0001095811-01-505885.txt : 20011031 0001095811-01-505885.hdr.sgml : 20011031 ACCESSION NUMBER: 0001095811-01-505885 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20010731 FILED AS OF DATE: 20011029 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PROCOM TECHNOLOGY INC CENTRAL INDEX KEY: 0001025711 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER PERIPHERAL EQUIPMENT, NEC [3577] IRS NUMBER: 330268063 STATE OF INCORPORATION: CA FISCAL YEAR END: 0731 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-21653 FILM NUMBER: 1769355 BUSINESS ADDRESS: STREET 1: 58 DISCOVERY CITY: IRVINE STATE: CA ZIP: 92618 BUSINESS PHONE: 9497944257 MAIL ADDRESS: STREET 1: 58 DISCOVERY CITY: IRVINE STATE: CA ZIP: 92618 10-K 1 a76566e10-k.txt FORM 10-K SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 ---------------- FORM 10-K FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JULY 31, 2001 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) HTTP://WWW.PROCOM.COM (Registrant's Web Site) SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: None. SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, $.01 PAR VALUE (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] As of October 10, 2001 the aggregate market value of the voting stock of the Registrant held by non-affiliates of the Registrant was approximately $20.2 million. The number of shares of Common Stock, $.01 par value, outstanding on October 10, 2001, was 15,998,064. DOCUMENTS INCORPORATED BY REFERENCE Information required by Part III is incorporated by reference to portions of the Registrant's Proxy Statement for the 2002 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after the close of the 2001 fiscal year. PROCOM TECHNOLOGY, INC. INDEX TO ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED JULY 31, 2001 PART I Item 1. Business ............................................................................ 3 Item 2. Facilities .......................................................................... 11 Item 3. Legal Proceedings ................................................................... 12 Item 4. Submission of Matters to a Vote of Security Holders ................................. 12 PART II Item 5. Market for Registrant's Common Stock and Related Stockholder Matters ................ 12 Item 6. Selected Financial Data ............................................................. 13 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 7A. Quantitative and Qualitative Disclosures About Market Risk .......................... 34 Item 8. Financial Statements and Supplementary Data ......................................... 35 Item 9. Changes and Disagreements with Accountants on Accounting and Financial Disclosures .. 53 PART III Item 10. Directors and Executive Officers of the Registrant .................................. 54 Item 11. Executive Compensation .............................................................. 55 Item 12. Security Ownership of Certain Beneficial Owners and Management ...................... 55 Item 13. Certain Relationships and Related Transactions ...................................... 55 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K ..................... 55
THE INFORMATION CONTAINED IN THIS REPORT ON FORM 10-K INCLUDES FORWARD-LOOKING STATEMENTS. WHEN USED IN THIS REPORT, THE WORDS "ANTICIPATES," "BELIEVES," "EXPECTS," "INTENDS," "FORECASTS," "PLANS," "FUTURE," "STRATEGY" OR WORDS OF SIMILAR IMPORT ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. OTHER STATEMENTS OF THE COMPANY'S PLANS AND OBJECTIVES MAY ALSO BE CONSIDERED TO BE FORWARD LOOKING STATEMENTS. SUCH STATEMENTS ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES, WHICH COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED IN THE FORWARD-LOOKING STATEMENTS. READERS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH SPEAK ONLY AS OF THE DATE HEREOF. THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLISH REVISED FORWARD-LOOKING STATEMENTS TO REFLECT THE OCCURRENCE OF UNANTICIPATED EVENTS OR CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCE OF UNANTICIPATED EVENTS. READERS ARE URGED TO CAREFULLY REVIEW AND CONSIDER THE VARIOUS DISCLOSURES MADE BY THE COMPANY TO ADVISE INTERESTED PARTIES OF CERTAIN RISKS AND OTHER FACTORS THAT MAY AFFECT THE COMPANY'S BUSINESS AND OPERATING RESULTS, INCLUDING THE DISCLOSURES MADE UNDER THE CAPTION "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" IN THIS REPORT, AS WELL AS THE COMPANY'S OTHER PERIODIC REPORTS ON FORM 10-K, 10-Q AND 8-K FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. Historically, the Company's fiscal year was a 52 or 53 week year ending on the Saturday nearest July 31. During the fiscal year ended July 31, 1997, the Company modified its accounting period so that each quarter and yearly accounting period would end on the last day of each month. Accordingly, the fiscal year ended July 31, 1997 contains four additional days. Unless otherwise indicated, references herein to specific years and quarters are to the Company's fiscal years and fiscal quarters. The Company's principal executive offices are located at 58 Discovery, Irvine, CA 92618; its telephone number is (949) 852-1000 and its web site is HTTP://WWW.PROCOM.COM. 2 PART I ITEM 1. BUSINESS GENERAL We are a designer and provider of network data storage and access appliances. Appliances are specialized devices that perform a specific function within the computer network. Data storage appliances are emerging as the solution of choice to manage the rapidly growing data storage requirements of computer networks. These appliances provide superior performance at a lower cost than general-purpose computers used as file servers. We have developed network attached storage, or NAS, appliances that we believe are faster, more reliable and easier to install and operate than similarly configured and comparably priced appliances. We achieve these advantages by integrating into our appliances proprietary, specialized operating system software optimized for data storage and retrieval. Industry Overview Large and Growing Need for Data Storage Companies increasingly view data as a strategic asset that creates a competitive advantage. Continuous and rapid access to this data is critical to managing a business effectively. The volume of data produced and stored by businesses is growing rapidly. According to IDC research, data storage needs triple every two years. The factors contributing to the growth in network storage requirements include: - proliferation of e-commerce; - new communication media such as e-mail, digital imaging and video storage; - widespread use of enterprise applications, including enterprise resource planning, sales force automation, supply chain and customer relationship management systems; and - increasing personalization of consumer marketing and product development. As a result of these factors, expenditures for data storage are growing rapidly and consuming an increasing percentage of total information technology expenditures. Specifically, networked storage is rapidly becoming the dominant method for data management and sharing. According to a recent IDC study, networked storage will increase from 29% of the total storage market in 2001 to 62% of the total storage market in 2004. We are focused on delivering solutions to meet the requirements of the networked storage market. Common Solutions to Network Storage Requirements There are several approaches to providing network data storage capacity. These approaches include: - General Purpose Servers. Companies can increase their data storage capacity by adding general purpose computers as data file servers or by attaching external storage devices directly to existing servers. General purpose servers are designed to execute computer applications and perform a wide variety of functions, including providing database, electronic mail, network management, file management and application services. They are not specifically designed to store and retrieve files. As a result, general purpose computers used as file servers often provide unsatisfactory file input/output, or I/O, performance, do not support computing platforms other than that of the server itself, and require significant maintenance and support. Moreover, because of their complexity, general purpose servers often cost more to purchase and operate than other alternatives and therefore represent a poor long-term value when used principally as storage devices. - Storage Area Networks. A storage area network, or SAN, is a self-contained fiber-optic network of high-speed storage devices. While SANs may be the preferred storage solution in very large computing environments with particular data access characteristics, they also have a number of disadvantages. SAN installations require significant upfront costs, and SAN systems 3 are expensive to maintain. Moreover, they require the implementation and maintenance of a separate and proprietary fibre channel network, which is not compatible with the fibre channel networks of other SAN vendors. - Network Attached Storage. NAS appliances have been developed to offload basic file I/O tasks from general purpose servers. NAS appliances are designed to store and retrieve larger amounts of data more quickly than general purpose servers. Freed of all hardware and operating system elements unrelated to file I/O tasks, NAS appliances provide greater file throughput, usually for less cost. Unlike SAN devices, NAS appliances can be easily connected to an existing computer network, with additional appliances added over time as storage needs grow. NAS appliances can also complement a SAN deployment. These characteristics make NAS appliances a scalable, versatile and cost-effective data storage solution. The advantages of NAS have been acknowledged in the marketplace. Because storage appliances are designed to perform specific dedicated functions, NAS appliances are ideal for companies seeking a storage solution that: - is easy to install, use and administer; - is easy to integrate with existing infrastructure components; - provides immediate return on investment through server consolidation; - has a low acquisition price and low total cost of ownership; and - provides high speed data access, high capacity and scalability. Specific Challenges in Data Management In general, enterprises using networked computing environments face challenges in managing rapidly growing volumes of distributed data. These challenges include: - Poor Data Access Performance. Data access performance across networks has historically been improved by increasing processor performance or by increasing network bandwidth. However, this approach has its limits. The remaining bottleneck in data access performance is caused by the file server's operating system, which must also perform many additional tasks unrelated to data access. These unrelated tasks slow the server's ability to respond to file I/O requests. - Difficulties Accessing Shared Data. Organizations require solutions that provide access to shared data. These organizations often install applications that run on differing and incompatible computing operating systems. However, many of these operating systems are incapable of accessing or sharing data created or stored on other systems without the assistance of additional software. - Unavailable Data. Unavailable data can result in costly business interruptions. Data availability is critical to worker productivity, making it imperative that network data storage devices have low failure rates, rapid recovery times and the ability to provide uninterrupted data service. Data unavailability can be caused by hardware and/or software failure. - Data Administration Challenges. Network data administration, including the backup and expansion of data storage capacity, requires the management of both hardware and software systems. This becomes more complex with large volumes of data, increasing numbers of users accessing data and wide distribution of data stored across the network. Storage devices that cannot be managed remotely place an added burden on technical personnel and resources. - Solutions That Are Not Easily Scalable. Given the continuing increase in data storage needs, effective storage solutions will provide a simple and economical means to increase capacity over time. Preferred solutions allow enterprises to modify their existing infrastructure and incur only incremental costs as they grow rather than to make extensive and expensive modifications to their computing networks. - High Total Cost of Ownership. The total cost of ownership for a storage solution includes not only the initial system purchase price, but also the costs associated with ongoing maintenance and support. Systems that require frequent service can have total ownership costs significantly greater than their initial purchase price. 4 The Procom Solution Our NAS appliances are well suited to address the growth in data storage as well as the specific challenges of data management. A key element of our solution is our proprietary operating system software, which we integrate with high-performance, industry-standard hardware components to provide our customers with the following benefits: - Fast File Service Response Times. Our NAS appliances are designed to achieve rapid I/O response times. We have developed proprietary operating system software optimized for data access and storage. This software enables our NAS appliances to execute user read and write requests significantly faster than general purpose computers used as file servers. - Cross-Platform Compatibility. Our NAS appliances provide native support and enable simultaneous shared file services for environments using UNIX, including Linux, and Windows NT operating systems. As a result, users can share data across multiple operating systems, eliminating the need to duplicate data or have separate storage devices for each computing environment. This functionality allows organizations to consolidate their data storage onto fewer devices, providing performance efficiencies and lower total cost of ownership. - High Levels of Data Availability and Product Reliability. Our appliances are designed to provide high levels of data availability with minimal incremental cost. Data journaling and hardware redundancies help ensure the protection and availability of data in the event of hardware component failure. Moving basic storage functions from a server to a NAS appliance improves the server's reliability and its ability to process non-storage functions. - Ease of Installation, Administration and Maintenance. Our appliances are easier to install and operate than both general purpose computers and NAS appliances from other vendors. Our NAS appliances are specifically designed to be installed easily and quickly, some in just minutes. Moreover, our appliances' management software is accessible via a Web browser, making remote initiation of diagnosis and management utilities possible. In general, our appliances simplify system administration and permit more efficient use of technical personnel. - Scalable Solution. Our appliances are designed so that storage capacity can grow on an incremental and cost-effective basis while maintaining high throughput levels. A system administrator can incrementally increase storage capacity by adding disk drives to an existing appliance, or by adding additional NAS appliances to the existing network infrastructure without an interruption in access to stored data. Adding one of our NAS appliances to a network takes less time than adding a general purpose file server. This capability allows customers to expand their storage capacity incrementally without significant changes to their network infrastructure. - File and Block access to data. Through our available DUET option, our NetFORCE 3000 series of products can be configured to deliver both file and block level access to data. This capability positions Procom to uniquely deliver targeted solutions to those applications that require block level access to data, including most of the Microsoft line of enterprise servers such as Exchange and SQL Server. - Low Total Cost of Ownership. We reduce the initial cost of ownership by taking advantage of the price and performance of commercial off-the-shelf hardware components. Our products are easy to install, which also helps to reduce the initial cost of ownership. We reduce the ongoing cost of ownership by providing products with exceptional reliability and low maintenance costs. Strategy Our objective is to become the leading provider of network data storage and access appliances for the midrange market by employing the following strategies: - Seek NAS Market Leadership by Building On Our Storage Experience. Over the past several years, we have designed, developed and distributed NAS appliances. We plan to expand our NAS market presence by continuing to develop our NAS technology and expanding our NetFORCE product line and NAS related software. As part of this strategy, we will seek to build on our data storage experience and existing customer relationships. 5 - Make high end networked storage technology available to middle market companies. We intend to leverage our deep technical knowledge of the networked storage market and make features that are in the domain of high-end servers available at prices that are acceptable to the midrange of the market. - Expand our Field Sales Force and Target Data-Intensive Markets. We intend to increase the size of our field sales force over the next 12 months. We believe that a strong field sales force presence is important in penetrating data-intensive markets, including e-business, networking, and enterprises using applications such as Web and e-mail hosting, data warehousing, imaging, multimedia and digital video production. We intend to use our field sales force to complement and support our channel partners through joint sales calls, market education and development and post-sales support. - Increase Indirect Sales. We plan to expand our relationships with our existing channel partners, especially UNIX networking and storage resellers that have access to our targeted markets. We also intend to engage new channel partners to enhance our ability to penetrate targeted markets. We intend to continue the expansion of our distribution capabilities by entering into additional agreements with selected distributors, VARs and system integrators. - Focus on Software Differentiation. We will continue to differentiate our appliances by developing additional features and functionality within our proprietary operating system software. We believe this approach provides us with a competitive advantage and allows us to design systems with advanced features that provide an exceptional level of system speed, availability and reliability. We also intend to work closely with industry leading software providers to enable our NAS appliances to be integrated with their software architectures. Products We were formed in 1987 to develop and market computer storage-related products. We began developing NAS appliances in 1997 as a natural evolution of our market-leading position in CD/DVD-ROM server and array appliances. We continue to sell these products, as well as storage upgrade products, such as higher capacity disk drive upgrade kits for notebook computers. Sales of these non-NAS products accounted for $13.5 million, or 32.2%, of net sales for fiscal 2001 and $45.8 million, or 72.4%, of our net sales for fiscal 2000. 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 revenue in fiscal 2001. We believe that sales and gross margins on these products will continue to decline as demand for CD servers is reduced because internet solutions can provide access to large amounts of discrete data previously contained on CD-ROMs. We also believe demand for third party storage upgrade products will continue to decline as computer manufacturers ship new desktop and laptop computers with disk drives containing increasingly greater storage capacity. As a result, we expect to reduce our emphasis and reliance on sales of these products in the future. We provide a line of high-performance NAS appliances that allows us to address the price and performance needs of our customers. We currently offer two broad categories of products: NAS appliances and other data storage products. During fiscal 2001, sales of NAS and related technologies represented a majority of our overall business. Our NAS appliances represented 7.9%, 27.6% and 67.8% of our net sales in fiscal 1999, 2000 and 2001, respectively. Network Attached Storage Products NetFORCE. Our NetFORCE appliances are disk-based, read and write NAS storage appliances with optimized software providing faster I/O performance than stand-alone file servers and direct attached storage products. Our NetFORCE product line ranges from an entry level, plug and play, 75 gigabyte device designed for remote offices and small-sized computer workgroups to our highest performance, fault tolerant network data server that provides up to 17 terabytes of storage capacity. The list prices for our NetFORCE product line range from approximately $12,000 to $540,000, depending primarily on the model purchased and the product configuration specified by the customer. The table below describes the key features and target markets for each of these appliances. 6 DataFORCE. Our DataFORCE appliances are CD/DVD-ROM-based, read only NAS storage devices. Our product line consists of devices that provide a high-speed economical means to distribute data to user workstations from as many as 250 CD-ROM disks. In 1999, DataFORCE was awarded "Editor's Choice Award" by Network Computing magazine and "Product of the Year" by Imaging and Documents Solutions magazine. The table below also describes the key features and target markets for each of these products we currently offer.
PRODUCT KEY FEATURES TARGET MARKETS ------- ------------ -------------- NetFORCE 3100HA - High performance, high availability filers, Businesses requiring the highest level of NetFORCE 3200C with Fibre Channel backend data availability and integrity, including NetFORCE 3500/3600 - 3200C and 3600C feature active-active cluster storage intensive enterprises using Windows failover capability, with no single point of NT, UNIX and Linux-based systems. failure - Files accessed and shared by both Windows NT and UNIX-based systems - Snap shot, NDMP and dynamic expansion capabilities - Web-based remote device management - Fully supports Microsoft ADS and domain architecture and ACLs DUET - Integrates NAS and SAN functionality in a Installations requiring both file access and pre-tested, pre-configured solution block access to data. This includes most - File and Block access to data Microsoft server applications such as - Successfully completed Microsoft HCL testing Exchange and SQL Server. - Integrated management, monitoring and failover capabilities - Fully supports Microsoft Cluster Servers ProMirror - Highly reliable, Safe-Asynchronous Mirroring Businesses requiring uninterrupted flow of (SAM) architecture data. As an integrated part of a disaster - Highly cost effective, using existing IP recovery solution. ProMirror delivers highly infrastructure advanced capabilities very cost effectively. - Near real-time reflection of data between source and target servers - Continuous replication of data, with fast reversion from source to target in case of primary site failure - Software features are available on all NetFORCE filers - Web-based, easy to use management tools NetFORCE 1700 - High performance, high capacity mid-range Workgroups using Windows NT, UNIX and filer Linux-based systems, especially mid-sized - Highest storage density in class, over 1.8TB e-businesses and engineering intensive in 5U of rack space environments. - Highest performance in its class, 4054 IOPS - Complete feature set, including snap shots, NDMP support, ADS, ACLs - Simple, 15 minutes plug and play installation DataFORCE 1000R - 250 CD-ROM capacity Organizations that use document imaging and Rack-mountable - Web-based remote device management and firms with extensive data access needs, modular fault tolerant design including libraries, law firms, accounting - Supports Windows NT, UNIX, Novell and firms, educational and other institutions. Macintosh environments
7
PRODUCT KEY FEATURES TARGET MARKETS ------- ------------ -------------- DataFORCE 200/300 - Up to 115 CD-ROM capacity with web-based Organizations that use document imaging remote device management technologies. Also, libraries, law firms, - Easy to install public accounting firms, educational and - Supports Windows NT, UNIX, Novell and other institutions. Macintosh environments
We are currently in the process of developing our next generation NetFORCE appliances. These new appliances are expected to provide even greater performance and capacity at the high end, and deliver even greater value and capabilities at the low end of our product spectrum. We continue to invest in research and development to deliver solutions that are easily integrated within our customers' information technology infrastructure and leverage upcoming technologies such as iSCSI. Other Data Storage Products We also develop and market a number of other data storage products, including disk drive upgrades, standalone and networked CD/DVD-ROM servers and arrays, as well as tape backup products. Our disk drive upgrades allow users to increase the storage capacity of their laptop and desktop computers, which extends the life of their initial hardware investment. Our CD/DVD-ROM servers and arrays allow users to access software and data stored on these media. Our tape backup products provide reliable backup storage for large amounts of data. We offer these products in a variety of configurations depending on the price and performance requirements of our customers. Together, these products constituted 32.2% of our total net sales in fiscal 2001, and 72.4% for fiscal 2000. We expect our sales of these products to decline over time, especially as a percentage of total net sales, as we continue to transition to the growth opportunity presented by the NAS market. We plan to provide continued technical and customer support for these products to our customers and channel partners. However, we have determined that demand for these products will likely decline and we have decided to reduce our emphasis on sales of these product lines in the future. Technology Our NAS operating system and the associated software and hardware components are designed to achieve the following objectives: - providing high-speed access to data by optimizing network, computer processor and hard drive features and interfaces; - allowing files created in both the UNIX and Windows NT environments to be shared simultaneously and across multiple operating systems, while protecting the integrity of the underlying data; - supporting the native security features of both UNIX and Windows NT; - supporting remote management and monitoring of the NAS device via Web-based software; - supporting the backup and restoring functionality of commonly used storage management software applications; - providing both file and block level access to data through DUET; - providing disaster recovery capabilities through ProMirror; and - enabling ease of installation by the user. Although our core technical competence is in the development of software, we also possess hardware engineering expertise. We use this expertise to integrate our software with best-of-breed hardware components. A key element of our design philosophy is to utilize hardware components from third-party vendors to the extent possible. This approach allows us to benefit from the technological advances of numerous competing hardware vendors, while benefiting from the constant price erosion in several hardware sectors. Moreover, this philosophy reduces our dependence on any one supplier. We intend to improve the performance of our software, 8 incorporate anticipated advances in disk drive and computer processor hardware, and support the complementary storage technologies and software applications of other vendors. Customers The customers that use our NAS appliances and our other data storage products represent a broad array of enterprises within diverse industry sectors, including e-businesses, financial services, communications, healthcare and governmental agencies. Generally, NAS customers are organizations that require highly reliable, readily accessible, and easily managed storage. These organizations are typically in highly competitive markets and rely on data-intensive applications, such as Web servers, search engines, data warehousing and data mining, multimedia, engineering, digital video production, and ERP. Our NAS appliances and other data storage products are currently sold primarily through distributors, VARs and system integrators under the Procom brand. Sales and Marketing We have an international marketing and distribution strategy. We distribute our products through a number of channels including distributors, VARs, system integrators and field sales. As of July 31, 2001, we employed a total of 100 individuals in sales and marketing, composed of 66 in field sales, 21 in customer service and technical support, and 13 in marketing. Sales We use a variety of selling channels, which are selected based on the needs and characteristics of our markets and products. For example, we sell our entry-level NAS and non-NAS products principally through VARs and distributors. We sell our high-end NAS appliances through VARs and system integrators supported by our own field sales force. We believe this hybrid approach is the most efficient and cost-effective strategy for distributing these high-end appliances, which often require custom configuration and typically involve significant customer contact and a longer sales cycle. Field Sales. As of July 31, 2001, our field sales force consisted of 48 domestic and 18 international sales professionals and technical sales support specialists. Many of these employees are based at our headquarters office. We also have field sales employees based elsewhere in the U.S. and abroad. Our field sales force focuses on generating and supporting sales opportunities with our channel partners, which enables cooperation between our channel partners and our field sales force. Indirect Sales. Our indirect channel partners consist of system integrators, VARs and distributors. Our indirect channel partners market, sell, implement and support our products. We intend to enhance our existing relationships with these partners and develop relationships with additional indirect channel partners - especially those that we expect to enhance our ability to penetrate target markets. Marketing Our marketing organization consists of a product management group and marketing communications group. Our product management group is responsible for product direction, market opportunity identification and strategic positioning, as well as industry research and education. Our product management activities also include development of relationships with indirect channel partners, participation in tradeshows to promote and launch our products and coordination of our involvement in various industry standards organizations. One of our employees currently chairs the NAS committee of the Storage Networking Industry Association (SNIA), a committee whose purpose is to define and promote NAS standardization. Our marketing communications group is responsible for increasing awareness of our company and our products. These efforts include brand promotion, public relations, advertising, industry trade show participation, speaking engagements, seminars, direct mail and Web site content development. Our marketing communications professionals also produce data sheets, presentations, and product demonstrations. Customer Service and Support We are committed to providing our customers with timely and effective service and support. Our engineers and technicians work closely with our sales personnel to provide system integrators, VARs and distributors with pre- and post-sales support, technical support, education, training and consulting services. We provide these services by telephone and facsimile, as well as through online bulletin board services and Web sites. As of July 31, 2001, our customer service and support team consisted of 21 people, including 14 9 in our headquarters in California and seven in the field. We also rely on our system integrators, VARs, and distributors to provide technical support and service. Research and Development We believe that a substantial commitment to research and development is essential to our ability to introduce new and enhanced products that address emerging market opportunities. As of July 31, 2001, our engineering and product development staff consisted of 49 employees, which includes 35 software engineers and 14 hardware engineers. Before we develop a new product, our research and development engineers work with marketing managers and customers to develop specifications for product requirements. Our engineers then design the new product around those specifications. After we commercially release a new product, our engineers continue to work with customers to refine the specifications for future generations and upgrades of our products. In order to respond to the short product life cycle inherent in the industry, our research and development team monitors industry trends to aid in selecting new technologies and features for potential development and incorporation into our appliances. We have devoted substantial resources to the development of our proprietary operating system software. Our total expenses for research and development were $5.5 million in fiscal 1999, $7.2 million for fiscal 2000 and $6.4 million for fiscal 2001. As we continue to support the growth of our NAS business, we do anticipate a decrease in our research and development expenses in the next fiscal year as we undertake cost saving initiatives in fiscal 2002. We intend to devote a decreasing amount of resources toward the support and further development of our other data storage products. Manufacturing and Assembly We conduct our primary manufacturing and assembly activities at our headquarters in Irvine, California. These activities consist of testing, assembly and component integration. We have historically operated without a significant backlog and generally purchase the major components of our products based on historical requirements and forecast needs. Some of our products require printed circuit boards, special metal or plastic housings, software, manuals, additional hardware components and certain custom components manufactured to our specifications. We subcontract with third-party vendors for the manufacture of these items. Our strategy has been to develop cooperative relationships with our most important suppliers, which involves exchanging critical information and implementing joint quality training programs. This strategy helps to minimize supply disruptions and maintain component quality. We test and evaluate the components used in our products. In addition, we perform quality assurance testing on our completed products. We use just-in-time manufacturing techniques and believe we have sufficient manufacturing capacity to meet foreseeable production needs. In December 1999 we were awarded ISO 9001 certification. Competition The market for NAS appliances is rapidly evolving and competitive. We believe we compete with the following companies: - other NAS companies, such as Network Appliance, EMC and Auspex; - companies which provide entry level NAS filers such as Quantum and Maxtor; and - computer manufacturers which also provide NAS solutions along with other data storage products, such as Compaq, Sun Microsystems and Dell. Our overall success depends to a great extent on our ability to continue to develop appliances that incorporate new and rapidly evolving technologies to provide users with cost-effective data storage and information access solutions. In our NAS business, we compete principally on the basis of: - product features and performance; - ease of installation, administration and maintenance; - cross-platform compatibility and scalability; - total cost of ownership; 10 - engineering, technical expertise and development of proprietary software; - time to market with new features and appliances; and - technical support and customer service. We believe that we compete effectively in each of these areas. Additionally, we believe that our accumulated expertise in developing operating system software differentiates our NAS appliances from those of our competitors and poses a barrier to entry for current and potential competitors. We believe that our channel relationships with system integrators, computer resellers, VARs and distributors as well as the price and performance characteristics of our NAS appliances provide us with a competitive advantage. The market for our other data storage appliances is mature and intensely competitive. Within our non-NAS product businesses, we believe we compete with the following companies in the following categories: - computer manufacturers which provide storage upgrades for their appliances, such as IBM, Compaq and Dell; and - hard drive, CD server/array and tape backup manufacturers, such as Maxtor and Quantum. We believe we compete effectively with these competitors by offering a broad range of reasonably priced appliances, by maintaining relationships with computer resellers and VARs that possess key relationships with decision makers at end users, and at the same time developing brand name identity through marketing and advertisements. INTELLECTUAL PROPERTY Our success and ability to compete is dependent on our ability to develop and maintain the proprietary aspects of our technology and operate without infringing on the proprietary rights of others. We rely primarily on a combination of copyright and trade secret protections and confidentiality agreements to establish and protect our intellectual property rights. We seek to protect our software, documentation and other written materials under trade secret, copyright and patent laws, which afford only limited protection. We have registered our "Procom" name and logo. We will continue to evaluate the registration of additional trademarks as appropriate. We generally enter into confidentiality agreements with our employees, resellers and customers. We have exclusive rights to our domain name, "www.procom.com." EMPLOYEES As of July 31, 2001, we had 211 full-time employees. Of the total, 100 are in sales and marketing (including 66 in field sales, 21 in customer service and technical support and 13 in marketing), 33 in manufacturing (including testing, quality assurance, warehousing and materials functions), 49 in engineering and product development (including 35 in software development and 14 in hardware development) and 29 in finance and administration. We have 177 employees in the United States, 12 in Germany, 14 in Italy and eight in other countries in Europe. None of our employees is represented by any collective bargaining agreement. We have never experienced a work stoppage and consider relations with our employees to be good. ITEM 2. FACILITIES Our principal administrative, sales, marketing, manufacturing and research and development facility had been located in approximately 62,000 square feet of leased office space in Santa Ana, California. The lease for this office space expired on August 31, 2000. In September 2000, we moved into our new headquarters in Irvine, California. This facility is approximately 127,000 square feet, of which we occupy approximately 80,000 square feet. In August 2001, we subleased approximately 5,400 square feet of this facility for a lease term of four years. We anticipate leasing the remaining 41,600 square feet of our new facility and have initiated discussions with interested parties. However, no assurance can be given that we will be successful in completing such a lease. We also lease space aggregating 37,919 square feet to house operations of our subsidiaries and sales offices located outside the United States in Germany, Italy, Switzerland, Canada, France and Great Britain. 11 ITEM 3. LEGAL PROCEEDINGS. We are not a party to any material legal proceedings. We are from time to time involved in litigation related to our ordinary operations, such as collection actions and vendor disputes. We do not believe that the resolution of any such other existing claim or lawsuit will have a material adverse affect on our business, results of operations or financial condition. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2001. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (1) Our common stock is listed on the Nasdaq National Market System under the symbol "PRCM". The approximate number of holders of record of our common stock as of September 30, 2001 was 98 and the number of beneficial owners is believed to be in excess of 6,500. Our common stock was first listed on the date of our public offering of shares on December 18, 1996. (2) We have never paid cash dividends on our common stock. We currently anticipate retaining future earnings, if any, to internally finance growth and product development. Payment of dividends in the future will depend upon our earnings and financial condition and various other factors our directors may deem appropriate at the time. Our line of credit agreement restricts the payment of cash dividends. (3) The range of high and low sales prices of our common stock, as reported by the Nasdaq National Market System, for each quarter of fiscal 1999, 2000 and 2001:
FIRST QUARTER SECOND QUARTER THIRD QUARTER FOURTH QUARTER ------------------ ------------------ ------------------ ------------------ HIGH LOW HIGH LOW HIGH LOW HIGH LOW ------ ------ ------ ------ ------ ------ ------ ------ Fiscal 2001 $50.00 $21.06 $26.44 $11.25 $20.38 $ 5.20 $13.50 $ 6.75 Fiscal 2000 $10.13 $ 5.63 $38.25 $ 8.63 $89.75 $15.50 $74.00 $21.19 Fiscal 1999 $ 6.50 $ 4.25 $12.63 $ 5.94 $ 9.56 $ 4.00 $ 9.75 $ 3.81
12 ITEM 6. SELECTED FINANCIAL DATA. FINANCIAL HIGHLIGHTS
YEAR ENDED JULY 31, ----------------------------------------------------------------------- 1997 1998 1999 2000 2001 --------- --------- --------- --------- --------- STATEMENT OF OPERATIONS DATA: (in `000s except per share data) Net sales $ 109,332 $ 111,886 $ 101,290 $ 63,210 $ 41,882 Cost of sales 72,684 75,527 73,003 46,189 26,625 --------- --------- --------- --------- --------- Gross profit 36,648 36,359 28,287 17,021 15,257 Selling, general and administrative expenses 19,155 22,257 26,314 21,930 21,235 Research and development expenses 3,922 4,788 5,502 7,187 6,403 Acquired in-process research and development -- 1,693 -- -- 4,262 Impairment and restructuring charge -- -- 1,626 -- -- --------- --------- --------- --------- --------- Total operating expenses 23,077 28,738 33,442 29,117 31,900 --------- --------- --------- --------- --------- Operating income (loss) 13,571 7,621 (5,155) (12,096) (16,643) Interest income (expense), net 328 1,229 1,222 1,048 (907) --------- --------- --------- --------- --------- Income (loss) before income taxes 13,899 8,850 (3,933) (11,048) (17,550) Provision (benefit) for income taxes 5,452 3,474 (1,058) (3,064) 1,800 --------- --------- --------- --------- --------- Net income (loss) $ 8,447 $ 5,376 $ (2,875) $ (7,984) $ (19,350) ========= ========= ========= ========= ========= Net income (loss) per share: Basic $ 0.83 $ 0.48 $ (0.26) $ (0.70) $ (1.54) ========= ========= ========= ========= ========= Diluted $ 0.81 $ 0.48 $ (0.26) $ (0.70) $ (1.54) ========= ========= ========= ========= ========= Weighted average number of shares Basic 10,205 11,114 11,241 11,351 12,533 ========= ========= ========= ========= ========= Diluted 10,374 11,252 11,241 11,351 12,533 ========= ========= ========= ========= ========= CONSOLIDATED BALANCE SHEET DATA (in `000s): Cash and short-term marketable securities $ 18,777 $ 23,362 $ 22,433 $ 15,515 $ 25,419 Working capital 29,220 32,873 31,245 10,604 27,041 Total assets 43,274 54,439 57,088 52,796 65,227 Lines of credit -- 210 254 610 8 Loan payable -- -- 7,500 10,750 -- Convertible debenture -- -- -- -- 9,726 Total shareholders' equity $ 30,067 $ 36,732 $ 34,286 $ 27,556 $ 47,066
13 ITEM 7. 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 non-NAS 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 non-NAS products, and we hope to transition users of these products to our growing line of more complex, generally higher margin NAS solutions. Changing Business Mix. In recent periods, we have experienced significantly reduced demand, revenues and gross margins for our non-NAS products and we have discontinued some non-NAS 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 generally record sales upon product shipment. In the case of sales to most of our distributors, we record sales when the distributor receives the products. We recognize our product service and support revenues over the terms of their respective contractual periods. Our agreements with many of our VARs, system integrators and distributors allow limited product returns, including stock balancing, and price protection privileges. We maintain reserves, which are adjusted at each financial reporting date, to state fairly the anticipated returns, including stock balancing, and price protection claims relating to each reporting period. We calculate the reserves based on historical rates of sales and returns, including price protection and stock balancing claims, our experience with our customers, our contracts with them, and current information as to the level of our inventory held by our customers. In addition, under a product evaluation program established by us, our indirect channel partners and end-users generally are able to purchase 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 July 31, 2000 and 2001, inventory related to evaluation units was approximately $1.5 million and $2.2 million, respectively. We do not record evaluation units as sales until the customer has notified us of acceptance of these units. Costs and Expenses. 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. Selling, general and administrative expenses include 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 14 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. Our 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:
YEAR ENDED JULY 31, -------------------------------- STATEMENT OF OPERATIONS 1999 2000 2001 ----- ----- ----- Net sales 100.0% 100.0% 100.0% Cost of sales 72.1 73.1 63.6 ----- ----- ----- Gross profit 27.9 26.9 36.4 Operating expenses: Selling, general and administrative 26.0 34.7 50.7 Research and development 5.4 11.4 15.3 Acquired in-process research and development -- -- 10.2 Impairment and restructuring charge 1.6 -- -- ----- ----- ----- Total operating expenses 33.0 46.1 76.2 ----- ----- ----- Operating loss (5.1) (19.2) (39.8) ----- ----- ----- Interest income (expense), net 1.2 1.7 (2.2) ----- ----- ----- Loss before income taxes (3.9) (17.5) (42.0) Provision (benefit) for income taxes (1.1) (4.8) 4.3 ----- ----- ----- Net loss (2.8)% (12.7)% (46.3)% ===== ===== =====
FISCAL YEAR ENDED JULY 31, 2001 COMPARED TO FISCAL YEAR ENDED JULY 31, 2000 Net sales decreased by 33.7% to $41.9 million in fiscal 2001, from $63.2 million in fiscal 2000. This decrease resulted from a significant decrease in unit sales of our legacy products, which include CD servers and arrays and disk drive storage upgrade systems, and the effect of the strategic discontinuance of specific product lines. We expect to see continued weakness in the demand for our disk drive storage upgrade systems, CD servers and arrays and non-NAS product sales throughout fiscal 2002, and we may accelerate the discontinuance of our non-NAS products. Net sales related to our NAS appliances increased 62.7% to $28.4 million in fiscal 2001, from $17.4 million in fiscal 2000. This increase was primarily the result of increased unit sales of our NetFORCE NAS appliances offset by decreased sales of our DataFORCE NAS appliances. International sales were $23.3 million, or 55.7% of our net sales, for fiscal 2001 compared to $26.2 million, or 41.4% of our net sales, in fiscal 2000. The decrease in international sales is due primarily to reduced sales of non-NAS products by our German subsidiary. As a percentage of overall sales, international sales improved over fiscal 2000 due primarily to sales of our NAS products to customers in Europe and Asia, including sales of approximately $5.2 million to a European storage service provider, other sales of NAS appliances by our German and Swiss subsidiaries, and reduced U.S. sales of our CD servers and arrays. There can be no assurance that our revenues of our NAS products will continue to increase in any particular quarter or period, or that any specific customers will continue to purchase our products in such period. Gross profit decreased to $15.3 million for fiscal 2001 from $17.0 million for fiscal 2000. Gross margin increased to 36.4% for the year ended July 31, 2001, from 26.9% for the comparable period in fiscal 2000. The increase in gross margin was primarily the result of the higher percentage of NAS revenues, offset to a lesser extent by a reduction in sales of CD servers and arrays, which have historically experienced higher margins, and an increase in our inventory reserves associated with the discontinuation of specific product lines in the fourth quarter of fiscal 2001. In addition, we realized reduced margins on lower sales of disk drive upgrade systems due to price erosion in the disk drive upgrade industry. We expect that gross margins may be impacted by continuing reductions in sales of some of our higher margin non-NAS product lines, such as CD servers and arrays. 15 Selling, general and administrative expenses decreased 3.2% to $21.2 million in fiscal 2001, from $21.9 million in fiscal 2000, and increased as a percentage of net sales to 50.7% from 34.7%. The dollar decrease in selling, general and administrative expenses was primarily the result of reduced sales and administrative salaries and commissions, reduced cooperative advertising costs and reduced expenses of our German subsidiary offset by increased selling and administrative costs of our Italian subsidiary and a $3.3 million increase in our accounts receivables reserves due primarily to the weak economic conditions and their impact on the financial stability of several of our customers. In addition, we incurred reduced advertising, marketing and travel costs, offset somewhat by increased legal fees and increases in the cost of personnel necessary to support our NAS sales and marketing efforts. During fiscal 2001, we continued to identify and eliminate certain positions and functions not related to our core NAS activities. As a result, we experienced some reductions in selling, general and administrative expenses in the past year. We expect overall selling, general and administrative expenses in the next fiscal year to continue to decrease as we continue our cost saving initiatives undertaken in fiscal 2001. Research and development expenses decreased 10.9% to $6.4 million, or 15.3% of net sales, in fiscal 2001, from $7.2 million, or 11.4% of net sales, in fiscal 2000. The dollar decrease was due primarily to reduced costs for evaluation units and test supplies offset slightly by increases in compensation expense for additional NAS software programmers and hardware developers. As we continue to support the growth of our NAS business, we do anticipate a decrease in our research and development expenses in the next fiscal year as we undertake cost saving initiatives in fiscal 2002. Acquired in-process research and development. In December 2000, we acquired the outstanding shares of Scofima, an Italian company engaged in software development. We employed an appraiser to value the assets of Scofima. The appraiser assigned a value of approximately $4.3 million to in-process research and development relating to software being developed by Scofima which had not yet reached technological feasibility and for which no alternative future use was available. As a result, we incurred a one-time charge of $4.3 million in the second quarter of fiscal 2001. See discussion of assumptions used by appraiser in Note 12 to the Consolidated Financial Statements. Interest income decreased 23.3% to $0.8 million in fiscal 2001, from $1.1 million in fiscal 2000. This decrease is due primarily to a decline in our average investable cash position, which we had historically invested in investment-grade commercial paper with maturities of less than 90 days, during fiscal 2001. This decrease was partially offset by interest earned on net proceeds received from the sale of our common stock in the fourth quarter of fiscal 2001. Interest expense increased to $1.7 million for the year ended July 31, 2001 compared to the comparable period in fiscal 2000. The increase is attributable to the issuance of a $15.0 million 6% convertible debenture, borrowings under our CIT term loan agreement and amortization of prepaid loan costs, which included a write-off of $0.3 million in debt issuance costs associated with the $5.0 million convertible debenture repayment. In addition, in the first quarter of fiscal 2001 our new corporate headquarters was placed into service and we began to incur interest expense on the amount we have financed for our building. Previously, interest expense had been capitalized as part of the development cost of our headquarters. Provision (Benefit) for Income Taxes. The fiscal 2001 provision of $1.8 million represents primarily an increase in our deferred tax asset valuation allowance. At July 31, 2001, we have recorded a valuation allowance equal to the net deferred tax asset. As to our ability to successfully transition to and grow our NAS product sales, the realization of the tax benefits relating to our net deferred tax asset will be dependent on our ability to return to profitability, which management believes will occur in fiscal 2002. FISCAL YEAR ENDED JULY 31, 2000 COMPARED TO FISCAL YEAR ENDED JULY 31, 1999 Net sales decreased by 37.6% to $63.2 million for the year ended July 31, 2000, from $101.3 million for the year ended July 31, 1999. This decrease resulted from a significant decrease in unit sales of CD servers and arrays and disk drive storage upgrade systems, combined with the effect of significant price erosion of the average selling price of these products. We expect to see continued weakness in the demand for our disk drive storage upgrade systems and CD servers and arrays and non-NAS product sales throughout fiscal 2001, and we may accelerate the discontinuance of our non-NAS products. Net sales related to our disk based NAS appliances increased 118.3% to $17.4 million for the year ended July 31, 2000, from $8.0 million for the year ended July 31, 1999. This increase was primarily the result of increased unit sales of our NetFORCE NAS appliances including approximately $3.0 million in sales to Hewlett-Packard under our five-year agreement with them and, to a lesser extent, increased sales of our DataFORCE NAS appliances. International sales fell to $26.2 million, or 41.4% of our net sales, for the year ended July 31, 2000, compared to $33.7 million, or 33.3% of our net sales, in the year ended July 31, 1999. While the decrease in absolute dollars was the result of reduced sales of 16 commodity disk drive and tape backup systems internationally, the increase in international sales as a percentage of our net sales was due primarily to reduced U.S. sales of our CD servers and arrays. Gross profit decreased 39.8% to $17.0 million, for the year ended July 31, 2000, from $28.3 million, for the year ended July 31, 1999. Gross margin decreased to 26.9% of net sales for the year ended July 31, 2000, from 27.9% of net sales for the year ended July 31, 1999. The decrease in gross margin was primarily the result of the higher percentage of total revenues of our European subsidiaries, which have historically experienced lower margins, and to a lesser extent, a reduction in sales of CD servers and arrays, which have historically experienced higher margins. In addition, we realized reduced margins on lower sales of disk drive upgrade systems due to competition and price erosion in the disk drive upgrade industry. We expect further reductions in gross margins due to decreases in sales of some of our higher margin non-NAS product lines, such as CD servers and arrays, until sales of our NAS appliances significantly increase as a percentage of our total sales. Selling, general and administrative expenses decreased 16.7% to $21.9 million in the year ended July 31, 2000, from $26.3 million in the year ended July 31, 1999, and increased as a percentage of net sales to 34.7% from 26.0%. The dollar decrease in selling, general and administrative expenses was primarily the result of reduced sales commissions, occasioned by lower gross profit. In addition, we incurred reduced advertising and marketing costs, and reduced legal fees, offset by increases in the cost of personnel necessary to support our NAS sales and marketing efforts. During the year ended July 31, 2000, we identified and eliminated certain positions and functions not related to our core NAS activities. As a result, we experienced a slight reduction in selling, general and administrative expenses in the third and fourth quarters of fiscal 2000. However, we expect overall selling, general and administrative expense to increase in future periods as we plan to substantially increase spending on efforts to market our NAS appliances and we expect increased facilities costs, such as utilities, taxes and maintenance, as we utilize our recently completed corporate headquarters. Research and development expenses increased 30.6% to $7.2 million, or 11.4% of net sales, for the year ended July 31, 2000, from $5.5 million, or 5.4% of net sales, for the year ended July 31, 1999. These increases were primarily due to compensation expense for additional NAS software programmers and hardware developers. We anticipate that our research and development expenses will continue to increase, both in absolute dollars and as a percentage of net sales, with the expected addition of dedicated NAS engineering resources. Interest Income (Expense). Net interest income decreased 14.2% to $1.0 million for the year ended July 31, 2000, from $1.2 million for the year ended July 31, 1999. During fiscal year 2000, we invested the majority of our available cash in investment-grade commercial paper with maturities of less than 90 days. As a result of a decrease in our investable cash position, partially offset by slightly increased interest rates, net interest income decreased in fiscal 2000. Interest expense for each of the applicable periods includes relatively minor amounts of interest paid on lines of credit maintained by our foreign subsidiaries. We expect that interest income will be reduced in the future and that interest expense will increase significantly due to the financing of our corporate headquarters, and our need to borrow additional amounts to finance our operations. Provision (Benefit) for Income Taxes. Our effective tax benefit rate for the year ended July 31, 2000 was (27.7%), compared to an effective tax benefit rate of (26.9%) for the same period in fiscal 1999. The fiscal 2000 benefit approximates the federal and state statutory rates applied to our U.S. operating losses, reduced by unusable foreign operating losses, and adjusted for research and development credits. The corresponding fiscal 1999 effective tax rate reflects the statutory rates and unusable foreign losses, partially offset by research and development tax credits. 17 LIQUIDITY AND CAPITAL RESOURCES As of July 31, 2001, we had cash and cash equivalents totaling $25.4 million. Net cash used in operating activities was $18.2 million in fiscal 2001 and $4.4 million in fiscal 2000. Net cash provided by operating activities was $1.3 million in fiscal 1999. Net cash used in operating activities in fiscal 2001 relates primarily to our net loss, net of a $4.3 million one-time charge relating to acquired in-process research and development, increases in our accounts receivable as we granted extended terms to our foreign customers offset by an increase in reserves of $3.3 million relating to weak global economic conditions and their impact on the financial stability of several of our customers, and a decrease in accounts payable, as we paid off nearly all of the costs of our corporate headquarters which was completed in September 2000. These uses of cash were slightly offset by decreases in our inventories, which included an increase in reserves of $1.2 million primarily associated with the discontinuation of specific product lines and the receipt of approximately $2.7 million of our income tax refund receivable. Net cash used in operating activities in fiscal 2000 resulted from a net loss before non-cash charges of $8.0 million offset in part by a decrease in working capital. Net cash provided by operating activities in fiscal 1999 was entirely the result of a decrease in working capital as our net loss adjusted for non-cash charges was negligible. Net cash used in investing activities was $3.0 million in fiscal 2001, while net cash provided by investing activities was $1.7 million in fiscal 2000 and $18.0 million in fiscal 1999. Net cash used in investing activities in fiscal 2001 was the result of expenditures of $1.5 million to complete our corporate headquarters and purchases of $1.3 million of other property and equipment. Net cash provided by investing activities in fiscal 2000 was a result of the redemption of $9.0 million of short-term marketable securities partially offset by purchases of $1.7 million of property and equipment and $5.6 million in costs to construct our corporate headquarters. Net cash used in investing activities in 1999 resulted from the purchases of $9.1 million of property and equipment and $9.0 million of investments in short-term marketable securities. Net cash provided by financing activities was $31.2 million in fiscal 2001 compared to $5.0 million and $6.8 million in fiscal 2000 and fiscal 1999, respectively. Net cash provided by financing activities in fiscal 2001 resulted primarily from the sale of 3,800,000 shares of our common stock, the issuance of a $15.0 million convertible debenture, and approximately $1.1 million in stock option exercises and employee stock purchases, reduced by the repayment of approximately $10.8 million in loans previously secured by our commercial paper portfolio and $5.0 million in convertible debentures. Net cash provided by financing activities in fiscal 2000 resulted primarily from a $3.3 million increase in a loan payable and $1.4 million in stock option exercises and employee stock purchases. Net cash provided by financing activities in fiscal 1999 was primarily the result of borrowings of $7.5 million under a loan partially offset by net payments on our lines of credit and repurchases of common stock. On July 31, 2000, we had established a revolving line of credit with Finova Capital Corporation. The line had been based on a percentage of our eligible accounts receivable and inventory, up to a maximum of $10,000,000. In early October 2000, we paid off all amounts outstanding under the Finova line of credit and replaced it with the line of credit with CIT Business Credit (see below). 18 On October 10, 2000, we entered into a term loan agreement and a three-year working capital line of credit with CIT 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 (6.75% per annum at July 31, 2001), plus .5%, with increases if the loan 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 July 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 July 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 July 31, 2001, we were not in compliance with the minimum EBITDA requirement. Although we have repaid all amounts outstanding under the credit facility and do not intend to borrow against the line of credit in fiscal 2002, CIT may elect to decline making any advances under the line of credit or may terminate the line. In addition, if advances are made while we are out of compliance with the financial or other covenants, CIT may charge us the default rate of interest (currently 9.0% per annum) on those advances. We have initiated discussions with various other potential financing sources regarding an alternate short-term working capital financing arrangement. However, no assurance can be given that we will be successful in obtaining any such financing arrangement on favorable or any terms. The line of credit is collateralized by all of our assets. In addition to the CIT line of credit noted above, we replaced the Finova flooring line of credit with a flooring line with IBM Credit, which has committed to make $2.5 million in flooring inventory commitments available to us. As of July 31, 2001, we owed $531,000 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 covenant at July 31, 2001. The flooring line also requires us to represent, at the time we request advances under the line, that we are in compliance with the terms of our other loan agreements. Because of our default of the financial covenant of the CIT credit line, we were out of compliance with this provision of the flooring line at July 31, 2001. Although we have no borrowings outstanding under the CIT credit line, we have advised IBM of the CIT default and have requested IBM to advise us that IBM will not declare a default under the IBM flooring line in respect of the CIT covenant default outstanding under the CIT credit line. If IBM were to declare a default under the flooring line, IBM could decline to make further advances under this line and or terminates. As of July 31, 2001, we had $531,000 outstanding under the flooring line. 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 next re-set period begins on October 31, 2001 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 a re-set conversion price of approximately $9.71 per share. 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. Up to an additional $5.0 million of the debentures, plus any unpaid interest on that amount, may be converted at the re-set conversion price beginning on October 31, 2001, and any remaining portion of the debenture, plus any unpaid interest, may be converted at the re-set conversion price during any subsequent re-set period. 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. 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, which will be amortized through May 2002, the last re-set period. The principal amount of the debenture, net of the remaining unamortized warrant value, is classified as a current liability. At July 31, 2001, the debenture amount repayable was $10,000,000 and the unamortized warrant value was $274,000, for a net debenture value of $9,726,000. In addition to the warrant cost, approximately $700,000 of debt issuance costs were incurred in the debt transactions noted above. The unamortized cost of approximately $529,000 is included in prepaid expenses and will be amortized as interest expense through May 2002, the last re-set period. 19 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. We intend to use offering proceeds in the future to pay any remaining indebtedness under the debenture. As a result of this offering, the conversion price of our outstanding debenture was adjusted to $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 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 July 31, 2001, approximately $8,000 was outstanding under these lines. In March 1999, we purchased an 8.3 acre parcel of land for $7.3 million in Irvine, California, for development of our corporate headquarters facility. Construction commenced in late 1999 and was completed in September 2000. The cost of the land together with the cost of constructing the facility, including capitalized interest and other carrying costs, is approximately $15.9 million, including $0.8 million in capitalized interest costs. We have leased approximately 5,400 square feet of the facility to a tenant for a four year lease term. We are attempting to lease 41,600 square feet of the building, and we are currently considering a variety of other financing options. There can be no assurance that we will be able to lease the space on favorable or any terms, or that we will be able to obtain any other financing. On September 14, 1998, our board of directors approved an open market stock repurchase program. We were authorized to effect repurchases of up to $2.0 million in shares of our common stock. We have repurchased a total of 77,845 shares at an average cost of $5.15 per share. No repurchases were made in the year ended July 31, 2001, and we do not intend to make additional repurchases. In September 2000, our Board terminated the repurchase program. We are prohibited from repurchasing our stock under the terms of our outstanding debentures. As is customary in the computer reseller industry, we are contingently liable at July 31, 2001 under the terms of repurchase agreements with several financial institutions providing inventory financing for dealers of our appliances. Under these agreements, dealers purchase our appliances, 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 July 31, 2000 and 2001, we were contingently liable for purchases made under these agreements of approximately $560,000 and $62,000, respectively. During the three years ended July 31, 2001, we were not required to repurchase any previously sold inventory pursuant to the flooring agreements. At July 31, 2001, we recorded a valuation allowance equal to the net deferred tax asset totaling approximately $9.0 million. On December 28, 2000, we acquired all of the issued and outstanding capital stock of Scofima Software S.r.l., a company organized under the laws of Italy ("Scofima"), in exchange for 480,000 shares of our common stock. Under our agreement with the former shareholders of Scofima, we registered for resale by those shareholders the shares issued to them in the acquisition. Scofima had an option to acquire a software system designed as a caching and content distribution solution. Immediately prior to our acquisition of Scofima, Scofima exercised their option, and acquired the software system. The purpose of the software is to provide functionalities that are necessary for the content delivery market of the internet. The software had been in development for approximately 2-3 years, involving 5 programmers and system developers. The software was not complete at the date of acquisition, and was not yet determined to be technologically feasible. We are currently completing the software and expect to release it in the third quarter of fiscal 2002. We issued 480,000 shares valued at $12 per share and incurred approximately $250,000 in acquisition costs in exchange for the outstanding shares of Scofima. Scofima had net assets of approximately $500,000 at the date of acquisition. The transaction was accounted for as a purchase of assets. We employed an appraiser to identify the values of the assets acquired, including, among other assets, certain in process research and development costs. The amount of purchase price allocated to in-process research and development was determined by estimating the stage of development of the software, estimating future cash flows from projected revenues, and discounting those cash flows to present value. The discount rate applied was 25%. The incremental product sales resulting from the products incorporating the software are estimated to be $44 million over the initial four years of sales with sales growing from approximately $1.5 million in the initial year to $13.4 million in the fourth year. The appraiser concluded, and we have determined, that approximately $4.3 million of the purchase price was related to research and development 20 efforts that had not attained technological feasibility and for which no future alternative use was expected. We have expensed the value of the research and development as of the date of the acquisition of Scofima and capitalized the fair value of the other assets acquired as determined and allocated by the appraiser, including the value of the assembled workforce of approximately $0.2 million and developer relationships valued at $0.1 million, which will be amortized over 4 years, with the remainder of $1.4 million assigned to goodwill, which will be amortized over 4 years. We transact business in various foreign countries, but we only have significant assets deployed outside the United States in Germany, Italy and Switzerland. 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. While a significant reduction in valuation of various currencies such as the Euro (to which the value of the German mark and the Italian lira are pegged) and the Swiss franc could lead to lower sales as our products become more expensive for foreign customers, we do not believe that the currency fluctuations have had a material impact on our liquidity. Our reported sales can be affected by changes in the currency rates in effect in any particular period. Also, these foreign currency fluctuations can cause us to report more or less in sales by virtue of the translation of the subsidiary's sales into U.S. dollars at an average rate in effect throughout the year. Also, we have funded operational losses of our subsidiaries of approximately $3.2 million since we purchased them, and if our subsidiaries continue to incur operational losses, our cash and liquidity would be negatively impacted. 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. NEW ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, which defines derivatives, requires that all derivatives be carried at fair value, and provides for hedge accounting when certain conditions are met. This statement is effective for the first fiscal quarter of fiscal years beginning after June 15, 2000. Adoption of this statement did not have a material impact on our consolidated financial position, results of operations or cash flows. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," as amended, ("SAB 101") which was effective for us in the fourth quarter of fiscal 2001. Adoption of SAB101 did not have a material effect on our consolidated financial position or results of operations. 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 21 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 $142,000, $167,000 and $340,000 for the years ended July 31, 1999, 2000 and 2001, 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. 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-K. 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. 22 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 continued 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 non-NAS product development and marketing efforts. In the interim, we expect to continue to rely in part upon sales of our non-NAS products to fund operating and development expenses. Net sales of our non-NAS 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 non-NAS products varies significantly from our expectations, or the decline in net sales of our non-NAS 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. 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 and 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 is currently experiencing 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. It is not anticipated that the energy shortages will abate soon; 23 therefore, we expect to 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 DIRECT AND 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 appliances. To achieve these objectives, we believe it will be necessary to increase the number of our direct and indirect sales channels. We plan to increase the number of our field sales personnel. However, there is intense competition for these professionals, and we may not be able to attract and retain sufficient new sales personnel. We also plan to expand revenues from our indirect sales channels, including distributors, VARs, 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 OR RESELLERS, SUCH AS INGRAM MICRO, TECH DATA, COMPUCOM AND CUSTOM EDGE, THESE CUSTOMERS MAY GIVE HIGHER PRIORITY TO PRODUCTS OF COMPETITORS, WHICH COULD HARM OUR OPERATING RESULTS. Our distributors and resellers generally offer products of several different companies, including products of our competitors. Accordingly, these distributors and resellers, such as Ingram Micro, Tech Data, Compucom, and Custom Edge may give higher priority to products of our competitors, which could harm our operating results. In addition, our distributors and resellers 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 or resellers 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. 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. MARKETS FOR BOTH OUR NAS APPLIANCES AND OUR NON-NAS 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 24 results. We compete with other NAS companies, direct-selling storage providers and smaller vendors that provide storage solutions to end-users. In our non-NAS 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 SUCH AS INGRAM MICRO AND TECH DATA AND SPECIALIZED END-USERS, FOR A SUBSTANTIAL PORTION OF OUR NET SALES AND ACCOUNTS RECEIVABLE, AND CHANGES IN THE TIMING AND SIZE OF THESE CUSTOMERS' ORDERS MAY CAUSE OUR OPERATING RESULTS TO FLUCTUATE. Three customers accounted for approximately 45% and 54% of our total accounts receivable at July 31, 2000 and July 31, 2001, respectively, and one customer accounted for approximately 9% and 7% of our sales in fiscal 1999 and 2000, respectively, while another customer, Storway, a European storage service provider, accounted for 12% of our net sales in fiscal 2001. In fiscal 1999, 2000, and 2001, we sold our non-NAS products principally to distributors and master resellers such as Ingram Micro, Tech Data, Custom Edge (previously Inacom) and Compucom. 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 expect that single site purchasers of large installations of our NAS products will purchase large volumes of our NAS products over relatively short periods of time. This will cause both our sales and our accounts receivable to be highly concentrated and significantly dependent on one or only a few customers, as has occurred in fiscal year 2001. 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. During the fourth quarter of fiscal 2001, we increased our reserves for accounts receivable by $3.3 million. 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. OUR GROSS MARGINS OF OUR VARIOUS PRODUCT LINES HAVE FLUCTUATED SIGNIFICANTLY IN THE PAST AND MAY CONTINUE TO FLUCTUATE SIGNIFICANTLY. FOR EXAMPLE, WE MAY SEE REDUCED SALES OF HIGHER-MARGIN CD SERVERS OR NOTEBOOK UPGRADE PRODUCTS AND 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 disk drives, CD servers and arrays, and storage upgrade products. The market for these products is highly competitive and subject to intense pricing pressures. Some of these products, such as CD servers and arrays and some laptop storage upgrade systems, have historically generated high gross margins, although we have experienced significant declines in sales of these products. Sales of disk drive upgrade systems generally generate lower gross margins than those of our NAS products. If we fail to increase sales of our NAS appliances, or if demand, sales or gross margins for CD servers and arrays and our laptop storage upgrade systems decline rapidly, we believe our overall gross margins will 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. 25 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. 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. 26 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. We believe that our growth and profitability will require successful expansion of our international operations to which we have committed significant resources. 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 denominations other than U.S. dollars; - 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. 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 $160,000 in the first quarter of fiscal 2001, a foreign currency gain of $219,000 in the second quarter of fiscal 2001, and foreign currency losses of $97,000 and $16,000 in the third and fourth quarters of fiscal 2001, respectively. 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 $3.2 million between the date of purchase and July 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, hire additional personnel and recruit additional international distributors and 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 27 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 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. In recent periods, 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 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 non-NAS products, which continue to represent a majority of our net sales; - 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. 28 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 distribution and reseller customers have limited 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 fiscal 2000 and 2001, we experienced product return rates of approximately 14% and 12%, 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. We believe that our success will depend on the continued services of our executive officers and other key employees. In particular, we rely on the services of our four founders, Messrs. Razmjoo, Alaghband, Aydin and Shahrestany. We maintain employment agreements with each of our founders. We do not maintain key-person life insurance policies on these individuals. The loss of any of these 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 and $16.6 million (including a charge for in-process research and development) in fiscal year 2001. We expect to continue to incur operating losses through at least the third quarter of fiscal 2002. As part of our strategy to focus on the NAS market, we plan to increase our field sales force. 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. 29 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. The debentures provide that, in certain circumstances, the holder of the debentures may convert their 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 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 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 next re-set period begins on October 31, 2001 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 a re-set conversion price of approximately $9.71 per share. We have paid the investor in cash the $5.0 million principal amount of the debentures that the 30 investor elected to convert during the first re-set period. Up to an additional $5.0 million of the debentures, plus any unpaid interest on that amount, may be converted at the re-set conversion price beginning on October 31, 2001, and any remaining debentures, plus any unpaid interest, may be converted at the re-set conversion price during any subsequent re-set period. We have received a notice that the investor intends to seek payment or conversion of the payment, due on October 31, 2001. We intend to make a payment in cash to satisfy any investor demand. 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. 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 $.50 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 $.45 per share. If the remaining $10.0 million principal amount of the debentures were to be converted at this price, we would be required to issue the investor approximately 22,400,000 shares, which would result in the investor owning 58.4% 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 to $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 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, the last re-set period. At July 31, 2001, the amount relating to unamortized debt issuance costs and warrant costs was approximately $529,000. 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. 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 ENTIRE AMOUNT OWED IN CASH WITHIN THREE DAYS. IF AN EVENT OF DEFAULT OCCURS, WE MAY BE UNABLE TO IMMEDIATELY REPAY THE AMOUNT OWED, AND ANY REPAYMENT MAY LEAVE US WITH LITTLE OR NO WORKING CAPITAL IN 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; 31 - 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. 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. At July 31, 2001, we are in default under a financial covenant of the CIT loan agreement, although there is no amount outstanding under this loan agreement. The investor has informally advised us that it will not declare an event of default under the debenture as long as there is no amount outstanding under the CIT loan agreement. 32 If we were required to make a default payment at a time when all of the remaining $10.0 million principal amount of the debentures were outstanding, the payment required would be a minimum of $11.0 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, we may be unable to repay any part or all of the entire amount in cash. Any such repayment could leave us with little or no working capital for 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. In March 2001, the Staff of the Securities and Exchange Commission 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 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. 33 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-K 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-K 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-K. 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. As discussed elsewhere in this Report on Form 10-K, construction of our headquarters in Irvine, California was completed in September 2000. Total costs for the headquarters facility, including land costs, were approximately $15.9 million. We may be seeking long-term mortgage financing for all or some of the facility cost during the next fiscal year. We have not "locked" in a commitment, and may therefore find such financing to be much more expensive as a result. Since July 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 Germany. 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 fiscal 1999, 2000 and 2001, we incurred approximately $29,000, $213,000 and $54,000, respectively, in foreign currency losses which are included in our selling, general and administrative costs. 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, 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 because we translate sales of our subsidiaries at the average rate in effect during a financial reporting period. At July 31, 2001, approximately $9.6 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. 34 ITEM 8. FINANCIAL STATEMENTS INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE ---- Independent Auditors' Report .......................... 36 Consolidated Balance Sheets ........................... 37 Consolidated Statements of Operations ................. 38 Consolidated Statements of Shareholders' Equity ....... 39 Consolidated Statements of Cash Flows ................. 40 Notes to Consolidated Financial Statements ............ 41
35 INDEPENDENT AUDITORS' REPORT The Board of Directors of Procom Technology, Inc.: We have audited the accompanying consolidated balance sheets of Procom Technology, Inc. and subsidiaries as of July 31, 2000 and 2001, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the years in the three-year period ended July 31, 2001. In connection with our audits of the consolidated financial statements, we have also audited the consolidated financial statement schedule as of and for each of the years in the three-year period ended July 31, 2001. These consolidated financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Procom Technology, Inc. and subsidiaries as of July 31, 2000 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended July 31, 2001, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG LLP Orange County, California September 26, 2001 36 PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
JULY 31, ------------------------------- 2000 2001 ------------ ------------ ASSETS Current assets: Cash and cash equivalents ........................ $ 1,450,000 $ 25,419,000 Short-term marketable securities, held to maturity 14,065,000 -- Accounts receivable, less allowance for doubtful accounts and sales returns of $2,752,000 and $6,412,000, respectively ....................... 6,699,000 11,979,000 Inventories, net ................................. 8,430,000 6,292,000 Income tax receivable ............................ 2,699,000 18,000 Deferred income taxes ............................ 1,833,000 -- Prepaid expenses ................................. 372,000 1,184,000 Other current assets ............................. 296,000 310,000 ------------ ------------ Total current assets ......................... 35,844,000 45,202,000 Property and equipment, net ........................ 16,034,000 17,766,000 Other assets ....................................... 918,000 2,259,000 ------------ ------------ Total assets ................................. $ 52,796,000 $ 65,227,000 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Lines of credit .................................. $ 610,000 $ 8,000 Loan payable ..................................... 10,750,000 -- Accounts payable ................................. 8,888,000 4,151,000 Flooring line obligation ......................... 1,511,000 531,000 Accrued expenses and other current liabilities ... 1,837,000 2,052,000 Accrued compensation ............................. 1,213,000 1,194,000 Deferred service revenues ........................ 431,000 447,000 Income taxes payable ............................. -- 51,000 Convertible debenture ............................ -- 9,726,000 ------------ ------------ Total current liabilities .................... 25,240,000 18,160,000 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, 11,531,357 and 15,993,564 shares issued and outstanding, respectively ........... 115,000 160,000 Additional paid-in capital ....................... 19,685,000 58,575,000 Retained earnings (accumulated deficit) .......... 8,007,000 (11,343,000) Accumulated other comprehensive loss ............. (251,000) (325,000) ------------ ------------ Total shareholders' equity ................... 27,556,000 47,067,000 ------------ ------------ Total liabilities and shareholders' equity ... $ 52,796,000 $ 65,227,000 ============ ============
The accompanying notes are an integral part of these consolidated financial statements. 37 PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
THREE YEARS ENDED JULY 31, ----------------------------------------------------- 1999 2000 2001 ------------- ------------- ------------- Net sales .................................. $ 101,290,000 $ 63,210,000 $ 41,882,000 Cost of sales .............................. 73,003,000 46,189,000 26,625,000 ------------- ------------- ------------- Gross profit ........................... 28,287,000 17,021,000 15,257,000 Selling, general and administrative expenses 26,314,000 21,930,000 21,235,000 Research and development expenses .......... 5,502,000 7,187,000 6,403,000 Acquired in-process research and development -- -- 4,262,000 Impairment and restructuring charge ........ 1,626,000 -- -- ------------- ------------- ------------- Total operating expenses ............... 33,442,000 29,117,000 31,900,000 ------------- ------------- ------------- Operating loss ......................... (5,155,000) (12,096,000) (16,643,000) Interest income ............................ 1,248,000 1,055,000 809,000 Interest expense ........................... (26,000) (7,000) (1,716,000) ------------- ------------- ------------- Loss before income taxes ................. (3,933,000) (11,048,000) (17,550,000) Provision (benefit) for income taxes ..... (1,058,000) (3,064,000) 1,800,000 ------------- ------------- ------------- Net loss ................................... $ (2,875,000) $ (7,984,000) $ (19,350,000) ============= ============= ============= Net loss per common share: Basic and diluted ..................... $ (0.26) $ (0.70) $ (1.54) ============= ============= ============= Weighted average number of common shares: Basic and diluted ..................... 11,241,000 11,351,000 12,533,000 ============= ============= =============
The accompanying notes are an integral part of these consolidated financial statements. 38 PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
COMMON STOCK ACC. OTHER ------------------------ ADDITIONAL RETAINED COMPREHENSIVE SHARES AMOUNT PAID IN CAPITAL EARNINGS INCOME (LOSS) TOTAL ----------- --------- --------------- ------------ --------- ------------ BALANCE AT JULY 31, 1998 ................. 11,178,742 $ 112,000 $ 17,751,000 $ 18,866,000 $ 3,000 $ 36,732,000 Comprehensive loss: Net loss ................................. -- -- -- (2,875,000) -- (2,875,000) Foreign currency translation adjustment .. -- -- -- -- (18,000) (18,000) ------------ Comprehensive loss ..................... (2,893,000) Exercise of employee stock options ....... 41,013 -- 152,000 -- -- 152,000 Issuance of stock to employees ........... 5,531 -- 39,000 -- -- 39,000 Tax benefit from stock option exercises .. -- -- 71,000 -- -- 71,000 Stock repurchases ........................ (77,845) (1,000) (400,000) -- -- (401,000) Acquisition of businesses ................ 79,600 1,000 585,000 -- -- 586,000 ----------- --------- ------------ ------------ --------- ------------ BALANCE AT JULY 31, 1999 ................. 11,227,041 112,000 18,198,000 15,991,000 (15,000) 34,286,000 ----------- --------- ------------ ------------ --------- ------------ Comprehensive loss: Net loss ................................. -- -- -- (7,984,000) -- (7,984,000) Foreign currency translation adjustment .. -- -- -- -- (236,000) (236,000) ------------ Comprehensive loss ..................... (8,220,000) Compensatory stock options ............... -- -- 62,000 -- -- 62,000 Exercise of employee stock options ....... 278,587 3,000 1,112,000 -- -- 1,115,000 Issuance of stock to employees ........... 25,729 -- 313,000 -- -- 313,000 ----------- --------- ------------ ------------ --------- ------------ 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 =========== ========= ============ ============ ========= ============
The accompanying notes are an integral part of these consolidated financial statements. 39 PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED JULY 31, -------------------------------------------------- 1999 2000 2001 ------------ ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ................................................... $ (2,875,000) $ (7,984,000) $(19,350,000) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization .............................. 1,506,000 895,000 1,506,000 Amortization of debt issuance costs related to stock warrant -- -- 288,000 Compensatory stock options ................................. -- 62,000 41,000 Acquired in-process research and development ............... -- -- 4,262,000 Impairment and restructuring charge ........................ 1,408,000 -- -- Deferred income taxes ...................................... 19,000 -- 1,833,000 Changes in operating accounts: Accounts receivable ..................................... 7,883,000 1,949,000 (5,269,000) Inventories ............................................. (530,000) 1,543,000 2,138,000 Income tax receivable ................................... (2,859,000) 160,000 2,681,000 Prepaid expenses ........................................ 289,000 143,000 (812,000) Other current assets .................................... (54,000) (10,000) (14,000) Other assets ............................................ 187,000 (17,000) 61,000 Accounts payable ........................................ (1,872,000) (413,000) (4,847,000) Accrued expenses and compensation ....................... (1,041,000) (324,000) 196,000 Tax benefits from stock option exercises ................ 71,000 -- -- Deferred service revenues ............................... (87,000) (413,000) 16,000 Income taxes payable .................................... (768,000) (18,000) 51,000 ------------ ------------ ------------ Net cash provided by (used in) operating activities ........ 1,277,000 (4,427,000) (17,219,000) ------------ ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment ......................... (9,055,000) (7,289,000) (2,793,000) Purchases (redemptions) of short-term marketable securities (9,008,000) 9,008,000 -- Acquisitions, net of cash acquired ......................... 30,000 -- (250,000) ------------ ------------ ------------ Net cash provided by (used in) investing activities ..... (18,033,000) 1,719,000 (3,043,000) ------------ ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Issuance (repayment) of loan payable ....................... 7,500,000 3,250,000 (10,750,000) Issuance of convertible debenture .......................... -- -- 15,000,000 Repayment of convertible debenture ......................... -- -- (5,000,000) Borrowings (repayments) under lines of credit .............. (453,000) 356,000 (602,000) Flooring line obligation ................................... -- -- (980,000) Proceeds from employee stock purchases ..................... 39,000 313,000 234,000 Repurchase of common stock ................................. (401,000) -- -- Proceeds from exercise of stock options .................... 152,000 1,115,000 847,000 Net proceeds from issuance of common stock ................. -- -- 31,491,000 ------------ ------------ ------------ Net cash provided by financing activities ............... 6,837,000 5,034,000 30,240,000 Effect of exchange rate changes ................................ (18,000) (236,000) (74,000) ------------ ------------ ------------ Increase (decrease) in cash .................................... (9,937,000) 2,090,000 9,904,000 Cash and cash equivalents at beginning of period ............... 23,362,000 13,425,000 15,515,000 ------------ ------------ ------------ Cash and cash equivalents at end of period ..................... $ 13,425,000 $ 15,515,000 $ 25,419,000 ============ ============ ============ Supplemental disclosures of cash flow information: CASH PAID (RECEIVED) DURING THE YEAR FOR: Interest ................................................... $ 25,000 $ 7,000 $ 845,000 Income taxes ............................................... $ 2,275,000 $ (2,754,000) $ (2,765,000) SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITIES: Common stock warrant issued to convertible debenture investor $ -- $ -- $ 562,000 Common stock issued for acquisition of business ............. $ -- $ -- $ 5,760,000
The accompanying notes are an integral part of these consolidated financial statements. 40 PROCOM TECHNOLOGY, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION Procom Technology, Inc. (the "Company") was incorporated in California in 1987. The Company designs, manufactures and markets enterprise-wide data storage and information access solutions that are compatible with all major hardware platforms, network protocols and operating systems. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Procom Technology, Inc. and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation. The functional currencies of the European subsidiaries are those of their respective countries. The Company incurred foreign currency losses of approximately $29,000, $213,000 and $54,000 for the years ended July 31, 1999, 2000 and 2001, respectively. The Company did not engage in hedging activities for any of these periods. The Company follows the provisions of Statement of Financial Accounting Standards ("SFAS") 52 when translating assets and liabilities and results of operations for each period presented. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. FAIR VALUE OF FINANCIAL INSTRUMENTS - CASH AND SHORT-TERM MARKETABLE DEBT SECURITIES, HELD TO MATURITY For statement of cash flow purposes, short term marketable securities with original maturities less than 90 days are considered cash equivalents. The carrying amount of cash and cash equivalents approximates fair value for all periods presented due to the short-term maturities (less than 90 days) of these financial instruments. At July 31, 2000, approximately $11,900,000 of the short-term marketable securities were pledged as collateral for a repayment of a loan which was repaid in fiscal 2001. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, which defines derivatives, requires that all derivatives be carried at fair value, and provides for hedge accounting when certain conditions are met. This statement is effective for the first fiscal quarter of fiscal years beginning after June 15, 2000. Adoption of this statement did not have a material impact on the Company's consolidated financial position, results of operations or cash flows. ACCOUNTS RECEIVABLE The allowance for doubtful accounts represents management's estimate of the amount expected to be lost on specific accounts and on other as yet unidentified accounts included in accounts receivable. In estimating the potential losses on specific accounts, management relies on analyses prepared in-house and review of other available information. The allowance for sales returns represents management's estimates of anticipated sales returns relating to each reporting period. In estimating the allowance for sales returns, management relies on historical experience. Although the Company believes it has the continued ability to reasonably estimate the allowance for doubtful accounts and sales returns, the amounts the Company will ultimately incur could differ materially in the near term from the amounts assumed in arriving at the allowance for doubtful accounts and sales returns in the accompanying consolidated financial statements. INVENTORIES Inventories are valued at the lower of cost (on a first-in, first-out (FIFO) basis) or market. Allowances for obsolete inventory are based on management's estimate of the amount considered obsolete based on specific reviews of inventory items. In estimating the 41 allowance, management relies on its knowledge of the industry (including technological and design changes) as well as its current inventory levels. The amounts the Company will ultimately realize could differ materially in the near term from amounts estimated by management. LONG-LIVED ASSETS Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over the respective estimated useful lives of the assets, which range from three to seven years. Leasehold improvements are amortized using the straight-line method over the lesser of the lease term or the estimated useful life of the assets. Expenditures for major renewals and betterments are capitalized, while minor replacements, maintenance and repairs that do not extend the assets' lives are charged to operations as incurred. Upon sale or disposition, the cost and related accumulated depreciation are removed from the Company's accounts and any gain or loss is included in the statement of operations. Interest of approximately $208,000, $489,000 and $142,000 has been capitalized during fiscal years 1999, 2000 and 2001, respectively, and included in the cost of the Company's headquarters. Long-lived assets, goodwill and certain identifiable intangibles are reviewed for impairment in value based upon undiscounted future operating cash flows, and appropriate losses are recognized and reflected in current earnings, to the extent the carrying amount of an asset exceeds its estimated fair value determined by the use of appraisals, discounted cash flow analyses or comparable fair values of similar assets. INCOME TAXES The Company reports certain expenses differently for financial and tax reporting purposes and, accordingly, provides for the related deferred income taxes. Income taxes are accounted for under the asset and liability method in accordance with SFAS No. 109, "Accounting for Income Taxes." REVENUE RECOGNITION The Company generally records sales upon product shipment. In the case of sales to most of the distributors with whom the Company has contracts, the Company records sales when the distributor receives the products. The Company recognizes product service and support revenues over the terms of their respective contractual periods. The Company's agreements with many of its VARs, system integrators and distributors allow limited product returns, including stock balancing, and price protection privileges. The Company maintains reserves, which are adjusted at each financial reporting date, to state fairly the anticipated returns, including stock balancing and price protection claims relating to each reporting period. The Company calculates the reserves based on historical rates of sales and returns, including price protection and stock balancing claims, past experiences with its customers, the terms of its agreements with its customers, and current information as to the level of inventory held by the customer. The amounts the Company will ultimately realize could differ materially in the near term from the amounts estimated. In addition, under a product evaluation program established by the Company, its indirect channel partners and end-users generally are able to purchase 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 the evaluation units are included in inventory as finished goods. At July 31, 2000 and 2001, inventory related to evaluation units was approximately $1.5 million and $2.2 million, respectively. The Company does not record evaluation units as sales until notification of acceptance for these units is received from the customer. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," as amended, ("SAB 101") which was effective for us in the fourth quarter of fiscal 2001. Adoption of SAB101 did not have a material effect on the Company's consolidated financial position or results of operations. DEFERRED SERVICE REVENUE The Company markets and sells service contracts for certain of its appliances that require the Company to service previously sold appliances for a specified period of time, usually one to three years. Revenue from these contracts is billed to customers at the time of sale, but earned ratably over the life of the service agreement. A corresponding liability reflecting the unearned revenue is recorded as a current liability, since unearned revenue relating to service after 12 months is not material. 42 RESEARCH AND DEVELOPMENT COSTS Costs and expenses that can be clearly identified as research and development are charged to research and development expenses as incurred. CONCENTRATION OF CREDIT RISK Three customers accounted for approximately 45% and 54% of the Company's total accounts receivable on July 31, 2000 and 2001, respectively, and one customer accounted for approximately 9% and 7% of the Company's net sales in fiscal 1999 and 2000, respectively, while another customer accounted for 12% of the Company's net sales in fiscal 2001. The loss of any one of the Company's significant customers could have an adverse effect on the Company's business. NET LOSS PER COMMON SHARE Basic earnings per share are computed by dividing net loss by the weighted-average number of common shares outstanding during the period. Diluted earnings per share are computed by dividing net income by the weighted-average number of common shares outstanding during the period increased to include the number of additional shares that would be outstanding if the dilutive potential common shares had been issued. The dilutive effect of outstanding options and warrants is reflected in diluted earnings per share by application of the treasury-stock method. Due to the net losses in fiscal 1999, 2000 and 2001, no effect is given to the potential dilution of outstanding stock options. Approximately 367,000, 1,184,000 and 922,000 shares would have been included in the computation of diluted earnings per share if a net loss had not been incurred in fiscal 1999, 2000 and 2001. Weighted average number of shares for basic and diluted net loss per share are calculated as follows:
YEAR ENDED JULY 31, ------------------------------------------ 1999 2000 2001 ---------- ---------- ---------- Weighted average common shares outstanding during the period ...................... 11,241,000 11,351,000 12,533,000 Potential dilution ....................... -- -- -- ---------- ---------- ---------- Total shares ............................. 11,241,000 11,351,000 12,533,000 ========== ========== ==========
STOCK BASED COMPENSATION The Company measures stock based compensation for option grants to employees and members of the board of directors using a method which assumes that options granted at market price at the date of grant have no intrinsic value. Proforma net loss and net loss per share are presented in Note 10 as if the fair value method had been applied. Stock options issued to non-employees are recorded at the fair value of the stock options at the performance commitment date. IMPACT OF 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. 43 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 $142,000, $167,000 and $340,000 for the years ended July 31, 1999, 2000 and 2001, 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 the Company's consolidated financial position or results of operations. 44 2. INVENTORIES A summary of inventories is as follows:
YEAR ENDED JULY 31, -------------------------- 2000 2001 ---------- ---------- Raw materials ........... $4,225,000 $4,374,000 Work-in-process ......... 255,000 295,000 Finished goods .......... 3,950,000 1,623,000 ---------- ---------- $8,430,000 $6,292,000 ========== ==========
3. PROPERTY AND EQUIPMENT A summary of property and equipment is as follows:
YEAR ENDED JULY 31, ------------------------------- 2000 2001 ------------ ------------ Computer equipment ................ $ 2,813,000 $ 3,955,000 Furniture and fixtures ............ 1,048,000 1,167,000 Office equipment .................. 1,225,000 1,216,000 Vehicles .......................... 47,000 47,000 Leasehold improvements ............ 297,000 297,000 Land .............................. 7,999,000 8,283,000 Buildings ......................... 6,352,000 7,715,000 ------------ ------------ Subtotal ...................... 19,781,000 22,680,000 Less accumulated depreciation ..... (3,747,000) (4,914,000) ------------ ------------ Total ......................... $ 16,034,000 $ 17,766,000 ============ ============
Depreciation expense for fiscal 1999, 2000 and 2001 totaled $1,261,000, $728,000 and $1,166,000, respectively. 4. INCOME TAXES Loss before income taxes consisted of the following:
YEAR ENDED JULY 31 -------------------------------------------------- 1999 2000 2001 ------------ ------------ ------------ Pretax loss: United States .... $ (3,054,000) $ (9,772,000) $(14,032,000) Foreign .......... (879,000) (1,276,000) (3,518,000) ------------ ------------ ------------ $ (3,933,000) $(11,048,000) $(17,550,000) ============ ============ ============
The components of the provision (benefit) for income taxes for fiscal 1999, 2000 and 2001 are summarized as follows:
YEAR ENDED JULY 31 ----------------------------------------------- 1999 2000 2001 ----------- ----------- ----------- Current: Federal ............... $(1,077,000) $(3,064,000) $ (69,000) State ................. -- -- 7,000 Foreign ............... -- -- 29,000 ----------- ----------- ----------- (1,077,000) (3,064,000) (33,000) Deferred: Federal ............... 64,000 -- 1,405,000 State ................. (45,000) -- 428,000 ----------- ----------- ----------- 19,000 -- 1,833,000 ----------- ----------- ----------- Provision (benefit) for income taxes ...... $(1,058,000) $(3,064,000) $ 1,800,000 =========== =========== ===========
45 The following table reconciles the federal statutory income tax rate to the effective tax rate of the provision (benefit) for income taxes.
YEAR ENDED JULY 31 ---------------------------- 1999 2000 2001 ---- ---- ---- Federal statutory income tax rate .............. (34.0)% (34.0)% (34.0)% State income taxes, net of federal benefit ..... (1.8)% (2.4)% (2.9)% Research and development tax credit ............ (4.8)% (4.7)% (3.9)% State tax rate change .......................... 2.3% -- -- Foreign tax rate differential .................. (3.5)% -- -- Valuation allowance............................. 10.9% 13.8% 39.5% Purchased research and development ............. -- -- 8.3% Other .......................................... 4.0% (0.4)% 3.3% ---- ---- ---- Effective tax rate ........................... (26.9)% (27.7)% 10.3% ==== ==== ====
Deferred tax assets and liabilities are summarized below:
YEAR ENDED JULY 31, ----------------------------------------------- 1999 2000 2001 ----------- ----------- ----------- Deferred tax assets and liabilities: State and ................................. $ (146,000) $ (301,000) $ (569,000) Depreciation .............................. 66,000 94,000 13,000 Inventory reserves ........................ 338,000 456,000 1,167,000 Reserves for bad debts and returns ........ 614,000 806,000 1,691,000 Stock option exercises .................... 36,000 -- -- Deferred service revenue sales ............ 325,000 152,000 128,000 Research and development tax credit ....... 157,000 876,000 1,559,000 Accrued expenses .......................... 362,000 389,000 270,000 Net operating loss carry forwards - state . 67,000 274,000 524,000 Net operating loss carry forwards - federal -- 172,000 2,117,000 Net operating loss carry forwards - foreign 430,000 853,000 1,974,000 Other ..................................... 14,000 16,000 17,000 ----------- ----------- ----------- Total deferred income taxes ............ $ 2,263,000 $ 3,787,000 $ 8,891,000 Valuation allowance ....................... (430,000) (1,954,000) (8,891,000) ----------- ----------- ----------- Net deferred income taxes ................. $ 1,833,000 $ 1,833,000 $ -- =========== =========== ===========
In accordance with SFAS 109, "Accounting for Income Taxes," the Company has recorded a valuation allowance equal to the net deferred tax assets as it is more likely than not that the Company will not realize the benefits of the existing net deferred tax asset at July 31, 2000. The Company claimed no benefit in the current provision for some $3,518,000 in operating losses at its foreign subsidiaries. If those subsidiaries generate taxable income in future periods, the Company may realize a tax benefit for these operating losses. At July 31, 2001, the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $6,626,000 and $11,862,000, respectively, which are available to offset future taxable income, if any, through 2021 and 2015, respectively. Utilization of the net operating loss carryforwards may be limited under Internal Revenue Code Section 382. At July 31, 2001, the Company had tax credit carryforwards for federal and state income tax purpose of approximately $887,000 and $672,000, respectively. The federal and state carryforwards are available to offset future tax liability, if any, through 2021. Utilization of the credit carryforwards may be limited under Internal Revenue Code Section 382. 46 5. OTHER ASSETS Other assets consist of the following:
YEAR ENDED JULY 31, ----------------------------- 2000 2001 ----------- ----------- Goodwill ............................... $ 1,167,000 $ 2,958,000 Accumulated amortization of goodwill ... (371,000) (710,000) Other assets ........................... 122,000 11,000 ----------- ----------- $ 918,000 $ 2,259,000 =========== ===========
Goodwill relates to two acquisitions completed by the Company in fiscal 1998, two acquisitions completed in fiscal 1999 and one acquisition completed in fiscal 2001. Goodwill is amortized on a straight line basis over four to seven years. In fiscal 1999, 2000 and 2001, amortization of goodwill was $142,000, $167,000 and $340,000, respectively. 6. LINES OF CREDIT AND CONVERTIBLE DEBENTURE On July 31, 2000, the Company had established a revolving line of credit with Finova Capital Corporation. The line had been based on a percentage of the Company's eligible accounts receivable and inventory, up to a maximum of $10,000,000. In early October 2000, the Company paid off all amounts outstanding under the Finova line of credit and replaced it with the line of credit with CIT Business Credit. On October 10, 2000, the Company entered into a term loan agreement and a three-year working capital line of credit with CIT Business Credit. 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 (6.75% per annum at July 31, 2001), plus .5%, with increases if the loan 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 July 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 July 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 July 31, 2001, the Company was not in compliance with the minimum EBITDA requirement. Although the Company has repaid all amounts outstanding under the credit facility and does not intend to borrow against the line of credit in fiscal 2002, CIT may elect to decline making any advances under the line of credit or may terminate the line. In addition, if advances are made while the Company is out of compliance with the financial or other covenants, CIT may charge the Company the default rate of interest (currently 9.0% per annum) on those advances. The Company has initiated discussions with various other potential financing sources regarding an alternate short-term working capital financing arrangement. However, no assurance can be given that the Company will be successful in obtaining any such financing arrangement on favorable or any terms. 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 replaced the Finova flooring line of credit with a flooring line with IBM Credit who has committed to make $2.5 million in flooring inventory commitments available to the Company. As of July 31, 2001, the Company owed $531,000 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. As of July 31, 2001, the Company owed $531,000 under the flooring line. The flooring line requires the maintenance by the Company of a minimum net worth of $16.0 million. The flooring line also requires the Company to represent, at the time we request advances under the line, that the Company is in compliance with the terms of the Company's other loan agreements. Because of the Company's default of the financial covenant of the CIT credit line, the Company was out of compliance with this portion of the flooring line at July 31, 2001. Although the Company has no borrowings under the CIT credit line, the Company has advised IBM of the CIT default, and has requested that IBM not declare a default under IBM credit line in respect of the CIT covenant default under the CIT credit line. If IBM were to declare a default under the flooring line, IBM could decline to make further advances under this line and/or terminate the line. 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. 47 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 next re-set period begins on October 31, 2001 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 a re-set conversion price of approximately $9.71 per share. 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. Up to an additional $5.0 million of the debentures, plus any unpaid interest on that amount, may be converted at the re-set conversion price beginning on October 31, 2001, and any remaining portion of the debenture, plus any unpaid interest, may be converted at the re-set conversion price during any subsequent re-set period. 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. 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, which will be amortized through May 2002, the last re-set period. The principal amount of the debenture, net of the remaining unamortized warrant value is classified as a current liability. At July 31, 2001, the debenture amount repayable was $10,000,000 and the unamortized warrant value was $274,000, for a net debenture value of $9,726,000 and is classified as a current liability. In addition to the warrant cost, approximately $700,000 of debt issuance costs were incurred in the debt transactions noted above. The unamortized cost of approximately $529,000 is included in prepaid expenses and will be amortized as interest expense through May 2002, the last re-set period. At July 31, 2001, the Company is in default under the financial covenant of the CIT loan agreement. The investor has advised the Company informally that it will not declare an event of default under the debenture as long as there is no amount outstanding under the CIT loan agreement. 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. The Company intends to use up to $10.0 million of the offering proceeds in the future to pay any remaining indebtedness under the debenture. As a result of this offering, the conversion price of the outstanding debenture was adjusted to $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 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 July 31, 2001, approximately $8,000 was outstanding under these lines. In October 2000, the Company repaid the 18 month loan payable to an investment bank of $10.75 million. The loan, which originally matured in September 2000 but was subsequently renewed for an additional 6 month period, carried rates ranging from 6.125% to 7.4%. At July 31, 2000, approximately $11.9 million of the Company's commercial paper portfolio was pledged as collateral for repayment of this loan. 7. COMMITMENTS AND CONTINGENCIES LEASE COMMITMENTS At July 31, 2001, the Company leases facilities under non-cancelable operating leases in Munich, Germany; Milan and Rome, Italy; Ontario, Canada; Paris, France and Livingston, Scotland, Great Britain. In addition, the Company has various operating leases for certain office equipment and vehicles. 48 At July 31, 2001, future minimum lease payments under these leases were as follows:
OPERATING LEASES ---------- Fiscal year ending: 2002 .................. $ 382,000 2003 .................. 248,000 2004 .................. 165,000 2005 .................. 47,000 2006 .................. 47,000 Thereafter ............ 114,000 ---------- Total minimum lease payments $1,003,000 ==========
Rent expense was $1,439,000, $1,412,000 and $458,000 for fiscal 1999, 2000 and 2001, respectively. FLOORING AGREEMENTS As is customary in the computer reseller industry, the Company is contingently liable at July 31, 2001 under the terms of repurchase agreements with several financial institutions providing inventory financing for dealers of the Company's appliances. Under these agreements, dealers purchase the Company's appliances, and the financial institutions agree to pay the Company 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 the Company 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. The risk of loss is spread over several dealers and financial institutions. At July 31, 2000 and 2001, the Company was contingently liable for purchases made under these agreements of approximately $560,000 and $62,000, respectively. During the three years ended July 31, 2001, the Company was not required to repurchase any previously sold inventory pursuant to the flooring agreements. LITIGATION The Company is involved in routine litigation arising in the ordinary course of its business. While the outcome of litigation cannot be predicted with certainty, the Company believes that none of the pending litigation will have a material adverse effect on the Company's financial position or results of operations. EMPLOYMENT AGREEMENTS The Company has employment agreements with the Company's President and three Executive Vice Presidents. Each agreement is for a three-year term with an automatic renewal provision which provides that the agreement will perpetually maintain a three-year term unless terminated. Each agreement contains severance provisions that require the payment of 35 months of base salary in the event of the termination of the covered executives. Should all four executives be terminated, the aggregate commitment arising under the severance provisions would be approximately $2.6 million and, in addition, the Company would be obligated to pay a pro rata bonus for the year of termination and to continue for up to two years all life insurance and medical benefits. 8. RETIREMENT PLAN The Company has a defined contribution plan covering substantially all full-time employees with more than one year of service. Each participant can elect to contribute up to 15% of his or her annual compensation. While employer contributions to the plan are discretionary, during fiscal 1999, 2000 and 2001 the Company elected to make matching contributions equivalent to between 38% and 50% of the first 4% of each eligible employee's contribution. Total expense for fiscal 1999, 2000 and 2001 was $106,000, $86,000 and $82,000, respectively. 9. RELATED PARTY TRANSACTIONS During the three years ended July 31, 2001, the Company utilized the services of Advanced Construction Solutions, Inc. (ACS), an Orange County based real estate developer and general contractor to (a) locate a suitable facility for the Company to utilize as its corporate headquarters for approximately 18 months, (b) act as a general contractor to complete a build-out of necessary tenant improvements for the temporary facility, and (c) locate, and then negotiate the purchase of, and commence development of, a parcel of land in Irvine, California for the Company's long-term corporate headquarters. ACS is owned 50% by a brother of Frank Alaghband, 49 an Executive Vice President and Director of the Company. During the year ended July 31, 1999, the Company executed an 18 month lease with an unrelated landlord, calling for approximately $1,050,000 in lease payments, and the Company purchased an 8 acre site from an unrelated landowner for approximately $7.3 million. ACS received approximately $357,000 directly from the Company for the tenant improvement build-out (of approximately 60,000 square feet), $40,200 directly from the Company for services in planning and developing the Irvine facility, and approximately $142,000 in commissions paid by the temporary facility landlord and the land owner upon the completion of the transactions described. The Company had also agreed to utilize ACS in the construction of the Irvine facility. The Company has expended approximately $7.7 million for construction costs through July 31, 2001. A majority of the construction costs were paid to ACS. 10. STOCK OPTION PLAN AND EMPLOYEE STOCK PURCHASE PLAN During fiscal 1996, the Company instituted the 1995 Stock Option Plan (the "1995 Plan") for its key employees and reserved 540,000 shares for grant under the 1995 Plan. Subsequently, the Board and the Company's shareholders approved the reservation of an additional 3,050,000 shares for grant under the 1995 Plan. Pursuant to the terms of the 1995 Plan, options to purchase the Company's common stock may be granted with exercise prices equal to the fair market value of the stock on the date of grant. Options expire ten years from the date of the grant and generally vest over a period of four years. In September 1998, the Board authorized the re-pricing of 374,950 options previously granted with exercise prices in excess of $4.50 per share. The new exercise price was $4.50 per share, the fair value of the Company's stock on the date of such re-pricing. Repriced options are included in the granted and cancelled amounts below. The following table is a summary of stock option activity for the three years ended July 31, 2001:
YEAR ENDED JULY 31, ---------------------------------------------------------------------------------- 1999 2000 2001 ------------------------ ------------------------ ------------------------ WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE SHARES PRICE SHARES PRICE SHARES PRICE ---------- -------- ---------- ------ ---------- ------ Outstanding at beginning of year ......... 502,277 $ 6.53 1,403,449 $ 4.06 1,965,178 $ 8.43 Granted .............................. 1,653,890 $ 4.50 1,085,071 $11.91 735,579 $ 6.54 Exercised ............................ (41,013) $ 3.72 (278,587) $ 4.00 (157,401) $ 5.38 Cancelled ............................ (711,705) $ 6.44 (244,755) $ 5.60 (322,662) $ 9.96 ---------- ------ ---------- ------ ---------- ------ Outstanding at end of year ........... 1,403,449 $ 4.37 1,965,178 $ 8.43 2,220,694 $ 7.80 ========== ====== ========== ====== ========== ====== Exercisable end of year .............. 99,265 $ 3.43 247,748 $ 4.34 528,647 $ 8.10 ========== ====== ========== ====== ========== ====== Weighted fair value per option granted $ 4.11 $ 9.28 $ 5.84 ====== ====== ======
JULY 31, 2001 ----------------------------------------------------------------------------------------------------------------- OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------------------------------------------------- ---------------------------------- WEIGHTED-AVERAGE RANGE OF REMAINING WEIGHTED-AVERAGE WEIGHTED-AVERAGE EXERCISE PRICES NUMBER YEARS EXERCISE PRICE NUMBER EXERCISE PRICE ------------------ ----------------- ----------------- ----------------- ----------------- ---------------- $ 2.50 - 3.00 20,050 4.13 $ 2.50 20,050 $ 2.50 $ 4.50 - 6.48 1,629,731 8.55 $ 5.56 324,813 $ 4.65 $ 8.50 -16.25 570,913 8.58 $ 14.37 183,784 $14.80 -------- ------- 2,220,694 528,647 ========= =======
During the years ended July 31, 1999, 2000 and 2001, the Company recognized tax benefits of $71,000, $0 and $0, respectively, from the gains resulting from exercises by employees of non-qualified stock options. The tax benefit is recorded as an increase to additional paid-in-capital. Pro forma information regarding net loss and net loss per share is required by SFAS 123 as if the Company had accounted for its stock options under the fair value method of SFAS 123. The fair value of the Company's stock options was estimated using the Black-Scholes option valuation model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, the Black-Scholes model requires the input of highly subjective assumptions, including the expected stock volatility. Because the Company's stock options granted to employees have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock options granted to employees. The fair value of the Company's stock options granted to employees was estimated assuming no expected dividends and the following weighted average assumptions:
STOCK OPTION PLAN SHARES -------------------------- 1999 2000 2001 ---- ---- ---- Expected life (in years) 4.0 5.0 4.0 Risk-free interest rate 6.0% 6.0% 4.63% Volatility ............. 0.9 0.91 1.40
50 For purposes of pro forma disclosures, the estimated fair values of the options are amortized over the options' respective vesting period. The Company's pro forma information follows:
1999 2000 2001 -------------- -------------- -------------- Pro forma net loss ........................... $ (3,042,000) $ (8,414,000) $ (21,151,000) Pro forma basic and diluted net loss per share $ (.27) $ (.74) $ (1.69)
In fiscal 1999, the Company adopted an employee stock purchase plan ("ESPP") that operates in accordance with Section 423 of the Internal Revenue Code whereby eligible employees may, subject to certain limitations, authorize payroll deductions of up to 10% of their salary to purchase shares of the Company's common stock at 85% of the fair market value of the stock on the first or last date of semiannual purchase periods, whichever is less. The Company has reserved 250,000 shares of common stock for issuance under the ESPP. Approximately 6,000, 26,000 and 25,000 shares were issued under the ESPP during fiscal 1999, 2000 and 2001, respectively. 11. REVENUE BY PRODUCT AREA AND GEOGRAPHIC AREA REVENUES BY PRODUCT FAMILIES The Company operates in one principal industry segment: the design, manufacture and marketing of enterprise-wide data storage and information access solutions compatible with all major hardware platforms, networks and operating systems. No one customer accounted for more than 10% of the Company's net sales in fiscal 1999 or 2000. In fiscal 2001, one customer accounted for approximately 12% of the Company's net sales.
YEAR ENDED JULY 31, ---------------------------------------------- 1999 2000 2001 ------------ ----------- ----------- Net revenues: Network attached storage products $ 7,989,000 $17,442,000 $28,376,000 Other data storage products ..... 93,301,000 45,768,000 13,506,000 ------------ ----------- ----------- Total net revenues ........... $101,290,000 $63,210,000 $41,882,000 ============ =========== ===========
GEOGRAPHIC INFORMATION Export sales as a percentage of net sales amounted to 33%, 41% and 56% for fiscal years 1999, 2000 and 2001, respectively. A summary of the Company's net sales and gross profit by geographic area is as follows (in thousands):
YEAR ENDED JULY 31, --------------------------------------- 1999 2000 2001 --------- -------- -------- Net sales United States $ 67,549 $ 37,024 $ 18,567 Foreign ..... 33,741 26,186 23,315 --------- -------- -------- Total .... $ 101,290 $ 63,210 $ 41,882 ========= ======== ======== Gross profit United States $ 21,270 $ 11,878 $ 5,001 Foreign ..... 7,017 5,143 10,256 --------- -------- -------- Total .... $ 28,287 $ 17,021 $ 15,257 ========= ======== ======== Operating loss United States $ (4,455) $ (9,909) $(15,993) Foreign ..... (700) (2,187) (650) --------- -------- -------- Total .... $ (5,155) $(12,096) $(16,643) ========= ======== ========
International sales were primarily to European customers. As a result of the Company's February 1998 acquisition of the outstanding stock of Megabyte, and the subsequent acquisitions of Procom Technology, AG, Procom Technology, SPA and Scofima, the Company had identifiable assets used in connection with its foreign operations of approximately $7,054,000, $7,565,000 and $8,447,000 at July 31, 1999, 2000 and 2001, respectively. 51 12. ACQUISITIONS On December 28, 2000, the Company acquired all of the issued and outstanding capital stock of Scofima Software S.r.l., a company organized under the laws of Italy ("Scofima"), in exchange for 480,000 shares of the Company's common stock. Pursuant to its agreement with the former shareholders of Scofima, the Company registered for resale by those shareholders the shares issued to them in the acquisition. Scofima had an option to acquire a software system designed as a caching and content distribution solution. Immediately prior to the Company's acquisition of Scofima, Scofima exercised its option, and acquired the software system. The purpose of the software is to provide functionalities that are necessary for the content delivery market of the internet. The software had been in development for approximately 2-3 years, involving 5 programmers and system developers. The software was not complete at the date of acquisition, and was not yet determined to be technologically feasible. The Company is currently completing the software, and expects to release it in the third quarter of fiscal 2002. The Company issued 480,000 shares valued at $12 per share and incurred approximately $250,000 in acquisition costs in exchange for the outstanding shares of Scofima. Scofima had net assets of approximately $500,000 at the date of acquisition. The transaction was accounted for as a purchase of assets. The Company employed an appraiser to identify the values of the assets acquired, including, among other assets, certain in-process research and development costs. The amount of purchase price allocated to in-process research and development was determined by estimating the stage of development of the software, estimating future cash flows from projected revenues, and discounting those cash flows to present value. The discount rate applied was 25%. The incremental product sales resulting from the products incorporating the software are estimated to be $44 million over the initial four years of sales with sales growing from approximately $1.5 million in the initial year to $13.4 million in the fourth year. The appraiser concluded, and the Company has determined that approximately $4.3 million of the purchase price was related to the Company's research and development efforts that had not attained technological feasibility and for which no future alternative use was expected. The Company has expensed the value of the research and development as of the date of the acquisition of Scofima and capitalized the fair value of the other assets acquired as determined and allocated by the appraiser, including the value of the assembled workforce of approximately $0.2 million and developer relationships valued at $0.1 million which will be amortized over 4 years, with the remainder of $1.4 million assigned to goodwill, which will amortized over 4 years. The following is a summary of the net fair value of the assets acquired, the liabilities assumed, and the total consideration paid for Scofima: Net fair value of assets acquired ........... $ 6,120,000 Liabilities assumed ......................... (110,000) Common stock issued ......................... (5,760,000) ----------- Cash consideration paid, net of cash acquired $ 250,000 ===========
The following unaudited pro forma information has been prepared assuming that the acquisition of Scofima Software S.r.l. had taken place at the beginning of the respective periods presented. The pro forma financial information is not necessarily indicative of the combined results that would have occurred had the acquisition taken place at the beginning of the period, nor is it necessarily indicative of results that may occur in the future.
PRO FORMA FOR THE YEAR ENDED --------------------------------- July 31, 2000 July 31, 2001 ------------- ------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Net sales $ 63,215 $ 41,884 Operating loss $(12,521) $(12,556) Net loss $ (8,409) $(15,263) Net loss per share - basic and diluted $ (0.71) $ (1.20)
During fiscal 1999, the Company completed the acquisitions of Procom Technology, AG and Procom Technology, SPA. In November 1998, the Company acquired all of the outstanding stock of Procom Technology, AG in exchange for 28,500 shares of stock and $22,000 in cash. Procom Technology, AG is a relatively small Swiss distributor of computer storage peripherals, and has been a customer of the Company for more than five years. The Company treated the acquisition of Procom Technology, AG as a purchase, and recorded goodwill of approximately $168,000, which is being amortized over seven years. In January 1999, the Company acquired all of the outstanding stock of Procom Technology, SPA in exchange for 51,100 shares of stock and $50,000 in cash. Procom Technology, SPA is a relatively small Italian distributor of higher end computer storage peripherals. The Company's acquisition of Procom Technology, SPA, which was initially treated as a pooling-of-interests, has been changed to reflect the purchase accounting method. As a result of this change, revenue and net income for the second quarter of fiscal 1999 were reduced by approximately $3.1 million and $0.1 million, respectively, from that which was initially reported. The Company recorded goodwill of approximately $286,000, which is being amortized over seven years. 52 The following is a summary of the net fair value of the assets acquired, the goodwill on the date of acquisition, and the total consideration paid for the acquisitions made during fiscal 1999:
PROCOM PROCOM TECHNOLOGY, TECHNOLOGY, SPA AG TOTAL ----------- ----------- ----------- Fair value of assets acquired ................ $ 2,094,000 $ 280,000 $ 2,374,000 Liabilities assumed, including lines of credit (1,692,000) (126,000) (1,818,000) Common stock issued .......................... (436,000) (150,000) (586,000) ----------- ----------- ----------- Cash consideration paid, net of cash acquired $ (34,000) $ 4,000 $ (30,000) =========== =========== ===========
The following unaudited pro forma information has been prepared assuming that the acquisitions of Procom Technology, AG and Procom Technology, SPA had taken place at the beginning of the respective period presented. The pro forma financial information is not necessarily indicative of the combined results that would have occurred had the acquisitions taken place at the beginning of the period, nor is it necessarily indicative of results that may occur in the future.
PRO FORMA FOR THE YEAR ENDED ------------------------------------- JULY 31, 1999 ------------------------------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Net sales .................. $ 104,514 Operating loss ............. $ (5,025) Net loss ................... $ (2,841) Net loss per share - diluted $ (.25)
13. IMPAIRMENT AND RESTRUCTURING CHARGE As a result of changes to the Company's business operations, as well as significant operating losses of Invincible Technologies Corporation after its acquisition, in fiscal 1999, the Company determined it should restructure the operating activities of Invincible. At the time of acquisition, the Company sought to utilize Invincible's sales force to market and sell products of both Invincible and Procom's Netforce products. During the year after the acquisition, Invincible experienced significant margin pressure on its products and was unable to increase the sales of Netforce products. From the date of acquisition through April 1999, the Company had experienced significant financial losses from its Invincible operations. The restructuring consisted of closing several field offices, eliminating most of the Invincible product lines and reducing staff significantly. In connection with the restructuring, the Company also reviewed the long-lived assets purchased in the Invincible acquisition. After comparing the carrying value of the assets to the estimated future undiscounted cash flows from the assets, the Company determined that the value of the assets were impaired. The Company wrote off the goodwill remaining from the transaction of approximately $0.8 million, and wrote down the carrying value of certain Invincible fixed assets by $0.6 million. In addition, the Company recorded a restructuring charge comprised of approximately $0.2 million for lease termination and employee severance costs for approximately 10 employees relating to the Invincible operations. Approximately $0.2 million of the restructuring charge was accrued as of July 31, 1999 and was paid during fiscal 2000. In addition, the Company recorded, in cost of sales, additional reserves of approximately $0.8 million to reserve for the ultimate disposal of much of the Invincible inventory. As a result of the restructuring, the Company expects to see lower personnel costs and lower fixed charges such as depreciation relating to Invincible operations in the future. 14. QUARTERLY STATEMENTS OF OPERATIONS (UNAUDITED)
YEAR ENDED JULY 31, 2000 -------------------------------------------------------- Q1 Q2 Q3 Q4 ----------- ----------- ----------- ----------- Net Sales ....... 18,909,000 16,327,000 13,811,000 14,163,000 Gross Profit .... 5,241,000 3,806,000 3,333,000 4,641,000 Loss before Taxes (2,170,000) (3,872,000) (3,385,000) (1,621,000) Net Loss ........ (1,576,000) (2,681,000) (2,481,000) (1,246,000) Basic EPS ....... (0.14) (0.24) (0.22) (0.10) Diluted EPS ..... (0.14) (0.24) (0.22) (0.10)
YEAR ENDED JULY 31, 2001 -------------------------------------------------------- Q1 Q2 Q3 Q4(a) ----------- ----------- ----------- ----------- Net Sales ....... 13,264,000 11,722,000 8,002,000 8,894,000 Gross Profit .... 4,882,000 4,614,000 3,173,000 2,588,000 Loss before Taxes (1,485,000) (5,814,000) (2,979,000) (7,272,000) Net Loss ........ (1,091,000) (5,868,000) (3,040,000) (9,351,000) Basic EPS ....... (0.09) (0.50) (0.25) (0.64) Diluted EPS ..... (0.09) (0.50) (0.25) (0.64)
(a) In the fourth quarter of fiscal 2001, the Company's operating results included an increase in inventory reserves of $1.2 million primarily associated with the discontinuation of specific product lines and an increase in accounts receivable reserves of $3.3 million relating to weak global economic conditions and their impact on the financial stability of several of the Company's customers. Item 9. Change and Disagreements with Accountants on Accounting and Financial Disclosures Not Applicable. 53 PART III Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT There is incorporated herein by reference the information required by this Item included in the Company's Proxy Statement for the 2002 Annual Meeting of Shareholders under the captions "Management," "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance," which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended July 31, 2001. MANAGEMENT OUR DIRECTORS, EXECUTIVE OFFICERS AND KEY EMPLOYEES The following table sets forth information with respect to our executive officers, key employees and directors, as of July 31 and October 29, 2001:
NAME AGE POSITION ---- --- -------- Alex Razmjoo.................................... 39 Chairman of the Board, President and Chief Executive Officer Frank Alaghband................................. 38 Executive Vice President, Engineering and Operations, and Director Alex Aydin...................................... 39 Executive Vice President, Finance and Administration, Chief Financial Officer and Director Nick Shahrestany................................ 38 Executive Vice President, Sales and Marketing, and Director Dom Genovese.................................... 59 Director David Blake..................................... 61 Director Kevin Michaels.................................. 43 Director
Mr. Alex Razmjoo is one of the founders of Procom Technology, Inc. and has served as Procom's President, Chief Executive and Chairman since the Company's inception in 1987. Under his leadership, Procom led in the development of NAS technology and leveraged its position as world market leader in CD-caching appliances to address the disk-based data storage needs of workgroup, Internet and enterprise applications. Prior to forming Procom, Mr. Razmjoo was Director of Engineering for CMS Enhancements, Inc. from 1984 to 1987. He received his Bachelor of Science degree in Electrical Engineering from the University of California at Irvine (UCI) in 1985. He currently serves on the Board of Directors of UCI's Graduate School of Management and on the Advisory Board of UCI's Information and Computer Science Department. Mr. Alex Aydin is one of the founders of Procom Technology and has been an Executive Vice President and Director since 1987. Previously from 1984 to 1987, he served as Product Development Engineer for Toshiba America, Inc. He received dual B.S. degrees in Electrical Engineering and biological science in 1984 from the University of California, Irvine and an MS degree in biomedical engineering in 1985 from California State University, Long Beach. Mr. Frank Alaghband is a co-founder of Procom Technology and has served as the Company's Executive VP of Engineering and Operations and as a Director since 1987. Mr. Alaghband has been involved in product development in the storage industry since 1984. He started his career at McDonnell Douglas Computer Systems Company, where he developed high performance, multi-channel, caching disk controllers for the company's mini computers. At Procom Technology, he has led the development of a number of award-winning network storage products. He received his B.S. degree in Electrical Engineering from the University of California, Irvine, in 1984. Mr. Nick Shahrestany is one of the founders of Procom Technology and has served as an Executive Vice President and Director since 1987. From 1985 to 1987, Mr. Shahrestany was Regional Sales Manager for CMS Enhancements, Inc. He received his B.S. in Biological Sciences with a minor in Electrical Engineering from the University of California, Irvine. Mr. Jack Bonne is responsible for Procom's worldwide sales and field service and support. With more than 30 years of experience in IT Sales and Marketing, Mr. Jack Bonne brings a wealth of knowledge to this key management position at Procom. He has served as Senior VP, Division General Manager and Board Member of Sharp Microelectronics; CEO, President and Board Member of Sanyo Icon, a storage company acquired by EMC; Senior VP of Worldwide Sales Marketing and Field Service at McDonnell Douglas' Computer System Division and Manager of Corporate Computer sales at Xerox's Computer System Division. He received his MBA from the University of Chicago, Graduate School of Business and a B.S. in Mathematics and Physics from Northern Illinois University. Mr. Parsa Rohani is responsible for Procom's worldwide product management, corporate communications, channel marketing and strategic alliances. Prior to joining Procom, he served in various sales, engineering and marketing management positions at Microsoft Corporation. In his last position with Microsoft as an Architectural Consultant, Mr. Rohani worked closely with key Microsoft executives and customers to drive the adoption and implementation of Microsoft's strategic products and services. Prior to joining Microsoft, he served as a Senior Software Engineer for Hughes Aircraft. Mr. Rohani has a B.S. degree in Electrical Engineering from the University of Southern California. 54 Mr. Kevin Michaels has been a director since June, 2001. Mr. Michaels is Senior Vice President, Finance, Chief Financial Officer and Secretary for Powerwave Technologies (Nasdaq: PWAV). Prior to his current post, he served as Vice President, Treasurer, for AST Research. Item 11. EXECUTIVE COMPENSATION There is incorporated herein by reference the information required by this Item included in the Company's Proxy Statement for the 2002 Annual Meeting of Shareholders under the captions "Executive Compensation," "Compensation Committee Interlocks and Insider Participation" "Report of the Compensation Committee" and "Stock Performance Graph," which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended July 31, 2001. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT There is incorporated herein by reference the information required by this Item included in the Company's Proxy Statement for the 2002 Annual Meeting of Shareholders under the caption "Security Ownership of Beneficial Owners," which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended July 31, 2001. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There is incorporated herein by reference the information required by this Item included in the Company's Proxy Statement for the 2002 Annual Meeting of Shareholders under the caption "Certain Relationships and Related Transactions," which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended July 31, 2001. PART IV Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) DOCUMENTS FILED AS A PART OF THIS REPORT: (1) INDEX TO FINANCIAL STATEMENTS The financial statements included in Part II, Item 8 of this Annual Report on Form 10-K are filed as part of this Report. (2) FINANCIAL STATEMENT SCHEDULES The financial statement schedule is filed as part of this Report. All other schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. (b) REPORTS ON FORM 8-K: None. 55 (3) EXHIBITS EXHIBITS TO FORM 10-K
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) 10.1 Form of Indemnity Agreement between the Company and each of its executive officers and directors (incorporated by reference to Exhibit 10.1 in the Form S-1 filed on October 30, 1996) 10.2 Amended and Restated Procom Technology, Inc. 1995 Stock Option Plan (incorporated by reference to Exhibit 4 in the Form S-8 filed on July 2, 1999) 10.2.1 Procom Technology, Inc. 1999 Employee Stock Purchase Plan (incorporated by reference to Exhibit 4 in the Form S-8 filed on July 2, 1999) 10.3 Amended and Restated Executive Employment Agreement, dated as of October 28, 1996, between the Company and Alex Razmjoo (incorporated by reference to Exhibit 10.3 in the Form S-1 filed on October 30, 1996) 10.4 Amended and Restated Executive Employment Agreement, dated as of October 28, 1996, between the Company and Frank Alaghband (incorporated by reference to Exhibit 10.4 in the Form S-1 filed on October 30, 1996) 10.5 Amended and Restated Executive Employment Agreement, dated as of October 28, 1996, between the Company and Alex Aydin (incorporated by reference to Exhibit 10.5 in the Form S-1 filed on October 30, 1996) 10.6 Amended and Restated Executive Employment Agreement, dated as of October 28, 1996, between the Company and Nick Shahrestany (incorporated by reference to Exhibit 10.6 in the Form S-1 filed on October 30, 1996) 10.7 Form of Registration Rights Agreement (incorporated by reference to Exhibit 10.7 in the Form S-1 filed on October 30, 1996) 10.8 Agreement for Wholesale Financing (Security Agreement) between Procom Technology, Inc. and IBM Credit Corporation (incorporated by reference to Exhibit 10.1 to the Form S-3/A filed on January 17, 2001) 21.1 List of Subsidiaries 23.1 Consent of KPMG LLP
56 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, State of California, on the 29th day of October, 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 has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE --------- ----- ---- /s/ ALEX RAZMJOO Chairman of the Board, ----------------------------------------------------- President and Chief Executive Officer October 29, 2001 Alex Razmjoo (Principal Executive Officer) /s/ ALEX AYDIN Director and Executive Vice President, ----------------------------------------------------- Finance and Administration October 29, 2001 Alex Aydin (Principal Financial and Accounting Officer) /s/ FRANK ALAGHBAND Director October 29, 2001 ----------------------------------------------------- Frank Alaghband Director ----------------------------------------------------- Nick Shahrestany Director ----------------------------------------------------- Dom Genovese /s/ DAVID BLAKE Director October 29, 2001 ----------------------------------------------------- David Blake /s/ KEVIN MICHAELS Director October 29, 2001 ----------------------------------------------------- Kevin Michaels
57 SCHEDULE II SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED JULY 31, 1999, 2000 AND 2001
BALANCE AT CHARGED TO BALANCE AT BEGINNING COSTS AND END OF PERIOD EXPENSES OTHER DEDUCTIONS PERIOD ----------- ----------- ----------- ------------ ----------- YEAR ENDED JULY 31, 1999: Allowance for sales returns ............................ $ 1,044,000 $ 8,326,000 $ -- $(7,431,000) $ 1,939,000 Allowance for doubtful accounts ........................ 508,000 10,000 54,000 (50,000) 522,000 YEAR ENDED JULY 31, 2000: Allowance for sales returns ............................ $ 1,939,000 $ 5,917,000 $ -- $(5,781,000) $ 2,075,000 Allowance for doubtful accounts ........................ 522,000 360,000 -- (205,000) 677,000 YEAR ENDED JULY 31, 2001: Allowance for sales returns ............................ $ 2,075,000 $ 4,043,000 $ -- $(4,018,000) $ 2,100,000 Allowance for doubtful accounts ........................ 677,000 3,672,000 -- (37,000) 4,312,000
58 EXHIBITS TO FORM 10-K
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) 10.1 Form of Indemnity Agreement between the Company and each of its executive officers and directors (incorporated by reference to Exhibit 10.1 in the Form S-1 filed on October 30, 1996) 10.2 Amended and Restated Procom Technology, Inc. 1995 Stock Option Plan (incorporated by reference to Exhibit 4 in the Form S-8 filed on July 2, 1999) 10.2.1 Procom Technology, Inc. 1999 Employee Stock Purchase Plan (incorporated by reference to Exhibit 4 in the Form S-8 filed on July 2, 1999) 10.3 Amended and Restated Executive Employment Agreement, dated as of October 28, 1996, between the Company and Alex Razmjoo (incorporated by reference to Exhibit 10.3 in the Form S-1 filed on October 30, 1996) 10.4 Amended and Restated Executive Employment Agreement, dated as of October 28, 1996, between the Company and Frank Alaghband (incorporated by reference to Exhibit 10.4 in the Form S-1 filed on October 30, 1996) 10.5 Amended and Restated Executive Employment Agreement, dated as of October 28, 1996, between the Company and Alex Aydin (incorporated by reference to Exhibit 10.5 in the Form S-1 filed on October 30, 1996) 10.6 Amended and Restated Executive Employment Agreement, dated as of October 28, 1996, between the Company and Nick Shahrestany (incorporated by reference to Exhibit 10.6 in the Form S-1 filed on October 30, 1996) 10.7 Form of Registration Rights Agreement (incorporated by reference to Exhibit 10.7 in the Form S-1 filed on October 30, 1996) 10.8 Agreement for Wholesale Financing (Security Agreement) between Procom Technology, Inc. and IBM Credit Corporation (incorporated by reference to Exhibit 10.1 to the Form S-3/A filed on January 17, 2001) 21.1 List of Subsidiaries 23.1 Consent of KPMG LLP
EX-21.1 3 a76566ex21-1.txt EXHIBIT 21.1 EXHIBIT 21.1 PROCOM TECHNOLOGY, INC. LIST OF SUBSIDIARIES
STATE OR JURISDICTION NAME OF LEGAL ENTITY OF INCORPORATION -------------------- ------------------- Procom Technology FSC U.S. Virgin Islands Megabyte Computerhandels AG Germany Invincible Technology Acquisition Corp. Massachusetts Procom AG, formerly known as Pera AG Switzerland Procom SPA, formerly known as Gigatek SRL Italy Procom Technology, UK United Kingdom Scofima Software SRL Italy
All are wholly-owned subsidiaries of Procom Technology, Inc. EX-23.1 4 a76566ex23-1.txt EXHIBIT 23.1 EXHIBIT 23.1 INDEPENDENT AUDITORS' CONSENT The Board of Directors Procom Technology, Inc.: We consent to incorporation by reference in the registration statements (Nos. 333-23905, 333-82229 and 333-82231) on Form S-8 and registration statements (Nos. 333-59534, 333-57718 and 333-54462) on Form S-3 of Procom Technology, Inc., of our report dated September 26, 2001, relating to the consolidated balance sheets of Procom Technology, Inc. and subsidiaries as of July 31, 2000 and July 31, 2001, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended July 31, 2001, and the related schedule, which report appears in the July 31, 2001, annual report on Form 10-K of Procom Technology, Inc. KPMG LLP Orange County, California October 29, 2001