UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark one)
[X] Quarterly report pursuant to section 13 or 15(d) of the Securities Exchange
Act of 1934
For the quarterly period ended July 31, 2005
[ ] Transition report pursuant to section 13 or 15(d) of the Securities and
Exchange Act of 1934
For the transition period from _______ to ________
Commission file number 0-8419
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SBE, INC.
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(Exact name of registrant as specified in its charter)
Delaware 94-1517641
- ------------------------------- -----------------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2305 Camino Ramon, Suite 200, San Ramon, California 94583
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(Address of principal executive offices and zip code)
(925) 355-2000
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(Registrant's telephone number, including area code)
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 Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
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Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes No X
--- ---
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes No X
--- ---
The number of shares of Registrant's Common Stock outstanding as of July 31,
2005 was 9,864,533.
SBE, INC.
INDEX TO JULY 31, 2005 FORM 10-Q
PART I Financial Information
Item 1 Financial Statements (unaudited)
Condensed Consolidated Balance Sheets as of
July 31, 2005 and October 31, 2004...................................3
Condensed Consolidated Statements of Operations for the
three and nine months ended July 31, 2005 and 2004...................4
Condensed Consolidated Statements of Cash Flows for the
nine months ended July 31, 2005 and 2004.............................5
Notes to Condensed Consolidated Financial Statements....................6
Item 2 Management's Discussion and Analysis of Financial
Condition and Results of Operations........................21
Item 3 Quantitative and Qualitative Disclosures about
Market Risk................................................34
Item 4 Controls and Procedures....................................35
PART II Other Information
Item 6 Exhibits ..................................................36
SIGNATURES...................................................................39
EXHIBITS.....................................................................40
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PART I. Financial Information
Item 1. Financial Statements
SBE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
July 31, October 31,
2005 2004
-------------- --------------
(Unaudited)
Current assets:
Cash and cash equivalents $ 5,001 $ 1,849
Trade accounts receivable, net 1,377 1,668
Inventories 1,446 1,926
Other 252 227
Total current assets 8,076 5,670
Property, plant and equipment, net 380 427
Capitalized software costs, net 195 48
Intellectual property, net 12,183 ---
Other 33 28
----------- -----------
Total assets $ 20,867 $ 6,173
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 456 $ 856
Accrued payroll and employee benefits 236 391
Capital lease obligations - current portion 28 25
Deferred revenue 123 ---
Other accrued liabilities 231 459
----------- -----------
Total current liabilities 1,074 1,731
Capital lease obligations and long-term liabilities,
net of current portion 124 139
----------- -----------
Total liabilities 1,198 1,870
----------- -----------
Commitments
Stockholders' equity:
Common stock 35,373 15,755
Deferred compensation (2,548) ---
Accumulated deficit (13,156) (11,452)
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Total stockholders' equity 19,669 4,303
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Total liabilities and stockholders' equity $ 20,867 $ 6,173
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See notes to condensed consolidated financial statements.
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SBE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
Three months ended Nine months ended
July 31, July 31,
2005 2004 2005 2004
----------- ----------- ----------- -----------
Net sales $ 1,720 $ 2,899 $ 6,240 $ 8,846
Cost of sales 1,072 1,359 3,377 4,101
----------- ----------- ----------- -----------
Gross profit 648 1,540 2,863 4,745
Product research and development 626 548 1,672 1,596
Sales and marketing 520 539 1,646 1,592
General and administrative 446 376 1,241 1,140
Loan loss recovery -- -- -- (239)
----------- ----------- ----------- ------------
Total operating expenses 1,592 1,463 4,559 4,089
----------- ----------- ----------- -----------
Operating income (loss) (944) 77 (1,696) 656
Interest income (expense) (1) 2 (3) 4
------------ ----------- ------------ -----------
Income (loss) before income taxes (945) 79 (1,699) 660
Income tax provision --- --- 5 ---
------------ ----------- ----------- -----------
Net income (loss) $ (945) $ 79 $ (1,704) $ 660
============ =========== ============ ===========
Basic income (loss) per share $ (0.17) $ 0.02 $ (0.32) $ 0.13
============ =========== ============ ===========
Diluted income (loss) per share $ (0.17) $ 0.01 $ (0.32) $ 0.11
============ =========== ============ ===========
Basic - weighted average shares
used in per share computations 5,477 5,078 5,276 5,000
============ =========== =========== ===========
Diluted - weighted average shares
used in per share computations 5,477 5,866 5,276 6,009
============ =========== =========== ===========
See notes to condensed consolidated financial statements.
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SBE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Nine months ended
July 31,
2005 2004
----------- -----------
Cash flows from operating activities:
Net income (loss) $ (1,704) $ 660
Adjustments to reconcile net income (loss) to net cash
used in operating activities:
Deferred stock-based compensation 56 --
Depreciation and amortization:
Property, equipment and software 167 202
Amortization of intellectual property -- 306
Changes in operating assets and liabilities:
Trade accounts receivable 291 (864)
Inventories 479 (655)
Other current and non-current assets (29) (32)
Trade accounts payable (400) 369
Other accrued liabilities and deferred revenue (198) (256)
------------ ------------
Net cash used in operating activities (1,338) (270)
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Cash flows from investing activities:
Purchases of property, plant and equipment (81) (85)
Cash payments related to the purchase of PyX (359) --
Capitalized software costs (173) (111)
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Net cash used in investing activities (613) (196)
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Cash flows from financing activities:
Proceeds from the sale of common stock and the
exercise of warrants, net 4,999 202
Proceeds from repayment of stockholder note -- 142
Proceeds from exercise of stock options 104 241
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Net cash provided by financing activities 5,103 585
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Net increase in cash and cash equivalents 3,152 119
Cash and cash equivalents at beginning of period 1,849 1,378
----------- -----------
Cash and cash equivalents at end of period $ 5,001 $ 1,497
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SUPPLEMENTAL SCHEDULE OF NON-CASH FINANCING ACTIVITIES:
Non-cash stock portion of Antares purchase price $ 197 $ --
=========== ===========
Non-cash stock portion of PyX purchase price $ 11,714 $ --
=========== ===========
See notes to condensed consolidated financial statements.
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SBE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Interim Period Reporting:
These condensed consolidated financial statements of SBE, Inc. are unaudited and
include all adjustments, consisting of normal recurring adjustments, that are,
in the opinion of management, necessary for a fair presentation of the financial
position and results of operations and cash flows for the interim periods. The
results of operations for the three and nine and months ended July 31, 2005 are
not necessarily indicative of expected results for the full 2005 fiscal year.
Certain information and footnote disclosures normally contained in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. These condensed consolidated financial
statements should be read in conjunction with the financial statements and notes
contained in our Annual Report on Form 10-K for the year ended October 31, 2004.
Management Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles in the U.S. requires us to make estimates and assumptions
that affect the reported amounts of assets and liabilities, as well as certain
disclosure of contingent assets and liabilities as of the date of the financial
statements and the reported amounts of net sales and expenses during the
reporting period. Actual results could differ from these estimates. We made
significant estimates and judgments relating to matters such as potential
liability for sales allowances, warranty and indemnification obligations,
collectibility of accounts receivable, realizability of inventories and
recoverability of capitalized software and deferred tax assets.
2. Inventories:
Inventories were comprised of the following (in thousands):
July 31, October 31,
2005 2004
---------- ----------
Finished goods $ 997 $ 1,343
Parts and materials 449 583
---------- ----------
$ 1,446 $ 1,926
========== ==========
3. Intangible Assets:
Intangible Assets consists of the allocation of the intellectual property
relating to current products and the design of future Internet Small Computer
System Interface ("iSCSI") software products acquired in connection with our
acquisition of PyX Technologies on
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July 26, 2005. All capitalized intellectual property will be amortized to cost
of goods expense on a straight line basis over thirty-six months, beginning
August 1, 2005, which is the expected useful life and does not materially differ
from the expected cash inflow from the sale of products related to the acquired
PyX product line. Intangible Assets subject to amortization are as follows (in
thousands):
Accumulated
Gross Amortization Net
------- ------------- ---
Intellectual Property $12,183 $0 $12,183
======= ============= =======
The estimated aggregate remaining amortization expense for each of the
succeeding fiscal years is as follows (in thousands):
2005 $ 1,015
2006 4,061
2007 4,061
2008 3,046
---------
Total $ 12,183
4. Revenue Recognition and Concentration of Risk:
Our policy is to recognize revenue for hardware product sales when title
transfers and risk of loss has passed to the customer, which is generally upon
shipment of our hardware products to our customers. We defer and recognize
service revenue over the contractual period or as services are rendered. Our
policy complies with the guidance provided by Staff Accounting Bulletin No. 104,
"Revenue Recognition in Financial Statements," issued by the Securities and
Exchange Commission.
We account for the licensing of software in accordance with American Institute
of Certified Public Accountants ("AICPA") Statement of Position ("SOP") 97-2,
"Software Revenue Recognition". The application of SOP 97-2 requires judgment,
including whether a software arrangement includes multiple elements, and if so,
whether vendor-specific objective evidence ("VSOE") of fair value exists for
those elements. We will defer all revenue related to the sale of our software
products until such time that we are able to established VSOE for the
undelivered elements related to our iSCSI software products or when we fulfill
the undelivered elements.
Deferred revenue represents post-delivery engineering support and the right to
receive unspecified upgrades/enhancements of our iSCSI software on a
when-and-if-available basis.
In the three and nine months ended July 31, 2005 and 2004, most of our sales
were attributable to sales of communications products and were derived from a
limited number of original equipment manufacturer ("OEM") customers. In our
third quarter of fiscal 2005, we had sales to two customers that were each
greater than 10% of our net sales for the quarter. The sales to these customers
combined totaled 62% of net sales during the third quarter of fiscal 2005. In
our third quarter of fiscal 2004, we had sales to two customers
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that accounted for greater than 10% of our net sales for the quarter. The sales
to these two customers totaled 67% of our net sales for that quarter. In the
first nine months of fiscal 2005, we had sales to three customers that were each
greater than 10% of our sales for that period. The sales to these two customers
combined totaled 61% of net sales during the first nine-months of fiscal 2005.
In the first nine months of fiscal 2004, we had sales to two customers that
accounted for greater than 10% of our net sales for that period. The sales to
these customers totaled 59% of our net sales for the first nine-months of fiscal
2004.
We have two customer (Data Connection Ltd and Nortel Networks) that accounted
for more than 10% of our accounts receivable as of July 31, 2005 compared to two
customers that accounted for more than 10% of our accounts receivable at July
31, 2004.
5. Acquisition of PyX Technologies, Inc.:
Effective July 26, 2005, we acquired PyX Technologies, Inc., a California
corporation ("PyX") for a total purchase price of $11,714,000 paid to the
selling shareholders of PyX in the form of shares of our common stock and the
assumption of PyX's employee stock option plan plus cash expenses totaling
$359,000 for legal, accounting and valuation services. A total of 2,561,050
shares of our common stock has been issued in respect of outstanding PyX common
stock. We have agreed to register these shares pursuant to a Registration
Statement on Form S-3 within 90 days following the closing of the acquisition. A
total of 95% of the shares issued in connection with the merger will be subject
to a one-year market standoff, such that only 128,053 of such shares will be
freely tradable following registration prior to July 26, 2006. An additional
2,038,950 shares of our common stock will be issuable upon exercise of assumed
stock options for services of selling shareholders who became our employees. The
option shares are issuable upon exercise of options, subject to vesting
restrictions that do not begin to lapse until February 2006, except that if an
optionee's employment is terminated without cause or the optionee resigns for
certain specified reasons, the vesting on the option will accelerate and become
fully vested. We also agreed to register the option shares on a Form S-8 shortly
following the closing.
The acquisition enabled us to obtain intellectual property related to iSCSI
software which we consider to be complementary to our business. While this
product has reached technological feasibility and is being capitalized as an
intangible asset, we will continue to customize it to meet our specific customer
needs.
A summary of the assets acquired and consideration paid is as follows:
Tangible assets acquired $31,000
Intellectual property 12,183,000
-----------
Total assets acquired 12,214,000
Liabilities assumed 500,000
-----------
Net assets acquired $11,714,000
===========
Fair value of common stock provided 9,040,000
Fair value of stock options assumed 5,158,000
Less: value of deferred compensation
related to stock options (2,484,000)
-----------
Total consideration $11,714,000
===========
-8-
We used the purchase method of accounting for the acquisition and combined PyX
results of operations beginning July 26, 2005. The fair value of the common
stock provided to the PyX shareholders was calculated as the value of the
2,561,050 shares of common stock multiplied by the closing price of our common
stock on July 26, 2005 ($3.53 per share). The fair value of the 2,038,950 PyX
stock options assumed by us was calculated using the Black-Scholes valuation
model with the value of the unvested stock options recorded as deferred
compensation (see Note 11) and the remaining fair value applied as part of the
purchase price. We allocated the purchase price to the tangible assets and
liabilities based on fair market value at the time of the acquisition and to
intellectual property based on future expected cash flows to be derived from the
acquired iSCSI software product line.
The unaudited pro forma results are provided for comparison purposes only and
are not necessarily indicative of what actual results would have been had the
PyX acquisition and the private equity offering transactions been consummated on
such dates, nor do they give effect to the synergies, cost savings and other
changes expected to result from the acquisitions. Accordingly, the pro forma
financial results do not purport to be indicative of results of operations as of
the date hereof or for any period ended on the date hereof or for any other
future date or period. Had we acquired PyX at the beginning of the prior period,
our results of operations would have been as follows (in thousands, except per
share amounts):
For the periods ended, Three months ended Nine months ended
July 31, July 31,
2005 2004 2005 2004
---- ------ ---- ----
Revenues $1,720 $2,901 $6,240 $8,850
Net loss (2,438) (1,414) (6,182) (3,818)
Basic and diluted loss
per common share $(0.30) $(0.19) $(0.79) $(0.51)
We plan to amortize the intellectual property acquired in the PyX acquisition to
expense over 36 months which is the estimated useful life at the time of
acquisition.
6. Sale of Common Stock and Warrants:
On July 26, 2005, we closed a private placement with AIGH Investment Partners,
LLC and other accredited investors providing for the sales and issuance of
shares of our common stock and warrants to purchase shares of our common stock,
with gross proceeds to us of $5,150,000. The investors invested $5,150,000
purchasing units consisting of one share of our common stock and a warrant to
purchase 0.5 of a share of our common stock. The price per unit was $2.50 with
aggregate proceeds to us of $5,150,000. We issued 2,060,000 shares of our common
stock and warrants to purchase an additional 1,030,000 shares of our common
stock in the future in connection with the private placement.
The warrants issued in connection with the private placement have a term of five
years and are exercisable at a per share price equal to 133% of the unit price,
or $3.33 per
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share, subject to proportional adjustments for stock splits, stock dividends,
recapitalizations and the like. The warrants also contain a cashless exercise
feature.
We agreed to file a registration statement with 60 days of the closing of the
private placement registering for resale the shares of our common stock,
including shares issuable upon exercise of the warrants, issued to the
purchasers in the private placement.
7. Net Income Per Share:
Basic income per common share for the three and nine months ended July 31, 2005
and 2004 was computed by dividing the net income for such period by the weighted
average number of shares of common stock outstanding for such period. Common
stock equivalents for the three months and nine months ended July 31, 2005 were
anti-dilutive and as such are not included in the calculation of diluted net
income per share. Common stock equivalents for the three and nine months ended
July 31, 2004 have been included in the calculation of diluted net income per
share (in thousands).
Common Stock Equivalents Three months ended Nine months ended
July 31, July 31,
--------------------------- ---------------------------
2005 2004 2005 2004
----------- ----------- ----------- -----------
Employee stock options 475 652 554 849
Common Stock to be issued
related to purchase of Antares -- 69 -- 69
Warrants to purchase common stock 47 67 57 91
----------- ----------- ----------- -----------
Common stock equivalents 522 788 611 1,009
=========== =========== ========== ===========
Net Income (Loss) Per Share Three months ended Nine months ended
July 31, July 31,
--------------------------- ---------------------------
2005 2004 2005 2004
----------- ----------- ----------- -----------
BASIC
Weighted average number of
common shares outstanding 5,477 5,078 5,276 5,000
----------- ----------- ----------- -----------
Number of shares for computation of
basic net income (loss) per share 5,477 5,078 5,276 5,000
=========== =========== =========== ===========
Net income (loss) $ (945) $ 79 $ (1,704) $ 660
=========== =========== =========== ===========
Basic net income (loss) per share $ (0.17) $ 0.02 $ (0.32) $ 0.13
=========== =========== =========== ===========
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DILUTED
Weighted average number of
common shares outstanding 5,477 5,078 5,276 5,000
Shares issuable pursuant to options granted
under stock option plans and warrants
granted, less assumed repurchase at the average
fair market value for the period -- 788 -- 1,009
----------- ----------- ----------- -----------
Number of shares for computation of
diluted net income (loss) per share 5,477 5,866 5,276 6,009
=========== =========== =========== ===========
Net income (loss) $ (945) $ 79 $ (1,704) $ 660
=========== =========== =========== ===========
Diluted net income (loss) per share $ (0.17) $ 0.01 $ (0.32) $ 0.11
============ =========== =========== ===========
8. Stock Based Compensation:
At July 31, 2005, we had three stock-based employee compensation plans,
including the PyX employee stock option plan assumed as part of the purchase of
PyX on July 26, 2005, and one stock-based director compensation plan. We account
for these plans under the recognition and measurement principles of Accounting
Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations. Accordingly, no stock-based employee
compensation cost has been recognized in net income for the stock option plans.
Had compensation cost for our stock option plans been determined based on the
fair value recognition provisions of Statement of Financial Accounting Standards
(SFAS) No. 123, "Accounting for Stock-Based Compensation," our net income (loss)
and income (loss) per share would have been as follows (in thousands):
Three Months Nine Months
Ended July 31, Ended July 31,
2005 2004 2005 2004
------- -------- ------- ------
Net income (loss), as reported $ (945) $ 79 $(1,704) $ 660
Add: Total stock-based compensation
expense (benefit) included in the net income
determined under the recognition and
measurement principles of APB Opinion 25 -- -- -- --
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects 124 150 1,130 316
------- -------- ------- ------
Pro forma net income (loss) $(1,069) $ (71) $(2,834) $ 344
======= ======== ======= ======
Income (loss) per share:
Basic - as reported $ (0.17) $ 0.02 $ (0.32) $ 0.13
======= ======== ======= ======
Basic - pro forma $ (0.20) $ (0.01) $ (0.54) $ 0.05
======= ======== ======= ======
Diluted - as reported $ (0.17) $ 0.01 $ (0.32) $ 0.11
======= ======== ======= ======
Diluted - pro forma $ (0.20) $ (0.01) $ (0.54) $ 0.04
======= ======== ======= ======
-11-
There were 95,000 stock options granted plus the assumption of 2,038,950 stock
options outstanding under the PyX employee stock option plan in the quarter
ended July 31, 2005. The assumptions regarding the annual vesting of stock
options were 25% per year for options granted in 2005. The fair value of each
option grant is estimated on the date of grant using the Black-Scholes
option-pricing model with the following weighted-average assumptions used for
grants:
For the periods ended, Three months ended Nine months ended
July 31, July 31,
2005 2004 2005 2004
---- ---- ---- ----
Dividend yield 0% 0% 0% 0%
Volatility 115% 111% 115% 111%
Risk-free interest rate 3.87% 3.17% 3.87% 3.17%
Expected life - years 4 4 4 4
9. Warranty Obligations and Other Guarantees:
Warranty Reserve:
Our products are sold with warranty provisions that require us to remedy
deficiencies in quality or performance of our products over a specified period
of time, generally 12 months, at no cost to our customers. We accrue the
estimated costs to be incurred in performing warranty services at the time of
revenue recognition and shipment of our products to our customers. Our estimate
of costs to service our warranty obligations is based on historical experience
and expectation of future conditions. To the extent we experience increased
warranty claim activity or increased costs associated with servicing those
claims, the warranty accrual may increase, resulting in decreased gross margin.
The following table sets forth an analysis of our warranty reserve at (in
thousands):
July 31,
2005 2004
---- ----
Warranty reserve at beginning of period $ 20 $ 53
Less: Cost to service warranty obligations (4) (33)
Plus: Increases to reserves 4 33
- --
Total warranty reserve included in other accrued expenses $ 20 $ 20
==== ====
The following is a summary of our agreements that we have determined are within
the scope of the Financial Accounting Standards Board's ("FASB") Interpretation
No. 45 "Guarantor's Accounting and Disclosure Requirements for Guarantees" ("FIN
45").
-12-
Indemnification Agreements:
We have agreed to indemnify each of our executive officers and directors for
certain events or occurrences arising as a result of the officer or director
serving in such capacity. The term of the indemnification period is for the
officer's or director's lifetime. The maximum potential amount of future
payments we could be required to make under these indemnification agreements is
unlimited. However, we have a directors' and officers' liability insurance
policy that should enable us to recover a portion of any future amount paid. As
a result of our insurance policy coverage, we believe the estimated fair value
of these indemnification agreements is minimal and have no liabilities recorded
for these agreements as of July 31, 2005 and October 31, 2004.
We enter into agreements with other companies containing indemnification
provisions in the ordinary course of business, typically with business partners,
contractors, customers and landlords. Under these provisions, we generally agree
to indemnify and hold harmless the indemnified party for losses suffered or
incurred by the indemnified party as a result of our activities or, in some
cases, as a result of the indemnified party's activities under the agreement.
These indemnification provisions often relate to representations made by us with
regard to our intellectual property rights. These indemnification provisions
generally survive termination of the underlying agreement. The maximum potential
amount of future payments we could be required to make under these
indemnification provisions is unlimited. To date, we have not incurred material
costs to defend lawsuits or settle claims related to these indemnification
provisions. As a result, we believe the estimated fair value of these agreements
is minimal. Accordingly, we have no liabilities recorded for these agreements as
of July 31, 2005 and October 31, 2004.
Other:
We are the secondary guarantor on the lease assignment of our previous
headquarters that expires in 2006. We believe we will not have to make any
payments as a result of this guarantee and thus have not recorded a liability at
July 31, 2005.
10. Loan to Officer:
On November 6, 1998, we made a loan to one of our officers and stockholders,
which was used by the officer/stockholder to exercise an option to purchase
139,400 shares of our common stock and related taxes. The loan, as amended, was
collateralized by shares of our common stock, bore interest at a rate of 2.48%
per annum, with interest due annually and the entire amount of the principal due
on December 14, 2003.
On October 31, 2002, we determined that it was probable that we would be unable
to fully recover the balance of the loan on its due date of December 14, 2003.
Accordingly, a valuation allowance of $474,000 was recorded based on the fair
value of the common stock collateralizing the note at October 31, 2002 and the
amount of the officer's personal assets considered likely to be available to
settle the note in December 2003.
During the fourth quarter of fiscal 2003, the officer sold 139,400 shares of our
common stock and used the proceeds from the stock sale to repay $362,800 of the
loan. As a result of the fiscal 2003 loan payment, we recognized a benefit in
the fourth quarter of 2003 of
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$235,000 related to the reversal of the loan impairment charge taken by us in
fiscal 2002. In November 2003, the officer sold additional shares of our common
stock and used the proceeds to repay the remaining loan balance in full. As a
result, in our first quarter of fiscal 2004 we recorded a benefit of $239,000
resulting from the reversal of the remaining loan impairment charge.
11. Deferred Compensation:
On January 1, 2005, our retiring President and Chief Executive Officer was
awarded options to purchase 75,000 shares of our common stock at a price of
$4.00 per share (closing price on December 31, 2004). The fair value of this
option grant is estimated on the date of grant using the Black-Scholes
option-pricing model and is included as deferred compensation on the balance
sheet. The $120,000 deferred compensation is amortized to general and
administrative expense at the rate of $8,000 per month over the 15 month vesting
period ending March 2006 based on his continued service as a director. As of
July 31, 2005, $56,000 of the deferred compensation has been amortized to
expense and is included in General and Administrative expense.
We assumed the PyX employee stock option plan as part of the July 26, 2005
acquisition of PyX and as a result an additional 2,038,950 shares of our common
stock, with an exercise price of $2.17, will be issuable upon exercise of
assumed stock options. The fair value of these option grants is estimated on the
date of grant using the Black-Scholes option-pricing model and is included as
deferred compensation on the balance sheet. The $2,484,000 deferred compensation
related to this transaction will be amortized to expense at the rate of $57,800
per month over the remaining 43 month vesting period beginning August 2005 and
ending February 2009.
The estimated aggregate remaining amortization expense for each of the
succeeding fiscal years is as follows (in thousands):
2005 $ 205
2006 724
2007 692
2008 692
2009 235
-------
Total $ 2,548
=======
Forward Looking Statements
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that involve risks and
uncertainties. Words such as "believes," "anticipates," "expects," "intends" and
similar expressions are intended to identify forward-looking statements, but are
not the exclusive means of identifying such statements. Readers are cautioned
that the forward-looking statements reflect our analysis only as of the date
hereof, and we assume no obligation to update these statements. Actual events or
results may differ materially from the results
-14-
discussed in or implied by the forward-looking statements. Factors that might
cause such a difference include, but are not limited to, those risks and
uncertainties set forth under the caption "Risk Factors" below.
The following discussion should be read in conjunction with the Financial
Statements and the Notes thereto included in Item 1 of this Quarterly Report on
Form 10-Q and in our Form 10-K for the fiscal year ended October 31, 2004.
Risk Factors
In addition to the other information in this Quarterly Report on Form 10-Q,
stockholders or prospective investors should carefully consider the following
risk factors:
Risks Related to Our Business
We may not realize any anticipated benefits from the acquisition of PyX
Technologies, Inc..
We acquired PyX Technologies, Inc. (`PyX") on July 26, 2005. While we believe
that our opportunities are greater than our opportunities prior to the
acquisition and that we will be able to create substantially more stockholder
value, there is substantial risk that the synergies and benefits sought in the
acquisition might not be fully achieved. There is no assurance that PyX's
technology can be successfully integrated into our existing product platforms or
that our financial results will meet or exceed the financial results that would
have been achieved absent the acquisition. As a result, our operations and
financial results may suffer and the market price of our common stock may
decline.
If PyX's products contain undetected errors, we could incur significant
unexpected expenses and experience product returns and lost sales.
The Internet Small Computer System Interface ("iSCSI") software products
developed by PyX are highly technical and complex. While PyX's products have
been tested, because of their nature, we can not be certain of their performance
either as stand-alone products or when integrated with our existing product
line. Because of PyX's short operating history, we have little information on
the performance of its products. There can be no assurance that defects or
errors may not arise or be discovered in the future. Any defects or errors in
PyX's products discovered in the future could result in a loss of customers or
decrease in net revenue and market share.
If an unauthorized disclosure of a significant portion of our source code
occurs, we could potentially lose future trade secret protection for the source
code.
Source code, the detailed program commands for our iSCSI software programs, is
one of the most significant asset we own. While we license certain portions of
our source code to certain licensees, we take significant measures to protect
the secrecy of large portions of our source code. The loss of future trade
secret protection could make it easier for third parties to compete with our
products by copying functionality, which could adversely affect our revenue and
operating margins.
-15-
We depend upon a small number of Original Equipment Manufacturers ("OEM")
customers. The loss of any of these customers, or their failure to sell their
products, could limit our ability to generate revenues. In particular, the
Hewlett-Packard Company ("HP") ceased to be a significant customer of ours in
the first quarter of fiscal 2005, and our success depends on being able to
replace net sales previously attributable to HP with sales to other customers.
In the first three quarters of fiscal 2005 and 2004, sales of Versa Module
Europa ("VME") products to HP accounted for 16% and 47%, respectively, of our
net sales. We made our final shipment for $1.0 million of our VME products to HP
in the first quarter of fiscal 2005. Our future success depends on being able to
replace net sales previously attributable to HP with sales to other customers.
We can provide no assurance that we will succeed in obtaining new orders from
existing or new customers sufficient to replace or exceed the net sales
previously attributable to HP or that we will become a qualified supplier with
new OEM customers or remain a qualified supplier with existing OEM customers.
Orders by our OEM customers are affected by factors such as new product
introductions, product life cycles, inventory levels, manufacturing strategies,
contract awards, competitive conditions and general economic conditions. Our
sales to any single OEM customer are also subject to significant variability
from quarter to quarter. Such fluctuations may have a material adverse effect on
our operating results. A significant reduction in orders from any of our OEM
customers, could have a material adverse effect on our operating results,
financial condition and cash flows.
A failure to collect outstanding accounts receivable from any of our OEM
customers could have a material adverse effect on our business, operating
results, financial condition and cash flows.
Our future capital needs may exceed our ability to raise capital.
The development and marketing of our products is capital-intensive. We believe
that our existing cash balances and our anticipated cash flow from operations
will satisfy our working capital needs for the foreseeable future. Declines in
our sales or a failure to keep expenses in line with revenues could require us
to seek additional financing in fiscal 2006. In addition, should we experience a
significant growth in customer orders or wish to make strategic acquisitions of
a business or assets, we may be required to seek additional capital to meet our
working capital needs. There can be no assurance that additional financing, if
required, will be available on reasonable terms or at all. To the extent that
additional capital is raised through the sale of additional equity or
convertible debt securities, the issuance of such securities could result in
additional dilution to our stockholders.
Because of our dependence on single suppliers for some components, we may be
unable to obtain an adequate supply of such components, or we may be required to
pay higher prices or to purchase components of lesser quality.
-16-
The chip sets used in certain of our products are currently available only from
a single supplier. If these suppliers discontinue or upgrade some of the
components used in our products, we could be required to redesign a product to
incorporate newer or alternative technology. The inability to obtain sufficient
key components as required, or to develop alternative sources if and as required
in the future, could result in delays or reductions in product shipments or
margins that, in turn, would have a material adverse effect on our business,
operating results, financial condition and cash flows. If enough components are
unavailable, we may have to pay a premium in order to meet customer demand.
Paying premiums for parts, building inventories of scarce parts and obsolesce of
existing inventories could lower or eliminate our profit margin, reduce our cash
flow and otherwise harm our business. To offset potential component shortages,
we have in the past, and may in the future, carry an inventory of these
components. As a result, our inventory of components parts may become obsolete
and may result in write-downs.
If we fail to develop and produce new products, we may lose sales and our
reputation may be harmed.
The markets for our products are characterized by rapidly changing technologies,
evolving industry standards and frequent new product introductions. Our future
success will depend on our ability to enhance our existing products and to
introduce new products and features to meet and adapt to changing customer
requirements and emerging technologies such as Voice over IP ("VoIP"), third
generation wireless services ("3G Wireless"), Serial ATA ("SATA"), iSCSI, Serial
Attached SCSI ("SAS"), Gigabit Ethernet, 10 Gigabit Ethernet and TCP/IP Offload
Engine ("TOE"). There can be no assurance that we will be successful in
identifying, developing, manufacturing and marketing new products or enhancing
our existing products. In addition, there can be no assurance that services,
products or technologies developed by others will not render our products
obsolete.
We have focused a significant portion of our research and development, marketing
and sales efforts on VoIP, HighWire, wide area network ("WAN") and local area
network ("LAN") adapters, encryption, iSCSI and TOE products. The success of
these products is dependent on several factors, including timely completion of
new product designs, achievement of acceptable manufacturing quality and yields,
introduction of competitive products by other companies, market acceptance of
our products and our ability to sell our products. If the VoIP, TOE, iSCSI,
HighWire, encryption and adapter products or other new products developed by us
do not gain market acceptance, our business, operating results, financial
condition and cash flows would be materially adversely affected.
Our iSCSI and VoIP products will require a substantial product development
investment by us and we may not realize any return on our investment.
The development of new or enhanced products is a complex and uncertain process.
As we integrate the PyX products into our product line, our customers may
experience design, manufacturing, marketing and other difficulties that could
delay or prevent the development, introduction or marketing of new products and
enhancements, both to our existing product line as well as to the PyX products.
Development costs and expenses are incurred before we generate any net revenue
from sales of the products resulting from these efforts. We expect to incur
substantial research and development expenses relating
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to the PyX product line, which could have a negative impact on our earnings in
future periods.
The storage and embedded products market is intensely competitive, and our
failure to compete effectively could reduce our revenues and margins.
We compete directly with traditional vendors of storage software and hardware
devices, including Fibre Channel SAN products, open source "free" software,
TCP/IP Offload Engines and application-specific storage solutions. We compete
with communications suppliers of routers, switches, gateways, network interface
cards and other products that connect to the Public Switched Telephone Network
(PSTN) and the Internet. In the future, we expect competition from companies
offering client/server access solutions based on emerging technologies such as
Fibre Channel, switched digital telephone services, iSCSI, SAS, TOE, VoIP and
other technologies. In addition, we may encounter increased competition from
operating system and network operating system vendors to the extent that such
vendors include full communications and storage capabilities in their products.
We may also encounter future competition from telephony service providers (such
as AT&T or the regional Bell operating companies) and storage product providers
(such as EMC Corporation, Network Appliance, Inc. and Qlogic Corporation).
Increased competition with respect to any of our products could result in price
reductions and loss of market share, which would adversely affect our business,
operating results, financial condition and cash flows. Many of our current and
potential competitors have greater financial, marketing, technical and other
resources than we do. There can be no assurance that we will be able to compete
successfully with our existing competitors or will be able to compete
successfully with new competitors.
We depend on our key personnel. If we are unable to retain our current personnel
and hire additional qualified personnel as needed, our business will be harmed.
We are highly dependent on the technical, management, marketing and sales skills
of a limited number of key employees. We do not have employment agreements with,
or life insurance on the lives of, any of our key employees. The loss of the
services of any key employees could adversely affect our business and operating
results. Our future success will depend on our ability to continue to attract
and retain highly talented personnel to the extent our business grows.
Competition for qualified personnel in the networking and software industries,
and in the San Francisco Bay Area, is intense. There can be no assurance that we
will be successful in retaining our key employees or that we can attract or
retain additional skilled personnel as required.
We may be unable to protect our intellectual property, which could reduce any
competitive advantage we have.
Although we believe that our future success will depend primarily on continuing
innovation, sales, marketing and technical expertise and the quality of product
support and customer relations, we must also protect the proprietary technology
contained in our products. We do not currently hold any patents and rely on a
combination of copyright, trademark, trade secret laws and contractual
provisions to establish and protect proprietary rights in our products. There
can be no assurance that steps taken by us in
-18-
this regard will be adequate to deter misappropriation or independent
third-party development of our technology. Although we believe that our products
and technology do not infringe on the proprietary rights of others, there can be
no assurance that third parties will not assert infringement claims against us.
Risks Associated with Ownership of Our Common Stock
Our common stock has been at risk for delisting from the Nasdaq SmallCap Market.
If it is delisted, our stock price and your liquidity may be impacted.
Our common stock is currently listed on the Nasdaq SmallCap Market. Nasdaq has
requirements that a company must meet in order to remain listed on the Nasdaq
SmallCap Market. These requirements include maintaining a minimum closing bid
price of $1.00 and minimum stockholders' equity of $2.5 million. Our
stockholders' equity as of July 31, 2005 was approximately $19.7 million and our
closing bid price on July 29, 2005 was $3.46. Although we currently meet all the
minimum continued listing requirements for the Nasdaq SmallCap Market, should
our stock price decline, our common stock could be subject to potential
delisting from the Nasdaq SmallCap Market.
If we fail to maintain the standards necessary to be quoted on the Nasdaq
SmallCap Market and our common stock is delisted, trading in our common stock
would be conducted on the OTC Bulletin Board as long as we continue to file
reports required by the Securities and Exchange Commission. The OTC Bulletin
Board is generally considered to be a less efficient market than the Nasdaq
SmallCap Market, and our stock price, as well as the liquidity of our common
stock, may be adversely impacted as a result.
The market price of our common stock is likely to continue to be volatile. You
may not be able to resell your shares at or above the price at which you
purchased such shares.
The trading price of our common stock is subject to wide fluctuations in
response to quarter-to-quarter fluctuations in operating results, the failure to
meet analyst estimates, announcements of technological innovations or new
products by us or our competitors, general conditions in the computer and
communications industries and other events or factors. In addition, stock
markets have experienced extreme price and trading volume volatility in recent
years. This volatility has had a substantial effect on the market price of the
securities of many high technology companies for reasons frequently unrelated to
the operating performance of the specific companies. These broad market
fluctuations may adversely affect the market price of our common stock. Our
common stock has historically had relatively small trading volumes. As a result,
small transactions in our common stock can have a disproportionately large
impact on the quoted price of our common stock.
If we continue to experiences losses, we could experience difficulty meeting our
business plan, and our stock price could be negatively affected.
We may experience operating losses and negative cash flow from operations as we
develop and market the iSCSI software solution acquired in the PyX acquisition.
Any failure to achieve or maintain profitability could negatively impact the
market price of
-19-
our common stock. Historically, PyX has not been profitable on a quarterly or
annual basis, and we expect that the combined company will incur net losses for
the foreseeable future. We anticipate that we will continue to incur significant
product development, sales and marketing and administrative expenses. As a
result, we will need to generate significant quarterly revenues if we are to
achieve and maintain profitability. A substantial failure to achieve
profitability could make it difficult or impossible for us to grow our business.
Our business strategy may not be successful, and we may not generate significant
revenues or achieve profitability. Any failure to significantly increase
revenues would also harm our ability to achieve and maintain profitability. If
we do achieve profitability in the future, we may not be able to sustain or
increase profitability on a quarterly or annual basis.
Future sales of our common stock, including shares issued in the PyX acquisition
and the private placement could cause the market price for our common stock to
significantly decline.
Sales of substantial amounts of our common stock in the public market could
cause the market price of our common stock to fall, and could make it more
difficult for us to raise capital through public offerings or other sales of our
capital stock. In addition, the public perception that these sales might occur
could have the same undesirable effects. The PyX shareholders who received
shares of our common stock in the PyX acquisition entered into agreements that
provide, in part, that, with respect to 95% of the shares of our common stock
that the shareholder received in connection with the acquisition, the
shareholder will not sell these shares until one year after the acquisition is
completed. However, we are required to file a registration statement for the
resale of all shares that we issued in the merger no later than 90 days after
the acquisition was completed. In addition, we are required to register for sale
all of the shares issued in the private placement no later than 60 days after
the private placement was completed. The purchasers in the private placement are
not subject to any lockup with respect to the shares they purchased in the
private placement. Once the registration statement relating to such shares
becomes effective, the shares issued in the private placement will generally be
freely tradeable without restriction. Such free transferability could materially
and adversely affect the market price of our common stock. We intend to register
the shares issued in connection with the acquisition at the same time we
register the shares issued in connection with the private placement. As a
result, sales under the registration statement will include a very substantial
number of shares and percentage of our common stock. Holders of approximately
44.3% of the outstanding shares of our common stock will have the right to sell
their shares pursuant to these registration rights and holders of an additional
approximately 5.7% of the outstanding shares of our common stock, assuming no
further issuances of shares of our common stock, will have the right to sell
their shares after the one year period has passed.
Our certificate of incorporation and bylaws and the Delaware General Corporation
Law contain provisions that could delay or prevent a change in control.
Our board of directors has the authority to issue up to 2,000,000 shares of
preferred stock and to determine the price, rights, preferences and privileges
of those shares without any further vote or action by the stockholders. The
rights of the holders of common stock will be subject to, and may be materially
adversely affected by, the rights of the holders
-20-
of any preferred stock that may be issued in the future. The issuance of
preferred stock could have the effect of making it more difficult for a third
party to acquire a majority of our outstanding voting stock. Furthermore,
certain other provisions of our certificate of incorporation and bylaws may have
the effect of delaying or preventing changes in control or management, which
could adversely affect the market price of our common stock. In addition, we are
subject to the provisions of Section 203 of the Delaware General Corporation
Law, an anti-takeover law.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Overview
We believe that the economy has largely recovered from the recession that began
in 2001, caused primarily by "dot.com" companies exploiting the growth potential
of the Internet as well as telecommunications companies over-building
infrastructure. Today, capital spending in the United States has experienced two
and a half years of growth and many analysts are optimistic about continued
growth for several years. In addition, we believe that providers of computer
solutions are increasingly outsourcing their product needs to companies like us,
allowing these companies to respond faster with innovative new technology. By
entering into these outsourcing arrangements, these companies are able to
maintain a focus on their core competency while SBE provides the technical
expertise in network connectivity.
Due to the worldwide acceptance of the TCP/IP as the core building block of the
Internet, both consumers and businesses are converting vertical applications for
use on the Internet. The primary reasons for the success of Internet Protocol
("IP") based solutions include enhanced functionality, reduced start-up costs,
and lower cost of ownership. IP networking solutions address the expansion of
the virtual workforce, globalization, explosive growth of communications
traffic, and the increased need for business agility by breaking down distance
barriers and enabling new ways to share information and collaborate in a global
business environment. Consequently, these new solutions provide businesses a
competitive edge with improved productivity and communication.
Many of our customers and prospects have indicated their intentions to support
IP based software and hardware solutions. In order to realize our growth goals
we've been making several moves to maximize opportunities in two dynamic
markets, IP Storage and Voice over IP ("VoIP") communications. For example we
recently acquired PyX Technologies, Inc., a technology company that develops
software products for the Internet Small Computer System Interface ("iSCSI")
enterprise storage market. iSCSI enables networked computers to access and store
data using standard TCP/IP networks. Among the many features it offers, iSCSI
provides remote access to secure multi-terabyte storage using desktops, laptops,
PDAs, or other mobile devices, and offers significant cost savings over existing
storage alternatives. In addition, our development of digital signal processor
("DSP") modules allows SBE to leverage our current products to enable existing
customers to take advantage of a new and explosive market: VoIP.
Industry experts in IP storage and VoIP project growth trends that justify our
efforts in these markets. Recent reports from International Data Corporation
("IDC") indicate that
-21-
the iSCSI market grew from $18 million in 2003 to $113 million in 2004.
Furthermore, IDC forecasts the IP storage area network ("SAN") market to reach
$296 million in 2005 and $2.7 billion by 2008. Reports from Infonetics Research
indicate that the market for VoIP products grew from $1 billion in 2003 to $2
billion in 2004. Furthermore, Infonetics Research forecasts the VoIP market to
reach $3 billion in 2005 and $5 billion by 2007.
Following the PyX acquisition, we operate in two business units; Storage
Business Unit and Embedded Business Unit.
The Storage Business Unit
Our Storage Business Unit is focused on providing storage networking OEM
customers with scalable, reliable IP storage solutions. Our flagship storage
product is our iSCSI target and initiator software enabling remote storage
functionality on Linux host computers.
To date, the iSCSI software products have been successfully integrated into
solutions serving a variety of applications, including security surveillance,
storage virtualization, Network Attached Storage ("NAS"), and Remote Access
Storage ("RAS"). Our newly-formed Storage Business Unit is proactively engaging
in strategic initiatives to bring a broader spectrum of feature-rich IP storage
solutions to market. Over the course of the next year these solutions will
satisfy the growing and evolving requirements of the storage networking
industry.
Storage Products
iSCSI is an end-to-end protocol for transporting block level storage data over
the IP network. The protocol is used on servers (initiators), storage devices
(targets), and protocol transfer gateway devices. iSCSI uses standard Ethernet
switches and routers to move the data from the server to storage device. The
initiator is typically a host (either a PC, server or laptop) that is running an
iSCSI initiator driver that will be accessing storage on the IP SAN. The target
is any storage system, including disk drives, RAID, CDROM's, DVD's, or tapes.
All of our iSCSI products conform to the iSCSI standard as ratified by the
Internet Engineering Task Force ("IETF"). Fault tolerant features are inherent
to the core architecture, therefore our solutions support port aggregation (the
ability to dynamically add multiple ports together) and port failover (re-routes
data traffic around failing ports and subnets) if desired. The iSCSI target
software is "initiator agnostic" and is compatible with Microsoft Windows,
Solaris, BSD, and most other initiators on the market today. The software is
user friendly and features an intuitive graphical user interface ("GUI") for
fast integration and configuration into Linux systems.
In addition to software products, we have a considerable investment in TCP/IP
Offload Engine ("TOE") technology. Tuned with the iSCSI target and initiator
drivers, the TOE offers a dual port gigabit Ethernet interface for powerful port
aggregation and failover to the network. We intend to develop future products
leveraging both the iSCSI and TOE technologies to the extent there is market
demand.
-22-
Storage Business Unit Goals
We expect that the storage industry will begin to experience widespread iSCSI
deployment in 2006. Thus far, 2005 has been a strategic growth year, resulting
in several key OEM relationships including LSI Logic who bundles our iSCSI
target software with their SATA RAID controller products. This higher level of
integration adds value to large computer and storage OEM's as they respond to
increasing demand for iSCSI products.
The Embedded Business Unit
The Embedded Business Unit provides board-level network communications
solutions that are embedded in the computing equipment that OEM's sell to end
users. Our solutions enable both data communications and telecommunications
companies to rapidly deploy advanced networking products and services. We
currently offer a broad selection of WAN interfaces such as T1 and T3 and LAN
interfaces such as Gigabit Ethernet and programmable intelligent processor
platforms for the embedded server market. These products perform critical
computing and Input/Output ("I/O") functions in the embedded communications
markets, including VoIP, routers, switches, SS7 gateways, WiMAX concentrators,
and wireless base stations. Recently, we entered into a development and
marketing alliance with Texas Instruments ("TI") focused on the introduction a
series of new DSP modules. These modules are designed to enable the maximum
number of voice channels given the PTMC form factor.
Embedded Products
On the highest level, we provide integrated blade-level solutions based on a
flexible and programmable intelligent processor with user-defined combinations
of modules attached. With DSP and 24-port modules running T1/Telogy's
award-winning VoIP software, today's users can quickly and easily aggregate
telephones into a VoIP network. Software tools and protocols are available to
enhance the Linux operating system environment that controls the data pathway to
each I/O module used (DSP, T1, E1, T3, etc.)
The intelligent processor platforms and DSP modules can be purchased separately
and used for numerous applications ranging from military command and control to
industrial processing. Based on engineering standards, the products are
compatible with many third party products available.
The Embedded Business Unit continues to offer its WAN and LAN interface
adapters. These adapters provide connections to outside networks and support a
variety of clear channel T1/E1 and T3, or channelized access to individual DSOs,
including DSU/CSU capability. Our Gigabit Ethernet adapters provide network
access to either copper or fiber LAN's and offer connectivity and multi-port
density to gateways or other host processors.
Embedded Business Unit Goals
We expect to continue shipping our products at roughly the same revenue level as
2005 throughout 2006, and expect revenues from VoIP and gateway products to grow
in 2007.
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We further expect that our marketing alliance with TI will result in
more customers for our DSP based products.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles in the U.S. requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Significant estimates and judgments made by us
include matters such as indemnifications obligations, accounts receivable,
realizability of inventories and recoverability of capitalized software and
deferred tax assets. Actual results could differ from those estimates.
Our critical accounting policies and estimates include the following:
Revenue Recognition:
Hardware Products
Our policy is to recognize revenue for hardware product sales when title
transfers and risk of loss has passed to the customer, which is generally upon
shipment of our hardware products to our customers. We defer and recognize
service revenue over the contractual period or as services are rendered. We
estimate expected sales returns and record the amount as a reduction of revenue
and cost of goods sold ("COGS") at the time of shipment. Our policy complies
with the guidance provided by Staff Accounting Bulletin No. 104, "Revenue
Recognition in Financial Statements," issued by the Securities and Exchange
Commission. Judgments are required in evaluating the credit worthiness of our
customers. Credit is not extended to customers and revenue is not recognized
until we have determined that collectibility is reasonably assured. Our sales
transactions are denominated in U.S. dollars. The software component of our
hardware products is considered incidental. We, therefore do not recognize
software revenue related to our hardware products separately from the hardware
product sale.
When selling hardware, our agreements with OEMs, such as Data Connection Limited
and Nortel Networks Corp., typically incorporate clauses reflecting the
following understandings:
- all prices are fixed and determinable at the time of sale;
- title and risk of loss pass at the time of shipment (FOB shipping
point);
- collectibility of the sales price is probable (the OEM is obligated
to pay and such obligation is not contingent on the ultimate sale of
the OEM's integrated solution);
- the OEM's obligation to us will not be changed in the event of theft
or physical destruction or damage of the product;
- we do not have significant obligations for future performance to
directly assist in the resale of the product by the OEMs; and
- there is no contractual right of return other than for defective
products.
-24-
Our agreements with our distributors include certain product rotation and price
protection rights. All distributors have the right to rotate slow moving
products once each fiscal quarter. The maximum dollar value of inventory
eligible for rotation is equal to 25% of our products purchased by the
distributor during the previous quarter. In order to take advantage of their
product rotation rights, the distributors must order and take delivery of
additional products of ours equal to at least the dollar value of the products
that they want to rotate.
Each distributor is also allowed certain price protection rights. If and when we
reduce or plan to reduce the price of any of our products and the distributor is
holding any of the affected products in inventory, we will credit the
distributor the difference in price when they place their next order with us. We
record an allowance for price protection at the time of the price reduction,
thereby reducing our net sales and accounts receivable. The allowance is based
on the price difference of the inventory held by our stocking distributors at
the time we expect to reduce selling prices. We believe we are able to fully
evaluate potential returns and adjustments and continue to recognize the sale
based on shipment to our distributors. Reserves for the right of return and
restocking are established based on the requirements of SFAS 48, "Revenue
Recognition when Right of Return Exists."
During the quarter ended July 31, 2005, $173,000 or 10% of our sales were sold
to distributors compared to $168,000 or 6% in the same quarter of fiscal 2004.
During the nine months ended July 31, 2005, $426,000 or 7% of our sales were
sold to distributors compared to $706,000 or 8% in the same period of fiscal
2004. Our reserves for distributor programs total approximately $22,000 as of
July 31, 2005.
Software Products
With the acquisition of PyX, we will also derive future revenues from the
following sources: (1) software, which includes new iSCSI Target and Initiator
software licenses and (2) services, which include consulting. We account for the
licensing of software in accordance with American Institute of Certified Public
Accountants ("AICPA") Statement of Position ("SOP") 97-2, "Software Revenue
Recognition". The application of SOP 97-2 requires judgment, including whether a
software arrangement includes multiple elements, and if so, whether
vendor-specific objective evidence ("VSOE") of fair value exists for those
elements. Customers receive certain elements of our products over a period of
time. These elements include free post-delivery telephone support and the right
to receive unspecified upgrades/enhancements of our iSCSI software on a
when-and-if-available basis, the fair value of which is recognized over the
product's estimated life cycle. Changes to the elements in a software
arrangement, the ability to identify VSOE for those elements, the fair value of
the respective elements, and changes to a product's estimated life cycle could
materially impact the amount of earned and unearned revenue. Judgment is also
required to assess whether future releases of certain software represent new
products or upgrades and enhancements to existing products. We will defer all
revenue related to the sale of our software products until such time that we are
able to established VSOE for the undelivered elements related to our iSCSI
software products or when we fulfill the undelivered elements.
-25-
For software license arrangements that do not require significant modification
or customization of the underlying software, we will recognize new software
license revenue when: (1) we enter into a legally binding arrangement with a
customer for the license of software; (2) we deliver the products; (3) customer
payment is deemed fixed or determinable and free of contingencies or significant
uncertainties; and (4) collection is reasonably assured. Substantially all of
our new software license revenue will be recognized in this manner. No software
license revenue has been recognized to date.
Certain software arrangements include consulting implementation services sold
separately under consulting engagement contracts. Consulting revenues from these
arrangements are generally accounted for separately from new software license
revenues because the arrangements qualify as service transactions as defined in
SOP 97-2. The more significant factors considered in determining whether the
revenue should be accounted for separately include the nature of services (i.e.,
consideration of whether the services are essential to the functionality of the
licensed product), degree of risk, availability of services from other vendors,
timing of payments and impact of milestones or acceptance criteria on the
realizability of the software license fee. Revenues for consulting services are
generally recognized as the services are performed. If there is significant
uncertainty about the project completion or receipt of payment for the
consulting services, revenue is deferred until the uncertainty is sufficiently
resolved.
Allowance for Doubtful Accounts:
Our policy is to maintain allowances for estimated losses resulting from the
inability of our customers to make required payments. Credit limits are
established through a process of reviewing the financial history and stability
of each customer. Where appropriate, we obtain credit rating reports and
financial statements of the customer when determining or modifying their credit
limits. We regularly evaluate the collectibility of our trade receivable
balances based on a combination of factors. When a customer's account balance
becomes past due, we initiate dialogue with the customer to determine the cause.
If it is determined that the customer will be unable to meet its financial
obligation to us, such as in the case of a bankruptcy filing, deterioration in
the customer's operating results or financial position or other material events
impacting their business, we record a specific allowance to reduce the related
receivable to the amount we expect to recover.
We also record an allowance for all customers based on certain other factors
including the length of time the receivables are past due and historical
collection experience with customers. We believe our reported allowances are
adequate. If the financial conditions of those customers were to deteriorate,
however, resulting in their inability to make payments, we may need to record
additional allowances which would result in additional general and
administrative expenses being recorded for the period in which such
determination was made.
Warranty Reserves:
We accrue the estimated costs to be incurred in performing warranty services at
the time of revenue recognition and shipment of the products to the OEMs.
Because there is no contractual right of return other than for defective
products, we can reasonably estimate such returns and record a warranty reserve
at the point of shipment. Our estimate of costs to service our warranty
obligations is based on historical experience and expectation of
-26-
future conditions. To the extent we experience increased warranty claim activity
or increased costs associated with servicing those claims, the warranty accrual
will increase, resulting in decreased gross margin.
Inventories:
We are exposed to a number of economic and industry factors that could result in
portions of our inventory becoming either obsolete or in excess of anticipated
usage, or subject to lower of cost or market issues. These factors include, but
are not limited to, technological changes in our markets, our ability to meet
changing customer requirements, competitive pressures in products and prices,
and the availability of key components from our suppliers. Our policy is to
establish inventory reserves when conditions exist that suggest that our
inventory may be in excess of anticipated demand or is obsolete based upon our
assumptions about future demand for our products and market conditions. We
regularly evaluate our ability to realize the value of our inventory based on a
combination of factors including the following: historical usage rates,
forecasted sales or usage, product end-of-life dates, estimated current and
future market values and new product introductions. Purchasing practices and
alternative usage avenues are explored within these processes to mitigate
inventory exposure. When recorded, our reserves are intended to reduce the
carrying value of our inventory to its net realizable value. If actual demand
for our products deteriorates, or market conditions are less favorable than
those that we project, additional inventory reserves may be required.
Inventories are stated at the lower of cost, using the first-in, first-out
method, or market value.
Deferred Taxes:
We record a valuation allowance to reduce our deferred taxes to the amount that
is more likely than not to be realized. Based on the uncertainty of future
pre-tax income, we have fully reserved our deferred tax assets as of July 31,
2005 and October 31, 2004, respectively. In the event we were to determine that
we would be able to realize our deferred tax assets in the future, an adjustment
to the deferred tax asset would increase income in the period such determination
was made.
Acquisitions:
The PyX acquisition has been accounted for using the purchase method of
accounting and, accordingly, the statements of operations include the results of
PyX since the date of acquisition, July 26, 2005. The assets acquired and
liabilities assumed are recorded at estimates of fair values as determined by
management based on information available. Management considers a number of
factors, including third-party valuations or appraisals, when making these
determinations. We allocated the purchase price to the tangible assets and
liabilities based on fair market value at the time of the acquisition and to
intellectual property based on future expected cash flows to be derived from the
acquired iSCSI software product line.
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Intangible Assets:
We do not amortize goodwill from acquisitions, but do amortize other
acquisition-related intangibles and costs in accordance with Financial
Accounting Standards Board ("FASB") Statements of Financial Accounting Standards
("SFAS") No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other
Intangible Assets". All of the intangible assets that we currently own are
intellectual property acquired in the PyX acquisition.
For intangible assets, we amortize the cost over the estimated useful life and
assess any impairment by estimating the future cash flow from the associated
asset in accordance with SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets". If the estimated undiscounted cash flow related
to these assets decreases in the future or the useful life is shorter than
originally estimated, we may incur charges for impairment of these assets. The
impairment is based on the estimated discounted cash flow associated with the
asset. An impairment could result if the underlying technology fails to gain
market acceptance, we fail to deliver new products related to these technology
assets, the products fail to gain expected market acceptance or if market
conditions are unfavorable.
New Accounting Pronouncements:
In December 2004, the FASB issued Statement of Financial Accounting Standards
No. 123R, "Share Based Payments" ("SFAS 123R"), which amends Statement of
Financial Accounting Standard No. 123, "Accounting for Stock-Based
Compensation," and requires public entities (other than those filing as small
business issuers) to report stock-based employee compensation in their financial
statements. As modified in April 2004, we will be required to comply with the
provisions of SFAS 123R as of the first interim period for the fiscal year
beginning on or after June 15, 2005. Thus, we will be required to comply with
SFAS 123R beginning with our quarter ending January 31, 2006. We currently have
recorded compensation expense related to stock options awarded to our retired
President and Chief Executive Officer. The value of these stock options were
recorded as deferred compensation and are amortized to expense over the vesting
period. We also recorded deferred compensation on the balance sheet related to
the fair value of the stock options assumed in the acquisition of PyX. We will
amortize this deferred compensation to expense over the future vesting period of
these stock options beginning August 1, 2005. . We currently do not record
compensation expense related to our other stock-based employee compensation
plans in our financial statements.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs" ("SFAS 151").
The provisions of this statement become effective for us in fiscal 2006. SFAS
151 amends the existing guidance on the recognition of inventory costs to
clarify the accounting for abnormal amounts of idle expense, freight, handling
costs, and wasted material (spoilage). Existing rules indicate that under some
circumstances, items such as idle facility expense, excessive spoilage, double
freight, and rehandling costs may be so abnormal as to require treatment as
current period charges. SFAS 151 requires that those items be recognized as
current period charges regardless of whether they meet the criterion of "so
abnormal". In addition, SFAS 151 requires that allocation of fixed production
overheads to the costs of conversion be based on the normal capacity of the
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production facilities. The adoption of this Statement is not expected to have a
material impact on the valuation of inventory or operating results.
In May 2005, the FASB issued SFAS No. 154, "Account Changes and Error
Corrections." This new standard replaces APB Opinion 20, "Accounting Changes",
and FASB No. 3, "Reporting Accounting Changes in Interim Financial Statements".
Among other changes, SFAS No. 154 requires that a voluntary change in accounting
principle to be applied retrospectively with all prior period financial
statements presented on a new accounting principle, unless it is impracticable
to do so. SFAS No. 154 also provides that (1) a change in method of depreciating
or amortizing a long-lived non-financial asset be accounted for as a change in
estimate (prospectively) that was effected by a change in accounting principle,
and (2) correction of errors in previously issued financial statements should be
termed a "restatement." The new standard is effective for accounting changes and
correction of errors made in fiscal years beginning after December 15, 2005. We
believe the adoption of the provisions of SFAS No. 154 will not have a material
impact on our results of operations, financial positions or liquidity..
Results of Operations
The following table sets forth, as a percentage of net sales, consolidated
statements of operations data for the three and nine months ended July 31, 2005
and 2004. These operating results are not necessarily indicative of our
operating results for any future period.
Three Months Ended Nine Months Ended
-------------------------- --------------------------
July 31, July 31,
-------- --------
2005 2004 2005 2004
----------- ----------- ----------- -----------
Net sales 100% 100% 100% 100%
Cost of sales 62 47 54 46
----------- ----------- ----------- -----------
Gross profit 38 53 46 54
----------- ----------- ----------- -----------
Product research and development 37 19 27 18
Sales and marketing 30 19 26 18
General and administrative 26 13 20 13
Loan loss recovery --- --- --- (3)
----------- ----------- ----------- ------------
Total operating expenses 93 51 73 46
----------- ----------- ----------- -----------
Net income (loss) (55)% 3% (27)% 8%
=========== =========== =========== ============
Net Sales
Net sales for the third quarter of fiscal 2005 were $1.7 million, a 41% decrease
from $2.9 million in the third quarter of fiscal 2004. For the first nine months
of fiscal 2005, net sales were $6.2 million, which represented a 29% decrease
over net sales of $8.8 million for the same period in fiscal 2004. This decrease
was primarily attributable to a decrease in shipments to HP. We had no shipments
to HP in the three months ended July 31, 2005 and $1.0 million in the nine
months ending July 31, 2005, compared to $1.6 million and $4.2 million for the
same periods of fiscal 2004. Sales to HP, consisting primarily of VME
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products, represented 0% and 16% of total sales for the three and nine months
ended July 31, 2005, respectively, compared to 55% and 47% of total sales during
the comparable periods in fiscal 2004. Data Connection Limited ("DCL") has
partially filled the gap left by the termination of our OEM agreement with HP.
DCL accounted for over 42% and 28% of our net sales for the three and nine month
period ended July 31, 2005, respectively, compared to 11% and 6% of sales in the
same periods of 2004. In addition, Nortel Networks accounted for 20% and 17% of
our net sales for the quarter and nine months ended July 31, 2005, respectively,
as compared to 6% and 13% of our net sales for the same periods in 2004.
Sales of our products acquired in the Antares acquisition in 2003 continue to
decrease and were $173,000 and $426,000 for the three and nine months ended July
31, 2005, respectively, as compared to $203,000 and $1.0 million for the same
periods in 2004. We expect to continue to see a degradation in the sales of
these products as they reach the end of their technological lifecycle. Sales of
our adapter products were $756,000 and $2.3 million for the three and nine
months ended July 31, 2005, respectively, as compared to $1.1 million and $3.6
million for the same periods in fiscal 2004. Sales of our HighWire products were
$703,000 and $1,994,000 for the three and nine months ended July 31, 2005,
respectively, as compared to $401,000 and $876,000 for the same periods in
fiscal 2004.
Our adapter products are used primarily in edge-of-the-network applications such
as Virtual Private Network ("VPN") and other routers, VoIP gateways and security
devices. Our HighWire products are primarily targeted at core-of-the-network
applications used primarily by telecommunications central offices and VoIP
providers. The Gigabit Ethernet and other adapter products we acquired in the
Antares acquisition are used primarily in enterprise applications such as
high-end servers and storage arrays using both Solaris and Linux software.
In the next few years, we expect our net sales will be generated primarily by
sales of our iSCSI storage software products, followed by sales of our
VoIP/HighWire products and with Linux software. We have begun to see market
acceptance of our iSCSI software products and have signed software contracts
with four OEM's in the storage marketplace including LSI Logic for use in
conjunction with their newly introduced iMegaRAID(R) adapter product and OnStor
for use in their Bobcat NAS gateway product. To date, our iSCSI software
products have been successfully integrated into solutions serving a variety of
applications, including security surveillance, storage virtualization, Network
Attached Storage ("NAS"), and Remote Access Storage ("RAS"). Our most recent
iSCSI customer is using our iSCSI software in conjunction with our TOE adapter
card in a storage gateway switching product. Although we expect to see sales
growth in our iSCSI products as these products continue to gain market
acceptance, there can be no assurance that such an increase or adoption will
occur. We also expect to see continued slowness in the sale of our adapter
products, but are encouraged by the acceptance of our HighWire products and
expect to see continued growth in these high margin products. In addition, we
will continue to sell and support our older VME products, but expect sales for
them to decline significantly as the OEM products in which they are embedded are
phased out.
Our sales backlog at July 31, 2005 was $1.6 million compared to a backlog on
July 31, 2004 of $3.9 million, including an HP order of VME products of $1.7
million. Our customers typically require a "just-in-time" ordering and delivery
cycle where they will
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place a purchase order with us after they receive an order from their customer.
This "just-in-time" inventory purchase cycle by our customers has made
forecasting of our future sales volumes very difficult. Because our sales are
generally concentrated among a small group of OEM customers, we could experience
significant fluctuations in our quarterly sales volumes due to fluctuating
demand from any major customer or delay in the rollout of any significant new
product by a major customer.
Gross Margin
Gross margin as a percentage of sales in the third quarter of fiscal 2005 was
38% compared to 53% for the third quarter of fiscal 2004. For the first nine
months of fiscal 2005 our gross margin was 46% compared to 54% for the same
period in fiscal 2004. The decrease in the gross margin is due primarily to the
product mix of our sales. In the quarter ended July 31, 2005, we had no sales to
HP as compared to net sales of $1.6 million in the same quarter of fiscal 2004
and in the nine months ended July 31, 2005, we had net sales of $1.0 million to
HP as compared to $4.2 million in the same period last year. The gross margin on
the HP sales was approximately 70% as compared to the average gross margin on
HighWire products approximately 60% and adapter products approximately 55%. We
also wrote down obsolete Antares inventory which contributed to the decline in
our gross margin for the quarter. We expect our gross margin to range between
47% and 49% for fiscal 2005. We expect to see a significant improvement in our
future gross margin as we begin to sell our iSCSI software and VoIP products.
Software is a very high gross margin product and our VoIP products will have a
60% gross margin and as these product lines increase as a percentage of our
total sales we will see a corresponding increase in our overall gross margin.
However, if market and economic conditions, particularly in the communications
and storage sectors, deteriorate or fail to recover, our gross margin may be
lower than expected.
We recorded $12.2 million in intellectual property costs consist of the
allocation of costs associated with the purchase of current and the design of
future products from PyX on July 26, 2005. All capitalized intellectual property
will be amortized to costs of goods expense over thirty-six months which is the
expected useful life. The quarterly amortization expense will be approximately
$1,015,000 and will commence on August 1, 2005.
Product Research and Development
Product research and development expenses for the three and nine months ended
July 31, 2005 were $626,000 and $1.7 million, respectively, a slight increase
from $548,000 and $1.6 million for the same periods in fiscal 2004. The increase
resulted primarily from the salaries related to engineering staffing increases.
We will continue to see increases in engineering expenses as a result of the PyX
acquisition. As part of the acquisition we hired four PyX engineers and will
continue to hire additional engineering resources, particularly software
engineers and engineering support personnel to continue to develop the iSCSI
storage software and VoIP products. We did not capitalize any internal software
development costs in the nine-month period ended July 31, 2005.
Sales and Marketing
Sales and marketing expenses for the three and nine month periods ended July 31,
2005
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were $520,000 and $1.6 million, respectively, a slight decrease from $539,000
and $1.6 million for the same periods in fiscal 2004. The decrease is primarily
due to decreased commissions directly related to decrease sales. We will
continue to increase our marketing program spending for iSCSI storage software
and VoIP products, in addition to hiring new marketing and sales personnel. We
hired a sales Vice President and an additional sales professional to sell our
PyX iSCSI storage product and will hire additional product managers and a
technical support engineers as required. We expect our sales and marketing
expenses to continue to increase as we execute against our sales and marketing
strategies in the coming year.
General and Administrative
General and administrative expenses for the three and nine months periods ended
July 31, 2005 were $446,000 and $1.2 million, respectively, an increase from
$376,000 and $1.1 million for the same periods of fiscal 2004. This increase was
due to an increase in our reserves for uncollectible accounts receivable in the
quarter ended July 31, 2005. In addition, we incurred considerable expense in
our compliance efforts related to Section 404 of the Sarbanes-Oxley Act of 2002.
We will continue to control our spending in the general and administrative side
of the business and focus the majority of our spending on our product
development and sales efforts.
We assumed the PyX employee stock option plan as part of the July 26, 2005
acquisition of PyX and recorded $2,484,000 of deferred compensation. The
amortization expense related to the deferred compensation will be include in our
general and administrative expense and will be amortized at the rate of $57,800
per month over the remaining 43 month vesting period beginning August 2005 and
ending February 2009.
Loan Reserve Benefit
On November 6, 1998, we made a loan to our former president and chief executive
offer, who retired as of December 31, 2004, which was used by him to exercise an
option to purchase 139,400 shares of our common stock and pay related taxes. The
loan, as amended, was collateralized by shares of our common stock, bore
interest at a rate of 2.48% per annum and was due on December 14, 2003.
On October 31, 2002, we determined that it was probable that we would be unable
to fully recover the balance of the loan on its due date of December 14, 2003.
Accordingly, a valuation allowance of $474,000 was recorded against the loan at
October 31, 2002.
During the fourth quarter of fiscal 2003, the officer repaid $362,800 of the
loan and, as a result, we recognized a benefit of $235,000 related to the
reversal of the loan impairment charge taken by us in fiscal 2002. During the
first quarter of fiscal 2004, the officer repaid the remaining loan balance in
full and, as a result, we recorded a benefit of $239,000 relating to the
reversal of the remaining loan impairment charge.
Net Income (Loss)
As a result of the factors discussed above, we recorded a net loss of $945,000
and $1.7 million in the three and nine months ended July 31, 2005, as compared
to net income of $79,000 and $660,000 for the same periods in fiscal 2004.
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Off-Balance Sheet Arrangements
We do not have any transactions, arrangements, or other relationships with
unconsolidated entities that are reasonably likely to affect our liquidity or
capital resources. We have no special purpose or limited purpose entities that
provide off-balance sheet financing, liquidity, or market or credit risk
support. We also do not engage in leasing, hedging, research and development
services, or other relationships that could expose us to liability that is not
reflected on the face of the financial statements.
Liquidity and Capital Resources
Our liquidity is dependent on many factors, including sales volume, operating
profit and the efficiency of asset use and turnover. Our future liquidity will
be affected by, among other things:
- the actual versus anticipated increase in sales of our products;
- ongoing cost control actions and expenses, including, for example,
research and development and capital expenditures;
- timing of product shipments which occur primarily during the last
month of the quarter;
- the gross profit margin;
- the ability to raise additional capital, if necessary; and
- the ability to secure credit facilities, if necessary.
At July 31, 2005, we had cash and cash equivalents of $5.0 million, as compared
to $1.8 million at October 31, 2004. In the first nine months of fiscal 2005,
$1.3 million of cash was used in operating activities primarily as a result of
generating net losses of $1.7 million for the nine months ended July 31, 2005.
The net loss for the period was partially offset by a decrease in our inventory
and trade accounts receivable. We had a decrease in our accounts payable and
other liabilities that served to use additional cash. The decrease in inventory
is due to the shipment of VME products to HP in January 2005 with an inventory
cost of approximately $300,000 that was held as inventory at October 31, 2004.
We have also been carefully controlling our spending on inventory and are
actively attempting to reduce our overall level of inventory. The decrease in
trade accounts receivable is due to a general decrease in overall sales activity
in fiscal 2005 as compared to the end of fiscal 2004. The decrease in accounts
payable is related to payments to our contract manufacturers in the beginning of
fiscal 2005 for finished goods inventory received at the end of October 2004.
Working capital, comprised of our current assets less our current liabilities,
at July 31, 2005 was $7.0 million, as compared to $3.9 million at October 31,
2004.
In the first nine months of fiscal 2005, we purchased $81,000 of fixed assets,
consisting primarily of computer and engineering equipment and $173,000 in
software, primarily for engineering and product design activities and payments
related to the contract to design our VoIP products. Capital expenditures for
the remaining quarter of fiscal 2005 is expected to range from $25,000 to
$100,000.
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We received $104,000 in the first nine months of fiscal 2005 from payments
related to common stock purchases made by employees pursuant to our employee
stock purchase plan and the exercise of employee stock options.
On July 27, 2005, we sold 2,060,000 shares of common stock plus warrants to
purchase 1,030,000 shares of common stock for approximately $5.2 million in a
private placement transaction with AIGH Investment Partners, LLC and other
accredited investors. The net cash proceeds after expenses were approximately
$5.0 million.
We cancelled our working capital line of credit with a Bank on its renewal date
of May 14, 2005.
Our projected quarterly cash flow break-even point is approximately $3.3 million
to $3.6 million in net sales at a gross margin of 75% to 77%. Although our
current gross margin is significantly lower than the mid-70% range, we expect
our gross margin to increase significantly as software sales become the dominant
product in our product sales mix. We do expect to continue to increase our
expenditures on engineering and sales and marketing activities to develop and
market new and existing products, especially in the IP storage and
communications markets. We will have significant non-cash expenses in the coming
quarters and years related to the amortization of the intellectual property and
deferred compensation recorded as a result of the PyX acquisition. Because of
the non-cash expenses related to the PyX acquisition and anticipated increases
in our expenditure levels, we expect to generate net losses for the foreseeable
future. Our projected sales are to a limited number of new and existing OEM
customers and are based on internal and customer-provided estimates of future
demand, not firm customer orders. In addition, the markets for IP storage,
particularly iSCSI NAS and SAN storage appliances, is a new market and may not
gain acceptance as quickly as we predict. If our projected sales do not
materialize, we may need to reduce expenses and raise additional capital through
customer prepayments or the issuance of debt or equity securities. If additional
funds are raised through the issuance of preferred stock or debt, these
securities could have rights, privileges or preferences senior to those of
common stock, and debt covenants could impose restrictions on our operations.
The sale of equity or debt could result in additional dilution to current
stockholders, and such financing may not be available to us on acceptable terms,
if at all.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Our cash and cash equivalents are subject to interest rate risk. We invest
primarily on a short-term basis, principally money market instruments with
maturities of less than three months. We have no other investments with
significant interest rate risks. If interest rates increased by 10%, the
expected effect on net income related to our financial instruments would be
immaterial. We hold no assets or liabilities denominated in a foreign currency.
Since October 31, 2004, there has been no change in our exposure to market risk.
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Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
An evaluation as of July 31, 2005 was carried out under the supervision of
and with the participation of the Company's management, including the Company's
Chief Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of the Company's "disclosure controls and procedures,"
which are defined under SEC rules as controls and other procedures of a company
that are designed to ensure that information required to be disclosed by a
company in the reports that it files under the Securities Exchange Act of 1934
(the "Exchange Act") is recorded, processed, summarized and reported within
required time periods. Based upon that evaluation, the Company's Chief Executive
Officer and Chief Financial Officer concluded that the Company's disclosure
controls and procedures were effective.
Changes in Internal Controls over Financial Reporting
The Company's management, including the Company's Chief Executive Officer
and Chief Financial Officer, has evaluated any changes in the company's internal
control over financial reporting that occurred during the quarter ended July 31,
2005, and has concluded that there was no change during such quarter that has
materially affected, or is reasonably likely to materially affect, the Company's
internal control over financial reporting.
Limitations on the Effectiveness of Controls
A control system, no matter how well conceived and operated, can provide
only reasonable, not absolute, assurance that the objectives of the controls are
met. Because of the inherent limitations in all control systems, no evaluation
of controls can provide absolute assurance that all control issues, if any,
within a company have been detected. Accordingly, the Company's disclosure
controls and procedures are designed to provide reasonable, not absolute,
assurance that the objectives of our disclosure control system are met and, as
set forth above, the Company's Chief Executive Officer and Chief Financial
Officer have concluded, based on their evaluation as of the end of the period
covered by this quarterly report on Form 10-Q, that the Company's disclosure
controls and procedures were sufficiently effective to provide reasonable
assurance that the objectives of the Company's disclosure control system were
met.
PART II. Other Information
Item 4. Submission of Matters to a Vote of Security Holders
(a) A special meeting of stockholders was held on Tuesday, July 26, 2005, at
our corporate offices located at 2305 Camino Ramon, Suite 200, San Ramon,
California.
The stockholders approved the following two items:
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1. Approval of the merger agreement between the Company and PyX
Technologies, Inc. and the issuance of 2,561,050 shares of the Company's common
stock to PyX Technologies, Inc. shareholders, was 2,727,537 votes for to 38,540
votes against with 13,355 votes abstaining; on that basis, the merger agreement
was ratified and approved.
2. Approve the unit subscription agreement and the issuance of units
consisting of one share of the Company's common stock and a warrant to purchase
an additional one-half share of the Company's common stock for an aggregate
gross proceeds of $5,150,000 in a private placement, was 2,723,452 votes for to
41,922 votes against with 14,058 votes abstaining; on that basis, the unit
subscription agreement was ratified and approved.
Item 6. Exhibits
Exhibit
Number Description
------- -----------
2.1 (1) Asset Purchase Agreement dated August 8, 2003, by and
between D.R. Barthol & Company and SBE, Inc.
2.2 Agreement and Plan of Merger and Reorganization, dated March 28,
2005, by and among SBE, Inc., PyX Acquisition Sub, LLC, PyX
Technologies, Inc. and the parties identified on Exhibit A
thereto.
3.1(2) Certificate of Incorporation, as amended through
December 15, 1997.
3.2(3) Bylaws, as amended through December 8, 1998.
4.1 Investor Rights Agreement, dated July 26, 2005, between SBE,
Inc. and the investors listed on Exhibit A thereto.
4.2 Form of warrant issued on July 26, 2005.
10.1(4)* 1996 Stock Option Plan, as amended.
10.2(4)* 1991 Non-Employee Directors' Stock Option Plan, as amended.
10.3(4) 1992 Employee Stock Purchase Plan, as amended.
10.4(4) 1998 Non-Officer Stock Option Plan as amended.
10.5(5) Lease for 4550 Norris Canyon Road, San Ramon, California dated
November 2, 1992 between the Company and PacTel Properties.
10.6(6) Amendment dated June 6, 1995 to lease for 4550 Norris Canyon
Road, San Ramon, California, between the Company and CalProp
L.P. (assignee of PacTel Properties).
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10.7(4)* Full Recourse Promissory Note executed by William B. Heye, Jr.
in favor of the Company dated November 6, 1998, as amended and
restated on December 14, 2001.
10.8(4)+ Letter Agreement, dated October 30, 2001, amending (i)
Amendment No. S/M018-4 dated April 3, 2001, and (ii) Purchase
Agreement dated May 6, 1991, each between SBE, Inc. and Compaq
Computer Corporation
10.9(7) Stock subscription agreement and warrant to purchase 111,111 of
SBE, Inc. Common Stock dated April 30, 2002 between SBE, Inc.
and Stonestreet Limited Partnership.
10.10(8) Amendment dated August 22, 2002 to stock subscription agreement
dated April 20, 2002 between SBE, Inc. and Stonestreet LP.
10.11(9) Securities Purchase Agreement, dated July 27, 2003, between
SBE, Inc. and purchasers of SBE's common stock thereunder,
including form of warrant issued thereunder
10.12(9) Form of warrant issued to associates of Puglisi & Co. ($1.50
exercise price)
10.13(9) Form of warrant issued to associates of Puglisi & Co. ($1.75 and
$2.00 exercise price)
10.14 Unit Subscription Agreement, dated May 4, 2005, by and between
SBE, Inc. and the other parties thereto.
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32.1 Certification required pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
* Indicates management contract or compensation plans or
arrangements filed pursuant to Item 601(b)(10) of Regulation SK.
+ Certain confidential information has been deleted from this
exhibit pursuant to a confidential treatment order that has
been granted.
(1) Filed as an exhibit to Current Report on Form 8-K, dated
April 30, 2002 and incorporated herein by reference.
(2) Filed as an exhibit to Annual Report on Form 10-K for the year
ended October 31, 1997 and incorporated herein by reference.
(3) Filed as an exhibit to Annual Report on Form 10-K for the
year ended October 31, 1998 and incorporated herein by
reference.
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(4) Filed as an exhibit to Annual Report on Form 10-K for the year
ended October 31, 2002 and incorporated herein by reference.
(5) Filed as an exhibit to Annual Report on Form 10-K for the year
ended October 31, 1993 and incorporated herein by reference.
(6) Filed as an exhibit to Annual Report on Form 10-K for the year
ended October 31, 1995 and incorporated herein by reference.
(7) Filed as an exhibit to Registration Statement on Form S-3 dated
May 23, 2002 and incorporated herein by reference.
(8) Filed as an exhibit to Quarterly Report on Form 10-Q for the
quarter ended July 31, 2002 and incorporated herein by
reference.
(9) Filed as an exhibit to Registration Statement on Form S-3 dated
July 11, 2003 and incorporated herein by reference.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized, on August 31, 2005.
SBE, Inc.
---------
Registrant
Date: August 31, 2005 By: /s/ Daniel Grey
------------------
Daniel Grey.
Chief Executive Officer and
President
(Principal Executive Officer)
Date: August 31, 2005 By: /s/ David W. Brunton
------------------------------
David W. Brunton
Chief Financial Officer,
Vice President, Finance
and Secretary
(Principal Financial and
Accounting Officer)
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