our revenues are highly
dependent upon our achievement of design wins, the timing and
success of our customers' development cycles, and our
customers' product sales. Any of these factors could have a
material adverse effect on our business, results of operations
and financial condition.
THE CYCLICALITY OF THE SEMICONDUCTOR INDUSTRY MAY RESULT IN
SUBSTANTIAL PERIOD-TO-PERIOD FLUCTUATIONS.
Our semiconductor products provide networking capabilities for
intelligent, network-enabled devices and other embedded
systems. The semiconductor industry is highly cyclical and
subject to rapid technological change and has been subject to
significant economic downturns at various times, characterized
by diminished product demand, accelerated erosion of average
selling prices and production overcapacity. The semiconductor
industry also periodically experiences increased demand and
production capacity constraints. As a result, we may
experience substantial period-to-period fluctuations in future
operating results due to general semiconductor industry
conditions, overall economic conditions or other factors.
OUR ABILITY TO COMPETE COULD BE JEOPARDIZED IF WE ARE UNABLE
TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS.
19
Our ability to compete depends in part on our proprietary
rights and technology. We have one patent and rely on a
combination of copyright and trademark laws, trade secrets,
confidentiality procedures and contract provisions to protect
our proprietary rights.
We generally enter into confidentiality agreements with our
employees, and sometimes with our customers and potential
customers and limit access to the distribution of our
software, hardware designs, documentation and other
proprietary information. There can be no assurance that the
steps taken by us in this regard will be adequate to prevent
the misappropriation of our technology. Our patent may be
circumvented by our competitors and our current and future
patent applications may be denied. Furthermore, there can be
no assurance that others will not develop technologies that
are superior to ours. Despite our efforts to protect our
proprietary rights, unauthorized parties may attempt to copy
aspects of our products or to obtain and use information that
we regard as proprietary. In addition, the laws of some
foreign countries do not protect our proprietary rights as
fully as do the laws of the United States. There can be no
assurance that our means of protecting our proprietary rights
in the United States or abroad will be adequate or that
competing companies will not independently develop similar
technology. Our failure to adequately protect our proprietary
rights could have a material adverse effect on our business,
results of operations and financial condition.
We exclusively license the right to use the NET+ARM trademark
from ARM Limited according to a royalty-free agreement
expiring in 2008. We depend on ARM to enforce its rights to
the trademark against third-party infringement. There can be
no assurance that ARM will promptly and adequately enforce
these rights which could have a material adverse effect on our
business, results of operations and financial condition.
WE COULD BECOME SUBJECT TO CLAIMS AND LITIGATION REGARDING
INTELLECTUAL PROPERTY RIGHTS, WHICH COULD SERIOUSLY HARM US
AND REQUIRE US TO INCUR SIGNIFICANT COSTS.
The semiconductor and networking industries are characterized
by frequent litigation regarding patent and other intellectual
property rights. Although we have not been notified that our
products infringe any third-party intellectual property
rights, there can be no assurance that we will not receive
such notification in the future. Any litigation to determine
the validity of third-party infringement claims, whether or
not determined in our favor or settled by us, would at a
minimum be costly and divert the efforts and attention of our
management and technical personnel from productive tasks,
which could have a material adverse effect on our business,
results of operations and financial condition. There can be no
assurance that any infringement claims by third parties or any
claims for indemnification by customers or end users of our
products resulting from infringement claims will not be
asserted in the future or that such assertions, if proven to
have merit, will not materially adversely affect our business,
results of operations or financial condition. In the event of
an adverse ruling in any such matter, we would be required to
pay substantial damages, cease the manufacture, use and sale
of infringing products, discontinue the use of certain
processes or be required to obtain a license under the
intellectual property rights of the third party claiming
infringement. There can be no assurance that a license would
be available on reasonable terms or at all. Any limitations on
our ability to market our products, or delays and costs
associated with redesigning our products or payments of
license fees to third parties, or any failure by us to develop
or license a substitute technology on commercially reasonable
terms could have a material adverse effect on our business,
results of operations and financial condition.
WE FACE RISKS ASSOCIATED WITH OUR INTERNATIONAL OPERATIONS AND
EXPANSION THAT COULD IMPAIR OUR ABILITY TO GROW OUR REVENUES
ABROAD.
20
In the fiscal years ended January 31, 2001, 2000 and 1999,
international sales constituted approximately 55%, 50% and 51%
of our net sales and approximately 68%, 77% and 46% of our
domestic sales were to customers headquartered in Asia,
respectively.
We believe that our future growth is dependent in part upon
our ability to increase sales in international markets, and
particularly to manufacturers located in Japan, which sell
their products worldwide. These sales are subject to a variety
of risks, including fluctuations in currency exchange rates,
tariffs, import restrictions and other trade barriers,
unexpected changes in regulatory requirements, longer accounts
receivable payment cycles and potentially adverse tax
consequences and export license requirements. In addition, we
are subject to the risks inherent in conducting business
internationally, including political and economic instability
and unexpected changes in diplomatic and trade relationships.
In particular, the economies of certain countries in the
Asia-Pacific region are experiencing considerable economic
instability and downturns. Because our sales to date have been
denominated in United States dollars, increases in the value
of the United States dollar could increase the price in local
currencies of our products in non-US markets and make our
products more expensive than competitors' products denominated
in local currencies. In addition, an integral part of our
business strategy is to form strategic alliances for the
manufacture and distribution of our products with third
parties, including foreign corporations. There can be no
assurance that one or more of the factors described above will
not have a material adverse effect on our business, results of
operations and financial condition.
We intend to expand our presence in Europe to address new
markets. One change resulting from the formation of a European
Economic and Monetary Union ("EMU") required EMU member states
to irrevocably fix their respective currencies to a new
currency, the euro, as of January 1, 1999. Business in the EMU
member states will be conducted in both the existing national
currency such as the French franc or the Deutsche mark, and
the euro through 2002. As a result, companies operating or
conducting business in EMU member states will need to ensure
that their financial and other software systems are capable of
processing transactions and properly handling these
currencies, including the euro. There can be no assurance that
the conversion to the euro will not have a material adverse
effect on our business, results of operations and financial
condition.
IF WE LOSE KEY PERSONNEL IT COULD PREVENT US FROM EXECUTING
OUR BUSINESS STRATEGY.
Our business and prospects depend to a significant degree upon
the continuing contributions of our executive officers and our
key technical personnel. Competition for such personnel is
intense, and there can be no assurance that we will be
successful in attracting and retaining qualified personnel.
Our stock price and the number of options outstanding with
exercise prices in excess of their market price could make it
more difficult to attract and retain key personnel. Failure to
attract and retain key personnel could result in our failure
to execute our business strategy and have a material adverse
effect on us. We have employment contracts with our Vice
President, Intelligent Device Markets Europe; Vice President,
Imaging; Executive Vice President, Finance & Operations, and
Chief Financial Officer; and the Chairman and Chief Executive
Officer. We do not maintain any key-man life insurance
policies.
ANY FAILURE TO COMPLY WITH SIGNIFICANT REGULATIONS AND
EVOLVING INDUSTRY STANDARDS COULD DELAY INTRODUCTION OF OUR
PRODUCTS.
The market for our products is subject to a significant number
of communications regulations and industry standards, some of
which are evolving as new technologies are
21
deployed. In the United States, our products must comply with
various regulations defined by the Federal Communications
Commission and standards established by Underwriters'
Laboratories. Some of our products may not comply with current
industry standards, and this noncompliance must be addressed
in the design of those products. Standards for networking are
still evolving. As the standards evolve, we may be required to
modify our products or develop and support new versions of our
products. The failure of our products to comply or delays in
compliance, with the various existing and evolving industry
standards could delay introduction of our products, which
could have a material adverse effect on our business, results
of operations and financial condition.
ANY MATERIAL PRODUCT DEFECTS COULD RESULT IN LOSS OF MARKET
SHARE, DELAY OF MARKET ACCEPTANCE OR PRODUCT LIABILITY CLAIMS
OR LOSSES.
Complex products such as those offered by us may contain
undetected or unresolved defects when first introduced or as
new versions are released. The occurrence of material errors
in the future could, and the failure or inability to correct
such errors would, result in the loss of market share, the
delay or loss of market acceptance of our products, material
warranty expense, diversion of engineering and other resources
from our product development efforts, the loss of credibility
with our customers or product recall. The use of our products
for applications in devices that interact directly with the
general public, where the failure of the embedded system could
cause property damage or personal injury, could expose us to
significant product liability claims. Although we have not
experienced any product liability or economic loss claims to
date, the sale and support of our products may entail the risk
of such claims. Any of such occurrences could have a material
adverse effect upon our business, results of operations and
financial condition.
IF WE DO NOT SUCCESSFULLY MANAGE OUR GROWTH, IT COULD HAVE A
MATERIAL ADVERSE EFFECT ON US.
We have limited internal infrastructure and any significant
growth would place a substantial strain on our financial and
management personnel and information systems and controls.
Such growth would require us to implement new and enhance
existing financial and management information systems and
controls and add and train personnel to operate such systems
effectively. Our intention to continue to pursue our growth
strategy through efforts to increase sales of existing
products and new products can be expected to place even
greater pressure on our existing personnel and compound the
need for increased personnel, expanded information systems,
and additional financial and administrative control
procedures. There can be no assurance that we will be able to
successfully manage expanding operations. Our inability to
manage our expanded operations effectively could have a
material adverse effect on our business, results of operations
and financial condition.
A SUBSTANTIAL NUMBER OF SHARES OF OUR COMMON STOCK COULD BE
SOLD INTO THE PUBLIC MARKET, WHICH COULD DEPRESS OUR STOCK
PRICE.
Sales of a substantial number of shares of common stock in the
public market could adversely affect the market price for our
common stock and could make it more difficult for us to raise
funds through equity offerings in the future.
Subject to applicable federal and securities laws and the
restrictions set forth below, Sorrento Networks Corporation,
formerly Osicom Technologies, Inc. ("Sorrento"), a holder of
6,972,700 shares of our non-voting common stock, may sell any
and all of the shares of common stock beneficially owned by it
or distribute any or all such shares of common stock to its
stockholders. Sales or distributions by Sorrento of
substantial
22
amounts of common stock in the public market or to its
stockholders, or the perception that such sales or
distribution could occur, could adversely affect the
prevailing market prices for the common stock. Sorrento is not
subject to any obligation to retain its shares in NetSilicon.
As a result, there can be no assurance concerning the period
of time during which Sorrento will maintain its beneficial
ownership of our common stock. Moreover, there can be no
assurance that, in any transfer by Sorrento of a controlling
interest in us, any holders of common stock will be able to
participate in such transaction or will realize any premium
with respect to their shares of common stock.
At January 31, 2001, options to purchase an aggregate of
5,051,149 shares of our common stock were outstanding. Of
these options, 852,394 were exercisable as of January 31,
2001, with additional vesting to occur from time to time.
ANY ACQUISITIONS WE HAVE MADE OR WILL MAKE COULD DISRUPT OUR
BUSINESS AND SERIOUSLY HARM OUR FINANCIAL CONDITION.
We continue to consider investments in complementary
companies, products or technologies. We may buy businesses,
products or technologies in the future. In the event of any
future purchases, we could:
- issue stock that would dilute our current
stockholders' percentage ownership;
- incur debt;
- assume liabilities;
- incur amortization expenses related to goodwill
and other intangible assets; or
- incur large and immediate write-offs.
FAILURE TO COMPLETE THE MERGER WITH DIGI INTERNATIONAL, INC.
COULD NEGATIVELY IMPACT OUR STOCK PRICE AND FUTURE BUSINESS
OPERATIONS.
If the proposed merger with Digi International, Inc. is not
completed for any reason, we may be subject to the following
risks:
- if the merger is terminated and our board of
directors determines to seek another business
combination, we may not be able to find a partner
willing to pay an equivalent or more attractive
price than the price to be paid in the proposed
merger;
- various costs related to the merger, including
legal, accounting, and financial advisory fees,
must be paid by us even if the merger is not
completed; and
- the price of our common stock may decline to the
extent that the current market price reflects an
assumption that the merger will be completed.
OUR OPERATION OF ANY ACQUIRED BUSINESS WILL ALSO INVOLVE
NUMEROUS RISKS, INCLUDING:
- problems combining the purchased operations,
technologies or products;
- unanticipated costs;
- diversion of management's attention from our core
business;
- difficulties integrating businesses in different
countries and cultures;
- adverse effects on existing business relationships
with suppliers and customers;
- risks associated with entering markets in which we
have no or limited prior experience; and
- potential loss of key employees, particularly those
of the purchased organizations.
We cannot assure you that we will be able to successfully
integrate any businesses, products, technologies or personnel
that we have acquired or that we might acquire in the
23
future and any failure to do so could disrupt our business and
seriously harm our financial condition.
BECAUSE THE NASDAQ NATIONAL MARKET IS LIKELY TO EXPERIENCE
EXTREME PRICE AND VOLUME FLUCTUATIONS, THE PRICE OF OUR
COMMON STOCK MAY DECLINE.
The market price of our shares is likely to be highly volatile
and could be subject to wide fluctuations in response to
numerous factors, including the following:
- actual or anticipated variations in our quarterly
operating results or those of our competitors;
- announcements by us or our competitors of new
products or technological innovations;
- introduction and adoption of new industry
standards;
- changes in financial estimates or recommendations
by securities analysts;
- changes in the market valuations of our
competitors;
- announcements by us or our competitors of
significant acquisitions or partnerships; and
- sales of our common stock.
Many of these factors are beyond our control and may
negatively impact the market price of our common stock,
regardless of our performance. In addition, the stock market
in general, and the market for technology companies in
particular, has been highly volatile. Our common stock may not
trade at the same levels of shares as that of other technology
companies and shares of technology companies, in general, may
not sustain their current market prices. In the past,
securities class action litigation has often been brought
against a company following periods of volatility in the
market price of its securities. We may be the target of
similar litigation in the future. Securities litigation could
result in substantial costs and divert management's attention
and resources, which could seriously harm our business and
operating results.
PROVISIONS OF OUR CHARTER DOCUMENTS, OUR SHAREHOLDER RIGHTS
PLAN AND LAW MAY HAVE ANTI-TAKEOVER EFFECTS THAT COULD PREVENT
A CHANGE OF CONTROL.
Provisions of our amended and restated articles of
organization, bylaws, our shareholder rights plan, and of
Massachusetts law could make it more difficult for a third
party to acquire us, even if doing so would be beneficial to
our stockholders. Operating alone or together, the above
provisions or statutes may render more difficult or discourage
a merger, consolidation or tender offer, the assumption of
control by a holder of a large block of our shares, and the
removal of incumbent management.
ITEM 3. Quantitative and Qualitative Disclosure About Market Risk
We own financial instruments that are sensitive to market
risks as part of our investment portfolio. The investment
portfolio is used to preserve our capital until it is required
to fund operations, including our research and development
activities. None of these
24
market-risk sensitive instruments are held for trading
purposes. We do not own derivative financial instruments in
our investment portfolio. The investment portfolio contains
instruments that are subject to the risk of a decline in
interest rates.
Investment Rate Risk. Our investment portfolio includes debt
instruments that primarily have durations of less than one
year. These bonds are subject to interest rate risk, and could
decline in value if interest rates fluctuate. Our investment
portfolio also at times includes certain commercial paper
which is also subject to interest rate risk. Due to the short
duration and conservative nature of these instruments, we do
not believe that we have a material exposure to interest rate
fluctuations.
We have foreign operations in Europe and Japan. As a result,
we are exposed to fluctuations in foreign exchange rates.
However, we do not expect that changes in foreign exchange
rates will have a significant impact on our results of
operations, financial position or cash flows. We plan to
continue to expand our operations globally which may increase
our exposure to foreign exchange fluctuations.
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
On or about August 9, 2001, a purported securities class
action lawsuit captioned "Ellis Investments, Ltd. v.
NetSilicon, Inc., et al." (01-CV-7281) was filed in the United
States District Court for the Southern District of New York.
Later in August, 2001, two additional, nearly identical
complaints were filed in the same Court in lawsuits captioned
"Michael Rasner v. NetSilicon, Inc., et al." (01-CV-7651) and
"Walter Weitz v. NetSilicon, Inc. et al." (01-CV-8217). The
suits name as defendants the Company, certain of its officers
and directors, and certain underwriters involved in the
Company's initial public offering ("IPO"). The Ellis
Investments suit also names Osicom Technologies, Inc. as a
defendant. The complaints in these actions are allegedly
brought on behalf of purchasers of the Company's common stock
during the period from September 15, 1999 to December 6, 2000,
and assert, among other things, that the Company's IPO
prospectus and registration statement violated federal
securities laws because they contained material
misrepresentations and/or omissions regarding the conduct of
the Company's IPO underwriters in allocating shares in the
Company's IPO to the underwriters' customers. The actions seek
rescission or rescissory and other damages, fees and costs
associated with the litigation, and interest. The Company
understands that various plaintiffs have filed substantially
similar lawsuits against over a hundred other publicly traded
companies in connection with the underwriting of their initial
public offerings. The Company and its officers and directors
believe that the allegations in the complaints are without
merit and intend to contest them vigorously. An unfavorable
resolution of the actions could have a material adverse effect
on the business, results of operations or financial condition
of the Company.
On November 2, 2001, the Company and Websprocket, LLC entered
into a Settlement Agreement and Mutual Release settling all
claims between the companies, including all claims and
counterclaims asserted in the litigation captioned
Websprocket, LLC v. NetSilicon, Inc., Civil Action No.
C-00-20915 RMV pending in the United States District Court for
the Northern District of California. On November 13, 2001, the
court approved and entered a Stipulation of Dismissal With
Prejudice, in which the Company and Websprocket, LLC dismissed
all claims in the litigation and waived all rights to appeal.
The Company has paid Websprocket, LLC approximately $162,000
as part of the settlement agreement.
ITEM 2. Changes in Securities and Use of Proceeds
None
25
ITEM 3. Defaults Upon Senior Securities
None
ITEM 4. Submission of Matters to a Vote of Security Holders
None
ITEM 5. Other Information
None
ITEM 6. Exhibits and Reports on Form 8-K
Reports on 8-K
November 5, 2001 - Form 8-K filed relating to the Agreement
and Plan of Merger dated as of October 30, 2001 by and among
NetSilicon, Inc., Dove Sub, Inc. and Digi International, Inc.
and the Second Amendment, dated October 30, 2001, to the
Rights Agreement, dated as of September 30, 2000 between
NetSilicon, Inc. and American Stock Transfer and Trust
Company.
26
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NETSILICON, INC.
-----------------------------------------
(Registrant)
December 11, 2001 By /s/ Cornelius Peterson, VIII
---------------------------------------
(Cornelius Peterson, VIII, Chairman and
Chief Executive Officer)
December 11, 2001 By /s/ Daniel J. Sullivan
---------------------------------------
(Daniel J. Sullivan, Executive Vice
President, Finance and Operations)
27