================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-Q
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
FOR THE QUARTERLY PERIOD ENDED DECEMBER 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: 1-16027
------------------------
LANTRONIX, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 33-0362767
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
15353 BARRANCA PARKWAY, IRVINE, CALIFORNIA
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
92618
(ZIP CODE)
------------------------
(949) 453-3990
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Former name, former address and former fiscal year, if changed since last
report: N/A
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 by check mark whether the registrant is an accelerated filer (as
defined by Rule 12b-2 of the Exchange Act). Yes |_| No |X|.
As of January 21, 2005 58,238,149 shares of the Registrant's common stock
were outstanding.
================================================================================
LANTRONIX, INC.
FORM 10-Q
FOR THE QUARTER ENDED DECEMBER 31, 2004
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION............................................. 3
Item 1. Financial Statements.............................................. 3
Unaudited Condensed Consolidated Balance Sheets at December 31,
2004 and June 30, 2004......................................... 3
Unaudited Condensed Consolidated Statements of Operations for
the Three and Six Months Ended December 31, 2004 and 2003...... 4
Unaudited Condensed Consolidated Statements of Cash Flows for
the Six Months Ended December 31, 2004 and 2003................ 5
Notes to Unaudited Condensed Consolidated Financial Statements.... 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations......................................... 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk........ 31
Item 4. Controls and Procedures........................................... 31
PART II. OTHER INFORMATION................................................. 32
Item 1. Legal Proceedings................................................. 32
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds....... 32
Item 3. Defaults Upon Senior Securities................................... 32
Item 4. Submission of Matters to a Vote of Security Holders............... 32
Item 5. Other Information................................................. 32
Item 6. Exhibits ......................................................... 32
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
LANTRONIX, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS EXCEPT SHARE AMOUNTS)
DECEMBER 31, JUNE 30,
2004 2004
----------- -----------
ASSETS
------
Current assets:
Cash and cash equivalents ......................................... $ 7,606 $ 9,128
Marketable securities ............................................. 625 3,050
Accounts receivable, net .......................................... 3,591 3,242
Inventories ....................................................... 6,115 6,677
Contract manufacturers receivable, net ............................ 771 999
Settlement receivable ............................................. 1,200 -
Prepaid expenses and other current assets ......................... 1,289 1,450
----------- -----------
Total current assets ............................................ 21,197 24,546
Property and equipment, net ........................................... 561 865
Goodwill .............................................................. 9,488 9,488
Purchased intangible assets, net ...................................... 1,279 2,056
Officer loans ......................................................... 113 110
Other assets .......................................................... 191 185
----------- -----------
Total assets .................................................... $ 32,829 $ 37,250
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current liabilities:
Bank line of credit ............................................... $ 250 $ 500
Accounts payable .................................................. 4,504 4,049
Accrued payroll and related expenses .............................. 1,811 1,599
Warranty reserve .................................................. 1,810 1,770
Restructuring reserve ............................................. 386 752
Accrued settlement ................................................ 1,200 -
Other current liabilities ......................................... 2,785 2,922
Convertible note payable .......................................... - 867
----------- -----------
Total liabilities ............................................... 12,746 12,459
Commitments and contingencies ......................................... - -
Stockholders' equity:
Preferred stock, $0.0001 par value; 5,000,000 shares authorized;
none issued and outstanding .................................... - -
Common stock, $0.0001 par value; 200,000,000 shares authorized;
58,238,149 and 58,154,747 shares issued and outstanding at
December 31, 2004 and June 30, 2004, respectively .............. 6 6
Additional paid-in capital ........................................ 181,231 180,712
Deferred compensation ............................................. (30) (103)
Accumulated deficit ............................................... (161,512) (156,078)
Accumulated other comprehensive income ............................ 388 254
----------- -----------
Total stockholders' equity ...................................... 20,083 24,791
----------- -----------
Total liabilities and stockholders' equity ...................... $ 32,829 $ 37,250
=========== ===========
See accompanying notes.
3
LANTRONIX, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED SIX MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------- ----------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Net revenues (A) ................................................. $ 12,908 $ 12,498 $ 23,953 $ 24,699
Cost of revenues (B) ............................................. 6,652 6,854 12,140 12,899
--------- --------- --------- ---------
Gross profit ..................................................... 6,256 5,644 11,813 11,800
--------- --------- --------- ---------
Operating expenses:
Selling, general and administrative (C) ...................... 6,732 5,192 13,636 11,455
Research and development (C) ................................. 1,423 1,758 3,720 3,545
Stock-based compensation (B) (C) ............................. 107 63 287 218
Amortization of purchased intangible assets .................. 19 45 48 89
--------- --------- --------- ---------
Total operating expenses ......................................... 8,281 7,058 17,691 15,307
--------- --------- --------- ---------
Loss from operations ............................................. (2,025) (1,414) (5,878) (3,507)
Interest income, net ............................................. 7 11 16 35
Other income (expense), net ...................................... 472 (10) 542 (180)
--------- --------- --------- ---------
Loss before income taxes ......................................... (1,546) (1,413) (5,320) (3,652)
Provision for income taxes ....................................... 109 103 170 136
--------- --------- --------- ---------
Loss from continuing operations .................................. (1,655) (1,516) (5,490) (3,788)
Income (loss) from discontinued operations ....................... - (3,739) 56 (4,516)
--------- --------- --------- ---------
Net loss ......................................................... $ (1,655) $ (5,255) $ (5,434) $ (8,304)
========= ========= ========= =========
Basic and diluted net income (loss) per share
Loss from continuing operations .............................. $ (0.03) $ (0.03) $ (0.09) $ (0.07)
Income (loss) from discontinued operations ................... - (0.06) - (0.08)
--------- --------- --------- ---------
Basic and diluted net loss per share ............................. $ (0.03) $ (0.09) $ (0.09) $ (0.15)
========= ========= ========= =========
Weighted average shares (basic and diluted) ...................... 58,149 57,098 58,033 55,693
========= ========= ========= =========
(A) Includes net revenues from related parties ................... $ 296 $ 491 $ 614 $ 802
========= ========= ========= =========
(B) Cost of revenues includes the following:
Amortization of purchased intangible assets ............... $ 364 $ 532 $ 729 $ 1,064
Stock-based compensation .................................. - 10 - 27
--------- --------- --------- ---------
$ 364 $ 542 $ 729 $ 1,090
========= ========= ========= =========
(C) Stock-based compensation is excluded from the following:
Selling, general and administrative expenses .............. $ 91 $ 75 $ 148 $ 188
Research and development expenses ......................... 16 (12) 139 30
--------- --------- --------- ---------
$ 107 $ 63 $ 287 $ 218
========= ========= ========= =========
See accompanying notes.
4
LANTRONIX, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
SIX MONTHS ENDED
DECEMBER 31,
----------------------
2004 2003
--------- ---------
Cash flows from operating activities:
Net loss .................................................................... $ (5,434) $ (8,304)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation ............................................................. 391 949
Amortization of purchased intangible assets .............................. 777 1,153
Stock-based compensation ................................................. 287 245
Provision for doubtful accounts .......................................... 221 (76)
Provision for inventory reserve .......................................... (69) (561)
Loss on sale of fixed assets ............................................. - 20
Equity losses from unconsolidated businesses ............................. - 413
Restructuring recovery ................................................... (56) -
Changes in operating assets and liabilities:
Accounts receivable ................................................... (570) (71)
Inventories ........................................................... 631 874
Contract manufacturers receivable ..................................... 228 574
Prepaid expenses and other current assets ............................. 161 1,853
Other assets .......................................................... (9) 10
Accounts payable ...................................................... 455 (1,880)
Due to Gordian ........................................................ - (1,000)
Warranty reserve ...................................................... 40 96
Restructuring reserve ................................................. (310) (152)
Other current liabilities ............................................. 75 1,504
Net assets of discontinued operations ................................. - 3,340
--------- ---------
Net cash used in operating activities ....................................... (3,182) (1,013)
--------- ---------
Cash flows from investing activities:
Purchase of property and equipment, net .................................. (82) (122)
Payment of convertible note .............................................. (867) --
Purchases of marketable securities ....................................... (1,000) (302)
Proceeds from sale of marketable securities .............................. 3,425 4,052
--------- ---------
Net cash provided by investing activities ................................... 1,476 3,628
--------- ---------
Cash flows from financing activities:
Net proceeds from issuances of common stock .............................. 306 202
Payment of line of credit ................................................ (250) -
--------- ---------
Net cash provided by financing activities ................................... 56 202
--------- ---------
Effect of foreign exchange rates on cash .................................... 128 108
--------- ---------
Increase (decrease) in cash and cash equivalents ............................ (1,522) 2,925
Cash and cash equivalents at beginning of period ............................ 9,128 7,328
--------- ---------
Cash and cash equivalents at end of period .................................. $ 7,606 $ 10,253
========= =========
See accompanying notes.
5
LANTRONIX, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004
1. BASIS OF PRESENTATION
The condensed consolidated financial statements included herein are
unaudited. They contain all normal recurring accruals and adjustments which, in
the opinion of management, are necessary to present fairly the consolidated
financial position of Lantronix, Inc. and its subsidiaries (collectively, the
"Company") at December 31, 2004, the consolidated results of its operations for
the three and six months ended December 31, 2004 and 2003, and its cash flows
for the six months ended December 31, 2004 and 2003. All intercompany accounts
and transactions have been eliminated. It should be understood that accounting
measurements at interim dates inherently involve greater reliance on estimates
than at year-end. The results of operations for the three and six months ended
December 31, 2004 are not necessarily indicative of the results to be expected
for the full year or any future interim periods.
These financial statements do not include certain footnotes and financial
presentations normally required under generally accepted accounting principles.
Therefore, they should be read in conjunction with the audited consolidated
financial statements and notes thereto for the year ended June 30, 2004,
included in the Company's Annual Report on Form 10-K/A filed with the Securities
and Exchange Commission ("SEC") on October 12, 2004.
In March 2004, the Company completed the sale of substantially all of the
net assets of Premise Systems, Inc. ("Premise") (Note 8). The Company's
condensed consolidated financial statements have been presented to reflect
Premise as a discontinued operation for all periods presented.
STOCK-BASED COMPENSATION
The Company has in effect several stock-based plans under which
non-qualified and incentive stock options have been granted to employees,
non-employee board members and other non-employees. The Company also has an
employee stock purchase plan for all eligible employees. The Company accounts
for stock-based awards to employees in accordance with APB Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations, and has
adopted the disclosure-only alternative of SFAS No. 123, and SFAS No. 148,
"Accounting for Stock-Based Compensation-Transition and Disclosure." Options
granted to non-employees, as defined, have been accounted for at fair market
value in accordance with SFAS No. 123.
In accordance with the disclosure requirements of SFAS No. 123, set forth
below are the assumptions used and pro forma statement of operations data of the
Company giving effect to valuing stock-based awards to employees using the
Black-Scholes option pricing model instead of the guidelines provided by APB No.
25. Among other factors, the Black-Scholes model considers the expected life of
the option and the expected volatility of the Company's stock price in arriving
at an option valuation.
The results of applying the requirements of the disclosure-only alternative
of SFAS No. 123 to the Company's stock-based awards to employees would
approximate the following (in thousands, except per share data):
THREE MONTHS ENDED SIX MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------- ----------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Net loss - as reported ................................................ $ (1,655) $ (5,255) $ (5,434) $ (8,304)
Add: Stock-based compensation expense included in net loss - as
reported, net of related tax effects ............................... 107 73 287 245
Deduct: Stock-based compensation expense determined under fair value
method, net of related tax effects ................................. (370) (830) (816) (1,783)
--------- --------- --------- ---------
Net loss - pro forma .................................................. $ (1,918) $ (6,012) $ (5,963) $ (9,842)
========= ========= ========= =========
Net loss per share (basic and diluted) - as reported .................. $ (0.03) $ (0.09) $ (0.09) $ (0.15)
========= ========= ========= =========
Net loss per share (basic and diluted) - pro forma .................... $ (0.03) $ (0.11) $ (0.10) $ (0.18)
========= ========= ========= =========
6
2. ACCOUNTING PRONOUNCEMENTS
In November 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 151, "Inventory Costs -
An Amendment of ARB No. 43, Chapter 4." This new standard is the result of a
broader effort by the FASB to improve financial reporting by eliminating
differences between generally accepted accounting principles ("GAAP") in the
United States and accounting principles developed by the International
Accounting Standards Board ("IASB"). As part of this effort, the FASB and the
IASB identified opportunities to improve financial reporting by eliminating
certain narrow differences between their existing accounting standards. SFAS No.
151 clarifies that abnormal amounts of idle facility expense, freight handling
costs and spoilage costs should be expensed as incurred and not included in
overhead. Further, SFAS No. 151 requires that allocation of fixed production
overheads to conversion costs should be based on normal capacity of the
production facilities. The provisions in SFAS No. 151 are effective for
inventory costs incurred during fiscal years beginning after June 15, 2005.
Companies must apply the standard prospectively. Management does not expect the
adoption of SFAS No. 151 to have a material impact on the Company's financial
position, results of operations or cash flows.
In December 2004, the FASB issued SFAS No. 123R, "Share Based Payment," a
revision to SFAS 123, "Accounting for Stock-Based Compensation," and supersedes
APB Opinion No. 25, "Accounting for Stock Issued to Employees," and its related
implementation guidance. SFAS No. 123R establishes standards for the accounting
for transactions in which an entity exchanges instruments for goods or services.
It also addresses transactions in which an entity incurs liabilities in exchange
for goods or services that are based on the fair value of the entity's equity
instruments or that may be settled by the issuance of those equity instruments.
SFAS 123R established the accounting treatment for transactions in which an
entity obtains employee services in share-based payment transactions. SFAS 123R
requires companies to recognize in the statement of operations the grant-date
fair value of stock options and other equity-based compensation issued to
employees. SFAS 123R requires the Company to value the share-based compensation
based on the classification of the share-based award. If the share-based award
is to be classified as a liability, the Company must re-measure the award at
each balance sheet date until the award is settled. If the share-based award is
to be classified as equity, the Company will measure the value of the
share-based award on the date of grant but the award will not be re-measured at
each balance sheet date. SFAS 123R does not change the accounting guidance for
share-based payment transactions with parties other than employees provided in
SFAS 123 as originally issued and EITF Issue No. 96-18, "Accounting for Equity
Instruments that are Issued to Other than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services." SFAS 123R is effective for public
companies that do not file as small business issuers as of the beginning of
interim or annual reporting periods that begin after June 15, 2005 (the
effective date for small business issuers is December 15, 2005). All public
companies must use either the modified prospective or modified retrospective
transition method. Under the modified prospective method, awards that are
granted, modified, or settled after the date of adoption should be measured and
accounted for in accordance with SFAS 123R. Unvested equity classified awards
that were granted prior to the effective date should continue to be accounted
for in accordance to SFAS 123 except that the amounts must be recognized in the
statement of operations. Under the modified retrospective method, the previously
reported amounts are restated (either to the beginning of the year of adoption
or for all periods presented) to reflect SFAS 123 amounts in the statement of
operations. Management is in the process of determining the effect SFAS 123R
will have upon the Company's financial position and statement of operations.
Other recent accounting pronouncements issued by the FASB (including its
Emerging Issues Task Force), the American Institute of Certified Public
Accountants and the Securities and Exchange Commission (the "SEC") did not or
are not believed by management to have a material impact on the Company's
present or future consolidated financial statements.
3. NET LOSS PER SHARE
Basic net loss per share is calculated by dividing net loss from continuing
operations, net income (loss) from discontinued operations, and net loss by the
weighted average number of common shares outstanding during the period. Diluted
net loss per share is calculated by adjusting outstanding shares assuming any
dilutive effects of options. However, for periods in which the Company incurred
a net loss, these shares are excluded because their effect would be to reduce
recorded net loss per share.
4. MARKETABLE SECURITIES
The Company classifies its marketable securities as available for sale.
Marketable securities consist of obligations of municipal bonds which can
readily be converted to cash.
7
5. INVENTORIES
Inventories are stated at the lower of cost (first-in, first-out) or market
and consist of the following (in thousands):
DECEMBER 31, JUNE 30,
2004 2004
--------- ---------
Raw materials ...................................... $ 4,464 $ 4,047
Finished goods ..................................... 6,288 7,368
Inventory at distributors .......................... 1,212 1,291
--------- ---------
11,964 12,706
Reserve for excess and obsolete inventory .......... (5,849) (6,029)
--------- ---------
$ 6,115 $ 6,677
========= =========
6. GOODWILL AND PURCHASED INTANGIBLE ASSETS
The composition of purchased intangible assets is as follows (in
thousands):
DECEMBER 31, 2004 JUNE 30, 2004
---------------------------------- ----------------------------------
USEFUL ACCUMULATED ACCUMULATED
LIVES GROSS AMORTIZATION NET GROSS AMORTIZATION NET
--------- --------- ------------ --------- --------- ------------ ---------
Existing technology ......... 1-5 years $ 7,090 $ (5,829) $ 1,261 $ 7,090 $ (5,101) $ 1,989
Patent/core technology ...... 5 405 (392) 13 405 (365) 40
Tradename/trademark ......... 5 32 (27) 5 32 (24) 8
Non-compete agreements ...... 2-3 140 (140) 0 140 (121) 19
--------- --------- --------- --------- --------- ---------
Total ................. $ 7,667 $ (6,388) $ 1,279 $ 7,667 $ (5,611) $ 2,056
========= ========= ========= ========= ========= =========
The amortization expense for purchased intangible assets for the three
months ended December 31, 2004 was approximately $383,000, of which
approximately $364,000 was amortized to cost of revenues and approximately
$19,000 was amortized to operating expenses. The amortization expense for
purchased intangible assets for the three months ended December 31, 2003 was
approximately $577,000 of which approximately $532,000 was amortized to cost of
revenues and approximately $45,000 was amortized to operating expenses. The
amortization expense for purchased intangible assets for the six months ended
December 31, 2004 was approximately $777,000, of which approximately $729,000
was amortized to cost of revenues and approximately $48,000 was amortized to
operating expenses. The amortization expense for purchased intangible assets for
the six months ended December 31, 2003 was approximately $1.2 million of which
approximately $1.1 million was amortized to cost of revenues and approximately
$100,000 was amortized to operating expenses. The estimated amortization expense
for the remainder of fiscal 2005 and the next year is as follows:
COST OF OPERATING
Fiscal year ending June 30: REVENUES EXPENSES TOTAL
-------- -------- --------
2005 (Remainder of fiscal year) ....... $ 704 $ 16 $ 720
2006 .................................. 557 2 559
-------- -------- --------
Total ................................. $ 1,261 $ 18 $ 1,279
======== ======== ========
The goodwill balance as of both December 31, 2004 and June 30, 2004 was
$9.5 million. Goodwill was recorded as a result of acquisitions over the years.
The current carrying value of goodwill is related to the acquisitions of
Lightwave and Stallion businesses. The Company performs an annual impairment
test of Goodwill under the guidelines of SFAS No. 142 in April.
8
7. RESTRUCTURING RESERVE
A summary of the activity in the restructuring reserve account is as
follows (in thousands):
RESTRUCTURING CASH RESTRUCTURING
RESERVE AT CHARGES RESERVE AT
JUNE 30, AGAINST RESTRUCTURING DECEMBER 31,
2004 RESERVE RECOVERY 2004
--------- --------- --------- ---------
Consolidation of excess facilities .... $ 752 $ (310) $ (56) $ 386
========= ========= ========= =========
On September 12, 2002 and March 14, 2003, the Company announced a
restructuring plan to prioritize its initiatives around the growth areas of its
business, focus on profit contribution, reduce expenses, and improve operating
efficiency. These restructuring plans included a worldwide workforce reduction,
consolidation of excess facilities and other charges. The Company recorded
restructuring costs totaling $5.6 million, which were classified as operating
expenses in the Company's consolidated statement of operations for the year
ended June 30, 2003. These restructuring plans resulted in the termination of
approximately 58 regular employees worldwide. The Company recorded workforce
reduction charges of approximately $1.2 million related to severance and fringe
benefits for the terminated employees. The Company recorded charges of
approximately $4.4 million related to consolidation of excess facilities,
relating primarily to lease terminations, non-cancelable lease costs, and
write-off of leasehold improvements and termination of a contractual obligation.
During the quarter ended March 31, 2004, restructuring charges were
adjusted, including an increase of lease obligations of $409,000 related to the
consolidation of excess facilities from the September 12, 2002 and March 14,
2003 restructuring plans, which were previously accrued for in fiscal year 2003.
The remaining restructuring reserve is related to facility closures in
Naperville, Illinois; Hillsboro, Oregon; and Ames, Iowa. Payments under the
lease obligations will end in fiscal 2007.
8. DISCONTINUED OPERATIONS
In August 2001, the FASB issued SFAS No. 144. SFAS No. 144 supersedes SFAS
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of"; however, it retains the fundamental provisions of
that statement related to the recognition and measurement of the impairment of
long-lived assets to be "held and used." SFAS No. 144 also supersedes the
accounting and reporting provisions of APB Opinion No. 30, "Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," for the disposal of a segment of a business. Under SFAS No. 144,
a component of a business is held for sale and is reported in discontinued
operations if (i) the operations and cash flows will be, or have been,
eliminated from the ongoing operations of the company, and (ii) the company will
not have any significant continuing involvement in such operations.
In March 2004, the Company completed the sale of substantially all of the
net assets of its Premise business unit for $1.0 million. Additionally, the
Company incurred $383,000 of disposal costs. As a result of the sale of the
Premise business unit, the net goodwill and purchased intangibles of Premise at
December 31, 2003 have been included as part of discontinued operations.
The net revenues and loss from discontinued operations are as follows (in
thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
DECEMBER 31, DECEMBER 31,
--------------------- ---------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Net revenues .................................................................. $ - $ 33 $ - $ 63
========= ========= ========= =========
Income (loss) from discontinued operations, net of income taxes of $0 ......... $ - $ (3,739) $ 56 $ (4,516)
========= ========= ========= =========
Basic and diluted net income (loss) per share from discontinued operations .... $ - $ (0.06) $ - $ (0.08)
========= ========= ========= =========
9
9. WARRANTY
Upon shipment to its customers, the Company provides for the estimated cost
to repair or replace products to be returned under warranty. The Company's
current warranty periods generally range from ninety days to two years from the
date of shipment. In addition, the Company also sells extended warranty services
which extend the warranty period for an additional one to three years. The
following table is a reconciliation of the changes to the product warranty
liability for the period presented:
SIX MONTHS
ENDED
DECEMBER 31,
2004
---------
Balance beginning of period ........................... $ 1,770
Charged to cost of revenues ........................... 247
Deductions ............................................ (207)
---------
Balance end of period ................................. $ 1,810
=========
10. PROVISION FOR INCOME TAXES AND EFFECTIVE TAX RATE
The Company utilizes the liability method of accounting for income taxes as
set forth in SFAS No. 109, "Accounting for Income Taxes." The Company's
effective tax rate was 3% and 4% for the six month periods ended December 31,
2004 and 2003, respectively. The Company's condensed consolidated financial
statements have been presented to reflect Premise as a discontinued operation
for all periods presented. The federal statutory rate was 34% for both periods.
The effective tax rate associated with the income tax expense for both the six
month periods ended December 31, 2004 and 2003 was lower than the federal
statutory rate primarily due to an increase in the valuation allowance, due to
our inability to estimate future taxable income, and foreign taxes. In 2003, the
Internal Revenue Service completed its audit of the Company's federal income tax
returns for the years ended June 30, 1999, 2000 and 2001. As a result, the
Company paid tax and interest to the IRS and the California Franchise Tax Board
of approximately $222,000, $441,000 and $113,000 in quarters ended March 31,
2004, June 30, 2004 and September 30, 2004, respectively.
The Company is under current discussions with the Swiss Federal Tax
Authorities ("SFTA") regarding the inability of the Company's Swiss subsidiary,
Lantronix International AG, to meet certain guidelines as set within a tax
ruling that was obtained in May 2001. The ruling provided for reduced Swiss tax
rates. The subsidiary was unable to meet the guidelines set forth in the ruling
due to slower than planned growth in this subsidiary, consistent with the
overall Company, and has since converted to a holding company. Based on recent
discussions with the SFTA, the Company estimates the potential tax exposure to
be approximately $53,000, and the Company has provided for this in the
consolidated financial statements for quarter ended December 31, 2004.
11. BANK LINE OF CREDIT AND DEBT
In January 2002, the Company entered into a two-year line of credit with a
bank in an amount not to exceed $20.0 million. Borrowings under the line of
credit bear interest at either, (i) the prime rate or (ii) the LIBOR rate plus
2.0%. The Company was required to pay a $100,000 facility fee which was reduced
to $62,500 and was paid. The Company was also required to pay a quarterly unused
line fee of .125% of the unused line of credit balance. Since establishing the
line of credit, the Company has twice reduced the amount of the line, modified
customary financial covenants, and adjusted the interest rate to be charged on
borrowings to the prime rate plus .50% and eliminated the LIBOR option.
Effective July 25, 2003, the Company further modified this line of credit,
reducing the revolving line to $5.0 million, and adjusting the customary
affirmative and negative covenants. The Company is also required to maintain
certain financial ratios as defined in the agreement. The agreement has an
annual revolving maturity date that renews on the effective date. The agreement
was renewed on July 24, 2004 with an amendment to a financial ratio. The Company
paid a $12,500 facility fee for the renewal. The Company's borrowing base at
December 31, 2004 was $3.6 million. As of December 31, 2004 the Company had
borrowed $250,000 against this line of credit. Additionally, the Company has
used letters of credit available under its line of credit totaling approximately
$451,000 in place of cash to fund deposits on leases, tax account deposits and
security deposits. As a result, the Company's available line of credit at
December 31, 2004 was $2.9 million. The Company is currently in compliance with
the revised financial covenants of the July 24, 2004 amended line of credit.
Pursuant to the line of credit, the Company is restricted from paying any
dividends.
10
The Company issued a two-year note in the principal amount of $867,000 as a
result of its acquisition of Stallion, accruing interest at a rate of 2.5% per
annum. Interest expense related to the note totaled approximately $5,000 and
$11,000 for the six months ended December 31, 2004 and 2003, respectively. The
notes were convertible into the Company's common stock at any time, at the
election of the holders, at a $5.00 conversion price. The notes were due and
paid in August 2004 as the holders elected not to convert the notes into the
Company's common stock.
12. COMPREHENSIVE LOSS
SFAS No. 130, "Reporting Comprehensive Income (Loss)," establishes
standards for reporting and displaying comprehensive income (loss) and its
components in the condensed consolidated financial statements.
The components of comprehensive loss are as follows (in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------- ----------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Net loss ................................................................. $ (1,655) $ (5,255) $ (5,434) $ (8,304)
Other comprehensive loss:
Change in accumulated translation adjustments, net of taxes of $0 ..... 114 97 133 108
--------- --------- --------- ---------
Total comprehensive loss ................................................. $ (1,541) $ (5,158) $ (5,301) $ (8,196)
========= ========= ========= =========
13. LITIGATION
GOVERNMENT INVESTIGATION
The Securities and Exchange Commission is conducting a formal investigation
of the events leading up to the Company's restatement of its financial
statements on June 25, 2002. The Department of Justice is also conducting an
investigation concerning events related to the restatement.
CLASS ACTION LAWSUITS
Beginning on May 15, 2002, a number of securities class actions were filed
against the Company and certain of its current and former directors and former
officers alleging violations of the federal securities laws. These actions were
consolidated into a single action pending in the United States District Court
for the Central District of California and entitled: In re Lantronix, Inc.
Securities Litigation, Case No. CV 02-3899 GPS (JTLx). After the Court appointed
a lead plaintiff, amended complaints were filed by the plaintiff, and the
defendants filed various motions to dismiss directed at particular allegations.
Through that process, certain of the allegations were dismissed by the Court.
On October 18, 2004, the plaintiff filed the third amended complaint, which
is now the operative complaint in the action. The Complaint alleges violations
of Sections 11 and 15 of the Securities Act of 1933 and violations of Sections
10(b) and 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934. The 1933
Act claims are brought on behalf of all persons who purchased common stock of
Lantronix pursuant or traceable to the Company's August 4, 2000 initial public
offering ("IPO"). The 1934 Act claims are based on alleged misstatements related
to the Company's financial results that were contained in the Registration
Statement and Prospectus for the IPO. The claims brought under the 1934 Act are
brought on behalf of all persons and entities that purchased or acquired
Lantronix securities from November 1, 2000 through May 30, 2002 (the "Class
Period"). The Complaint alleges that defendants issued false and misleading
statements concerning the business and financial condition in order to allegedly
inflate the value of the Company's securities during the Class Period. The
complaint alleges that during the Class Period, Lantronix overstated financial
results through improper revenue recognition and failure to comply with GAAP.
Defendants have filed an answer to the complaint and the case is now in
discovery. The Court has set a trial date in September 2006. While the complaint
does not specify the damages plaintiff may seek on behalf of the purported
classes of shareholders, a recovery by the plaintiff and the plaintiff classes
could have a material adverse impact on the Company.
DERIVATIVE LAWSUIT
On July 26, 2002, Samuel Ivy filed a shareholder derivative complaint
entitled: Ivy v. Bernhard Bruscha, et al., No. 02CC00209, in the Superior Court
of the State of California, County of Orange, against certain of the Company's
current and former directors and former officers. On January 7, 2003, the
plaintiff filed an amended complaint. The amended complaint alleges causes of
action for breach of fiduciary duty, abuse of control, gross mismanagement,
unjust enrichment, and improper insider stock sales. The complaint seeks
unspecified damages against the individual defendants on the Company's behalf,
equitable relief, and attorneys' fees. All defendants have answered the
complaint and generally denied the allegations. Discovery has commenced, but no
trial date has been established.
11
All of the parties except for Steve Cotton have agreed in principle to
settle the action. Specifically, the Company's Board recently approved a
tentative settlement proposal which involves the adoption of certain corporate
governance measures and payment of attorneys' fees and expenses to the
derivative plaintiff's counsel in the amount of $1.2 million. The settling
parties are seeking court approval of the settlement. If Mr. Cotton does not
agree to join the settlement, Plaintiff as part of the settlement has agreed to
seek dismissal of all of the defendants, including Mr. Cotton. The settlement is
subject to a number of conditions, including court approval of the proposed
settlement. We have recorded a liability in our financial statements for the
proposed amount of the settlement. In addition, because the insurance carrier
involved in this suit agreed to pay the entire $1.2 million settlement amount
and, therefore, recovery from the insurance carrier is probable, a receivable
was also recorded for the same amount. Accordingly, there is no impact to the
statement of operations because the amounts of the settlement and the insurance
recovery fully offset each other.
EMPLOYMENT SUIT BROUGHT BY FORMER CHIEF FINANCIAL OFFICER AND CHIEF OPERATING
OFFICER STEVE COTTON
On September 6, 2002, Steve Cotton, the Company's former CFO and COO, filed
a complaint entitled Cotton v. Lantronix, Inc., et al., No. 02CC14308, in the
Superior Court of the State of California, County of Orange. The complaint
alleges claims for breach of contract, breach of the covenant of good faith and
fair dealing, wrongful termination, misrepresentation, and defamation. The
complaint seeks unspecified damages, declaratory relief, attorneys' fees and
costs.
The Company filed a motion to dismiss on October 16, 2002, on the grounds
that Mr. Cotton's complaints are subject to the binding arbitration provisions
in Mr. Cotton's employment agreement. On January 13, 2003, the Court ruled that
five of the six counts in Mr. Cotton's complaint are subject to binding
arbitration. The court is staying the sixth count, for declaratory relief, until
the underlying facts are resolved in arbitration. No arbitration date has been
set.
SECURITIES CLAIMS BROUGHT BY FORMER SHAREHOLDERS OF SYNERGETIC MICRO SYSTEMS,
INC. ("SYNERGETIC")
On October 17, 2002, Richard Goldstein and several other former
shareholders of Synergetic filed a complaint entitled Goldstein, et al. v.
Lantronix, Inc., et al. in the Superior Court of the State of California, County
of Orange, against the Company and certain of its former officers and directors.
Plaintiffs filed an amended complaint on January 7, 2003. The amended complaint
alleges fraud, negligent misrepresentation, breach of warranties and covenants,
breach of contract and negligence, all stemming from its acquisition of
Synergetic. The complaint seeks an unspecified amount of damages, interest,
attorneys' fees, costs, expenses, and an unspecified amount of punitive damages.
On May 5, 2003, the Company answered the complaint and generally denied the
allegations in the complaint. Discovery has commenced and the court has set a
trial date in March 2006.
PATENT INFRINGEMENT LITIGATION
On April 13, 2004, Digi International Inc. ("Digi") filed a complaint
against the Company in the U.S. District Court in Minnesota. The complaint
alleges that certain of the Company's products infringe Digi's U.S. Patent No.
6,446,192. The complaint seeks both monetary and non-monetary relief. The
Company has filed an answer and counterclaim alleging invalidity of the patent.
The counterclaim seeks both monetary and non-monetary relief.
On May 3, 2004, the Company filed a complaint against Digi in the U.S.
District Court for the Central District of California. The complaint alleges
that certain of Digi's products infringe the Company's U.S. Patent No.
6,571,305. The Complaint seeks both monetary and non-monetary relief. Digi has
filed an answer and counterclaim alleging invalidity of the patent. The
counterclaim seeks both monetary and non-monetary relief.
OTHER
From time to time, the Company is subject to other legal proceedings and
claims in the ordinary course of business. The Company is currently not aware of
any such legal proceedings or claims that it believes will have, individually or
in the aggregate, a material adverse effect on its business, prospects,
financial position, operating results or cash flows.
The pending lawsuits involve complex questions of fact and law and likely
will continue to require the expenditure of significant funds and the diversion
of other resources to defend. Management is unable to determine the outcome of
its outstanding legal proceedings, claims and litigation involving the Company,
its subsidiaries, directors and officers and cannot determine the extent to
which these results may have a material adverse effect on the Company's
business, results of operations and financial condition taken as a whole. The
results of litigation are inherently uncertain, and adverse outcomes are
possible. The Company is unable to estimate the range of possible loss from
outstanding litigation, and no amounts have been provided for such matters in
the consolidated financial statements.
12
14. SUBSEQUENT EVENTS
On February 7, 2005, the Company filed a complaint against Digi in the U.S.
District Court for the Eastern District of Texas. The complaint alleges that
certain of Digi's device server and other server products infringe U.S. Patent
No. 4,972,470. The Company is the exclusive licensee of this patent in the
device server field of use. The complaint seeks both monetary and non-monetary
relief.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
You should read the following discussion and analysis in conjunction with
the Unaudited Condensed Consolidated Financial Statements and related Notes
thereto contained elsewhere in this Report. The information in this Quarterly
Report on Form 10-Q is not a complete description of our business or the risks
associated with an investment in our common stock. We urge you to carefully
review and consider the various disclosures made by us in this Report and in
other reports filed with the Securities and Exchange Commission, including our
Annual Report on Form 10-K/A for the fiscal year ended June 30, 2004 and our
subsequent reports on Form 8-K that discuss our business in greater detail.
The section entitled "Risk Factors" set forth below, and similar
discussions in our other SEC filings, discuss some of the important factors that
may affect our business, results of operations and financial condition. You
should carefully consider those factors, in addition to the other information in
this Report and in our other filings with the SEC, before deciding to invest in
our company or to maintain or increase your investment.
This report contains forward-looking statements which include, but are not
limited to, statements concerning projected net revenues, expenses, gross profit
and income (loss), the need for additional capital, market acceptance of our
products, our ability to consummate acquisitions and integrate their operations
successfully, our ability to achieve further product integration, the status of
evolving technologies and their growth potential and our production capacity.
These forward-looking statements are based on our current expectations,
estimates and projections about our industry, our beliefs and certain
assumptions made by us. Words such as "anticipates," "expects," "intends,"
"plans," "believes," "seeks," "estimates," "may," "will" and variations of these
words or similar expressions are intended to identify forward-looking
statements. In addition, any statements that refer to expectations, projections
or other characterizations of future events or circumstances, including any
underlying assumptions, are forward-looking statements. These statements are not
guarantees of future performance and are subject to certain risks, uncertainties
and assumptions that are difficult to predict. Therefore, our actual results
could differ materially and adversely from those expressed in any
forward-looking statements as a result of various factors. We undertake no
obligation to revise or update publicly any forward-looking statements for any
reason.
OVERVIEW
Lantronix designs, develops and markets products and software solutions
that make it possible to access, manage, control and configure almost any
electronic device over the Internet or other networks. We are a leader in
providing innovative networking solutions. We were initially formed as
"Lantronix," a California corporation, in June 1989. We reincorporated as
"Lantronix, Inc.," a Delaware corporation in May 2000.
We have a history of providing devices that enable information technology
("IT") equipment to network using standard protocols for connectivity, including
fiber optic, Ethernet and wireless. Our first device was a terminal server that
allowed "dumb" terminals to connect to a network. Building on the success of our
terminal servers, we introduced a complete line of print servers in 1991 that
enabled users to inexpensively share printers over a network. Over the years, we
have continually refined our core technology and have developed additional
innovative networking solutions that expand upon the business of providing our
customers network connectivity. With the expansion of networking and the
Internet, our technology focus is increasingly broader, so that our device
solutions provide a product manufacturer with the ability to network their
products within the industrial, service and consumer markets.
We provide three broad categories of products: (i) "device networking
solutions" that enable almost any electronic product to be connected to a
network; (ii) "IT management solutions" that enable multiple pieces of hardware,
usually IT-related network hardware such as servers, routers, switches, and
similar pieces of equipment to be managed over a network; and (iii) "non-core"
products and services that include visualization solutions, legacy print
servers, software revenues, and other miscellaneous products. The expansion of
our business in the future is directed at the first two of these categories,
device networking and IT management solutions. In various discussions and
presentations of our business, we refer to device networking and IT management
solutions as our "core" business from the standpoint they represent our focus on
product and business now, and for the immediate future.
13
Today, our solutions include fully integrated hardware and software
devices, as well as software tools to develop related customer applications.
Because we deal with network connectivity, we provide hardware solutions to
extremely broad market segments, including industrial, medical, commercial,
financial, governmental, retail, building automation, and many more. Our
technology is used to provide networking capabilities to products such as
medical instruments, manufacturing equipment, bar code scanners, building HVAC
systems, process control equipment, thermostats, security panels, temperature
sensors, point of sale terminals, time clocks, and many products that have some
form of standard data control capability. Our current product offerings include
a wide range of hardware devices of varying size, packaging and, where
appropriate, software solutions that allow our customers to network-enable
virtually any electronic product.
THE NATURE OF OUR BUSINESS
Currently, we develop our products through engineering and product
development activities of our research and development organization. In prior
years, most engineering and product development were outsourced with independent
contractors. In fiscal 2003, this practice was discontinued; however, some
product development activities such as specialized technical investigations or
qualification testing of new products is still subcontracted from time to time.
We engage outside contract manufacturers to make our products, which are then
taken to market by our marketing and sales organizations.
We sell our devices through distribution partners to a global network of
distributors, value-added resellers ("VARs"), manufacturers' representatives,
system integrators, and original equipment manufacturers ("OEMs"). In addition,
we sell directly to selected accounts. One distribution customer, Ingram Micro,
accounted for approximately 18.1% and 13.9% of our net revenues for the six
months ended December 31, 2004 and 2003, respectively. Another distribution
customer, Tech Data, accounted for approximately 10.8% and 8.8% of our net
revenues for the six months ended December 31, 2004 and 2003, respectively.
Accounts receivable attributable to these domestic customers accounted for
approximately 19.0% and 12.9% of total accounts receivable at December 31, 2004
and June 30, 2004, respectively.
One international customer, transtec AG, which is a related party due to
common ownership by our largest stockholder and former Chairman of our Board of
Directors, Bernhard Bruscha, accounted for approximately 2.6% and 3.3% of our
net revenues for the six months ended December 31, 2004 and 2003, respectively.
DISCONTINUED OPERATIONS
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"). SFAS No. 144
supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of"; however, it retains the
fundamental provisions of that statement related to the recognition and
measurement of the impairment of long-lived assets to be "held and used." SFAS
No. 144 also supersedes the accounting and reporting provisions of Accounting
Principles Board ("APB") Opinion No. 30, for the disposal of a segment of a
business. Under SFAS No. 144, a component of a business that is held for sale is
reported in discontinued operations if (i) the operations and cash flows will
be, or have been, eliminated from the ongoing operations of the company, and
(ii) the company will not have any significant continuing involvement in such
operations.
In March 2004, we completed the sale of substantially all of the net assets
of our Premise business unit for $1.0 million. Additionally, we incurred
$383,000 of disposal costs. As a result of the sale of the Premise business
unit, the net goodwill and purchased intangibles of Premise at December 31, 2003
have been included as part of discontinued operations.
SUMMARY OVERVIEW OF THE SECOND FISCAL QUARTER ENDED DECEMBER 31, 2004
The following discussion of results of operations includes discussion of
continuing operations only.
SUMMARY OVERVIEW OF THE SECOND FISCAL QUARTER ENDED DECEMBER 31, 2004
As described in more detail elsewhere in this document, our business has
continued to operate in a manner consistent with the fiscal year ended June 30,
2004 and the first fiscal quarter ended September 30, 2004. Net revenues
increased from $11.0 million for the quarter ended September 30, 2004, to $12.9
million this quarter. The increase of $1.9 million from the prior quarter is
primarily due to increased shipments of our device networking product lines.
Revenues of $12.9 million for the quarter ended December 31, 2004 compared to
revenues of $12.5 million for the same quarter a year earlier. The increase of
$.4 million in revenue is primarily due to increased shipments of our device
networking product lines.
14
Our cash, cash equivalents and marketable securities balances decreased by
$1.0 million, from $9.2 million at September 30, 2004 to $8.2 million at
December 31, 2004. We refer to the sum of these components as "cash" for the
purpose of discussing our liquidity. During the fiscal year ended June 30, 2004,
cash usage totaled $1.9 million. Cash usage increased to $3.0 million in the
first fiscal quarter, which included payments for increased marketing and sales
expenses for new product programs, repayment of a note of $867,000 related to
the Stallion acquisition, audit payments and other costs.
Our gross margin was 48.5% for the quarter ended December 31, 2004,
compared to a gross margin of 45.2% for the same quarter a year earlier and a
gross margin of 50.3% for the quarter ended September 30, 2004. The improvement
in gross margin for the quarter ended December 31, 2004 compared to a year
earlier is primarily due to lower costs related to amortization of intangible
assets that are recorded in cost of revenues; amortization expense for the
quarter decreased to approximately $364,000 compared to approximately $532,000 a
year earlier. These lower amortization costs will continue in future quarters.
For the quarter ended December 31, 2004, we had a loss from continuing
operations of $1.7 million, compared to a loss of $1.5 million for the same
quarter a year earlier. Operating expenses related to continuing operations
increased to $8.3 million for the quarter ended December 31, 2004 from $7.1
million for the same quarter a year earlier. The increase in selling general and
administrative is attributable to legal expenses recognized in the periods;
legal expenses in the quarter ended December 31, 2004 were approximately
$792,000, whereas a year earlier legal expenses were a favorable credit of
approximately $283,000. The liability for legal expenses is booked as incurred
and is reduced from time to time by the receipt of actual reimbursement of
expenses related to shareholder lawsuit matters by our insurance carrier.
OUTLOOK
Revenues for our second fiscal quarter ended December 31, 2004 were $12.9
million, in line with or goals for the period. Although revenues for the prior
quarter ended September 30, 2004 were $11.0 million, we view our most recent
results as a validation of a longer-term trend of increased unit shipments of
our products and revenue growth of our core business of device networking and IT
management solutions.
During the quarter ended December 31, 2004, we continued to reduce our
expenses. In January 2005, we further cut back our staff to continue to reduce
operating costs. We also closed a small sales office in Milford, Connecticut in
January. In addition, we are realigning our international sales operations and
have reduced our fixed costs in Japan and Germany. We anticipate that our cost
reduction initiatives implemented between October 2004 through January 2005 has
lowered our estimated cash breakeven point from $14.0-15.0 million in quarterly
revenue to approximately $13.0 million. Achieving cash breakeven is subject to
many factors, including the cost of on-going litigation and our actual operating
expenses and product margins, and may require more or less than $13.0 million in
revenue per quarter.
We are continuing to invest in the development of new and innovative
products, and to support expanded sales and marketing activities to promote our
recently introduced products. During the past several quarters we introduced
several new products we believe will contribute to growth in revenues. These
products include WiPort, a wireless version of our Xport device server; Wibox, a
wireless external device networking solution; Secure Box, AES-encryption device
networking products; a NEBS -compliant secure console server for
telecommunications applications; a SecureLinx Remote KVM product line designed
to remotely connect IT administrators to their Windows-based equipment and an
SLC line of console servers. There can be an extended delay from the time we
introduce a new product until the time we receive significant revenues. This is
due primarily to the nature of our products, which involve the customers design
cycles, our customers own new product introduction processes, or qualification
and other testing programs they may implement as part of their businesses.
Our device networking business fundamentally targets the market of products
that can be networked together and/or connected to the Internet. We see as
inevitable, a world where myriads of devices are interconnected to enhance their
operation, maintenance, or to provide new functionality. Independent researchers
have made varying estimates as to the size and rate of this expansion. However,
we believe that device networking growth as evidenced by our net revenue growth
or that of our peers is still in the early adoption phase. We believe in the
next several years, the market adoption of our networking solution devices will
be strongest in the commercial and industrial markets such as security, medical,
factory automation, and similar markets, rather than in consumer electronics.
Our IT management business provides remote management solutions to our
customers' IT infrastructure of servers, routers, switches, power supplies, and
other devices that comprise their networks. This business was severely impacted
by the recession of the past several years, and we are just beginning to emerge
from that recession. While we have not yet achieved a high rate of net revenue
growth, we have confidence in our position in this market, and we have recently
introduced new products that we believe are achieving recognition in the
marketplace.
15
We have had a target cash usage of approximately $1.0 million per quarter,
while we are operating at the revenue range of $11.0 to $13.0 million. Our
actual cash usage over the previous six quarters has varied due to a variety of
factors, including factors not related to our business revenues for those
quarters. For example, we incur legal expenses that vary each quarter. Moreover,
we have some expenses that we pay once per year, such as insurance premiums or
audit fees. We have benefited from other cash management activities to improve
cash flow by improving balance sheet accounts over these same periods such as
reducing our inventories. During that same period we have received cash from
specific transactions, such as our sale of Premise and our recovery of legal
expenses through insurance reimbursements. We have also exchanged deposits in
the form of cash with letters of credit. Our goal is to continue to manage
expenses and drive revenue increases to achieve cash breakeven, and then
profitability. As of December 31, 2004, we had a balance of cash, cash
equivalents and marketable securities of $8.2 million. We expect to use
approximately $1.5 million in cash for the quarter ending March 31, 2005,
partially as a result of severance, office closing and other costs related to
expense reduction actions taken in the second and third fiscal quarters.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States requires us to make estimates
and assumptions that affect the reported amounts of assets and liabilities at
the date of the financial statements and the reported amounts of net revenues
and expenses during the reporting period. We regularly evaluate our estimates
and assumptions related to net revenues, allowances for doubtful accounts, sales
returns and allowances, inventory reserves, goodwill and purchased intangible
asset valuations, warranty reserves, restructuring costs, litigation and other
contingencies. We base our estimates and assumptions on historical experience
and on various other factors that we believe 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. To the extent there are material differences between our
estimates and the actual results, our future results of operations will be
affected.
We believe the following critical accounting policies require us to make
significant judgments and estimates in the preparation of our condensed
consolidated financial statements:
REVENUE RECOGNITION
We do not recognize revenue until all of the following criteria are met:
persuasive evidence of an arrangement exists; delivery has occurred or services
have been rendered; our price to the buyer is fixed or determinable; and
collectibility is reasonably assured. Commencing July 1, 2001, we adopted a new
accounting policy for revenue recognition such that recognition of revenue and
related gross profit from sales to distributors are deferred until the
distributor resells the product. Net revenue from certain smaller distributors,
for which point-of-sale information is not available, is recognized one month
after the shipment date. This estimate approximates the timing of the sale of
the product by the distributor to the end-user. When product sales revenue is
recognized, we establish an estimated allowance for future product returns based
on historical returns experience; when price reductions are approved, we
establish an estimated liability for price protection payable on inventories
owned by product resellers. Should actual product returns or pricing adjustments
exceed our estimates, additional reductions to revenues would result. Revenue
from the licensing of software is recognized at the time of shipment (or at the
time of resale in the case of software products sold through distributors),
provided we have vendor-specific objective evidence of the fair value of each
element of the software offering and collectibility is probable. Revenue from
post-contract customer support and any other future deliverables is deferred and
recognized over the support period or as contract elements are delivered. Our
products typically carry a ninety-day to two-year warranty. Although we engage
in extensive product quality programs and processes, our warranty obligation is
affected by product failure rates, use of materials or service delivery costs
that differ from our estimates. As a result, additional warranty reserves could
be required, which could reduce gross margins. Additionally, we sell extended
warranty services which extend the warranty period for an additional one to
three years. Warranty revenue is recognized evenly over the warranty service
period.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. Our
allowance for doubtful accounts is based on our assessment of the collectibility
of specific customer accounts, the aging of accounts receivable, our history of
bad debts and the general condition of the industry. If a major customer's
credit worthiness deteriorates, or our customers' actual defaults exceed our
historical experience, our estimates could change and impact our reported
results. We also maintain a reserve for uncertainties relative to the collection
of officer notes receivable. Factors considered in determining the level of this
reserve include the value of the collateral securing the notes, our ability to
effectively enforce collection rights and the ability of the former officers to
honor their obligations.
16
INVENTORY VALUATION
Our policy is to value inventories at the lower of cost or market on a
part-by-part basis. This policy requires us to make estimates regarding the
market value of our inventories, including an assessment of excess and obsolete
inventories. We determine excess and obsolete inventories based on an estimate
of the future sales demand for our products within a specified time horizon,
generally three to twelve months. The estimates we use for demand are also used
for near-term capacity planning and inventory purchasing and are consistent with
our revenue forecasts. In addition, specific reserves are recorded to cover
risks in the area of end of life products, inventory located at our contract
manufacturers, deferred inventory in our sales channel and warranty replacement
stock.
If our sales forecast is less than the inventory we have on hand at the end
of an accounting period, we may be required to take excess and obsolete
inventory charges which will decrease gross margin and net operating results for
that period.
VALUATION OF DEFERRED INCOME TAXES
We have recorded a valuation allowance to reduce our net deferred tax
assets to zero, primarily due to our inability to estimate future taxable
income. We consider estimated future taxable income and ongoing prudent and
feasible tax planning strategies in assessing the need for a valuation
allowance. If we determine that it is more likely than not that we will realize
a deferred tax asset, which currently has a valuation allowance, we would be
required to reverse the valuation allowance which would be reflected as an
income tax benefit at that time.
GOODWILL AND PURCHASED INTANGIBLE ASSETS
The purchase method of accounting for acquisitions requires extensive use
of accounting estimates and judgments to allocate the purchase price to the fair
value of the net tangible and intangible assets acquired, including IPR&D.
Goodwill and intangible assets deemed to have indefinite lives are no longer
amortized but are subject to annual impairment tests. The amounts and useful
lives assigned to intangible assets impact future amortization and the amount
assigned to IPR&D is expensed immediately. If the assumptions and estimates used
to allocate the purchase price are not correct, purchase price adjustments or
future asset impairment charges could be required.
IMPAIRMENT OF LONG-LIVED ASSETS
We evaluate long-lived assets used in operations when indicators of
impairment, such as reductions in demand or significant economic slowdowns, are
present. Reviews are performed to determine whether the carrying values of
assets are impaired based on a comparison to the undiscounted expected future
cash flows. If the comparison indicates that there is impairment, the expected
future cash flows, using a discount rate based upon our weighted average cost of
capital, is used to estimate the fair value of the assets. Impairment is based
on the excess of the carrying amount over the fair value of those assets.
Significant management judgment is required in the forecast of future operating
results that is used in the preparation of expected discounted cash flows. It is
reasonably possible that the estimates of anticipated future net revenue, the
remaining estimated economic lives of the products and technologies, or both,
could differ from those used to assess the recoverability of these assets. In
the event they are lower, additional impairment charges or shortened useful
lives of certain long-lived assets could be required.
RESTRUCTURING CHARGE
Over the last several quarters we have undertaken, and we may continue to
undertake, significant restructuring initiatives, which have required us to
develop formalized plans for exiting certain business activities. We have had to
record estimated expenses for lease cancellations, contract terminations,
long-term asset write-downs, severance and outplacement costs and other
restructuring costs. Given the significance and timing of the execution of such
activities, this process is complex and involves periodic reassessments of
estimates made at the time the original decisions were made. Through December
31, 2002, the accounting rules for restructuring costs and asset impairments
required us to record provisions and charges when we had a formal and committed
plan. Beginning January 1, 2003, the accounting rules now require us to record
any future provisions and changes at fair value in the period in which they are
incurred. In calculating the cost to dispose of our excess facilities, we had to
estimate our future space requirements and the timing of exiting excess
facilities and then estimate for each location the future lease and operating
costs to be paid until the lease is terminated and the amount, if any, of
sublease income. This required us to estimate the timing and costs of each lease
to be terminated, including the amount of operating costs and the rate at which
we might be able to sublease the site. To form our estimates for these costs, we
performed an assessment of the affected facilities and considered the current
market conditions for each site. Our assumptions on future space requirements,
the operating costs until termination or the offsetting sublease revenues may
turn out to be incorrect, and our actual costs may be materially different from
our estimates, which could result in the need to record additional costs or to
reverse previously recorded liabilities. Our policies require us to periodically
evaluate the adequacy of the remaining liabilities under our restructuring
initiatives. As management continues to evaluate the business, there may be
additional charges for new restructuring activities as well as changes in
estimates to amounts previously recorded.
17
SETTLEMENT COSTS
From time to time, we are involved in legal actions arising in the ordinary
course of business. We cannot assure you that these actions or other third party
assertions against us will be resolved without costly litigation, in a manner
that is not adverse to our financial position, results of operations or cash
flows. As facts concerning contingencies become known, we reassess our position
and make appropriate adjustments to the financial statements. There are many
uncertainties associated with any litigation. If our initial assessments
regarding the merits of a claim prove to be wrong, our results of operations and
financial condition could be materially and adversely affected. In addition, if
further information becomes available that causes us to determine a loss in any
of our pending litigation is probable and we can reasonably estimate a range of
loss associated with such litigation, then we would record at least the minimum
estimated liability. However, the actual liability in any such litigation may be
materially different from our estimates, which could result in the need to
record additional costs. We record our legal expenses as incurred; reimbursement
of legal expenses from insurance or other sources are recorded upon receipt.
RECENT ACCOUNTING PRONOUNCEMENTS
In November 2004 the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 151 "Inventory Costs -
An Amendment of ARB No. 43, Chapter 4". This new standard is the result of a
broader effort by the FASB to improve financial reporting by eliminating
differences between Generally Accepted Accounting Principles ("GAAP") in the
United States and Accounting Principles developed by the International
Accounting Standards Board ("IASB"). As part of this effort, the FASB and the
IASB identified opportunities to improve financial reporting by eliminating
certain narrow differences between their existing accounting standards. SFAS No.
151 clarifies that abnormal amounts of idle facility expense, freight handling
costs and spoilage costs should be expensed as incurred and not included in
overhead. Further, SFAS No. 151 requires that allocation of fixed production
overheads to conversion costs should be based on normal capacity of the
production facilities. The provisions in SFAS No. 151 are effective for
inventory costs incurred during fiscal years beginning after June 15, 2005.
Companies must apply the standard prospectively. Management does not expect the
adoption of SFAS No. 151 to have a material impact on the Company's financial
position, results of operations or cash flows.
In December 2004 the FASB issued SFAS No. 123R, a revision to SFAS No. 123
"Accounting for Stock-Based Compensation," and supersedes APB Opinion No. 25
"Accounting for Stock Issued to Employees" and its related implementation
guidance. SFAS No. 123R establishes standards for the accounting for
transactions in which an entity exchanges instruments for goods or services. It
also addresses transactions in which an entity incurs liabilities in exchange
for goods or services that are based on the fair value of the entity's equity
instruments or that may be settled by the issuance of those equity instruments.
SFAS No. 123R established the accounting treatment for transactions in which an
entity obtains employee services in share-based payment transactions. SFAS No.
123R requires companies to recognize in the statement of operations the
grant-date fair value of stock options and other equity-based compensation
issued to employees. SFAS No. 123R requires the Company to value the share-based
compensation based on the classification of the share-based award. If the
share-based award is to be classified as a liability, the Company must
re-measure the award at each balance sheet date until the award is settled. If
the share-based award is to be classified as equity, the Company will measure
the value of the share-based award on the date of grant, but the award will not
be re-measured at each balance sheet date. SFAS No. 123R does not change the
accounting guidance for share-based payment transactions with parties other than
employees provided in SFAS No. 123 as originally issued and EITF Issue No. 96-18
"Accounting for Equity Instruments that are Issued to Other than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services." SFAS No. 123R is
effective for public companies that do not file as small business issuers as of
the beginning of interim or annual reporting periods that begin after June 15,
2005 (the effective date for small business issuer is December 15, 2005). All
public companies must use either the modified prospective or modified
retrospective transition method. Under the modified prospective method, awards
that are granted, modified, or settled after the date of adoption should be
measured and accounted for in accordance with SFAS No. 123R. Unvested equity
classified awards that were granted prior to the effective date should continue
to be accounted for in accordance to SFAS No. 123 except that the amounts must
be recognized in the statement of operations. Under the modified retrospective
method, the previously reported amounts are restated (either to the beginning of
the year of adoption or for all periods presented) to reflect SFAS No. 123
amounts in the statement of operations. Management is in the process of
determining the effect SFAS No. 123R will have upon the Company's financial
position and statement of operations.
Other recent accounting pronouncements issued by the FASB (including its
Emerging Issues Task Force), the American Institute of Certified Public
Accountants and the Securities and Exchange Commission (the "SEC"), did not or
are not believed by management to have a material impact on the Company's
present or future consolidated financial statements.
18
CONSOLIDATED RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the percentage
of net revenues represented by each item in our condensed consolidated statement
of operations:
THREE MONTHS ENDED SIX MONTHS ENDED
DECEMBER 31, DECEMBER 31,
----------------------- -----------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Net revenues ............................................ 100.0% 100.0% 100.0% 100.0%
Cost of revenues ........................................ 51.5 54.8 50.7 52.2
--------- --------- --------- ---------
Gross profit ............................................ 48.5 45.2 49.3 47.8
--------- --------- --------- ---------
Operating expenses:
Selling, general and administrative .................. 52.2 41.5 56.9 46.4
Research and development ............................. 11.0 14.1 15.5 14.4
Stock based compensation ............................. 0.9 0.5 1.2 0.8
Amortization of purchased intangible assets .......... 0.1 0.4 0.2 0.4
--------- --------- --------- ---------
Total operating expenses ................................ 64.2 56.5 73.8 62.0
--------- --------- --------- ---------
Loss from operations .................................... (15.7) (11.3) (24.5) (14.2)
Interest income, net .................................... 0.0 0.1 0.1 0.1
Other income (expense), net ............................. 3.7 (0.1) 2.2 (0.7)
--------- --------- --------- ---------
Loss before income taxes ................................ (12.0) (11.3) (22.2) (14.8)
Provision for income taxes .............................. 0.8 0.8 0.7 0.5
--------- --------- --------- ---------
Loss from continuing operations ......................... (12.8) (12.1) (22.9) (15.3)
--------- --------- --------- ---------
Income (loss) from discontinued operations .............. - (29.9) 0.2 (18.3)
--------- --------- --------- ---------
Net loss ................................................ (12.8)% (42.0)% (22.7)% (33.6)%
========= ========= ========= =========
COMPARISON OF THE THREE AND SIX MONTHS ENDED DECEMBER 31, 2004 AND 2003
The following discussion of results of operations includes discussion of
continuing operations only.
NET REVENUES BY PRODUCT CATEGORY
THREE MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
PRODUCT CATEGORIES 2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
------------------ -------- -------- -------- -------- -------- --------
Device networking ....... $ 8,079 62.6% $ 6,975 55.8% $ 1,104 15.8%
IT management ........... 3,299 25.6% 3,290 26.3% 9 0.3%
Non core ................ 1,530 11.8% 2,233 17.9% (703) (31.5)%
-------- -------- -------- -------- -------- --------
TOTAL ................... $ 12,908 100.0% $ 12,498 100.0% $ 410 3.3%
======== ======== ======== ======== ======== ========
SIX MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
PRODUCT CATEGORIES 2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
------------------ -------- -------- -------- -------- -------- --------
Device networking ....... $ 14,305 59.7% $ 13,494 54.6% $ 811 6.0%
IT management ........... 6,421 26.8% 6,348 25.7% 73 1.1%
Non core ................ 3,227 13.5% 4,857 19.7% (1,630) (33.6)%
-------- -------- -------- -------- -------- --------
TOTAL ................... $ 23,953 100.0% $ 24,699 100.0% $ (746) (3.0)%
======== ======== ======== ======== ======== ========
The increase for the three months ended December 31, 2004 was primarily
attributable to an increase in net revenues from our device networking products,
offset by a decrease in our non-core products. The decrease in our non-core
product net revenues is primarily due to a decrease in our print server,
visualization, and other products. We are no longer investing in the development
of these product lines and expect net revenues related to these products to
continue to decline in the future as we focus our investment in device
networking and IT management products.
19
The decrease for the six months ended December 31, 2004 is primarily
attributable to a decrease in net revenue from our non-core products offset by
an increase in our device networking products. The decrease in our non-core
product net revenues is primarily due to a decrease in our print server,
visualization and other products. We are no longer investing in the development
of these product lines and expect net revenues related to these products to
continue to decline in the future as we focus our investment in device
networking and IT management products.
NET REVENUES BY REGION
THREE MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
GEOGRAPHIC REGION 2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
----------------- --------- --------- --------- --------- --------- ---------
Americas ......................................... $ 8,463 65.6% $ 8,597 68.8% $ (134) (1.6)%
Europe ........................................... 3,412 26.4% 2,911 23.3% 501 17.2%
Other ............................................ 1,033 8.0% 990 7.9% 43 4.3%
--------- --------- --------- --------- --------- ---------
TOTAL ............................................ $ 12,908 100.0% $ 12,498 100.0% $ 410 3.3%
========= ========= ========= ========= ========= =========
SIX MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
GEOGRAPHIC REGION 2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
----------------- --------- --------- --------- --------- --------- ---------
Americas ......................................... $ 15,994 66.8% $ 18,077 73.2% $ (2,083) (11.5)%
Europe ........................................... 6,205 25.9% 5,083 20.6% 1,122 22.1%
Other ............................................ 1,754 7.3% 1,539 6.2% 215 14.0%
--------- --------- --------- --------- --------- ---------
TOTAL ............................................ $ 23,953 100.0% $ 24,699 100.0% $ (746) (3.0)%
========= ========= ========= ========= ========= =========
The overall increase in net revenues for the three months ended December
31, 2004 is primarily due to an increase in the Europe region and, to a lesser
extent, an increase in Other regions, offset by a decrease in the Americas
region. The overall decrease in net revenues for the six months ended December
31, 2004 is primarily due to a decrease in the Americas region offset by an
increase in Europe and to a lesser extent Other regions. The decrease in net
revenues in the Americas region is primarily attributable to lower sales of
non-core products, offset by an increase in core products. We are no longer
investing in the development of these product lines and expect net revenues
related to these product lines to continue to decline in the future as we focus
our investment on device networking and IT management products. The increase in
the European region is primarily due to growth in our device networking
business.
GROSS PROFIT
THREE MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Gross profit ..................................... $ 6,256 48.5% $ 5,644 45.2% $ 612 10.8%
========= ========= ========= ========= ========= =========
SIX MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Gross profit ..................................... $ 11,813 49.3% $ 11,800 47.8% $ 13 0.1%
========= ========= ========= ========= ========= =========
Gross profit represents net revenues less cost of revenues. Cost of
revenues consists primarily of the cost of raw material components, subcontract
labor assembly from outside manufacturers, amortization of purchased intangible
assets, impairment of purchased intangible assets, establishing or relieving
inventory reserves for excess and obsolete products or raw materials, overhead
and warranty costs. Cost of revenues for the three months ended December 31,
2004 and 2003 includes $364,000 and $532,000 of amortization of purchased
intangible assets, respectively. Cost of revenues for the six months ended
December 31, 2004 and 2003 includes $729,000 and $1.1 million of amortization of
purchased intangible assets, respectively. At December 31, 2004, the unamortized
balance of purchased intangible assets that will be amortized to cost of
revenues was $1.3 million, of which $704,000 will be amortized in the remainder
of fiscal 2005, $557,000 in fiscal 2006. The slight increase in gross profit was
mainly attributable to higher revenues, lower inventory reserves recorded in the
quarter and lower amortization expense of purchased intangible assets.
20
SELLING, GENERAL AND ADMINISTRATIVE
THREE MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Selling, general and administrative .............. $ 6,732 52.2% $ 5,192 41.5% $ 1,540 29.7%
========= ========= ========= ========= ========= =========
SIX MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Selling, general and administrative .............. $ 13,636 56.9% $ 11,455 46.4% $ 2,181 19.0%
========= ========= ========= ========= ========= =========
Selling, general and administrative expenses consist primarily of
personnel-related expenses including salaries and commissions, facility
expenses, information technology, trade show expenses, advertising, insurance
proceeds, and professional legal and accounting fees. Selling, general and
administrative expense increased primarily due to an increase in legal expenses,
and to a lesser extent, increased selling expense in channel sales and increased
marketing expenses for new product introductions and existing products. These
increases were partially offset by decreases in professional fees as well as
depreciation expense. The legal fees increased due to the timing of
reimbursements from the insurance company. Legal fees incurred in defense of the
shareholder suits are reimbursable to the extent provided in our directors and
officers liability insurance policies, and subject to the coverage limitations
and exclusions contained in such policies. For the three months ended December
31, 2004 and 2003, we have been reimbursed approximately $71,000 and $1.1
million of these expenses, respectively. For the six months ended December 31,
2004 and 2003, we have been reimbursed approximately $179,000 and $1.5 million,
respectively.
Because reimbursement of legal expenses, where covered by insurance, do not
typically occur within the month they are incurred, the net amount of legal
expense incurred in any one quarter may vary significantly from another. Legal
expenses are included in the selling, general and administrative expenses
category. Management expects to receive additional reimbursements from insurance
sources for legal fees in the future.
RESEARCH AND DEVELOPMENT
THREE MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Research and development ......................... $ 1,423 11.0% $ 1,758 14.1% $ (335) (19.1)%
========= ========= ========= ========= ========= =========
SIX MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Research and development ......................... $ 3,720 15.5% $ 3,545 14.4% $ 175 4.9%
========= ========= ========= ========= ========= =========
Research and development expenses consist primarily of personnel-related
costs of employees, as well as expenditures to third-party vendors for research
and development activities. The decrease in research and development expenses
for the three months ended December 2004 is primarily due to a reduction in
outside services as we finalized our contractual obligations with our outside
R&D firm in the quarter ending December 31, 2003. The increase in Research and
Development for the six months ended December 31, 2004 is primarily due to
increased headcount in R&D as well as some severance pay during the quarter
ending September 30, 2004, partially offset by a reduction in outside R&D costs
as mentioned above.
STOCK-BASED COMPENSATION
THREE MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Stock-based compensation ......................... $ 107 0.8% $ 63 0.5% $ 44 69.8%
========= ========= ========= ========= ========= =========
SIX MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Stock-based compensation ......................... $ 287 1.2% $ 218 0.9% $ 69 31.7%
========= ========= ========= ========= ========= =========
21
Stock-based compensation generally represents the amortization of deferred
compensation. We recorded no deferred compensation or deferred compensation
forfeitures for the six months ended December 31, 2004. Deferred compensation
represents the difference between the fair value of the underlying common stock
for accounting purposes and the exercise price of the stock options at the date
of grant as well as the fair market value of the vested portion of non-employee
stock options utilizing the Black-Scholes option pricing model. Deferred
compensation also includes the value of employee stock options assumed in
connection with our acquisitions calculated in accordance with current
accounting guidelines. Deferred compensation is presented as a reduction of
stockholders' equity and is amortized ratably over the respective vesting
periods of the applicable options, which is generally four years.
Included in cost of revenues is stock-based compensation of $0 and $10,000
for the three months ended December 31, 2004 and 2003, respectively, and $0 and
$26,000 for the six months ended December 31, 2004 and 2003, respectively.
The increase in stock-based compensation for the six months ended December
31, 2004 is primarily attributable to charges for the valuation of vested
options for two terminated executives, one occurring in the quarter ended
September 30, 2004 and the second in the quarter ended December 31, 2004. At
December 31, 2004, a balance of approximately $30,000 remains. Of the remaining
$30,000 approximately $13,000 will be amortized over the balance of fiscal 2005,
and approximately $17,000 will be amortized in fiscal 2006.
AMORTIZATION OF PURCHASED INTANGIBLE ASSETS
THREE MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Amortization of purchased intangible assets ...... $ 19 0.1% $ 45 0.4% $ (26) (57.8)%
========= ========= ========= ========= ========= =========
SIX MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Amortization of purchased intangible assets ...... $ 48 0.2% $ 89 0.4% $ (41) (46.1)%
========= ========= ========= ========= ========= =========
Purchased intangible assets primarily include existing technology, patents
and non-compete agreements and are amortized on a straight-line basis over the
estimated useful lives of the respective assets, ranging from one to five years.
We obtained independent appraisals of the fair value of tangible and intangible
assets acquired in order to assist us in allocating the purchase price. In
addition, approximately $364,000 and $532,000 of amortization of purchased
intangible assets has been classified as cost of revenues for the three months
ended December 31, 2004 and 2003, respectively, and $729,000 and $1.1 million
for the six months ended December 31, 2004 and 2003, respectively. The decrease
in amortization of purchased intangible assets is primarily due to assets
becoming fully amortized. At December 31, 2004, the unamortized balance of
purchased intangible assets that will be amortized to future operating expense
was $18,000, which will be amortized in the remainder of fiscal 2005.
RESTRUCTURING CHARGES
During the six months ended December 31, 2004, approximately $56,000 of
restructuring charges were recovered for a facility lease settlement related to
a discontinued operation.
INTEREST INCOME (EXPENSE), NET
THREE MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Interest income (expense), net ................... $ 7 0.1% $ 11 0.1% $ (4) (36.4)%
========= ========= ========= ========= ========= =========
SIX MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Interest income (expense), net ................... $ 16 0.1% $ 35 0.1% $ (19) (54.3)%
========= ========= ========= ========= ========= =========
22
Interest income (expense), net consists primarily of interest earned on
cash, cash equivalents and marketable securities. The decrease is primarily due
to lower average investment balances and interest rates.
OTHER INCOME (EXPENSE), NET
THREE MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Other income (expense), net ...................... $ 472 3.7% $ (10) (0.1)% $ 482 4,820.0%
========= ========= ========= ========= ========= =========
SIX MONTHS ENDED
DECEMBER 31,
------------
% OF NET % OF NET $ %
2004 REVENUE 2003 REVENUE VARIANCE VARIANCE
--------- --------- --------- --------- --------- ---------
Other income (expense), net ...................... $ 542 2.3% $ (180) (0.7)% $ 722 401.1%
========= ========= ========= ========= ========= =========
Other income (expense), net improved over the prior year, primarily due to
the write-off of our Xanboo investment in June 2004, thereby eliminating our
equity share of losses in this investment.
PROVISION FOR INCOME TAXES - EFFECTIVE TAX RATE
We utilize the liability method of accounting for income taxes as set forth
in SFAS No. 109, "Accounting for Income Taxes." Our effective tax rate was 3%
and 4% for the six months ended December 31, 2004 and 2003, respectively. The
federal statutory rate was 34% for both periods. Our effective tax rate
associated with the income tax expense for both six month periods ended December
31, 2004 and 2003 was lower than the federal statutory rate primarily due to an
increase in the valuation allowance, primarily due to our inability to estimate
future taxable income, and foreign taxes.. In 2003, the Internal Revenue Service
completed its audit of our federal income tax returns for the years ended June
30, 1999, 2000 and 2001. As a result, we paid tax and interest to the IRS and
the California Franchise Tax Board of approximately $222,000, $441,000 and
$113,000 in quarters ended March 31, 2004, June 30, 2004 and September 30, 2004,
respectively.
We are currently having discussions with the Swiss Federal Tax Authorities
("SFTA") regarding the inability of our Swiss subsidiary, Lantronix
International AG, to meet certain guidelines as set within a tax ruling that was
obtained in May 2001. The ruling provided for reduced Swiss tax rates. The
subsidiary was unable to meet the guidelines set forth in the ruling due to
slower than planned growth in this subsidiary, consistent with our overall
Company, and has since converted to a holding company. Based on recent
discussions with the SFTA, we estimated the potential tax exposure to be
approximately $53,000, and we have provided for this in the consolidated
financial statements for quarter ended December 31, 2004.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, we have financed our operations through the issuance of
common stock and through net cash generated from operations. We consider all
highly liquid investments purchased with original maturities of 90 days or less
to be cash equivalents. Cash and cash equivalents consisting of money-market
funds and commercial paper totaled approximately $7.6 million at December 31,
2004. Marketable securities are income yielding securities which can be readily
converted to cash. Marketable securities consist of obligations of U.S.
Government agencies, state, municipal and county government notes and bonds and
totaled approximately $625,000 at December 31, 2004.
Our operating activities used cash of $3.2 million for the six months ended
December 31, 2004. We incurred a net loss of $5.4 million, which includes the
following adjustments: depreciation of $391,000, amortization of purchased
intangible assets of $777,000, amortization of stock-based compensation of
$287,000, provision for doubtful accounts of $221,000 offset by a recovery in
the restructuring reserve of $56,000 and a benefit from the inventory reserve of
$69,000. The changes in our operating assets consist of a decrease in inventory
of $631,000, decrease in contract manufacturer receivables of $228,000, decrease
in prepaid expenses and other assets of $161,000, an increase in accounts
payable of $455,000, and an increase in other liabilities of $75,000, offset by
an increase in accounts receivable of $570,000 and a decrease in restructuring
reserve of $310,000. The decrease in inventory is primarily attributable to a
reduction in slower moving products due to marketing programs and increased
revenue in quarter ended December 31, 2004, partially offset by an increase in
new product inventory. The decrease in contract manufacturer receivables is due
to improved collections. The decrease in prepaid expenses and other current
assets is primarily due to the amortization of prepaid expense during the
period. The decrease in the restructuring reserve is due to payments on lease
obligations. The increase in accounts receivable is due to slower collections
from our large distributor customers. The increase in accounts payable is due to
the timing of payments to our suppliers.
23
Cash provided by investing activities was $1.5 million for the six months
ended December 31, 2004. We received $3.4 million in proceeds from the sale of
marketable securities. We used $1.0 million to purchase marketable securities
and $867,000 to pay the convertible note from the Stallion acquisition. We also
used $82,000 to purchase property and equipment.
Financing activities provided $56,000 in the six months ended December 31,
2004. We received $306,000 related to the purchase of common shares. We used
$250,000 to pay down our bank loan.
In January 2002, we entered into a two-year line of credit with a bank in
an amount not to exceed $20.0 million. Borrowings under the line of credit bear
interest at either (i) the prime rate or (ii) the LIBOR rate plus 2.0%. We were
required to pay a $100,000 facility fee which was reduced to $62,500 and was
paid. We are also required to pay a quarterly unused line fee of .125% of the
unused line of credit balance. Since establishing the line of credit, we have
twice reduced the amount of the line, modified customary financial covenants and
adjusted the interest rate to be charged on borrowings to the prime rate plus
..50% and eliminated the LIBOR option. Effective July 25, 2003, we further
modified this line of credit, reducing the revolving line to $5.0 million and
adjusting the customary affirmative and negative covenants. We are also required
to maintain certain financial ratios as defined in the agreement. The agreement
has an annual revolving maturity date that renews on the effective date. The
agreement was renewed on July 24, 2004 with an amendment to a financial ratio.
We paid a $12,500 facility fee for the renewal on August 31, 2004. Our borrowing
base at December 31, 2004, was $3.6 million. In March 2004, we borrowed $500,000
against this line of credit. In October and December 2004 we made two $125,000
payments leaving an outstanding balance of $250,000 for the period ended
December 31, 2004. Additionally, we have used letters of credit available under
our line of credit totaling approximately $451,000 in place of cash to fund tax
account deposits and security deposits. As a result, our available line of
credit at December 31, 2004 was $2.9 million. We are currently in compliance
with the revised financial covenants of the July 24, 2004 amended line of
credit. Pursuant to the line of credit, we are restricted from paying any
dividends.
The following table summarizes our contractual payment obligations and
commitments:
REMAINDER
OF FISCAL YEAR FISCAL YEARS
2005 2006 2007 2008 2009 TOTAL
-------- -------- -------- -------- -------- --------
Bank line of credit $ 250 $ - $ - $ - $ - $ 250
Operating leases 628 533 162 - - 1,323
-------- -------- -------- -------- -------- --------
Total $ 878 $ 533 $ 162 $ - $ - $ 1,573
======== ======== ======== ======== ======== ========
As of December 31, 2004, approximately $2.9 million of our net tangible
assets (primarily cash held in foreign bank accounts) were located outside the
United States. Such assets are unrestricted with regard to foreign liquidity
needs, however, our ability to utilize such assets to satisfy liquidity needs
outside of such foreign locations are subject to approval by the foreign
location board of directors. With the simplification of our foreign sales
structure and closing of several offices and reduction of operations in Europe,
our business has become simpler. We have significantly lower-cost operations and
no longer perform many administrative functions in Europe, having transferred
those activities to our Irvine, California offices. As a result, the balances
held in foreign accounts as of December 31, 2004 are greater than our needs, and
we will begin to transfer portions of those cash balances to U.S. accounts
during the third and fourth quarters of fiscal 2005.
Our cash, cash equivalents and marketable securities balances decreased by
$1.0 million, from $9.2 million at September 30, 2004 to $8.2 million at
December 31, 2004. We refer to the sum of these components as "cash" for the
purposes of discussing our liquidity. During the fiscal year ended June 30,
2004, cash usage totaled $1.9 million. Cash usage increased to $3.0 million in
the first fiscal quarter, which included payments for increased marketing and
sales expenses to kick off new product programs, repayment of a note of $867,000
related to the Stallion acquisition, audit payments and other costs. We had
previously indicated that our cash usage in the second fiscal quarter would
likely decrease to approximately $1.0 million.
Throughout the quarter ended December 31, 2004, we reduced expenses from
the levels of the first fiscal quarter, as part of a planned program. These
activities have been ongoing, and in January 2005 we further cut back our staff
to reduce operating costs. In the process, we realigned our international sales
operations and have reduced our fixed costs in Japan and Germany. We also closed
a small sales office in Milford, Connecticut. The cumulative effect of the
reductions initiated in October 2004 through January 2005 is that we are
lowering our operating costs to streamline operations and lower our cash
breakeven point from the earlier revenue range of $14-15 million in quarterly
revenues as an operating model, to approximately $13 million per quarter. This
target is based upon a financial model, and we expect that actual expenses may
vary in any quarter and thus, so would financial results impacting cash usage or
profitability. Also, because of severance payments and shutdown expenses, actual
results may vary from the financial model.
24
We believe that our existing cash, cash equivalents and marketable
securities and any available borrowings under our line of credit facility will
be adequate to meet our anticipated cash needs through at least the next twelve
months. Our future capital requirements will depend on many factors, including
the timing and amount of our net revenues, research and development and
infrastructure investments, and expenses related to ongoing government
investigations and pending litigation, which will affect our ability to generate
additional cash. If cash generated from operations and financing activities is
insufficient to satisfy our working capital requirements, we may need to borrow
funds through bank loans, sales of securities or other means. There can be no
assurance that we will be able to raise any such capital on terms acceptable to
us, if at all. If we are unable to secure additional financing, we may not be
able to develop or enhance our products, take advantage of future opportunities,
respond to competition or continue to operate our business.
RISK FACTORS
You should carefully consider the risks described below before making an
investment decision. The risks and uncertainties described below are not the
only ones facing our company. Our business operations may be impaired by
additional risks and uncertainties of which we are unaware or that we currently
consider immaterial.
Our business, results of operations or cash flows may be adversely affected
if any of the following risks actually occur. In such case, the trading price of
our common stock could decline, and you may lose all or part of your investment.
VARIATIONS IN QUARTERLY OPERATING RESULTS, DUE TO FACTORS INCLUDING CHANGES
IN DEMAND FOR OUR PRODUCTS AND CHANGES IN OUR MIX OF NET REVENUES, COULD CAUSE
OUR STOCK PRICE TO DECLINE.
Our quarterly net revenues, expenses and operating results have varied in
the past and might vary significantly from quarter to quarter in the future. We,
therefore, believe that quarter-to-quarter comparisons of our operating results
are not a good indication of our future performance, and you should not rely on
them to predict our future performance or the future performance of our stock
price. Our short-term expense levels are relatively fixed and are based on our
expectations of future net revenues. If we were to experience a reduction in net
revenues in a quarter, we would likely be unable to adjust our short-term
expenditures. If this were to occur, our operating results for that quarter
would be harmed. If our operating results in future quarters fall below the
expectations of market analysts and investors, the price of our common stock
would likely fall. Other factors that might cause our operating results to
fluctuate on a quarterly basis include:
o changes in the mix of net revenues attributable to higher-margin and
lower-margin products;
o customers' decisions to defer or accelerate orders;
o variations in the size or timing of orders for our products;
o changes in demand for our products;
o defects and other product quality problems;
o loss or gain of significant customers;
o short-term fluctuations in the cost or availability of our critical
components;
o announcements or introductions of new products by our competitors;
o changes in demand for devices that incorporate our products.
WE ARE CURRENTLY ENGAGED IN MULTIPLE SECURITIES CLASS ACTION LAWSUITS, A
STATE DERIVATIVE SUIT, A LAWSUIT BY OUR FORMER CFO AND COO STEVEN V. COTTON, A
LAWSUIT BY FORMER SHAREHOLDERS OF OUR SYNERGETIC SUBSIDIARY, AND PATENT
INFRINGEMENT LITIGATION, ANY OF WHICH, IF IT RESULTS IN AN UNFAVORABLE
RESOLUTION, COULD ADVERSELY AFFECT OUR BUSINESS, RESULTS OF OPERATIONS OR
FINANCIAL CONDITION.
From time to time, we are subject to other legal proceedings and claims in
the ordinary course of business.
We are currently involved in significant litigation, including multiple
security class action lawsuits, a state derivative lawsuit, litigation with a
former executive officer and patent infringement litigation. The pending
lawsuits involve complex questions of fact and law and will likely continue to
require the expenditure of significant funds and the diversion of other
resources to defend. We do not know what the outcome of outstanding legal
proceedings will be and cannot determine the extent to which these resolutions
might have a material adverse effect on our business, results of operations and
financial condition taken as a whole. The results of litigation are inherently
uncertain, and adverse outcomes are possible. For a more detailed description of
pending litigation, see Note 14 of Part I of this Form 10-Q.
25
WE MIGHT BECOME INVOLVED IN LITIGATION OVER PROPRIETARY RIGHTS, WHICH COULD
BE COSTLY AND TIME CONSUMING.
Substantial litigation regarding intellectual property rights exists in our
industry. There is a risk that third parties, including current and potential
competitors, current developers of our intellectual property, our manufacturing
partners, or parties with which we have contemplated a business combination,
will claim that our products, or our customers' products, infringe on their
intellectual property rights or that we have misappropriated their intellectual
property. In addition, software, business processes and other property rights in
our industry might be increasingly subject to third-party infringement claims as
the number of competitors grows and the functionality of products in different
industry segments overlaps. Other parties might currently have, or might
eventually be issued, patents that infringe on the proprietary rights we use.
Any of these third parties might make a claim of infringement against us. For
example, Digi International, ("Digi") has just filed a lawsuit alleging that we
infringe their `192 patent. We have filed suit alleging that Digi infringes our
`305 patent. Please refer to Note 14 of Part I of this Form 10-Q for more
information.
From time to time in the future we could encounter other disputes over
rights and obligations concerning intellectual property. We cannot assume that
we will prevail in intellectual property disputes regarding infringement,
misappropriation or other disputes. Litigation in which we are accused of
infringement or misappropriation might cause a delay in the introduction of new
products, require us to develop non-infringing technology, require us to enter
into royalty or license agreements, which might not be available on acceptable
terms, or at all, or require us to pay substantial damages, including treble
damages if we are held to have willfully infringed. In addition, we have
obligations to indemnify certain of our customers under some circumstances for
infringement of third-party intellectual property rights. If any claims from
third-parties were to require us to indemnify customers under our agreements,
the costs could be substantial, and our business could be harmed. If a
successful claim of infringement was made against us and we could not develop
non-infringing technology or license the infringed or similar technology on a
timely and cost-effective basis, our business could be significantly harmed.
WE HAVE ELECTED TO USE A CONTRACT MANUFACTURER IN CHINA, WHICH INVOLVES
SIGNIFICANT RISKS.
One of our contract manufacturers is based in China. There are significant
risks of doing business in China, including:
o China does not afford the same level of protection to intellectual
property as domestic or many foreign countries. If our products were
reverse-engineered or our intellectual property was otherwise pirated
(reproduced and duplicated without our knowledge or approval), our
revenues would be reduced.
o Delivery times are extended due to the distances involved, requiring
more lead-time in ordering and increasing the risk of excess
inventories.
o We could incur ocean freight delays because of labor problems, weather
delays or expediting and customs problems.
o China and U.S. foreign relations have, historically, been subject to
change. Political considerations and actions could interrupt our
expected supply of products from China.
INABILITY, DELAYS IN DELIVERIES OR QUALITY PROBLEMS FROM OUR COMPONENT
SUPPLIERS COULD DAMAGE OUR REPUTATION AND COULD CAUSE OUR NET REVENUES TO
DECLINE AND HARM OUR RESULTS OF OPERATIONS.
We and our contract manufacturers are responsible for procuring raw
materials for our products. Our products incorporate components or technologies
that are only available from single or limited sources of supply. In particular,
some of our integrated circuits are available from a single source. From time to
time in the past, integrated circuits we use in our products have been phased
out of production. When this happens, we attempt to purchase sufficient
inventory to meet our needs until a substitute component can be incorporated
into our products. Nonetheless, we might be unable to purchase sufficient
components to meet our demands, or we might incorrectly forecast our demands,
and purchase too many or too few components. In addition, our products use
components that have in the past been subject to market shortages and
substantial price fluctuations. From time to time, we have been unable to meet
our orders because we were unable to purchase necessary components for our
products. We rely on a number of different component suppliers. Because we do
not have long-term supply arrangements with any vendor to obtain necessary
components or technology for our products, if we are unable to purchase
components from these suppliers, product shipments could be prevented or
delayed, which could result in a loss of sales. If we are unable to meet
existing orders or to enter into new orders because of a shortage in components,
we will likely lose net revenues and risk losing customers and harming our
reputation in the marketplace.
26
IF A MAJOR CUSTOMER CANCELS, REDUCES, OR DELAYS PURCHASES, OUR NET REVENUES
MIGHT DECLINE AND OUR BUSINESS COULD BE ADVERSELY AFFECTED.
Our top five customers accounted for 44.4 of our net revenues for the six
months ended December 31, 2004. One customer, Ingram Micro, Inc., accounted for
approximately 18.1% and 13.9% of our net revenues for the six months ended
December 31, 2004 and 2003, respectively. Another customer, Tech Data, accounted
for approximately 10.8% and 8.8% of our net revenues for the six months ended
December 31, 2004 and 2003, respectively. Accounts receivable attributable to
these two domestic customers accounted for approximately 19.0% and 12.9% of
total accounts receivable at December 31, 2004 and June 30, 2004, respectively.
The number and timing of sales to our distributors have been difficult for us to
predict. While our distributors are customers in the sense they buy our
products, they are also part of our product distribution system. To some extent,
the business lost for some reason to a distributor would likely be replaced by
sales to other customer/distributors in a reasonable period, rather than a total
loss of that business such as from a customer who used our products in their
business.
The loss or deferral of one or more significant sales in a quarter could
harm our operating results. We have in the past, and might in the future, lose
one or more major customers. If we fail to continue to sell to our major
customers in the quantities we anticipate, or if any of these customers
terminate our relationship, our reputation, the perception of our products and
technology in the marketplace, the growth of our business could be harmed. The
demand for our products from our OEM, VAR and systems integrator customers
depends primarily on their ability to successfully sell their products that
incorporate our device networking solutions technology. Our sales are usually
completed on a purchase order basis and we have no long-term purchase
commitments from our customers.
Our future success also depends on our ability to attract new customers,
which often involves an extended process. The sale of our products often
involves a significant technical evaluation, and we often face delays because of
our customers' internal procedures for evaluating and deploying new
technologies. For these and other reasons, the sales cycle associated with our
products is typically lengthy, often lasting six to nine months and sometimes
longer. Therefore, if we were to lose a major customer, we might not be able to
replace the customer on a timely basis or at all. This would cause our net
revenues to decrease and could cause the price of our stock to decline.
THE MARKET FOR OUR PRODUCTS IS NEW AND RAPIDLY EVOLVING. IF WE ARE NOT ABLE
TO DEVELOP OR ENHANCE OUR PRODUCTS TO RESPOND TO CHANGING MARKET CONDITIONS, OUR
NET REVENUES WILL SUFFER.
Our future success depends in large part on our ability to continue to
enhance existing products, lower product cost and develop new products that
maintain technological competitiveness. The demand for network-enabled products
is relatively new and can change as a result of innovations or changes. For
example, industry segments might adopt new or different standards, giving rise
to new customer requirements. Any failure by us to develop and introduce new
products or enhancements directed at new industry standards could harm our
business, financial condition and results of operations. These customer
requirements might or might not be compatible with our current or future product
offerings. We might not be successful in modifying our products and services to
address these requirements and standards. For example, our competitors might
develop competing technologies based on Internet Protocols, Ethernet Protocols
or other protocols that might have advantages over our products. If this were to
happen, our net revenue might not grow at the rate we anticipate, or could
decline.
IF OUR RESEARCH AND DEVELOPMENT EFFORTS ARE NOT SUCCESSFUL, OUR NET
REVENUES COULD DECLINE AND OUR BUSINESS COULD BE HARMED.
For the six months ended December 31, 2004, we incurred $3.7 million in
research and development expenses, which comprised 15.5% of our net revenues. If
we are unable to develop new products as a result of this effort, or if the
products we develop are not successful, our business could be harmed. Even if we
do develop new products that are accepted by our target markets, we do not know
whether the net revenue from these products will be sufficient to justify our
investment in research and development.
27
THE AVERAGE SELLING PRICES OF OUR PRODUCTS MIGHT DECREASE, WHICH COULD
REDUCE OUR GROSS MARGINS.
In the past, we have experienced some reduction in the average selling
prices and gross margins of products and we expect that this will continue for
our products as they mature. In the future, we expect competition to increase,
and we anticipate this could result in additional pressure on our pricing. Our
average selling prices for our products might decline as a result of other
reasons, including promotional programs and customers who negotiate price
reductions in exchange for longer-term purchase commitments. We also may not be
able to increase the price of our products in the event that the prices of
components or our overhead costs increase. Changes in exchange rates between
currencies might change in such a way or over a period such that we cannot
adjust prices to maintain gross margins. If these were to occur, our gross
margins would decline. In addition, we may not be able to reduce the cost to
manufacture our products to keep up with the decline in prices.
THERE IS A RISK THAT THE SEC COULD LEVY FINES AGAINST US, OR DECLARE US TO
BE OUT OF COMPLIANCE WITH THE RULES REGARDING OFFERING SECURITIES TO THE PUBLIC.
The SEC is investigating the events surrounding the restatement of our
financial statements filed on June 25, 2002 for the year ended June 30, 2001 and
for the six months ended December 31, 2002. The SEC could conclude that we
violated the rules of the Securities Act of 1933 or the Securities and Exchange
Act of 1934. In either event, the SEC might levy civil fines against us, or
might conclude that we lack sufficient internal controls to warrant our being
allowed to continue offering our shares to the public. This investigation
involves substantial cost and could significantly divert the attention of
management. These costs, and the cost of any fines imposed by the SEC, are not
covered by insurance. In addition to sanctions imposed by the SEC, an adverse
determination could significantly damage our reputation with customers and
vendors, and harm our employees' morale.
WE INCORPORATE SOFTWARE LICENSED FROM THIRD PARTIES INTO SOME OF OUR
PRODUCTS AND ANY SIGNIFICANT INTERRUPTION IN THE AVAILABILITY OF THESE
THIRD-PARTY SOFTWARE PRODUCTS OR DEFECTS IN THESE PRODUCTS COULD REDUCE THE
DEMAND FOR, OR PREVENT THE SALE OR USE OF, OUR PRODUCTS.
Certain of our products contain components developed and maintained by
third-party software vendors or are available through the "open source" software
community. We also expect that we may incorporate software from third-party
vendors and open source software in our future products. Our business would be
disrupted if this software, or functional equivalents of this software, were
either no longer available to us or no longer offered to us on commercially
reasonable terms. In either case, we would be required to either redesign our
products to function with alternate third-party software or open source
software, or develop these components ourselves, which would result in increased
costs and could result in delays in our product shipments. Furthermore, we might
be forced to limit the features available in our current or future product
offerings. We presently are developing products for use on the Linux platform.
The SCO Group (SCO) has filed and threatened to file lawsuits against companies
that operate Linux for commercial purposes, alleging that such use of Linux
infringes SCO's rights. These allegations may adversely affect the demand for
the Linux platform and, consequently, the sales of our Linux-based products.
UNDETECTED PRODUCT ERRORS OR DEFECTS COULD RESULT IN LOSS OF NET REVENUES,
DELAYED MARKET ACCEPTANCE AND CLAIMS AGAINST US.
We currently offer warranties ranging from ninety days to two years on each
of our products. Our products could contain undetected errors or defects. If
there is a product failure, we might have to replace all affected products
without being able to book revenue for replacement units, or we may have to
refund the purchase price for the units. Because of our recent introduction of
our line of device servers, we do not have a long history with which to assess
the risks of unexpected product failures or defects for this product line.
Regardless of the amount of testing we undertake, some errors might be
discovered only after a product has been installed and used by customers. Any
errors discovered after commercial release could result in loss of net revenues
and claims against us. Significant product warranty claims against us could harm
our business, reputation and financial results and cause the price of our stock
to decline.
WE PRIMARILY DEPEND ON FIVE THIRD-PARTY MANUFACTURERS TO MANUFACTURE
SUBSTANTIALLY ALL OF OUR PRODUCTS, WHICH REDUCES OUR CONTROL OVER THE
MANUFACTURING PROCESS. IF THESE MANUFACTURERS ARE UNABLE OR UNWILLING TO
MANUFACTURE OUR PRODUCTS AT THE QUALITY AND QUANTITY WE REQUEST, OUR BUSINESS
COULD BE HARMED AND OUR STOCK PRICE COULD DECLINE.
We outsource substantially all of our manufacturing to five third-party
manufacturers, Venture Electronics Services, Varian, Inc., Irvine Electronics,
Inc., Uni Precision Industrial Ltd., and Universal Scientific Industrial
Company, LTD. Our reliance on these third-party manufacturers exposes us to a
number of significant risks, including:
o reduced control over delivery schedules, quality assurance,
manufacturing yields and production costs;
o lack of guaranteed production capacity or product supply; and
o reliance on third-party manufacturers to maintain competitive
manufacturing technologies.
28
Our agreements with these manufacturers provide for services on a purchase
order basis. If our manufacturers were to become unable or unwilling to continue
to manufacture our products in required volumes, at acceptable quality,
quantity, yields and costs, or in a timely manner, our business would be
seriously harmed. As a result, we would have to attempt to identify and qualify
substitute manufacturers, which could be time consuming and difficult, and might
result in unforeseen manufacturing and operations problems. Moreover, if we
shift products among third-party manufacturers, we may incur substantial
expenses, risk material delays, or encounter other unexpected issues. For
example, in the third quarter of fiscal 2003 we encountered product shortages
related to the transition to a third-party manufacturer. This product shortage
contributed to our net revenues falling below our publicly announced estimates.
In addition, a natural disaster could disrupt our manufacturers' facilities
and could inhibit our manufacturers' ability to provide us with manufacturing
capacity on a timely basis, or at all. If this were to occur, we likely would be
unable to fill customers' existing orders or accept new orders for our products.
The resulting decline in net revenues would harm our business. We also are
responsible for forecasting the demand for our individual products. These
forecasts are used by our contract manufacturers to procure raw materials and
manufacture our finished goods. If we forecast demand too high, we may invest
too much cash in inventory and we may be forced to take a write-down of our
inventory balance, which would reduce our earnings. If our forecast is too low
for one or more products, we may be required to pay expedite charges which would
increase our cost of revenues or we may be unable to fulfill customer orders,
thus reducing net revenues and therefore earnings.
BECAUSE WE ARE DEPENDENT ON INTERNATIONAL SALES FOR A SUBSTANTIAL AMOUNT OF
OUR NET REVENUES, WE FACE THE RISKS OF INTERNATIONAL BUSINESS AND ASSOCIATED
CURRENCY FLUCTUATIONS, WHICH MIGHT ADVERSELY AFFECT OUR OPERATING RESULTS.
Net revenues from international sales represented 33.2% and 26.8% of net
revenues for the six months ended December 31, 2004 and 2003, respectively. Net
revenues from Europe represented 25.9% and 20.6% of our net revenues for the six
months ended December 31, 2004 and 2003, respectively. Our revenues in Japan and
the People's Republic of China are increasing, as well.
We expect that international revenues will continue to represent a
significant portion of our net revenues in the foreseeable future. Doing
business internationally involves greater expense and many additional risks. For
example, because the products we sell abroad and the products and services we
buy abroad are priced in foreign currencies, we are affected by fluctuating
exchange rates. In the past, we have from time to time lost money because of
these fluctuations. We might not successfully protect ourselves against currency
rate fluctuations, and our financial performance could be harmed as a result. In
addition, we face other risks of doing business internationally, including:
o unexpected changes in regulatory requirements, taxes, trade laws and
tariffs;
o reduced protection for intellectual property rights in some countries;
o differing labor regulations;
o compliance with a wide variety of complex regulatory requirements;
o changes in a country's or region's political or economic conditions;
o greater difficulty in staffing and managing foreign operations; and
o increased financial accounting and reporting burdens and complexities.
Our international operations require significant attention from our
management and substantial financial resources. We do not know whether our
investments in other countries will produce desired levels of net revenues or
profitability.
THERE IS A RISK WE MAY BE UNABLE TO DISPOSE OF OUR INVENTORY.
Our products and therefore our inventories are subject to technological
risk. At any time, either new products may enter the market or prices of
competitive products may be introduced with more attractive features or at lower
prices than ours. There is a risk that we may be unable to sell our inventory in
a timely manner to avoid it becoming obsolete. As of December 31, 2004, our
inventories, including raw materials, finished goods and inventory at
distributors, were valued at $12.0 million and we had excess and obsolete
inventory reserves of $5.8 million against these inventories. As of June 30,
2004, our inventories, including raw materials, finished goods and inventory at
distributors were valued at $12.7 million and we had excess and obsolete
inventory reserves of $6.0 million against these inventories. In the event we
are required to substantially discount our inventory or are unable to sell our
inventory in a timely manner, we would be required to increase our reserves and
our operating results could be substantially harmed.
29
OUR EXECUTIVE OFFICERS AND TECHNICAL PERSONNEL ARE CRITICAL TO OUR
BUSINESS, AND WITHOUT THEM WE MIGHT NOT BE ABLE TO EXECUTE OUR BUSINESS
STRATEGY.
Our financial performance depends substantially on the performance of our
executive officers and key employees. We are dependent in particular on Marc
Nussbaum, who serves as our President and Chief Executive Officer, and James
Kerrigan, who serves as our Chief Financial Officer. We have no employment
contracts with those executives who are at-will employees. We are also dependent
upon our technical personnel, due to the specialized technical nature of our
business. If we lose the services of Mr. Nussbaum, Mr. Kerrigan or any of our
key personnel and are not able to find replacements in a timely manner, our
business could be disrupted, other key personnel might decide to leave, and we
might incur increased operating expenses associated with finding and
compensating replacements.
THERE IS A RISK THAT OUR OEM CUSTOMERS WILL DEVELOP THEIR OWN INTERNAL
EXPERTISE IN NETWORK-ENABLING PRODUCTS, WHICH COULD RESULT IN REDUCED SALES OF
OUR PRODUCTS.
For most of our existence, we primarily sold our products to distributors,
VARs and system integrators. Although we intend to continue to use all of these
sales channels, we have begun to focus more heavily on selling our products to
OEMs. Selling products to OEMs involves unique risks, including the risk that
OEMs will develop internal expertise in network-enabling products or will
otherwise provide network functionality to their products without using our
device networking solutions. If this were to occur, our stock price could
decline in value and you could lose part or all of your investment.
NEW PRODUCT INTRODUCTIONS AND PRICING STRATEGIES BY OUR COMPETITORS COULD
ADVERSELY AFFECT OUR ABILITY TO SELL OUR PRODUCTS AND COULD REDUCE OUR MARKET
SHARE OR RESULT IN PRESSURE TO REDUCE THE PRICE OF OUR PRODUCTS.
The market for our products is intensely competitive, subject to rapid
change and is significantly affected by new product introductions and pricing
strategies of our competitors. We face competition primarily from companies that
network-enable devices, semiconductor companies, companies in the automation
industry and companies with significant networking expertise and research and
development resources. Our competitors might offer new products with features or
functionality that are equal to or better than our products. In addition, since
we work with open standards, our customers could develop products based on our
technology that compete with our offerings. We might not have sufficient
engineering staff or other required resources to modify our products to match
our competitors. Similarly, competitive pressure could force us to reduce the
price of our products. In each case, we could lose new and existing customers to
our competition. If this were to occur, our net revenues could decline and our
business could be harmed.
OUR INTELLECTUAL PROPERTY PROTECTION MIGHT BE LIMITED.
We have not historically relied on patents to protect our proprietary
rights, although we are now building a patent portfolio. We rely primarily on a
combination of laws, such as copyright, trademark and trade secret laws, and
contractual restrictions, such as confidentiality agreements and licenses, to
establish and protect our proprietary rights. Despite any precautions that we
have taken:
o laws and contractual restrictions might not be sufficient to prevent
misappropriation of our technology or deter others from developing
similar technologies;
o other companies might claim common law trademark rights based upon use
that precedes the registration of our marks;
o other companies might assert other rights to market products using our
trademarks;
o policing unauthorized use of our products and trademarks is difficult,
expensive and time-consuming, and we might be unable to determine the
extent of this unauthorized use;
o courts may determine that our software programs use open source
software in such a way that deprives the entire programs of
intellectual property protection; and
o current federal laws that prohibit software copying provide only
limited protection from software pirates.
30
Also, the laws of other countries in which we market and manufacture our
products might offer little or no effective protection of our proprietary
technology. Reverse engineering, unauthorized copying or other misappropriation
of our proprietary technology could enable third-parties to benefit from our
technology without paying us for it, which could significantly harm our
business.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk for changes in interest rates relates primarily
to our investment portfolio. We do not use derivative financial instruments for
speculative or trading purposes. We place our investments in instruments that
meet high credit quality standards, as specified in our investment policy.
Information relating to quantitative and qualitative disclosure about market
risk is set forth below and in "Management's Discussion and Analysis of
Financial Condition and Results of Operations-Liquidity and Capital Resources."
INTEREST RATE RISK
Our exposure to interest rate risk is limited to the exposure related to
our cash, cash equivalents, marketable securities and our credit facilities,
which is tied to market interest rates. As of December 31, 2004 and June 30,
2004, we had cash and cash equivalents of approximately $7.6 million and $9.1
million, respectively, which consisted of cash and short-term investments with
original maturities of ninety days or less, both domestically and
internationally. As of December 31, 2004 and June 30, 2004, we had marketable
securities of approximately $625,000 and $3.1 million, respectively, consisting
of obligations of municipal bonds. We believe our marketable securities will
decline in value by an insignificant amount if interest rates increase, and
therefore would not have a material effect on our financial condition or results
of operations.
FOREIGN CURRENCY RISK
We sell products internationally. As a result, our financial results could
be harmed by factors such as changes in foreign currency exchange rates or weak
economic conditions in foreign markets.
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 our Chief Executive Officer and our
Chief Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934 (the "Exchange Act")) as of the end of
our second fiscal quarter. Based upon that evaluation, our Chief Executive
Officer and our Chief Financial Officer concluded that our disclosure controls
and procedures are effective in ensuring that information required to be
disclosed by us in reports that we file or submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in Securities and Exchange Commission's rules and forms.
(b) Changes in internal controls
During the period covered by this report, there have been no changes in our
internal control over financial reporting that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
As previously reported on our Form 8-K filed on January 17, 2005, during
the quarter ended December 31, 2004, we implemented several changes designed to
strengthen our internal controls, including the institution of more formal
closing procedures and revising the delegation of closing and external reporting
activities to provide a more thorough review. In addition, we implemented
several other changes during this period, including hiring a third-party to
provide EDGARization services, have contracted with a proof reader to review our
periodic filings and have added an additional level of management review in
connection with the preparation of our periodic reports. Although we do not
believe these changes have materially affected, or are reasonably likely to
materially affect, our internal controls, we believe periodic improvements such
as these will result in continuing improvement to our control procedures.
31
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information set forth in Note 14 of Part I, Item 1 of this Form 10-Q is
hereby incorporated by reference.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
(a) Changes in and Disagreements with accountants on accounting and
financial disclosure
The information required by this item has been previously furnished and is
incorporated herein by reference to our form 8-K filed on December 21, 2004.
ITEM 6. EXHIBITS
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ------ -----------------------
10.1 Silicon Valley Bank Amendment to Loan Documents
31.1 Certification of Principal Executive Officer pursuant to
Securities Exchange Act Rules 13a-15(e) and 15d-15(e), as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Principal Financial Officer pursuant to
Securities Exchange Act Rules 13a-15(e) and 15d-15(e), as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer and Chief Financial
Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.*
* Furnished, not filed.
32
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, the Registrant
has duly caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.
Date: February 14, 2005 LANTRONIX, INC.
(Registrant)
By: /s/ Marc H. Nussbaum
-----------------------------------
MARC H. NUSSBAUM
CHIEF EXECUTIVE OFFICER
(PRINCIPAL EXECUTIVE OFFICER)
By: /s/ James W. Kerrigan
-----------------------------------
JAMES W. KERRIGAN
CHIEF FINANCIAL OFFICER
(PRINCIPAL FINANCIAL OFFICER)
33