10-Q 1 a77919e10-q.txt FORM 10-Q QUARTER ENDED OCTOBER 31, 2001 Securities and Exchange Commission Washington, DC 20549 REPORT ON FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 31, 2001 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________ to _______________ Commission file number 0-21053 PROCOM TECHNOLOGY, INC. (Exact name of registrant as specified in its charter) California 33-0268063 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 58 Discovery, Irvine California 92618 (Address of principal executive office) (Zip Code) (949) 852-1000 (Registrant's telephone number, including area code) (Former name, former address and former fiscal year, if changed since last report.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The number of shares of Common Stock, $.01 par value, outstanding on November 28, 2001 was 15,998,064. PART I FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
OCTOBER 31, JULY 31, 2001 2001 ------------ ------------ ASSETS Current assets: Cash and cash equivalents ....................... $ 22,086,000 $ 25,419,000 Accounts receivable, less allowances for doubtful accounts and sales returns of $9,001,000 and $6,412,000, respectively .................. 10,953,000 11,979,000 Inventories ..................................... 6,033,000 6,292,000 Income tax receivable ........................... 14,000 18,000 Prepaid expenses ................................ 1,208,000 1,184,000 Other current assets ............................ 279,000 310,000 ------------ ------------ Total current assets ........................ 40,573,000 45,202,000 Property and equipment, net ....................... 17,422,000 17,766,000 Other assets ...................................... 2,160,000 2,259,000 ------------ ------------ Total assets ................................ $ 60,155,000 $ 65,227,000 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Lines of credit ................................. $ -- $ 8,000 Accounts payable ................................ 3,365,000 4,151,000 Flooring line obligation ........................ 1,023,000 531,000 Accrued expenses and other current liabilities .. 2,473,000 2,052,000 Accrued compensation ............................ 903,000 1,194,000 Deferred service revenues ....................... 504,000 447,000 Income taxes payable ............................ 51,000 51,000 Convertible debenture ........................... 9,879,000 9,726,000 ------------ ------------ Total current liabilities ................... 18,198,000 18,160,000 Commitments and contingencies Shareholders' equity: Preferred stock, no par value; 10,000,000 shares authorized, no shares issued and outstanding .. -- -- Common stock, $.01 par value; 65,000,000 shares authorized, 15,998,064 and 15,993,564 shares issued and outstanding, respectively .......... 160,000 160,000 Additional paid-in capital ...................... 58,616,000 58,575,000 Accumulated deficit ............................. (16,655,000) (11,343,000) Accumulated other comprehensive loss ............ (164,000) (325,000) ------------ ------------ Total shareholders' equity .................. 41,957,000 47,067,000 ------------ ------------ Total liabilities and shareholders' equity .. $ 60,155,000 $ 65,227,000 ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 2 PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS ENDED ------------------------------ OCTOBER 31, OCTOBER 31, 2001 2000 ------------ ------------ Net sales $ 8,290,000 $ 13,264,000 Cost of sales 4,394,000 8,382,000 ------------ ------------ Gross profit 3,896,000 4,882,000 Selling, general and administrative expenses 7,234,000 4,669,000 Research and development expenses 1,651,000 1,772,000 ------------ ------------ Total operating expenses 8,885,000 6,441,000 ------------ ------------ Operating loss (4,989,000) (1,559,000) Interest income 191,000 222,000 Interest expense (514,000) (148,000) ------------ ------------ Loss before income taxes (5,312,000) (1,485,000) Income tax benefit -- 394,000 ------------ ------------ Net loss $ (5,312,000) $ (1,091,000) ============ ============ Net loss per common share: Basic and diluted $ (0.33) $ (0.09) ============ ============ Weighted average number of common shares: Basic and diluted 15,997,000 11,570,000 ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (UNAUDITED)
RETAINED COMMON STOCK ADDITIONAL EARNINGS ACC. OTHER ---------------------- PAID IN (ACCUMULATED COMPREHENSIVE SHARES AMOUNT CAPITAL DEFICIT) LOSS TOTAL ----------- -------- ----------- ------------ ------------- ------------ BALANCE AT JULY 31, 2000 ................. 11,531,357 115,000 19,685,000 8,007,000 (251,000) 27,556,000 Comprehensive loss: Net loss ................................. -- -- -- (19,350,000) -- (19,350,000) Foreign currency translation adjustment .. -- -- -- -- (74,000) (74,000) ------------ Comprehensive loss ..................... (19,424,000) Issuance of common stock through public offering, net of issuance costs of $2.7 million........................... 3,800,000 38,000 31,453,000 -- -- 31,491,000 Acquisition of business .................. 480,000 5,000 5,755,000 -- -- 5,760,000 Compensatory stock options ............... -- -- 41,000 -- -- 41,000 Exercise of employee stock options ....... 157,401 2,000 845,000 -- -- 847,000 Issuance of stock to employees ........... 24,806 -- 234,000 -- -- 234,000 Issuance of stock warrant to investor .... -- -- 562,000 -- -- 562,000 ----------- -------- ----------- ------------ --------- ------------ BALANCE AT JULY 31, 2001 ................. 15,993,564 160,000 58,575,000 (11,343,000) (325,000) 47,067,000 ----------- -------- ----------- ------------ --------- ------------ Comprehensive loss: Net loss ................................. -- -- -- (5,312,000) -- (5,312,000) Foreign currency translation adjustment .. -- -- -- -- 161,000 161,000 ------------ Comprehensive loss ..................... (5,151,000) Compensatory stock options ............... -- -- 18,000 -- -- 18,000 Exercise of employee stock options ....... 4,500 -- 23,000 -- -- 23,000 ----------- -------- ----------- ------------ --------- ------------ BALANCE AT OCTOBER 31, 2001 .............. 15,998,064 $160,000 $58,616,000 $(16,655,000) $(164,000) $ 41,957,000 =========== ======== =========== ============ ========= ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 4 PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
THREE MONTHS ENDED OCTOBER 31, ------------------------------- 2001 2000 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ........................................................ $ (5,312,000) $ (1,091,000) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization ................................. 549,000 215,000 Amortization of debt issuance costs related to stock warrant .. 153,000 -- Compensatory stock options .................................... 18,000 6,000 Deferred income taxes ......................................... -- (298,000) Changes in operating accounts: Accounts receivable ....................................... 1,026,000 (2,331,000) Inventories ............................................... 259,000 (889,000) Income tax receivable ..................................... 4,000 2,678,000 Prepaid expenses .......................................... (24,000) (814,000) Other current assets ...................................... 31,000 120,000 Other assets .............................................. (20,000) (2,000) Accounts payable .......................................... (786,000) (1,603,000) Accrued expenses and compensation ......................... 130,000 115,000 Deferred service revenues ................................. 57,000 280,000 Income taxes payable ...................................... -- 19,000 ------------ ------------ Net cash used in operating activities ................... (3,915,000) (3,595,000) ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment ............................ (86,000) (1,498,000) CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of convertible debenture ............................. -- 15,000,000 Repayment of loan ............................................ -- (10,750,000) Net borrowings (repayments) on lines of credit ................ (8,000) 4,987,000 Flooring line obligation ...................................... 492,000 (368,000) Proceeds from exercise of stock options ....................... 23,000 442,000 ------------ ------------ Net cash provided by financing activities ............... 507,000 9,311,000 Effect of exchange rate changes ................................. 161,000 (161,000) ------------ ------------ Increase (decrease) in cash and cash equivalents ................ (3,333,000) 4,057,000 Cash and cash equivalents at beginning of period ................ 25,419,000 15,515,000 ------------ ------------ Cash and cash equivalents at end of period ...................... $ 22,086,000 $ 19,572,000 ============ ============ Supplemental disclosures of cash flow information: CASH PAID (RECEIVED) DURING THE PERIOD: Interest ...................................................... $ 150,000 $ 117,000 Income taxes .................................................. $ (38,000) $ (2,732,000) SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITIES: Common stock warrant issued to convertible debenture investor .................................................... $ -- $ 582,000
The accompanying notes are an integral part of these condensed consolidated financial statements. 5 PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. GENERAL. The accompanying financial information is unaudited, but in the opinion of management, reflects all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position of Procom Technology, Inc. and its consolidated subsidiaries (the "Company") as of the dates indicated and the results of operations for the periods then ended. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. While the Company believes that the disclosures are adequate to make the information presented not misleading, the financial information should be read in conjunction with the audited financial statements and notes thereto included in the Company's Report on Form 10-K for fiscal 2001. Results for the interim periods presented are not necessarily indicative of the results for the entire year. NOTE 2. INVENTORIES. Inventories are summarized as follows:
October 31, 2001 July 31, 2001 ---------------- ------------- Raw materials $3,550,000 $4,374,000 Work in process 399,000 295,000 Finished goods 2,084,000 1,623,000 ---------- ---------- Total $6,033,000 $6,292,000 ========== ==========
NOTE 3. NET LOSS PER SHARE. Basic net loss per share is computed using the weighted average number of shares of common stock outstanding during the period. Diluted net loss per share is computed using the weighted average number of shares of common stock outstanding and potentially dilutive common shares outstanding during the period. Potentially dilutive common shares consist of stock options and warrants. For the periods presented, basic and diluted net loss per share was based on the weighted average number of shares of common stock outstanding during the period. For the three months ended October 31, 2001 and 2000, respectively, the dilutive effect of options to purchase 71,000 and 1,394,000 shares of common stock, respectively, were not included in the computation of net loss per share as the effect would have been antidilutive. NOTE 4. COMPREHENSIVE LOSS. For the three months ended October 31, 2001 and 2000, the only differences between reported net loss and comprehensive loss was a foreign currency translation adjustment gain of $161,000 and a loss of $161,000, respectively. NOTE 5. BUSINESS SEGMENT INFORMATION. The Company operates in one industry segment: The design, manufacture and marketing of data storage devices. The Company has two major distinct product families: network attached storage products ("NAS") and other data storage products ("Legacy"), which includes disk drive storage upgrade systems, CD/DVD-ROM servers and arrays and tape backup products. Net sales of NAS products represented 82% and 59% of total product net sales for the three months ended October 31, 2001 and 2000, respectively. International sales as a percentage of net sales amounted to 50% and 58% for the three months ended October 31, 2001 and 2000, respectively. International sales were primarily to European customers. Identifiable assets used in connection with the Company's foreign operations were $8.8 million at October 31, 2001 and $8.5 million at July 31, 2001. NOTE 6. LINES OF CREDIT AND CONVERTIBLE DEBENTURE. On October 10, 2000, the Company entered into a term loan agreement and a three-year working capital line of credit with The CIT Group/Business Credit ("CIT"). A term loan of $4.0 million, due and payable upon the Company's finalization of a long-term mortgage on its corporate headquarters or paid in 12 monthly installments commencing April 1, 2001, was repaid in May 2001. An initial term loan of $1.0 million, due and payable in 90 days, was repaid on November 1, 2000. The term loans under the agreement incurred interest at the lender's prime rate (6.0% per annum at October 31, 2001), plus .5%, with increases if the 6 outstanding principal was not reduced according to a fixed amortization. The working capital line of credit allows for the Company to borrow, on a revolving basis, for a period of three years, a specified percentage of its eligible accounts receivable and inventories (approximately $2.9 million at October 31, 2001), up to a limit of $5.0 million. Amounts outstanding under the working capital line bear interest at the lender's prime rate plus .25%. At October 31, 2001, no amounts were outstanding under the various credit arrangements. The lender charged approximately $130,000 for the credit facility which is being amortized as interest expense over the term of the credit agreement. The line of credit accrues various monthly maintenance, minimum usage and early termination fees. The line of credit requires certain financial and other covenants, including the maintenance of a minimum EBITDA requirement for each fiscal quarter beginning in the quarter ended January 31, 2001. At October 31, 2001, the Company was not in compliance with the minimum EBITDA requirement. The lender has waived compliance with the covenant at October 31, 2001. The line of credit is collateralized by all of the assets of the Company. In addition to the CIT line of credit noted above, the Company has a flooring line with IBM Credit which, has committed to make $2.5 million in flooring inventory commitments available to the Company. As of October 31, 2001 and July 31, 2001, we owed $1,023,000 and $531,000, respectively, under the flooring line. The flooring line is collateralized by the specific inventory purchased pursuant to the flooring commitments. CIT and IBM Credit have entered into an intercreditor agreement which determines the level of priority of either lender's security interest. The flooring line requires the maintenance by the Company of a minimum net worth of $16.0 million. The Company was in compliance with the terms of the flooring line at October 31, 2001. The flooring line also requires the Company not to be in default of any covenants in the CIT agreement. IBM Credit has waived compliance with that requirement at October 31, 2001. On October 31, 2000, the Company issued a $15.0 million convertible unsecured debenture to a private investor. The debenture bears interest at 6.0% per annum, and is repayable in full on October 31, 2003, unless otherwise converted into the common stock of the Company. The debenture is convertible into the common stock of the Company at the investor's option at an initial conversion price of $22.79 per share, subject to antidilution adjustments, and at the Company's option, if the common stock of the Company trades at more than 135% of the conversion then in effect for at least 20 consecutive trading days. The conversion price can be adjusted if the Company sells shares of its common stock at a price less than $22.79 per share while the debentures are outstanding. The conversion price under the debenture automatically re-sets periodically. During these re-set periods, the conversion price will, for five consecutive trading days, adjust to 90% of the average closing price of the Company's stock during the 10 trading days preceding each re-set period if this amount is less than the conversion price that would otherwise apply. The first re-set period began on May 15, 2001 and ended May 21, 2001. The second re-set period began on October 31, 2001 and ended November 5, 2001. The next re-set period will begin on April 30, 2002 and additional re-set periods will occur every six months thereafter. During the first re-set period, the investor elected to convert $5.0 million of the debenture at the re-set conversion price. The Company had the option and elected to pay the investor in cash the $5.0 million principal amount of the debenture that the investor elected to convert during the first re-set period. During the second re-set period, the investor elected to convert $5.0 million of the debentures at the re-set conversion price. Subsequent to October 31, 2001, the Company paid the investor in cash the $5.0 million principal amount of the debentures that the investor elected to convert during the second re-set period. The remaining $5.0 million of the debentures, plus any unpaid interest on that amount, may be converted at the re-set conversion price at the third re-set period beginning on April 30, 2002 and at the additional re-set periods that will occur every six months thereafter until October 31, 2003. The Company has the right to pay the investor in cash the principal amount of any portion of the debenture the investor elects to convert during a re-set period. The Company also has the right to repurchase all, or any portion, of the outstanding principal amount of this debenture at a price equal to 110% of the outstanding principal amount, plus any unpaid interest at any time. If the Company were to issue shares at 90% of the trading price of its common stock upon conversion of the debenture during a re-set period, the Company would incur a charge to its statements of operations, which could be significant, based on the difference between the issuance price of the Company's common stock and the value of the common stock at October 31, 2000. In connection with the issuance of the debenture, the Company issued to the investor a 5-year warrant to purchase up to 32,916 shares of its common stock at an initial exercise price of $32.55 per share, with the number of shares for which the warrant is exercisable and the exercise price subject to antidilution adjustments. The Company has valued the warrant using the Black-Scholes model, with the following assumptions: Expected life -- 5 years, Risk free interest rate -- 6%, and Volatility -- 1.20. These factors yield a value of $562,000, of which $441,000 has been amortized as of October 31, 2001 and the balance will be amortized through May 2002. The principal amount of the debenture, net of the remaining unamortized warrant value is classified as a current liability. At October 31, 2001, the debenture amount repayable was $10,000,000 and the unamortized warrant value was $121,000, for a net debenture value of $9,879,000. In addition to the warrant cost, approximately $700,000 of debt issuance costs were incurred in the debt transactions noted above. The unamortized debt issuance costs of approximately $352,000 is included in prepaid expenses and will be amortized through May 2002. In June 2001, the Company completed the sale of 3,800,000 shares of common stock raising gross proceeds of approximately $34.2 million before offering costs of $2.7 million. As a result of this offering, the conversion price of the outstanding debenture was adjusted pursuant to a weighted average adjustment under the terms of the debenture. The adjusted conversion price is $19.57 pursuant to a weighted average adjustment under the terms of the debenture. In addition, the completion of the offering resulted in an adjustment to the exercise price of the warrant and to the number of our shares issuable upon exercise of the warrant pursuant to 7 anti-dilution provisions of the warrant. As so adjusted, the warrant exercise price is $27.95 and the number of shares issuable upon exercise of the warrant is 38,333. In addition to the line of credit, our foreign subsidiaries in Germany, Italy and Switzerland have lines of credit with banks in their respective countries that are utilized primarily for overdraft and short-term cash needs. At October 31, 2001, no amounts were outstanding under these lines. NOTE 7. RECENT ACCOUNTING PRONOUNCEMENTS. In July 2001, the FASB issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. SFAS 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. SFAS 142 will require that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 will also require that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The Company is required to adopt the provisions of SFAS 141 immediately, except with regard to business combinations initiated prior to July 1, 2001, which it expects to account for using the pooling-of-interests method, and SFAS 142 is effective August 1, 2002. Furthermore, any goodwill and any intangible asset determined to have an indefinite useful life that are acquired in a purchase business combination completed after June 30, 2001 will not be amortized, but will continue to be evaluated for impairment in accordance with the appropriate pre-SFAS 142 accounting literature. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 will continue to be amortized prior to the adoption of SFAS 142. SFAS 141 will require upon adoption of SFAS 142, that the Company evaluate its existing intangible assets and goodwill that were acquired in a prior purchase business combination, and to make any necessary reclassifications in order to conform with the new criteria in SFAS 141 for recognition apart from goodwill. Upon adoption of SFAS 142, the Company will be required to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations, and make any necessary amortization period adjustments by the end of the first interim period after adoption. In addition, to the extent an intangible asset is identified as having an indefinite useful life, the Company will be required to test the intangible asset for impairment in accordance with the provisions of SFAS 142 within the first interim period. Any impairment loss will be measured as of the date of adoption and recognized as the cumulative effect of a change in accounting principle in the first interim period. In connection with the transitional goodwill impairment evaluation, SFAS 142 will require the Company to perform an assessment of whether there is an indication that goodwill is impaired as of the date of adoption. To accomplish this, the Company must identify its reporting units and determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of the date of adoption. The Company will then have up to six months from the date of adoption to determine the fair value of each reporting unit and compare it to the reporting unit's carrying amount. To the extent a reporting unit's carrying amount exceeds its fair value, an indication exists that the reporting unit's goodwill may be impaired and the Company must perform the second step of the transitional impairment test. In the second step, the Company must compare the implied fair value of the reporting unit's goodwill, determined by allocating the reporting unit's fair value to all of it assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with SFAS 141, to its carrying amount, both of which would be measured as of the date of adoption. This second step is required to be completed as soon as possible, but no later than the end of the year of adoption. Any transitional impairment loss will be recognized as the cumulative effect of a change in accounting principle in the Company's statement of earnings. And finally, any unamortized negative goodwill existing at the date SFAS 142 is adopted must be written off as the cumulative effect of a change in accounting principle. As of the date of adoption, the Company expects to have unamortized goodwill in the amount of $1,140,000, and unamortized identifiable intangible assets in the amount of $630,000, all of which will be subject to the transition provisions of SFAS 141 and 142. Amortization expense related to goodwill was $119,000 and $42,000 for the quarters ended October 31, 2001 and 2000, respectively. Because of the extensive effort needed to comply with adopting SFAS 141 and 142, it is not practicable to reasonably estimate the impact of adopting these statements on the Company's financial statements at the date of this report, including whether any transitional impairment losses will be required to be recognized as the cumulative effect of a change in accounting principle. In October 2001, the FASB issued SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets." SFAS 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed 8 Of," and addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement is effective for fiscal years beginning after December 15, 2001. Adoption of this statement will not have a material impact on the Company's consolidated financial position or results of operations. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. We develop, manufacture and market NAS appliances and other storage devices for a wide range of computer networks and operating systems. Our NAS appliances, which consist of our DataFORCE and NetFORCE product lines, provide end-users with faster access to data at a lower overall cost than other storage alternatives. We refer to these products collectively as our NAS appliances. In addition, we sell disk drive storage upgrade systems, CD/DVD-ROM servers and arrays and tape backup products, which we refer to collectively as our Legacy products. Over the last four years, we have significantly increased our focus on the development and sale of NAS appliances. We continue to develop more advanced NAS appliances and expect this business to be our principal business in the future. We are currently analyzing the market demands and opportunities for all of our Legacy products, and we hope to transition users of these products to our growing line of more robust, generally higher margin NAS solutions. Changing Business Mix. We have experienced significantly reduced demand, revenues and gross margins for our Legacy products and, as a result, have discontinued some of these Legacy products. The demand for our CD servers and arrays has declined and we have experienced increased pricing pressures on our disk drive storage upgrade systems, resulting in lower overall revenues and gross margins. Our gross margins vary significantly by product line, and, therefore, our overall gross margin varies with the mix of products we sell. For example, our sales of CD servers and arrays have historically generated higher gross margins than those of our tape back-up and disk drive products. In future periods, as sales of our higher margin NAS appliances continue to increase as a percentage of total sales, we expect our overall gross margins to be positively affected. Our revenues and gross margins have been and may continue to be affected by a variety of factors including: - new product introductions and enhancements; - competition; - direct versus indirect sales; - the mix and average selling prices of products; and - the cost of labor and components. Revenue and Revenue Recognition. We sell NAS appliances primarily through direct sales channels and resellers. Revenue is generally recorded upon product shipment, while product service and support revenues are recognized over the terms of their respective contractual periods. We maintain reserves, which are adjusted at each reporting date, to estimate anticipated returns relating to each reporting period based on historical rates of sales returns. We sell Legacy products primarily through distributors. Revenue is recorded when the distributor receives the product. Our agreements with our distributors allow limited product returns, including stock balancing and price protection privileges. We maintain reserves, which are adjusted at each financial reporting date, to estimate anticipated returns, including stock balancing and price protection claims, relating to each reporting period. The reserves are based on historical rates of sales and returns, including price protection and stock balancing claims, and the level of our product held by our customers in their inventory. In addition, under a product evaluation program established by us, our indirect channel partners and end-users generally are able to purchase NAS appliances on a trial basis and return the appliances within a specified period, generally 30-60 days, if they are not satisfied. The period may be extended if the customer needs additional time to evaluate the product within the customer's particular operating environment. The value of evaluation units at customer sites at a financial reporting date are included in inventory as finished goods. At both October 31, 2001 and July 31, 2001, inventory related to evaluation units was approximately $2.2 million. We do not record evaluation units as sales until the customer has notified us of acceptance of these units. Cost of Sales. Our cost of sales consists primarily of the cost of components produced by our suppliers, such as disk drives, cabinets, power supplies, controllers and CPUs, our direct and indirect labor expenses and related overhead costs such as rent, utilities and manufacturing supplies and other expenses. In addition, cost of sales includes third party license fees, warranty expenses and reserves for obsolete inventory. 9 Selling, General and Administrative Expenses. Selling expenses consist primarily of costs directly associated with the selling process such as salaries and commissions of sales personnel, marketing, direct and cooperative advertising and travel expenses. General and administrative expenses include our general corporate expenses, such as salaries and benefits, rent, utilities, bad debt expense, legal and other professional fees and expenses, depreciation and amortization of goodwill. These costs are expensed as incurred. Research and Development Expenses. Research and development expenses consist of the costs associated with software and hardware development. Specifically, these costs include employee salaries and benefits, consulting fees for contract programmers, test supplies, employee training and other related expenses. The cost of developing new appliances and substantial enhancements to existing appliances are expensed as incurred. The following table sets forth consolidated statement of operations data as a percentage of net sales for each of the periods indicated:
THREE MONTHS ENDED OCTOBER 31, ------------------------------ STATEMENT OF OPERATIONS 2001 2000 ----- ----- Net sales 100.0% 100.0% Cost of sales 53.0 63.2 ----- ----- Gross profit 47.0 36.8 Operating expenses: Selling, general and administrative 87.3 35.2 Research and development 19.9 13.4 ----- ----- Total operating expenses 107.2 48.6 ----- ----- Operating loss (60.2) (11.8) ----- ----- Interest income (expense), net (3.9) 0.6 ----- ----- Loss before income taxes (64.1) (11.2) Income tax benefit -- 3.0 ----- ----- Net loss (64.1)% (8.2)% ===== =====
COMPARISON OF THREE MONTHS ENDED OCTOBER 31, 2001 AND 2000 Net sales decreased by 37.5% to $8.3 million for the three months ended October 31, 2001, from $13.3 million for the three months ended October 31, 2000. This decrease resulted primarily from a $3.9 million decrease in sales of our Legacy products and sales of $3.8 million to a European storage service provider in the first quarter of fiscal 2001 that were not repeated in the first quarter of fiscal 2002. Net sales related to our NAS products decreased 13.3% to $6.8 million for the three months ended October 31, 2001, from $7.9 million for the three months ended October 31, 2000. Excluding sales of $3.8 million to a European storage service provider in the first quarter of fiscal 2001 that were not repeated in the first quarter of fiscal 2002, NAS sales increased $2.7 million, or 66%, for the first quarter of 2002 compared to same period in fiscal 2001. As a percentage of total net sales, NAS product sales increased from 59% for the three months ended October 31, 2000 to 82% for the three months ended October 31, 2001. International sales were $4.1 million, or 49.5% of our net sales, for the three months ended October 31, 2001 compared to $7.7 million, or 58.0% of our net sales, for the three months ended October 31, 2000. This decrease is due primarily to sales of $3.8 million to a European storage service provider in the first quarter of fiscal 2001,as previously mentioned, that were not repeated in the first quarter of fiscal 2002. Gross profit decreased to $3.9 million for the three months ended October 31, 2001 from $4.9 million for the comparable period in fiscal 2001. The decrease in gross profit was primarily the result of lower sales for the three months ended October 31, 2001. Gross margin increased to 47.0% for the three months ended October 31, 2001, from 36.8% for the comparable period in fiscal 2001. The increase in gross margin was primarily the result of the higher percentage of NAS sales, which have higher margins. Selling, general and administrative expenses increased 54.9% to $7.2 million for the three months ended October 31, 2001, from $4.7 million in the comparable period of fiscal 2001 and increased as a percentage of net sales to 87.3% from 35.2%. In the first quarter of fiscal 2002, we increased our accounts receivable reserve $2.8 million due to the financial instability of three of our international customers. Excluding this additional provision, selling, general and administrative expenses decreased $0.3 million for the three months ended October 31, 2001 compared to the same period in fiscal 2001. The dollar decrease was primarily the result of a reduction in selling expenses associated with our Legacy products, reduced advertising and marketing costs, legal fees and lower expenses of our German subsidiary. This decrease was partially offset by increased sales and administrative salaries and 10 commissions in support of NAS sales and marketing efforts, along with increased selling and administrative costs of our Italian and Switzerland subsidiaries. Research and development expenses decreased 6.8% to $1.7 million, or 19.9% of net sales, in for the three months ended October 31, 2001, from $1.8 million, or 13.4% of net sales, for the three months ended October 31, 2000. The dollar decrease was due primarily to reduced expenses for outside programmers offset slightly by increased compensation expense for additional NAS software programmers and hardware developers. Interest income decreased 14.0% to $191,000 for the three months ended October 31, 2001, from $222,000 for the comparable period of fiscal 2001. This decrease is due primarily to a decline in the average interest rates earned on our investable cash balance. Interest expense increased to $0.5 million for the three months ended October 31, 2001 compared to $0.1 million for the three months ended October 31, 2000. The increase is attributable to the issuance of a $15.0 million 6% convertible debenture and the amortization of debt issuance costs. Income Tax Benefit. For the quarter ended October 31, 2001, we recorded no tax benefit as we recorded a valuation allowance equal to the deferred tax asset. The realization of the tax benefits relating to our net deferred tax asset will be dependent on our ability to return to profitability. LIQUIDITY AND CAPITAL RESOURCES As of October 31, 2001, we had cash and cash equivalents totaling $22.1 million. This cash balance does not reflect our payment on November 8, 2001, of $5.0 million principal amount on the debenture. Net cash used in operating activities was $3.9 million for the three months ended October 31, 2001 and $3.6 million for the three months ended October 31, 2000. Net cash used in operating activities in the three months ended October 31, 2001 relates primarily to our net loss and a decrease in our accounts payable. These uses of cash were offset partially by decreases in our inventories and accounts receivable. Net cash used in operating activities in the three months ended October 31, 2000 relates primarily to our net loss, increases in our accounts receivable and inventories and decreases in accounts payable, partially offset by a reduction of approximately $2.7 million in our income tax refund receivable. Net cash used in investing activities of $0.1 million for the three months ended October 31, 2001 was the result of purchases of property and equipment. Net cash used in investing activities of $1.5 million for the three months ended October 31, 2000 was the result of purchases of $1.3 million to complete our corporate headquarters and $0.2 million of other property and equipment. Net cash provided by financing activities of $0.5 million for the three months ended October 31, 2001 was primarily the result of a $0.5 million increase in our flooring line. Net cash provided by financing activities of $9.3 million for the three months ended October 31, 2000 was the result of the issuance of a $15.0 million convertible debenture, borrowings of approximately $5.0 million under the term loan line of credit agreement with The CIT Group/Business Credit (see below) and approximately $0.4 million in stock option exercises, reduced by the repayment of approximately $10.8 million in loans previously secured by our commercial paper portfolio. On October 10, 2000, we entered into a term loan agreement and a three-year working capital line of credit with The CIT Group/Business Credit ("CIT"). A term loan of $4.0 million, due and payable upon the finalization of a long-term mortgage on our corporate headquarters or paid in 12 monthly installments commencing April 1, 2001, was repaid in May 2001. An initial term loan of $1.0 million, due and payable in 90 days, was repaid on November 1, 2000. The term loans under the agreement incurred interest at the lender's prime rate (6% per annum at October 31, 2001), plus .5%, with increases if the outstanding principal was not reduced according to a fixed amortization. The working capital line of credit allows us to borrow, on a revolving basis, for a period of three years, a specified percentage of our eligible accounts receivable and inventories (approximately $2.9 million at October 31, 2001), up to a limit of $5.0 million. Amounts outstanding under the working capital line bear interest at the lender's prime rate plus .25%. At October 31, 2001, no amounts other than loan fees were outstanding under the various credit arrangements. The lender charged approximately $130,000 for the credit facility, which is being amortized as interest expense over the term of the credit agreement. The line of credit accrues various monthly maintenance, minimum usage and early termination fees. The line of credit requires certain financial and other covenants, including the maintenance of a minimum EBITDA requirement for each fiscal quarter beginning in the quarter ended January 31, 2001. At October 31, 2001, we were not in compliance with the minimum EBITDA requirement. The lender has waived compliance with the covenant at October 31, 2001. The line of credit is collateralized by all of our assets. In addition to the CIT line of credit noted above, we have a flooring line of credit with IBM Credit, which has committed to make $2.5 million in flooring inventory commitments available to us. As of October 31, 2001, we owed $1,023,000 under the flooring line. The flooring line is collateralized by the specific inventory purchased pursuant to the flooring commitments. CIT and IBM Credit have entered into an intercreditor agreement which determines the level of priority of either lender's security interest. The flooring line requires the maintenance of a minimum net worth of $16.0 million, and we were in compliance with this 11 covenant at October 31, 2001. The flooring line also requires us not to be in default of any covenants in the CIT agreement. IBM Credit has waived compliance with that requirement at October 31, 2001. On October 31, 2000, we issued a $15.0 million convertible unsecured debenture to a private investor. The debenture bears interest at 6.0% per annum and is repayable in full on October 31, 2003, unless otherwise converted into our common stock. The debenture is convertible into our common stock at the investor's option at an initial conversion price of $22.79 per share, subject to antidilution adjustments, and at our option, if our common stock trades at more than 135% of the conversion then in effect for at least 20 consecutive trading days. The conversion price can be adjusted if we sell shares of our common stock at a price less than $22.79 per share while the debentures are outstanding. The conversion price under the debenture also automatically re-sets periodically. During these re-set periods, the conversion price will, for five consecutive trading days, adjust to 90% of the average closing price of our stock during the 10 trading days preceding each re-set period if this amount is less than the conversion price that would otherwise apply. The first re-set period began on May 15, 2001 and ended May 21, 2001. The second re-set period began on October 31, 2001 and ended November 5, 2001. The next re-set period will begin on April 30, 2002 and additional re-set periods will occur every six months thereafter. During the first re-set period, the investor elected to convert $5.0 million of the debenture at the re-set conversion price. We elected to pay the investor in cash the $5.0 million principal amount of the debenture that the investor elected to convert during the first re-set period. During the second re-set period, the investor elected to convert $5.0 million of the debentures at the re-set conversion price. Subsequent to October 31, 2001 the Company paid the investor in cash the $5.0 million principal amount of the debentures that the investor elected to convert during the second re-set period. The remaining $5.0 million of the debentures, plus any unpaid interest on that amount, may be converted at the re-set conversion price at the third re-set period beginning on April 30, 2002 and at the additional re-set periods that will occur every six months thereafter until October 31, 2003. We have the right to pay the investor in cash the principal amount of any portion of the debenture the investor elects to convert during a re-set period. We also have the right to repurchase all, or any portion, of the outstanding principal amount of this debenture at a price equal to 110% of the outstanding principal amount, plus any unpaid interest at any time. If we were to issue shares at 90% of the trading price of our common stock upon conversion of the debenture during a re-set period, we would incur a material charge to our statement of operations, based on the difference between the price of our common stock and the value of the common stock at October 31, 2000. In connection with the issuance of the debenture, we issued to the investor a 5-year warrant to purchase up to 32,916 shares of our common stock at an initial exercise price of $32.55 per share, with the number of shares for which the warrant is exercisable and the exercise price subject to antidilution adjustments. We have valued the warrant using the Black-Scholes model, with the following assumptions: Expected life -- 5 years, Risk free interest rate -- 6%, and Volatility -- 1.20. These factors yield a value of $562,000, of which $441,000 has been amortized as of October 31, 2001 and the balance will be amortized through May 2002. The principal amount of the debenture, net of the remaining unamortized warrant value, is classified as a current liability. At October 31, 2001, the debenture amount repayable was $10,000,000 and the unamortized warrant value was $121,000, for a net debenture value of $9,879,000. In addition to the warrant cost, approximately $700,000 of debt issuance costs were incurred in the debt transactions noted above. The unamortized debt issuance costs of approximately $352,000 is included in prepaid expenses and will be amortized through May 2002. In June 2001, we completed the sale of 3,800,000 shares of common stock raising gross proceeds of approximately $34.2 million before issuance costs of $2.7 million. As a result of this offering, the conversion price of our outstanding debenture was adjusted pursuant to a weighted average adjustment under the terms of the debenture. The adjusted conversion price is $19.57 pursuant to this adjustment. In addition, the completion of the offering resulted in an adjustment to the exercise price of the warrant and to the number of our shares issuable upon exercise of the warrant pursuant to anti-dilution provisions of the warrant. As so adjusted, the warrant exercise price is $27.95 and the number of shares issuable upon exercise of the warrant is 38,333. In addition to the line of credit, our foreign subsidiaries in Germany, Italy and Switzerland have lines of credit with banks in their respective countries that are utilized primarily for overdraft and short-term cash needs. At October 31, 2001, no amounts were outstanding under these lines. We are contingently liable at October 31, 2001 under the terms of repurchase agreements with several financial institutions providing inventory financing for dealers of our products. Under these agreements, dealers purchase our products, and the financial institutions agree to pay us for those purchases, less a pre-set financing charge, within an agreed payment term. Two of these institutions, Finova and IBM Credit Corporation, have also provided us with vendor inventory financing. The contingent liability under these agreements approximates the amount financed, reduced by the resale value of any appliances that may be repurchased, and the risk of loss is spread over several dealers and financial institutions. At October 31, 2001 and 2000, we were contingently liable for purchases made under these agreements of approximately $88,000 and $263,000, respectively. We expect to have sufficient cash generated from operations and from our recently completed common stock offering to meet our anticipated cash requirements for the next twelve months. 12 NEW ACCOUNTING STANDARDS In July 2001, the FASB issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. SFAS 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. SFAS 142 will require that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 will also require that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The Company is required to adopt the provisions of SFAS 141 immediately, except with regard to business combinations initiated prior to July 1, 2001, which it expects to account for using the pooling-of-interests method, and SFAS 142 is effective August 1, 2002. Furthermore, any goodwill and any intangible asset determined to have an indefinite useful life that are acquired in a purchase business combination completed after June 30, 2001 will not be amortized, but will continue to be evaluated for impairment in accordance with the appropriate pre-SFAS 142 accounting literature. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 will continue to be amortized prior to the adoption of SFAS 142. SFAS 141 will require upon adoption of SFAS 142, that the Company evaluate its existing intangible assets and goodwill that were acquired in a prior purchase business combination, and to make any necessary reclassifications in order to conform with the new criteria in SFAS 141 for recognition apart from goodwill. Upon adoption of SFAS 142, the Company will be required to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations, and make any necessary amortization period adjustments by the end of the first interim period after adoption. In addition, to the extent an intangible asset is identified as having an indefinite useful life, the Company will be required to test the intangible asset for impairment in accordance with the provisions of SFAS 142 within the first interim period. Any impairment loss will be measured as of the date of adoption and recognized as the cumulative effect of a change in accounting principle in the first interim period. In connection with the transitional goodwill impairment evaluation, SFAS 142 will require the Company to perform an assessment of whether there is an indication that goodwill is impaired as of the date of adoption. To accomplish this, the Company must identify its reporting units and determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of the date of adoption. The Company will then have up to six months from the date of adoption to determine the fair value of each reporting unit and compare it to the reporting unit's carrying amount. To the extent a reporting unit's carrying amount exceeds its fair value, an indication exists that the reporting unit's goodwill may be impaired and the Company must perform the second step of the transitional impairment test. In the second step, the Company must compare the implied fair value of the reporting unit's goodwill, determined by allocating the reporting unit's fair value to all of it assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with SFAS 141, to its carrying amount, both of which would be measured as of the date of adoption. This second step is required to be completed as soon as possible, but no later than the end of the year of adoption. Any transitional impairment loss will be recognized as the cumulative effect of a change in accounting principle in the Company's statement of earnings. And finally, any unamortized negative goodwill existing at the date SFAS 142 is adopted must be written off as the cumulative effect of a change in accounting principle. As of the date of adoption, the Company expects to have unamortized goodwill in the amount of $1,140,000, and unamortized identifiable intangible assets in the amount of $630,000, all of which will be subject to the transition provisions of SFAS 141 and 142. Amortization expense related to goodwill was $119,000 and $42,000 for the three months ended October 31, 2001, and 2000 respectively. Because of the extensive effort needed to comply with adopting SFAS 141 and 142, it is not practicable to reasonably estimate the impact of adopting these statements on the Company's financial statements at the date of this report, including whether any transitional impairment losses will be required to be recognized as the cumulative effect of a change in accounting principle. In October 2001, the FASB issued SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets." SFAS 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement is effective for fiscal years beginning after December 15, 2001. Adoption of this statement will not have a material impact on our consolidated financial position or results of operations. 13 RISK FACTORS Before investing in our common stock, you should be aware that there are risks inherent in our business, including those indicated below. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of the following risks actually occurs, our business could be harmed. In that case, the trading price of our common stock could decline, and you might lose part or all of your investment. You should carefully consider the following risk factors as well as the other information in this Report on Form 10-Q. COMPETING DATA STORAGE TECHNOLOGIES MAY EMERGE AS A STANDARD FOR DATA STORAGE SOLUTIONS WHICH COULD CAUSE GROWTH IN THE NAS MARKET NOT TO MEET OUR EXPECTATIONS AND DEPRESS OUR STOCK PRICE. The market for data storage is rapidly evolving. There are other storage technologies in use, including storage area network technology, which provide an alternative to network attached storage. We are not able to predict how the data storage market will evolve. For example, it is not clear whether usage of a number of different solutions will grow and co-exist in the marketplace or whether one or a small number of solutions will be dominant and displace the others. It is also not clear whether network attached storage technology will emerge as a dominant or even prevalent solution. Whether NAS becomes an accepted standard will be due to factors outside our control. If a solution other than network attached storage emerges as the standard in the data storage market, growth in the network attached storage market may not meet our expectations. In such event, our growth and the price of our stock would suffer. IF GROWTH IN THE NAS MARKET DOES NOT MEET OUR EXPECTATIONS, OUR FUTURE FINANCIAL PERFORMANCE COULD SUFFER. We believe our future financial performance will depend in large part upon the future growth in the NAS market and on emerging standards in this market. We intend for NAS products to be our primary business. The market for NAS products, however, may not continue to grow. Long-term trends in storage technology remain unclear and some analysts have questioned whether competing technologies, such as storage area networks, may emerge as the preferred storage solution. If the NAS market grows more slowly than anticipated, or if NAS products based on emerging standards other than those adopted by us become increasingly accepted by the market, our operating results could be harmed. THE REVENUE AND PROFIT POTENTIAL OF NAS PRODUCTS IS UNPROVEN, AND WE MAY BE UNABLE TO ATTAIN REVENUE GROWTH OR PROFITABILITY FOR OUR NAS PRODUCT LINES. NAS technology is relatively recent, and our ability to be successful in the NAS market may be negatively affected by not only a lack of growth of the NAS market but also the lack of market acceptance of our NAS products. Additionally, we may be unable to achieve profitability as we transition to a greater emphasis on NAS products. IF WE FAIL TO SUCCESSFULLY MANAGE OUR TRANSITION TO A FOCUS ON NAS PRODUCTS, OUR BUSINESS AND PROSPECTS WOULD BE HARMED. We began developing NAS products in 1997. Since then, we have focused our efforts and resources on our NAS business, and we intend to continue to do so. We expect to continue to wind down our Legacy product development and marketing efforts. In the interim, we expect to continue to rely in part upon sales of Legacy products to fund operating and development expenses. Net sales of our Legacy products have been declining in amount and as a percentage of our overall net sales, and we expect these declines to continue. If the decline in net sales of our Legacy products varies significantly from our expectations, or the decline in net sales of our Legacy products is not substantially offset by increases in sales of our NAS products, we may not be able to generate sufficient cash flow to fund our operations or to develop our NAS business. We also expect our transition to a NAS-focused business to require us to continue: - engaging in significant marketing and sales efforts to achieve market awareness as a NAS vendor; - reallocating resources in product development and service and support of our NAS appliances; - modifying existing and entering into new channel partner relationships to include sales of our NAS appliances; and - expanding and reconfiguring manufacturing operations. In addition, we may face unanticipated challenges in implementing our transition to a NAS-focused company. We may not be successful in managing any anticipated or unanticipated challenges associated with this transition. Moreover, we expect to continue to incur costs in addressing these challenges, and there is no assurance that we will be able to generate sufficient revenues to cover these costs. If we fail to successfully implement our transition to a NAS-focused company, our business and prospects would be harmed. 14 THE RECENT TERRORIST ATTACKS MAY HAVE AN ADVERSE EFFECT ON OUR BUSINESS. The terrorist attacks in New York and Washington, D.C. on September 11, 2001 appear to be having an adverse effect on business, financial and general economic conditions. These effects may, in turn, have an adverse effect on our business and results of operations. At this time, however, we are not able to predict the nature, extent and duration of these effects on overall economic conditions or on our business and operating results. THE CALIFORNIA ENERGY CRISIS IS CAUSING US TO EXPERIENCE SIGNIFICANTLY HIGHER ENERGY COSTS AND OCCASIONAL INTERRUPTIONS IN OUR SUPPLY OF ELECTRICAL POWER, WHICH COULD DISRUPT OUR BUSINESS, HARM OUR OPERATING RESULTS AND DEPRESS THE PRICE OF OUR COMMON STOCK. California has recently experienced a shortage of electrical power and other energy sources. This shortage has resulted in significantly higher electricity and other energy costs and has occasionally resulted in rolling brown-outs, or the temporary and generally unannounced loss of the primary electrical power source. The computer and manufacturing equipment and other systems in our headquarters in Irvine, California, are powered by electricity. Currently, we do not have secondary electrical power sources to mitigate the impacts of temporary or longer-term electrical outages. We may continue to experience higher costs for electricity and other energy sources, as well as brown-outs and black-outs. We may also become subject to usage restrictions or other energy consumption regulations that could adversely impact or disrupt our manufacturing and other activities. Continued higher energy costs could materially harm our profitability and depress the price of our common stock. In addition, if we experience interruptions in our supply of electricity, our manufacturing and other operations would be disrupted, which could materially adversely affect our results of operations and depress the price of our common stock. DUE TO DETERIORATING U.S. AND WORLD ECONOMIC CONDITIONS, INFORMATION TECHNOLOGY SPENDING ON DATA STORAGE AND OTHER CAPITAL EQUIPMENT COULD DECLINE. IF TECHNOLOGY SPENDING IS REDUCED, OUR SALES AND OPERATING RESULTS COULD BE HARMED. Many of our customers are affected by economic conditions in the United States and throughout the world. Many companies have announced that they will reduce their spending on data storage and other capital equipment. If spending on data storage technology products is reduced by customers and potential customers, our sales could be harmed, and we may experience greater pressures on our gross margins. If economic conditions do not improve, or if our customers reduce their overall information technology purchases, our sales, gross profits and operating results may be reduced. IF WE FAIL TO INCREASE THE NUMBER OF INDIRECT SALES CHANNELS FOR OUR NAS PRODUCTS, OUR ABILITY TO INCREASE NET SALES MAY BE LIMITED. In order to grow our business, we will need to increase market awareness and sales of our NAS products. To achieve these objectives, we plan to expand revenues from our indirect sales channels, including resellers and systems integrators. To do this, we will need to modify and expand our existing relationships with these indirect channel partners, as well as enter into new indirect sales channel relationships. We may not be successful in accomplishing these objectives. If we are unable to expand our direct or indirect sales channels, our ability to increase revenues may be limited. BECAUSE WE DO NOT HAVE EXCLUSIVE RELATIONSHIPS WITH OUR DISTRIBUTORS FOR OUR LEGACY PRODUCTS, THESE CUSTOMERS MAY GIVE HIGHER PRIORITY TO PRODUCTS OF COMPETITORS, WHICH COULD HARM OUR OPERATING RESULTS. Our distributors generally offer products of several different companies, including products of our competitors. Accordingly, these distributors may give higher priority to products of our competitors, which could harm our operating results. In addition, our distributors often demand additional significant selling concessions and inventory rights, such as limited return rights and price protection. We cannot assure you that sales to our distributors will continue, or that these sales will be profitable. BECAUSE WE HAVE ONLY APPROXIMATELY FOUR YEARS OF OPERATING HISTORY IN THE NAS MARKET, WHICH IS NEW AND RAPIDLY EVOLVING, OUR HISTORICAL FINANCIAL INFORMATION IS OF LIMITED VALUE IN PROJECTING OUR FUTURE OPERATING RESULTS OR PROSPECTS. We have been manufacturing and selling our NAS products for only approximately four years. For the years ended July 31, 1999, 2000 and 2001, these products accounted for approximately 8%, 28% and 68% of our total net sales, respectively. For the three months ended October 31, 2001, these products accounted for approximately 82% of our total net sales. We expect sales of our NAS products to represent an increasing percentage of our net sales in the future. Because our operating history in the NAS product market is only approximately four years, as well as the rapidly evolving nature of the NAS market, it is difficult to evaluate our business or our prospects. In particular, our historical financial information is of limited value in projecting our future operating results. 15 MARKETS FOR BOTH OUR NAS APPLIANCES AND OUR LEGACY PRODUCTS ARE INTENSELY COMPETITIVE, AND IF WE ARE UNABLE TO COMPETE EFFECTIVELY, WE MAY LOSE MARKET SHARE OR BE REQUIRED TO REDUCE PRICES. The markets in which we operate are intensely competitive and characterized by rapidly changing technology. Increased competition could result in price reductions, reduced gross margins or loss of market share, any of which could harm our operating results. We compete with other NAS companies, direct-selling storage providers and smaller vendors that provide storage solutions to end-users. In our Legacy markets, we compete with computer manufacturers that provide storage upgrades for their own products, as well as with manufacturers of hard drives, CD servers and arrays and storage upgrade products. Many of our current and potential competitors have longer operating histories, greater name recognition, larger customer bases and greater financial, technical, marketing and other resources than we do. As a result, they may be able to respond more quickly to new or emerging technologies and changes in customer requirements, devote greater resources to the development, promotion, sale and support of their products, and reduce prices to increase market share. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We may not be able to compete successfully against current or future competitors. In addition, new technologies may increase competitive pressures. WE DEPEND ON A FEW CUSTOMERS, INCLUDING DISTRIBUTORS AND SPECIALIZED END-USERS, FOR A SUBSTANTIAL PORTION OF OUR NET SALES, AND CHANGES IN THE TIMING AND SIZE OF THESE CUSTOMERS' ORDERS MAY CAUSE OUR OPERATING RESULTS TO FLUCTUATE. For the three months ended October 31, 2001, three customers accounted for 19% of our net sales, while one customer accounted for 25% of our net sales for the three months ended October 31, 2000. Unless and until we diversify and expand our customer base for NAS products, our future success will depend to a large extent on the timing and size of future purchase orders, if any, from these customers. In addition, we may receive large volume purchases from single site purchasers of large installations of our NAS products over relatively short periods of time. This may cause our sales to be highly concentrated and significantly dependent on one or only a few customers. If we lose a major customer, or if one of our customers significantly reduces its purchasing volume or experiences financial difficulties and is unable to or does not pay amounts owed to us, our results of operations would be adversely affected. In fiscal 2001, we sold our Legacy products principally to distributors. We cannot be certain that customers that have accounted for significant revenues in past periods will continue to purchase our products or fully pay for products they purchase in future periods. During the first quarter of fiscal 2002, we increased our reserves for accounts receivable by $2.8 million, but we cannot assure that our reserves for accounts receivable will be adequate. OUR GROSS MARGINS OF OUR VARIOUS PRODUCT LINES HAVE FLUCTUATED SIGNIFICANTLY IN THE PAST AND MAY CONTINUE TO FLUCTUATE SIGNIFICANTLY. FOR EXAMPLE, WE MAY NOT SEE INCREASED SALES OF OUR NAS APPLIANCES. Historically, our gross margins have fluctuated significantly. Our gross margins vary significantly by product line and distribution channel, and, therefore, our overall gross margin varies with the mix of products we sell. Our markets are characterized by intense competition and declining average unit selling prices over the course of the relatively short life cycles of individual products. For example, we derive a significant portion of our sales from NAS products. The market for these products is highly competitive and subject to intense pricing pressures. If we fail to increase sales of our NAS appliances, or if demand, sales or gross margins for our Legacy products decline rapidly, we believe our overall gross margins may continue to decline. Our gross margins have been and may continue to be affected by a variety of other factors, including: - new product introductions and enhancements; - competition; - changes in the distribution channels we use; - the mix and average selling prices of products; and - the cost and availability of components and manufacturing labor. IF WE ARE UNABLE TO TIMELY INTRODUCE COST-EFFECTIVE HARDWARE OR SOFTWARE SOLUTIONS FOR NAS ENVIRONMENTS, OR IF OUR PRODUCTS FAIL TO KEEP PACE WITH TECHNOLOGICAL CHANGES IN THE MARKETS WE SERVE, OUR OPERATING RESULTS COULD BE MATERIALLY ADVERSELY AFFECTED. 16 Our future growth will depend in large part upon our ability to successfully develop and introduce new hardware and software for the NAS market. Due to the complexity of products such as ours, and the difficulty in estimating the engineering effort required to produce new products, we face significant challenges in developing and introducing new products. We may be unable to introduce new products on a timely basis or at all. If we are unable to introduce new products in a timely manner, our operating results could be harmed. Even if we are successful in introducing new products, we may be unable to keep pace with technological changes in our markets and our products may not gain any meaningful market acceptance. The markets we serve are characterized by rapid technological change, evolving industry standards, and frequent new product introductions and enhancements that could render our products obsolete and less competitive. As a result, our position in these markets could erode rapidly due to changes in features and functions of competing products or price reductions by our competitors. In order to avoid product obsolescence, we will have to keep pace with rapid technological developments and emerging industry standards. We may not be successful in doing so, and if we fail in this regard, our operating results could be harmed. WE RELY UPON A LIMITED NUMBER OF SUPPLIERS FOR SEVERAL KEY COMPONENTS USED IN OUR PRODUCTS, INCLUDING DISK DRIVES, COMPUTER BOARDS, POWER SUPPLIES, MICROPROCESSORS AND OTHER COMPONENTS, AND ANY DISRUPTION OR TERMINATION OF THESE SUPPLY ARRANGEMENTS COULD DELAY SHIPMENT OF OUR PRODUCTS AND HARM OUR OPERATING RESULTS. We rely upon a limited number of suppliers of several key components used in our products, including disk drives, computer boards, power supplies and microprocessors. In the past, we have experienced periodic shortages, selective supply allocations and increased prices for these and other components. We may experience similar supply issues in the future. Even if we are able to obtain component supplies, the quality of these components may not meet our requirements. For example, in order to meet our product performance requirements, we must obtain disk drives of extremely high quality and capacity. Even a small deviation from our requirements could render any of the disk drives we receive unusable by us. In the event of a reduction or interruption in the supply or a degradation in quality of any of our components, we may not be able to complete the assembly of our products on a timely basis or at all, which could force us to delay or reduce shipments of our products. If we were forced to delay or reduce product shipments, our operating results could be harmed. In addition, product shipment delays could adversely affect our relationships with our channel partners and current or future end-users. UNDETECTED DEFECTS OR ERRORS FOUND IN OUR PRODUCTS, OR THE FAILURE OF OUR PRODUCTS TO PROPERLY INTERFACE WITH THE PRODUCTS OF OTHER VENDORS, MAY RESULT IN DELAYS, INCREASED COSTS OR FAILURE TO ACHIEVE MARKET ACCEPTANCE, WHICH COULD MATERIALLY ADVERSELY AFFECT OUR OPERATING RESULTS. Complex products such as those we develop and offer may contain defects or errors, or may fail to properly interface with the products of other vendors, when first introduced or as new versions are released. Despite internal testing and testing by our customers or potential customers, we do, from time to time, and may in the future encounter these problems in our existing or future products. Any of these problems may: - cause delays in product introductions and shipments; - result in increased costs and diversion of development resources; - require design modifications; or - decrease market acceptance or customer satisfaction with these products, which could result in product returns. In addition, we may not find errors or failures in our products until after commencement of commercial shipments, resulting in loss of or delay in market acceptance, which could significantly harm our operating results. Our current or potential customers might seek or succeed in recovering from us any losses resulting from errors or failures in our products. IF WE ARE UNABLE TO MANAGE OUR INTERNATIONAL OPERATIONS EFFECTIVELY, OUR OPERATING RESULTS COULD BE MATERIALLY ADVERSELY AFFECTED. Net sales to our international customers, including export sales from the United States, accounted for approximately 33%, 41% and 56% of our net sales for the years ended July 31, 1999, 2000, 2001, respectively, and approximately 50% of our net sales in the three months ended October 31, 2001. We have committed significant operational resources to drive our international growth. Our international operations will expose us to operational challenges that we would not otherwise face if we conducted our operations only in the United States. These include: - currency exchange rate fluctuations, particularly when we sell our products in currencies other than U.S. dollars; 17 - difficulties in collecting accounts receivable and longer accounts receivable payment cycles; - reduced protection for intellectual property rights in some countries, particularly in Asia; - legal uncertainties regarding tariffs, export controls and other trade barriers; - the burdens of complying with a wide variety of foreign laws and regulations; and - seasonal fluctuations in purchasing patterns in other countries, particularly in Europe. Any of these factors could have an adverse impact on our existing international operations and business or impair our ability to continue expanding into international markets. For example, our reported sales can be affected by changes in the currency rates in effect during any particular period. The effects of currency fluctuations were evident in our results of operations for the fiscal year 2001 and the first quarter of fiscal 2002. During this period, the Euro and two currencies whose values are pegged to the Euro, fluctuated significantly against the U.S. dollar. As a result, we incurred a foreign currency loss of approximately $54,000 in fiscal 2001 and a foreign currency gain of $205,000 in the first quarter of fiscal 2002. Also, these currency fluctuations can cause us to report higher or lower sales by virtue of the translation of the subsidiary's sales into U.S. dollars at an average rate in effect throughout the fiscal year. In addition, we have funded operational losses of our subsidiaries of approximately $4.1 million between the date of purchase and October 31, 2001, and if our subsidiaries continue to incur operational losses, our cash and liquidity would be negatively impacted. In order to successfully expand our international sales, we must strengthen foreign operations and recruit additional international resellers. Expanding internationally and managing the financial and business operations of our foreign subsidiaries will also require significant management attention and financial resources. For example, our foreign subsidiaries in Europe have incurred operational losses. To the extent that we are unable to address these concerns in a timely manner, our growth, if any, in international sales will be limited, and our operating results could be materially adversely affected. In addition, we may not be able to maintain or increase international market demand for our products. OUR PROPRIETARY SOFTWARE RELIES ON OUR INTELLECTUAL PROPERTY, AND ANY FAILURE BY US TO PROTECT OUR INTELLECTUAL PROPERTY COULD ENABLE OUR COMPETITORS TO MARKET PRODUCTS WITH SIMILAR FEATURES THAT MAY REDUCE DEMAND FOR OUR PRODUCTS, WHICH WOULD ADVERSELY AFFECT OUR NET SALES. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our proprietary software or technology. We believe the protection of our proprietary technology is important to our business. If we are unable to protect our intellectual property rights, our business could be materially adversely affected. We currently rely on a combination of copyright and trademark laws and trade secrets to protect our proprietary rights. In addition, we generally enter into confidentiality agreements with our employees and license agreements with end-users and control access to our source code and other intellectual property. We have applied for the registration of some, but not all, of our trademarks. We have applied for U.S. patents with respect to the design and operation of our NetFORCE product, and we anticipate that we may apply for additional patents. It is possible that no patents will issue from our currently pending applications. New patent applications may not result in issued patents and may not provide us with any competitive advantages over, or may be challenged by, third parties. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries, and the enforcement of those laws, do not protect proprietary rights to as great an extent as do the laws of the United States. We cannot assure you that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology, duplicate our products or design around any patent issued to us or other intellectual property rights of ours. In addition, we may initiate claims or litigation against third parties for infringement of our proprietary rights to establish the validity of our proprietary rights. This litigation, whether or not it is resolved in our favor, could result in significant expense to us and divert the efforts of our technical and management personnel. WE MAY FROM TIME TO TIME BE SUBJECT TO CLAIMS OF INFRINGEMENT OF OTHER PARTIES' PROPRIETARY RIGHTS OR CLAIMS THAT OUR OWN TRADEMARKS, PATENTS OR OTHER INTELLECTUAL PROPERTY RIGHTS ARE INVALID, AND IF WE WERE TO SUBSEQUENTLY LOSE OUR INTELLECTUAL PROPERTY RIGHTS, OUR BUSINESS WOULD BE MATERIALLY ADVERSELY AFFECTED. We may from time to time receive claims that we are infringing third parties' intellectual property rights or claims that our own trademarks, patents or other intellectual property rights are invalid. For example, we have been notified by Intel Corporation that our products may infringe some of the intellectual property rights of Intel. In its notification, Intel offered us a non-exclusive license for patents in their portfolio. We are investigating whether our products infringe the patents of Intel, and we have had 18 discussions with Intel regarding this matter. We do not believe that we infringe the patents of Intel, but our discussions and our investigation are ongoing, and we expect we will continue discussions with Intel. We cannot assure you that Intel would not be successful in asserting a successful claim of infringement, or if we were to seek a license from Intel regarding its patents, that Intel would continue to offer us a non-exclusive license on any terms. We expect that companies in our markets will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. The resolution of any claims of this nature, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays, require us to redesign our products or require us to enter into royalty or licensing agreements, any of which could harm our operating results. Royalty or licensing agreements, if required, might not be available on terms acceptable to us or at all. The loss of access to any key intellectual property right could harm our business. OUR NET SALES AND OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY, AND ANY FLUCTUATIONS COULD CAUSE THE MARKET PRICE OF OUR COMMON STOCK TO DECLINE. We have experienced significant declines in net sales and gross profit and incurred operating losses, causing our quarterly operating results to vary significantly. If we fail to meet the expectations of investors or securities analysts, as well as our internal operating goals, as a result of any future fluctuations in our quarterly operating results, the market price of our common stock could decline significantly. Our net sales and quarterly operating results are likely to fluctuate significantly in the future due to a number of factors. These factors include: - market acceptance of our new products and product enhancements or those of our competitors; - the level of competition in our target product markets; - delays in our introduction of new products; - changes in sales volumes through our reseller and distribution channels, which have varying commission and sales discount structures; - changing technological needs within our target product markets; - the impact of price competition on the selling prices for our products; - the availability and pricing of our product components; - our expenditures on research and development and the cost to expand our sales and marketing programs; and - the volume, mix and timing of orders received. Due to these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indicators of future performance. In addition, it is difficult for us to forecast accurately our future net sales. This difficulty results from our limited operating history in the emerging NAS market, as well as the fact that product sales in any quarter are generally booked and shipped in that quarter. Because we incur expenses, many of which are fixed, based in part on our expectations of future sales, our operating results may be disproportionately affected if sales levels are below our expectations. Our revenues in any quarter may also be affected by product returns and any warranty obligations in that quarter. Many of our distributors have limited product return rights. In addition, we generally extend warranties to our customers that correspond to the warranties provided by our suppliers. If returns exceed applicable reserves or if a supplier were to fail to meet its warranty obligations, we could incur significant losses. In the first quarter of fiscal 2001 and 2000, we experienced product return rates of approximately 8.0% and 8.4%, respectively. This rate may vary significantly in the future, and we cannot assure you that our reserves for product returns will be adequate in any future period. IF WE ARE UNABLE TO ATTRACT QUALIFIED PERSONNEL OR RETAIN OUR EXECUTIVE OFFICERS AND OTHER KEY PERSONNEL, WE MAY NOT BE ABLE TO COMPETE SUCCESSFULLY. Our continued success depends, in part, on our ability to identify, attract, motivate and retain qualified technical and sales personnel. Competition for qualified engineers and sales personnel, particularly in Orange County, California, is intense, and we may not be able to compete effectively to retain and attract qualified, experienced employees. Should we lose the services of a significant number of our engineers or sales people, we may not be able to compete successfully in our targeted markets and our business would be harmed. 19 We believe that our success will depend on the continued services of our executive officers and other key employees. The loss of any of these key executive officers or other key employees could harm our business. WE MAY NOT BE ABLE TO ACHIEVE OR SUSTAIN PROFITABILITY, AND OUR FAILURE TO DO SO COULD REQUIRE US TO SEEK ADDITIONAL FINANCING, WHICH MAY NOT BE AVAILABLE TO US ON FAVORABLE OR ANY TERMS. In recent periods, we have experienced significant declines in net sales and gross profit, and we have incurred operating losses. We incurred operating losses of $5.2 million for fiscal 1999, $12.1 million for fiscal 2000, $16.6 million (including a charge for in-process research and development and increased reserves for inventory and accounts receivable) in fiscal year 2001 and $5.0 million for the three months ended October 31, 2001 (including a $2.8 million increase in accounts receivable reserves). We currently expect to incur operating losses through at least the third quarter of fiscal 2002, although this expectation is based on a variety of factors and subject to a number of risks, including those set forth in this and other risk factors in this report. We will need to increase our revenues from our NAS products to achieve and maintain profitability. The revenue and profit potential of these products is unproven. We may not be able to generate significant or any revenues from our NAS products or achieve or sustain profitability in the future. If we are unable to achieve or sustain profitability in the future, we will have to seek additional financing in the future, which may not be available to us on favorable or any terms. CONTROL BY OUR EXISTING SHAREHOLDERS COULD DISCOURAGE POTENTIAL ACQUISITIONS OF OUR BUSINESS THAT OTHER SHAREHOLDERS MAY CONSIDER FAVORABLE. As of October 10, 2001, our executive officers and directors beneficially owned approximately 5,800,000 shares, or approximately 36% of the outstanding shares of common stock. Acting together, these shareholders would be able to exert substantial influence on matters requiring approval by shareholders, including the election of directors. This concentration of ownership could have the effect of delaying or preventing a change in our control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which could in turn have an adverse effect on the market price of our common stock or prevent our shareholders from realizing a premium over the market price for their shares of common stock. THE MARKET PRICE FOR OUR COMMON STOCK HAS FLUCTUATED SIGNIFICANTLY IN THE PAST AND WILL LIKELY CONTINUE TO DO SO IN THE FUTURE, WHICH COULD RESULT IN A DECLINE IN YOUR INVESTMENT'S VALUE. The market price for our common stock has been volatile in the past, and particularly volatile in the last twelve months, and may continue to fluctuate substantially in the future. The value of your investment in our common stock could decline due to the impact of any of the above or of the following factors upon the market price of our common stock: - fluctuations in our operating results; - fluctuations in the valuation of companies perceived by investors to be comparable to us; - a shortfall in net sales or operating results compared to securities analysts' expectations; - changes in analysts' recommendations or projections; - announcements of new products, applications or product enhancements by us or our competitors; and - changes in our relationships with our suppliers or customers, including failures by customers to pay amounts owed to us. WE HAVE ISSUED CONVERTIBLE DEBENTURES, AND THE OBLIGATIONS OF THE DEBENTURES POSE RISKS TO THE PRICE OF OUR COMMON STOCK AND OUR OPERATIONS. On October 31, 2000, we issued 3-year $15 million convertible debentures to a private investor, of which we have repaid $10.0 million. The debentures provide that, in certain circumstances, the holder of the debentures may convert its position into our stock, or demand that we repay outstanding amounts with cash. The terms and conditions of the debentures pose unique and special risks to our operations and the price of our common stock. Some of those risks are discussed in more detail below. OUR ISSUANCE OF STOCK UPON THE CONVERSION OF THE DEBENTURES AND THE EXERCISE OF THE WARRANTS, AS WELL AS ADDITIONAL SALES OF OUR COMMON STOCK BY THE INVESTOR, MAY DEPRESS THE PRICE OF OUR COMMON STOCK AND SUBSTANTIALLY DILUTE YOUR SHARES. We have registered for resale by the investor in our debentures a total of 2,322,149 shares of our common stock. This number represents approximately 235% of the number of shares of our common stock issuable if our debentures were to remain outstanding until their stated maturity on October 31, 2003 and all interest on the debentures were to be paid in shares of our stock valued at $8.55 per share, the closing price of our stock on April 18, 2001, plus the number of shares of our common stock issuable if the investor's warrant were to be exercised in full. As is noted in the risk factor immediately below, if the investor were to 20 convert the debentures during a period when the re-set conversion price is in effect, we could be required to issue a substantially greater number of our shares to the investor. The issuance of all or any significant portion of the shares of our common stock that we have registered for resale, together with any additional shares that we may be required to register for resale if the remaining $5.0 million in debentures are converted during a period when the re-set conversion price is in effect, could result in substantial dilution to the interests of our other shareholders and a decrease in the price of our stock. A decline in the price of our common stock could encourage short sales of our stock, which could place further downward pressure on the price of our stock. THE CONVERSION PRICE UNDER THE DEBENTURES WILL AUTOMATICALLY RE-SET PERIODICALLY. IF THE INVESTOR CONVERTS SOME OR ALL OF THE DEBENTURES DURING THE RESET PERIODS AND WE DO NOT REPAY IN CASH THE DEBENTURES THAT THE INVESTOR THEN DESIRES TO CONVERT, WE WILL HAVE TO ISSUE SHARES SUBSTANTIALLY IN EXCESS OF THOSE ORIGINALLY CONTEMPLATED, AND THOSE ADDITIONAL SHARES WILL DILUTE YOUR SHARES. The conversion price under the debentures will automatically re-set periodically. During these re-set periods, the conversion price will, for five consecutive trading days, adjust to 90% of the average closing price of our stock during the 10 trading days preceding each re-set period if this amount is less than the conversion price that would otherwise apply. The first re-set period began on May 15, 2001 and ended on May 21, 2001. The second re-set period began on October 31, 2001 and ended on November 5, 2001. The next re-set period will begin on April 30, 2002 and additional re-set periods will occur every six months thereafter. During the first re-set period, the investor elected to convert $5.0 million of the debentures at the re-set conversion price. We have paid the investor in cash the $5.0 million principal amount of the debentures that the investor elected to convert during the first re-set period. During the second re-set period, the investor elected to convert $5.0 million of the debentures at the re-set conversion price. Subsequent to October 31, 2001, the Company paid the investor in cash the $5.0 million principal amount of the debentures that the investor elected to convert during the second re-set period. The remaining $5.0 million of the debentures, plus any unpaid interest on that amount, may be converted at the re-set conversion price at the third re-set period beginning on April 30, 2002 and at the additional re-set periods that will occur every six months thereafter until October 31, 2003. We have the right to pay the investor in cash the principal amount of any portion of the debentures the investor elects to convert during a re-set period. We also have the right to repurchase all, or any portion, of the outstanding principal amount of this debenture at a price equal to 110% of the outstanding principal amount, plus any unpaid interest. If we do not elect to pay cash to satisfy any future conversions of the remaining portion of the debentures during subsequent re-set periods, the number of shares of our common stock that we would be required to issue upon conversion of the remaining portion of the debentures at the re-set conversion price could be substantial. For example, if the 10-trading day average of our shares preceding a re-set period were to be $.42 per share, which is 75% lower than the lowest closing price reached by our shares since the date the debentures were issued, the re-set conversion price would be approximately $.37 per share. If the remaining $5.0 million principal amount of the debentures were to be converted at this price, we would be required to issue the investor approximately 13,500,000 shares, which would result in the investor owning approximately 46% of our outstanding stock after giving effect to such issuance to the investor. WE WILL RECORD A CHARGE IF THE DEBENTURES ARE CONVERTED AT A CONVERSION PRICE THAT IS LESS THAN $22.79, OR IF WE SATISFY AN INVESTOR DEMAND FOR REPAYMENT OR CONVERSION. If we issue shares of our common stock at a conversion price that is less than $22.79 per share, we will record a charge to our statement of operations in an amount equal to the intrinsic value of the beneficial conversion feature. This value would be determined by subtracting the number of shares of our common stock issuable upon conversion of the applicable portion of the debentures at a conversion price of $22.79 from the number of shares issuable upon conversion of that portion of the debentures at the lower conversion price, and multiplying the difference by $22.79, the closing price of our common stock on the date we issued the debentures. Any such charge, if recorded, would be a material non-cash charge and would not affect our net shareholders' equity. In June 2001, we completed the sale of 3,800,000 shares of common stock raising gross proceeds of approximately $34.2 million before issuance costs of $2.7 million. As a result of this offering, the conversion price of our outstanding debenture was adjusted pursuant to a weighted average adjustment under the terms of the debenture. The adjusted conversion price is $19.57 pursuant to this adjustment. In addition, the completion of the offering resulted in an adjustment to the exercise price of the warrant and to the number of our shares issuable upon exercise of the warrant pursuant to anti-dilution provisions of the warrant. As so adjusted, the warrant exercise price is $27.95 and the number of shares issuable upon exercise of the warrant is 38,333. Also, we are amortizing certain debt issuance costs and the cost of the warrant we issued to the investor. These costs will be amortized as interest expense through May 2002. At October 31, 2001, the amount relating to unamortized debt issuance costs and warrant costs was approximately $352,000. IF OUR SHARES ARE ISSUED TO THE INVESTOR, THOSE SHARES MAY BE SOLD INTO THE MARKET, WHICH COULD DEPRESS THE PRICE OF OUR STOCK AND ENCOURAGE SHORT SALES OF OUR STOCK. 21 To the extent the debentures are converted or interest on the debentures is paid in shares of our common stock rather than cash, a significant number of these shares of our common stock may be sold into the market, which could decrease the price of our common stock and encourage short sales. Short sales could place further downward pressure on the price of our common stock. In that case, we could be required to issue an increasingly greater number of shares of our common stock upon future conversions of the debentures as a result of the adjustments described above, sales of which could further depress the price of our common stock. THE DEBENTURES PROVIDE FOR VARIOUS EVENTS OF DEFAULT THAT WOULD ENTITLE THE INVESTOR TO REQUIRE US TO REPAY THE REMAINING BALANCE OWED OF $5.0 MILLION IN CASH WITHIN THREE DAYS. IF AN EVENT OF DEFAULT OCCURS, THE REPAYMENT MAY SIGNIFICANTLY REDUCE OUR WORKING CAPITAL TO FUND OUR BUSINESS. The debentures provide for various events of default, including the following: - the occurrence of an event of default under our loan agreements with The CIT Group; - our failure to pay the principal, interest or any liquidated damages due under the debentures; - our failure to make any payment on any indebtedness of $1 million or more to any third party if that failure results in the acceleration of the maturity of that indebtedness; - an acquisition after October 31, 2000 by any individual or entity, other than the investor and its affiliates, of more than 40% of our voting or equity securities; - the replacement of more than 50% of the persons serving as our directors as of October 31, 2000, unless the replacement director or directors are approved by our directors as of October 31, 2000 or by successors whose nominations they have approved; - a merger or consolidation of our company or a sale of more than 50% of its assets unless the holders of our securities immediately prior to such transaction continue to hold at least a majority of the voting rights and equity interests of the surviving entity or the acquirer of our assets; - our entry into bankruptcy; - our common stock fails to be listed or quoted for trading on the New York Stock Exchange, the American Stock Exchange, the Nasdaq National Market or the Nasdaq SmallCap Market; - our completion of a "going private" transaction under SEC Rule 13e-3; - a holder of shares issuable under the debentures or the warrant is not permitted to sell those securities under our registration statement covering those shares for a period of five or more trading days; - after the effective date of the registration statement covering the resale of the shares issuable pursuant to the debentures and the investor's warrant, the investor is not permitted, for five or more trading days, to sell our shares under that registration statement or any replacement registration statement we may file; - our failure to deliver certificates evidencing shares of our common stock underlying the debentures or the warrant within five days after the deadline specified in our transaction documents with the investor; - our failure to have a sufficient number of authorized but unissued and otherwise unreserved shares of our common stock available to issue such stock upon any exercise or conversion of the warrant and the debentures; - the exercise or conversion rights of the investor under the warrant or the debentures are suspended for any reason, except as provided in the applicable transaction documents; - our default on specified obligations under our registration rights agreement with the investor and failure to cure that default within 60 days; and - other than the specified defaults under the registration rights agreement referred to above, our default in the timely performance of any obligation under the transaction documents with the investor and failure to cure that default for 20 days after we are notified of the default. 22 If an event of default occurs, the investor can require us to repurchase all or any portion of the principal amount of any outstanding debentures at a repurchase price equal to the greater of 110% of such outstanding principal amount, plus all accrued but unpaid interest on such outstanding debentures through the date of payment, or the total value of all of our shares issuable upon conversion of such outstanding debentures, valued based on the average closing price of our common stock for the preceding five trading days, plus any accrued but unpaid interest on such outstanding debentures. In addition, upon an event of default under the debentures, the investor could also require us to repurchase from the investor any of our shares of common stock issued to the investor upon conversion of the debentures within the preceding 30 days, which would be valued at the average closing price of our common stock over the preceding five trading days. We would be required to complete these repurchases no later than the third trading day following the date an event of default notice is delivered to us. As of October 31, 2001, we were in default under a financial covenant of the CIT loan agreement; CIT has waived compliance with the covenant. If we were required to make a default payment at a time when all of the remaining $5.0 million principal amount of the debentures were outstanding, the payment required would be a minimum of $5.5 million and could be substantially greater depending upon the market price of our common stock at the time. In addition, if we default in the timely performance of specified obligations under our registration rights agreement with the investor, we would also be obligated to pay as liquidated damages to the investor an amount equal to $300,000 each month until any such default is cured. Some of the events of default include matters over which we may have some, little or no control, such as various corporate transactions in which the control of our company changes, or if our common stock ceases to be listed on a trading market. If an event of default occurs, the repayment could significantly reduce our working capital to fund our business. THE PAYMENT TO BRIGHTON CAPITAL, LTD. IN CONNECTION WITH OUR SALE OF OUR CONVERTIBLE DEBENTURES MAY BE INCONSISTENT WITH THE PROVISIONS OF SECTION 15 OF THE SECURITIES EXCHANGE ACT AND MAY ENABLE THE INVESTOR TO RESCIND ITS INVESTMENT. We paid Brighton Capital, Ltd. $375,000 for its introduction to us of the purchaser of our 6% convertible debentures. The Staff of the Securities and Exchange Commission has informed us that the receipt by Brighton Capital of this payment may be inconsistent with the registration provisions of Section 15 of the Securities Exchange Act of 1934, as amended. If this payment were determined to be inconsistent with Section 15, then, under Section 29 of the Securities Exchange Act: - Montrose Investments L.P., the purchaser of our debentures, might have the right to rescind its purchase of these securities, which would require us to repay to Montrose Investments L.P. the $15.0 million that it invested in us; - We might be subject to regulatory action; and - We might be able to recover the $375,000 fee that we paid to Brighton Capital in connection with the transaction. THE DEBENTURES RESTRICT OUR ABILITY TO RAISE ADDITIONAL EQUITY WITHOUT THE CONSENT OF THE INVESTOR, WHICH COULD HINDER OUR EFFORTS TO OBTAIN ADDITIONAL NECESSARY FINANCING TO OPERATE OUR BUSINESS OR TO REPAY THE DEBENTURE HOLDERS. The agreements we executed when we issued these debentures prohibit us from obtaining additional equity or equity equivalent financing for a period of 180 trading days after the effective date (May 11, 2001) of the registration statement covering the resale of the shares issuable upon conversion of the debentures, we would not, without the investor's consent, obtain additional equity or equity equivalent financing unless we first offer the investor the opportunity to provide such financing upon the terms and conditions proposed. These restrictions have several exceptions, such as issuances of options to employees and directors, strategic transactions and acquisitions and bona fide public offerings with gross proceeds exceeding $20 million. The restrictions described in this paragraph may make it extremely difficult to raise additional equity capital during this 180-day period. We may need to raise such additional capital, and if we are unable to do so, we may have little or no working capital for our business, and the market price of our stock may decline. WE MAY BE REQUIRED TO PAY LIQUIDATED DAMAGES IF WE DO NOT OBTAIN SHAREHOLDER APPROVAL FOR ISSUANCE OF OUR COMMON STOCK, OR IF WE ARE UNABLE TO TIMELY REGISTER THESE SHARES. We are subject to National Association of Securities Dealers Rule 4350, which generally requires shareholder approval of any transaction that would result in the issuance of securities representing 20% or more of an issuer's outstanding listed securities. Upon conversion or the payment of interest on debentures we are not able to issue more than 2,322,150 shares, or 19.99% of our outstanding common stock on October 30, 2000, the day prior to the date of issuance of the debentures. The terms of the convertible debentures purchase agreement also provide that the shareholder desiring to convert has the option of requiring us either to seek shareholder approval within 75 days of the request or to pay the converting holder the monetary value of the 23 debentures that cannot be converted, at a premium to the converting holder. If the shareholder requires that we convert the debentures into shares and we have not obtained the requisite shareholder approval within 75 days, we would be obligated to pay the monetary value to the purchaser as liquidated damages. Also, under the terms of the Registration Rights Agreement, we will incur liquidated damages of approximately $300,000 per month if the investor is not permitted, for five or more trading days, to sell our shares under our registration statement covering the resale of those shares or under any replacement registration statement that we may file. EVEN IF WE NEVER ISSUE OUR STOCK UPON THE CONVERSION OF THE DEBENTURES OR UPON EXERCISE OF THE INVESTOR'S WARRANTS, WE MAY ISSUE ADDITIONAL SHARES, WHICH WOULD REDUCE YOUR OWNERSHIP PERCENTAGE AND DILUTE THE VALUE OF YOUR SHARES. Other events over which you have no control could result in the issuance of additional shares of our common stock, which would dilute your ownership percentage. Our issuance of 480,000 shares in connection with the acquisition of Scofima Software S.r.l. is an example of an issuance of additional shares to finance an acquisition that may dilute your ownership. Also in June 2001, we completed the sale of 3.8 million shares of our common stock in an offering. In the future, we may issue additional shares of common stock or preferred stock to raise additional capital or finance acquisitions, upon the exercise or conversion of outstanding options, warrants and shares of convertible preferred stock, or in lieu of cash payment of dividends. Our issuance of additional shares would dilute your shares. SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS. This Report on Form 10-Q contains "forward-looking" statements, including, without limitation, the statements under the captions "Risk Factors," and "Management's Discussion and Analysis of Financial Condition and Results of Operations," You can identify these statements by the use of words like "may," "will," "could," "should," "project," "believe," "anticipate," "expect," "plan," "estimate," "forecast," "potential," "intend," "continue," and variations of these words or comparable words. In addition, all of the non-historical information in this Report on Form 10-Q is forward-looking. Forward-looking statements do not guarantee future performance and involve risks and uncertainties. Actual results may and probably will differ substantially from the results that the forward-looking statements suggest for various reasons, including those discussed under "Risk Factors." These forward-looking statements are made only as of the date of this Report on Form 10-Q. We do not undertake to update or revise the forward-looking statements, whether as a result of new information, future events or otherwise. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS INTEREST RATE RISK Our exposure to market risk for changes in interest rates relates primarily to the increase or decrease in the amount of interest income we can earn on our investment portfolio as well as the fluctuation in interest rates on our various borrowing arrangements. We do not use derivative financial instruments in our investment portfolio. We invest in high-credit quality issuers and, by policy, we limit the amount of credit exposure to any one issuer. As stated in our policy, we ensure the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in safe and high-credit quality securities and by constantly positioning our portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer, guarantor or depository. The portfolio includes only marketable securities with active secondary or resale markets to help ensure reasonable portfolio liquidity. Since October 31, 2000, we have entered into a line of credit and term loan agreements pursuant to which amounts outstanding bear interest at the lender's prime rate plus up to .50%. Accordingly, if we were to borrow funds under such agreements, we expect that we will experience interest rate risk on our debt. FOREIGN CURRENCY EXCHANGE RISK We transact business in various foreign countries, but we only have significant assets deployed outside the United States in Europe. We have effected intercompany advances and sold goods to our German subsidiary, as well as our subsidiaries in Italy and Switzerland, denominated in U.S. dollars, and those amounts are subject to currency fluctuation and require constant revaluation on our financial statements. In the three months ended October 31, 2001 we incurred $205,000 in foreign currency gains and in the three month period ended October 31, 2000 we incurred $160,000 of foreign currency losses which are included in our selling, general and administrative expenses. We do not operate a hedging program to mitigate the effect of a significant rapid change in the value of the Euro, the German mark, the Swiss franc, or the Italian lira compared to the U.S. dollar. If such a change did occur, we would have to take into account a currency exchange gain or loss in the amount of the change in the U.S. dollar denominated balance of the amounts outstanding at the time of such change. Our net sales can also be affected by a change in the exchange rate 24 because we translate sales of our subsidiaries at the average rate in effect during a financial reporting period. At October 31, 2001, approximately $9.4 million in current intercompany advances and accounts receivable from our foreign subsidiaries were outstanding. We can not assure you that we will not sustain a significant loss if a rapid or unpredicted change in value of the Euro or related European currencies should occur. We can not assure you that such a loss would not have an adverse material effect on our results of operations or financial condition. 25 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Irvine, County of Orange, State of California, on the 17th of December, 2001. PROCOM TECHNOLOGY, INC. By: /s/ Alex Razmjoo ------------------------------- Alex Razmjoo Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report on Form 10-Q has been signed below by the following persons in the capacities and on the dates indicated.
SIGNATURE TITLE DATE --------- ----- ---- /s/ Alex Razmjoo Chairman of the Board, President December 17, 2001 ----------------------------------- and Chief Executive Officer Alex Razmjoo (Principal Executive Officer) /s/ Robert Rankin Chief Financial Officer December 17, 2001 ----------------------------------- Robert Rankin
26 INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION ------- ----------- 3.1 Amended and Restated Articles of Incorporation of the Company (incorporated by reference to Exhibit 3.1 in the Form S-1A filed on November 14, 1996) 3.2 Amended and Restated Bylaws of the Company (incorporated by reference to Exhibit 3.2 in the Form S-1A filed on November 14, 1996) 4.1 Form of Convertible Debenture dated October 31, 2000 (incorporated by reference to Exhibit 4.1 in the Registration Statement on Form S-3 of Procom filed on November 22, 2000) 4.1.1 Amendment to Convertible Debenture (incorporated by reference to Exhibit 4.1.1 in the Form S-3 filed on April 25, 2001) 4.2 Form of Common Stock Purchase Warrant dated October 31, 2000 (incorporated by reference to Exhibit 4.2 in the Report on Form 8-K filed on November 3, 2000) 4.3 Securities Purchase Agreement dated October 31, 2000 (incorporated by reference to Exhibit 4.3 in the Report on Form 8-K filed on November 3, 2000) 4.4 Registration Rights Agreement dated October 31, 2000 by and between the Registrant and Montrose Investments, Ltd. (incorporated by reference to Exhibit 4.4 in the Report on Form 8-K filed on November 3, 2000) 4.5 Subordination Agreement dated October 31, 2000 by and between the Registrant, Montrose Investments, Ltd. and CIT Group/Business Credit, Inc. (incorporated by reference to Exhibit 4.5 in the Report on Form 8-K filed on November 3, 2000)
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