10-Q

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended May 31, 2002

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                              to                             

Commission file number 0-14843

DPAC TECHNOLOGIES CORP.
(Exact Name of Registrant Issuer as Specified in Its Charter)

CALIFORNIA (State or other Jurisdiction of Incorporation or Organization)	33-0033759 (IRS Employer Identification No.)
7321 LINCOLN WAY GARDEN GROVE, CALIFORNIA (Address of Principal Executive Offices)	92841 (Zip)

(714) 898-0007
Registrant's Telephone Number, Including Area Code

Not Applicable
(Former Name, Former Address and Former Fiscal Year If Changed Since Last Report)

        Indicate by Check Mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Exchange Act during the past 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 ý    No o

APPLICABLE ONLY TO CORPORATE REGISTRANTS

        The number of shares of common stock, no par value, outstanding as of May 31, 2002 was 21,044,029.

PART I- FINANCIAL INFORMATION

ITEM 1. Financial Statements

DPAC Technologies Corp.
Condensed Balance Sheets

			May 31, 2002			February 28, 2002
			(unaudited)
ASSETS
Current Assets:
	Cash and cash equivalents		$	7,398,763		$	6,258,836
	Accounts receivable, net			2,731,871			3,673,779
	Inventories, net			2,292,341			1,172,384
	Prepaid expenses and other current assets			443,773			505,221
		Total current assets		12,866,748			11,610,220
Property, net				4,362,606			4,580,929
Goodwill, net				4,782,921			4,782,921
Other assets				358,606			367,283
			$	22,370,881		$	21,341,353
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
	Current portion of capital lease obligations		$	443,400		$	472,577
	Accounts payable			1,710,015			943,930
	Accrued compensation			583,472			1,013,707
	Other accrued liabilities			266,514			298,913
	Deferred revenue			—			15,000
		Total current liabilities		3,003,401			2,744,127
Capital lease obligations, less current portion				311,932			421,176
Stockholders' equity
	Common stock			24,944,444			24,868,200
	Accumulated deficit			(5,888,896	)		(6,692,150	)
		Total stockholders' equity		19,055,548			18,176,050
			$	22,370,881		$	21,341,353

See accompanying notes to condensed financial statements.

DPAC Technologies Corp.
Condensed Statements of Operations
(Unaudited)

			For the quarter ended:
			May 31, 2002			May 31, 2001
NET SALES			$	11,936,850		$	7,453,389
COST OF SALES				9,110,902			5,239,066
GROSS PROFIT				2,825,948			2,214,323
COSTS AND EXPENSES:
	Selling, general and administrative			1,578,801			1,528,654
	Research and development			456,196			417,852
	Amortization of goodwill			—			193,454
		Total costs and expenses		2,034,997			2,139,960
INCOME FROM OPERATIONS				790,951			74,363
OTHER INCOME:
	Interest income			35,276			67,379
	Interest expense			(22,973	)		(31,052	)
		Total other income		12,303			36,327
INCOME BEFORE INCOME TAX PROVISION				803,254			110,690
INCOME TAX PROVISION				—			—
NET INCOME			$	803,254		$	110,690
NET INCOME PER SHARE:
	Basic		$	0.04		$	0.01
	Diluted		$	0.04		$	0.01
WEIGHTED-AVERAGE SHARES OUTSTANDING:
	Basic			21,016,000			20,943,000
	Diluted			21,374,000			21,126,000

See accompanying notes to condensed financial statements.

DPAC Technologies Corp.
Condensed Statements of Cash Flows
(Unaudited)

			For the three months ended
			May 31, 2002			May 31, 2001
CASH FLOWS FROM OPERATING ACTIVITIES:
		Net income	$	803,254		$	110,690
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
	Depreciation and amortization			356,462			536,411
Changes in operating assets and liabilities:
		Accounts receivable		941,908			665,021
		Inventories		(1,119,957	)		(410	)
		Other current assets		70,125			8,375
		Accounts payable		766,085			(381,898	)
		Accrued compensation		(430,235	)		(119,988	)
		Other accrued liabilities		(32,399	)		(152,756	)
		Deferred revenue		(15,000	)		(250,439	)
Net cash provided by operations:				1,340,243			415,006
CASH FLOWS FROM INVESTING ACTIVITIES:
		Property additions		(138,139	)		(176,295	)
		Acquired income tax obligation		—			(1,545,000	)
Net cash used in investing activities:				(138,139	)		(1,721,295	)
CASH FLOWS FROM FINANCING ACTIVITIES:
		Principal payments on other long-term debt		(138,421	)		(126,262	)
		Proceeds from issuance of common stock		76,244			15,603
Net cash used in financing activities				(62,177	)		(110,659	)
NET INCREASE (DECREASE) IN CASH				1,139,927			(1,416,948	)
CASH, BEGINNING OF YEAR				6,258,836			5,346,525
CASH, END OF QUARTER			$	7,398,763		$	3,929,577
SUPPLEMENTAL CASH FLOW INFORMATION:
		Interest paid	$	22,973		$	31,362
		Income taxes paid	$	—		$	1,545,000

        See accompanying notes to condensed financial statements.

DPAC TECHNOLOGIES CORP.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)

NOTE 1—General Background—DPAC Technologies Corp. (formerly Dense-Pac Microsystems, Inc.) ("we," "us," "DPAC" or the "Company") is a technology company that provides patented component packaging technology to create high-density, space-saving surface mount electronic components. High-density design and manufacturing allows customers to meet their electronic system performance and time-to-market objectives for maximum system integration. Our products are used in applications such as network servers, computer storage devices, guidance systems, medical instrumentation and communication electronics. The Company also provides outsourced engineering design services to aid customers in creating cost-saving circuit designs, as well as contract manufacturing of prototype designs and medium volume production runs of circuit boards. We were formed as a California corporation on September 7, 1983. On August 10, 2001, Dense-Pac Microsystems, Inc. stockholders voted in favor of changing the Company name to DPAC Technologies Corp. Our website is at www.DPACtech.com. The information on our website is not part of this report.

NOTE 2—Basis of Presentation—The accompanying unaudited interim Condensed Financial Statements of DPAC as of May 31, 2002 and for the three months ended May 31, 2002 and 2001, respectively, reflect all adjustments (consisting of normal recurring accruals) which, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for completed-year financial statements.

These financial statements should be read in conjunction with the audited financial statements included in the Company's Annual Report on Form 10-K for the year ended February 28, 2002. Effective March 1, 2001, the Company no longer qualified as a "small business issuer" under Rule 12b-2 and began filing Forms 10-Q and 10-K under the application of Regulation S-K for its quarterly and annual reports.

Operating results for the three months ended May 31, 2002 are not necessarily indicative of the results that may be expected for the full year ending February 28, 2003.

NOTE 3—Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards, SFAS No. 142 ("FASB"), "Goodwill and Other Intangible Assets". SFAS 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. Goodwill and intangible assets that have indefinite useful lives will not be amortized into results of operation but, instead, will be evaluated at least annually for impairment and written down when the recorded value exceeds the estimated fair value. The Company adopted the provisions of SFAS 142 on March 1, 2002. As a result, the Company has ceased amortization of goodwill. The effect of the change in accounting

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during the three months ended May 31, 2002 was to increase net income by $195,000, or $0.01 per basic and diluted share.

	For the three months ended May 31,
	2002		2001
Net income as reported	$	803,254	$	110,690
Add back amortization of goodwill		—		193,454
Adjusted net income	$	803,254	$	304,144
Net income per share, basic and diluted, as reported	$	0.04	$	0.005
Amortization of goodwill		—		0.009
Adjusted net income per share — basic and diluted	$	0.04	$	0.014

In August 2001, the FASB issued Statement of Financial Accounting Standards No. 143 ("SFAS 143"), Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 is required to be adopted for fiscal years beginning after June 15, 2002. The Company has not yet determined what effect this statement will have on its financial statements.

Also in August 2001, the FASB issued Statement of Financial Accounting Standards No. 144 ("SFAS 144"), Accounting for the Impairment or Disposal of Long-Lived Assets, which supersedes FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. This new statement also supersedes certain aspects of Accounting Principles Board ("APB") 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, with regard to reporting the effects of a disposal of a segment of a business and will require expected future operating losses from discontinued operations to be reported in discontinued operations in the period incurred (rather than as of the measurement date as presently required by APB 30). In addition, more dispositions may qualify for discontinued operations treatment. The provisions of this statement are required to be applied for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The Company has adopted SFAS 144 effective March 1, 2002, and such adoption did not have a material impact on the Company's financial statements.

NOTE 4—The following table summarizes stock option activity under DPAC's 1985 and 1996 Stock Option Plans for the three months ended May 31, 2002:

		Number of Shares		Price per Share	Number of Options Exercisable
Balance, February 28, 2002		2,579,520		$.94—7.56	1,210,628
	Granted	185,000		$3.10 — 3.50
	Exercised	(58,000	)	$1.00 — 2.56
	Canceled	(11,250	)	$1.00 — 6.00
Balance, May 31, 2002		2,695,270		$.94 — 7.56	1,472,129

        At May 31, 2002, a total of 4,185,421 shares were available for grant under all of the Company's stock option plans.

        NOTE 5—The Company computes net income per share in accordance with SFAS No. 128, Earnings Per Share. Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earning per share reflects the

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potential dilution of securities by including other common stock equivalents, such as stock options, in the weighted-average number of shares outstanding, if dilutive.

        The table below sets forth the reconciliation of the denominator of the earnings per share calculations:

	May 31,
Three months ended	2002	2001
Shares used in computing basic net income per share	21,016,000	20,943,000
Dilutive effect of stock options	358,000	183,000
Shares used in computing diluted net income per share	21,374,000	21,126,000

NOTE 6—SEGMENT INFORMATION Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company's chief operating decision-maker, or decision-making group, in deciding how to allocate resources and in assessing performance.

        Subsequent to the acquisition of Productivity Enhancement Products, Inc. ("PEP") in fiscal 2001, the Company began reporting results under three operating segments, the "Advanced Packaging Group", the "System Design Group", and the "Value Added Manufacturing Group", based on the structure of the two companies and the operating reports reviewed and used by the Company's chief executive officer at that time. As the Company integrated PEP during fiscal 2002, the personnel, facilities, accounting systems, and overhead structures were combined with DPAC. The initially identified operating segments also began to combine and share resources, including facilities, management, sales, production, and development personnel. As a result, the Company has discontinued the preparation of separate financial information for the three segments and the Company's CEO is now reviewing financial information and making operational decisions based upon the Company as a whole. Due to these changes, the Company combined the previously reported three operating segments into a single operating segment as of November 30, 2001 and expects to continue with such reporting structure in future periods.

        The Company had export sales (primarily to Western European customers) accounting for approximately 15% and 4% of net sales for the three months ended May 31, 2002 and 2001, respectively

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ITEM 2 Management's Discussion and Analysis of Financial Condition and Results of Operation.

FORWARD-LOOKING STATEMENTS

        Included in the Notes to Financial Statements, this Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, and elsewhere in this Report are statements that do not present historical information. These are forward-looking statements which reflect the Company's current expectations. Although the Company believes that its expectations are based on reasonable assumptions, there can be no assurance that the Company's financial goals or expectations will be realized. Numerous factors may affect the Company's actual results and may cause results to differ materially from those expressed in forward-looking statements made by or on behalf of the Company.

        Some of these factors include demand for, and acceptance of, new and existing products, technological advances and product obsolescence, availability of semiconductor devices at reasonable prices, competitive factors, costs and risks concerning litigation, the ability to protect proprietary intellectual property, limited experience in acquisitions, business interruptions due to acts of terrorism or natural disasters, and the availability of capital to finance growth. These and other factors which could cause actual results to differ materially from those in the forward-looking statements are discussed in greater detail in the Company's Annual Report on Form 10-K for the year ended February 28, 2002 as filed with the Securities and Exchange Commission (SEC) on May 28, 2002, under the headings "Risk Factors" and "Cautionary Statements." Such Cautionary Statements are incorporated herein by this reference. Investors are cautioned against ascribing undue weight to any forward-looking statements herein or elsewhere.

RESULTS OF OPERATIONS

        Net sales for the quarter ended May 31, 2002 increased by $4.5 million or 60% to $11.9 million from $7.5 million for the quarter ended May 31, 2001. The increase in net sales was primarily due to a change in product mix toward a greater percentage of commercial stacking revenue that contained purchased memory. Stacking revenues containing purchased memory, or "memory stacking", involve DPAC purchasing memory chips, stacking them, and then selling the stacked product to the customer. In these cases where the costs of memory chips are included in the sales price of products, the Company will purchase material for the commercial order concurrently with finalizing the sales price thereof, in order to avoid any price volatility in the components. Revenues from memory stacking may vary significantly from period-to-period based not only on quantities shipped but also on the current market price of purchased memory. The balance of commercial stacking revenues is from "service stacking", where customers provide us with consigned memory chips and we provide services to configure and stack the memory to customer specifications. As there is no memory chip component cost to service stacking, revenues per unit are significantly lower than revenues per unit of memory stacking sales. Of total revenue in the first quarter of fiscal year 2003, approximately 67% related to memory stacking and 33% to service stacking, as compared with 43% and 57%, respectively, in the first quarter of fiscal year 2002. See "Forward-Looking Statements."

        The quantity of commercial stacks shipped during the first quarter of fiscal year 2003 increased by 101% from the comparable period of the previous fiscal year. The increased quantity of stacks shipped during the first quarter of fiscal year 2003 was partially offset from a revenue perspective by a decline in memory prices and reduced prices for stacking services.

        Gross profit in the first quarter of fiscal 2003 increased by $612,000, or 28% from the comparable prior period. The increase in total gross profit is attributable to the increase in stacked units shipped partially offset by lower prices for stacking services and changes in product mix. Gross profit as a percentage of sales decreased to 24% for the quarter ended May 31, 2002, as compared to 30% for the quarter ended May 31, 2001. The decrease in the gross margin percentage can primarily be attributed to the lower prices for stacking services and the increased percentage of revenues from memory

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stacking, which has a lower gross margin than revenues derived from service stacking, due to low margins on the memory component on the sales price.

        The Company believes that it has been able to define a niche for products that use a unique proprietary stacking technology and has been marketing these products to a defined market. During the first quarter of fiscal year 2003, the Company continued its offering of commercial products and focused on those products that relate to the Company's proprietary packaging technology. Additionally, the Company has numerous products that have been designed into industrial, defense and aerospace applications. It is unknown at this time whether or not there will be a change in demand for these proprietary products. See "Forward-Looking Statements."

        Selling, general and administrative expenses increased in the first quarter of fiscal year 2003 by $50,000 or 3% from the first quarter of the prior fiscal year. For the quarter ended May 31, 2002, selling, general, and administrative expenses represented 13% of net sales as compared to 21% of net sales from the same quarter in the previous fiscal year. The increase in selling, general and administrative expenses is mainly attributed to expenses of $180,000 incurred for an acquisition search, offset by reduced legal fees of $93,000.

        Research and development costs increased by $38,000 for the quarter ended May 31, 2002 from the first quarter of the prior fiscal year. For the quarter ended May 31, 2002, research and development expense represented 4% of net sales as compared to 6% of net sales from the same quarter in the previous fiscal year. The amount in absolute dollars spent on research and development has remained relatively constant year over year. The continued investment in research and development is primarily due to continued efforts to allocate resources to the development and production of unique new technologies. The Company is continuing to invest in research and development for new products in the advanced technology marketplace. See "Forward-Looking Statements."

        For the three months ended May 31, 2002, interest income decreased $32,000 from the same period last year. These changes primarily relate to the impact of declining interest rates. Interest expense decreased slightly for the same period.

        For the three months ended May 31, 2002 and 2001, the Company recorded no income tax provision as available net operating loss carryforwards are expected to offset any current year income taxes.

LIQUIDITY AND CAPITAL RESOURCES

        The Company's primary source of liquidity for the three months ended May 31, 2002 and May 31, 2001 was from cash provided by operations. The Company believes that the cash from operations will be sufficient to meet the Company's operating cash needs for the next twelve months. Additionally, the Company has available at May 31, 2002 a credit facility for $3.0 million from a financial institution, which the Company can utilize if the need should arise for additional working capital to support operations. The credit facility contains certain financial covenants, including minimum tangible net worth requirements. The Company was in compliance with all covenants at May 31, 2002. See "Forward-Looking Statements."

        Net cash provided by operating activities was approximately $1,340,000 and $415,000 during the three months ended May 31, 2002 and 2001, respectively, and substantially consisted of net income and depreciation and amortization.

        The Company purchased for cash approximately $138,000 and $176,000 in new equipment during three months ended May 31, 2002 and 2001, respectively. The Company is expecting that it may incur additional lease debt with the acquisition of additional equipment during the next nine months. The Company expects that it will not acquire more than $1.0 million in additional equipment for the remainder of the fiscal year. See "Forward-Looking Statements." The Company also paid a $1.5 million

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tax liability assumed in the Productivity Enhancement Products acquisition during the first quarter ended May 31, 2001.

        Net cash used in financing activities was approximately $62,000 and $111,000 for the three months ended May 31, 2002 and 2001, respectively, and principally relates to debt repayments offset by proceeds from the issuance of common stock.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

        The Company invests excess cash in money market funds. Money market funds do not have maturity dates and do not present a material market risk. For the three-month period covered by this Report, interest expense was not sensitive to the general level of the U.S. interest rates because our debt instruments, consisting principally of capital lease agreements, were based on fixed interest rates.

PART II—OTHER INFORMATION

Item 1—Legal Proceedings

        Use of the name DPAC below also includes a reference to the name Dense-Pac Microsystems, Inc., the Company's corporate name until changed in fiscal year 2001.

        On September 23, 1998, DPAC was served with a complaint from SimpleTech (formerly Simple Technology, Inc.), filed in U.S. District Court for the Central District of California, Santa Ana Division, alleging that DPAC's stacking technology infringed on a SimpleTech stacking patent. On October 23, 1998, DPAC filed a counterclaim in the same action for patent infringement against SimpleTech alleging that SimpleTech was infringing upon DPAC's earlier issued patent.

        On April 11, 2000, DPAC filed suit, in Superior Court for the State of California, Orange County, against SimpleTech and its Chief Operating Officer. The complaint alleged trade secret misappropriation, unfair competition, and intentional and negligent interference with prospective business advantages. DPAC dismissed the suit without prejudice on February 28, 2001.

        On February 8, 2001, the U.S. District Court for the Central District ruled that SimpleTech did not infringe DPAC's patent. On March 29, 2001, the U.S. District Court for the Central District of California ruled that DPAC did not infringe on the SimpleTech patent and entered a final judgment of no liability. As part of the ruling, DPAC was awarded court costs.

        On April 17, 2001, SimpleTech's appeal was docketed in the U.S. Court of Appeals for the Federal Circuit.

        On March 5, 2002, the U.S. Court of Appeals heard the appeal. A decision on the appeal was reached on March 6, 2002, confirming the lower courts ruling that DPAC did not infringe on the SimpleTech patent.

        On February 21, 2001, DPAC was served with a new complaint from SimpleTech, filed in U.S. District Court for the Central District of California for an undetermined amount, alleging that DPAC's stacking technology infringes on SimpleTech's reissued stacking patent. DPAC intends to vigorously defend itself against these charges. The ultimate outcome or any resulting potential loss is not presently determinable.

        On June 7, 2002, SimpleTech petitioned the U.S. Supreme Court for a review of the Court of Appeal's affirmance.

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Item 6—Exhibits and Reports on Form 8-K

(a)

Exhibits
99.1 Cautionary Statements are incorporated by reference to pages 19    through 25, inclusive, of the Registrant's Form 10-K filed May 28, 2002 with the Securities and Exchange Commission.



(b)

Reports on Form 8-K—No reports on Form 8-K were filed during the first quarter of fiscal year 2003 covered by this Form 10-Q.

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SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	DPAC TECHNOLOGIES CORP. (Registrant)
July 11, 2002 Date	By:	/s/  TED BRUCE Ted Bruce, Chief Executive Officer
July 11, 2002 Date	By:	/s/  WILLIAM M. STOWELL William M. Stowell, Chief Financial Officer

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EXHIBIT INDEX

Exh. No.	Description
99.1	Cautionary Statements

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APPLICABLE ONLY TO CORPORATE REGISTRANTS
PART I- FINANCIAL INFORMATION
DPAC TECHNOLOGIES CORP. NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED)
PART II—OTHER INFORMATION
SIGNATURES

EX-99.1

EXHIBIT 99.1

Cautionary Statements

        Statements in this 10-Q which are not historical facts, including all statements about the Company's business strategy or expectations, or information about new and existing products and technologies or market characteristics and conditions, are forward-looking statements that involve risks and uncertainties. These include, but are not limited to, the factors described below which could cause actual results to differ from those contemplated by the forward-looking statements.

Product Development and Technological Change

        The semiconductor and memory module industries are characterized by rapid technological change and are highly competitive with respect to timely product innovation. The Company's memory products are subject to obsolescence or price erosion because semiconductor manufacturers are continuously introducing chips with the same or greater memory density as the Company's modules. As a result, memory products typically have a product life of not more than three to five years.

        The Company's future success depends on its ability to develop new products and product enhancements to keep up with technological advances and to meet customer needs. Any failure by the Company to anticipate or respond adequately to technological developments and customer requirements, or any significant delays in product development or introduction, could have a material adverse effect on the Company's financial condition and results of operations.

        There can be no assurance that the Company will be successful in its product development or marketing efforts, or that the Company will have adequate financial or technical resources for future product development and promotion.

Uncertainty of Market Acceptance or Profitability of New Products

        The introduction of new products will require the expenditure of funds for research and development, tooling, manufacturing processes, inventory and marketing. In order to achieve high volume production, the Company will need to make substantial investments in inventory and capital equipment or, as currently contemplated, the Company will need to out source production to third parties. The Company has limited marketing capabilities and resources and is dependent upon internal sales and marketing personnel and a network of independent sales representatives for the marketing and sale of its products. There can be no assurance that our products will achieve or maintain market acceptance, result in increased revenues, or be profitable.

Parts Shortages and Over-Supplies and Dependence on Suppliers

        The semiconductor industry is characterized by periodic shortages or over-supplies of parts which have in the past, and may in the future, negatively affect the Company's operations. The Company is dependent on a limited number of suppliers for semiconductor devices used in its products, and it has no long-term supply contracts with any of them.

        Due to the cyclical nature of the semiconductor industry and competitive conditions, the Company may experience difficulties in meeting its supply requirements in the future. Any inability to obtain adequate deliveries of parts, either due to the loss of a supplier or industry-wide shortages, could delay shipments of the Company's products, increase its cost of goods sold, and have a material adverse effect on its business, financial condition and results of operations.

Concentration of Credit Risk

        The Company grants credit to customers included in the military, aerospace, and a variety of commercial industries. Credit is extended based on an evaluation of the customer's financial condition and collateral is not required. Estimated credit losses are provided for in the financial statements.

During the quarter ended May 31, 2002, sales to two major customers accounted for 45% and 17% of net sales. Accounts receivable from these two customers accounted for 43% of total net accounts receivable at May 31, 2002. During the quarter ended May 31, 2001, sales to two major customers accounted for 34% and 17% of net sales. Accounts receivable from these two customers accounted for 32% of total net accounts receivable at May 31, 2001. A decision by a significant customer to substantially decrease or delay purchases from the Company or the Company's inability to collect receivables from these customers could have a material adverse effect on the Company's business, financial condition, and results of operations.

Dependence on Defense-Related Business

        The Company has historically derived a portion of its revenues from defense-related contracts. As a result, the Company's business has been impacted by reductions in the federal defense budget and will continue to be subject to risks affecting the defense industry, including changes in governmental appropriations and changes in national defense policies and priorities. The Company has sought to reduce its dependence on defense-related business by developing products with commercial applications, although such products generally have lower margins than defense-related products.

Intellectual Property Rights

        The Company's ability to compete effectively is dependent on its proprietary know-how, technology and patent rights. The Company holds U.S. patents on certain aspects of its 3-D stacking technology and has applied for additional patents. There can be no assurance that the Company's patent applications will be approved, that any issued patents will afford the Company's products any competitive advantage or will not be challenged or circumvented by third parties, or that patents issued to others will not adversely affect the sales, development, or commercialization of the Company's present or future products.

Management of Growth

        Successful expansion of the Company's operations will depend on, among other things, the ability to obtain new customers, to attract and retain skilled management and other personnel, to secure adequate sources of supply on commercially reasonable terms and to successfully manage growth. To manage growth effectively, the Company will have to continue to implement and improve its operational, financial and management information systems, procedures and controls. As the Company expands, it may from time-to-time experience constraints that will adversely affect its ability to satisfy customer demand in a timely fashion. Failure to manage growth effectively could adversely affect the Company's financial condition and results of operations.

Competition

        There are memory companies which offer, or are in the process of developing, three-dimensional products, including Irvine Sensors, Staktek, Samsung and others. Some of such companies have greater financial, manufacturing and marketing capabilities than the Company. The Company could also experience competition from established and emerging computer memory companies. There can be no assurance that the Company's products will be competitive with existing or future products, or that the Company will be able to establish or maintain a profitable price structure for its products.

Product Liability

        In the course of its business, the Company may be subject to claims for product liability for which its insurance coverage is excluded or inadequate.

Variability of Gross Margin

        Any change in the gross margins can typically be attributed to the type of products that the Company was selling during the year, as well as the royalty income generated during the periods. As

the Company markets its products both to military and aerospace, and commercial customers, the product mix that each category of the customers orders may be different and result in changes in the gross margin. Due to the various configuration and applications of the Company's product, prices range from less than $5 for commercial modules to over $2,000 for high-end military specification modules.

        The Company expects that its net sales and gross margin may vary significantly based on these and other factors, including the mix of products sold and the manufacturing services provided, the channels through which the Company's products are sold, changes in product selling prices and component costs, the level of manufacturing efficiencies achieved and pricing by competitors. The selling prices of the Company's products may decline depending upon the price changes of DRAM, SRAM and Flash semiconductors, which would have a material adverse effect on the Company's net sales and could have a material adverse effect on the Company's business, financial condition and results of operation. Accordingly, the Company's ability to maintain or increase net sales will be highly dependent upon its ability to increase unit sales volumes of existing products and to introduce and sell new products in quantities sufficient to compensate for the anticipated declines in selling prices. Declining product selling prices may also materially and adversely affect the Company's gross margin, unless the Company is able to reduce its cost per unit to offset declines in product selling prices. There can be no assurance that the Company will be able to increase unit sales volumes, introduce and sell new products, or reduce its cost per unit.

Decline of Demand for Product Due to Downturn of Related Industries

        The Company may experience substantial period-to-period fluctuations in operating results due to factors affecting the semiconductor, computer, telecommunications and networking industries. From time- to-time, each of these industries has experienced downturns, often in connection with, or in anticipation of, declines in general economic conditions. A decline or significant shortfall in growth in any one of these industries could have a material adverse impact on the demand for the Company's products and, therefore, a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company's net sales and results of operations will not be materially and adversely affected in the future due to changes in demand from individual customers or cyclical changes in the semiconductor, computer, telecommunications, networking, or other industries utilizing the Company's products.

Fluctuations in Operating Results

        The Company's results of operations and gross margin have been subject to fluctuations from period-to- period. The primary factors that have affected, and may in the future affect, the Company's results of operations include adverse changes in the mix of products sold, the inability to procure required components, and the partial or complete loss of a principal customer or the reduction in orders from a customer due to, among other things, excess product inventory accumulation by such customer. Other factors that have affected, and may in the future affect, the Company's results of operations include fluctuating market demand for and declines in the selling prices of the Company's products, decreases or increases in the costs of the components of the Company's products, market acceptance of new products and enhanced versions of the Company's products, the Company's competitors selling products that compete with the Company's products at lower prices or on better terms than the Company's products, delays in the introduction of new products and enhancements to existing products, manufacturing inefficiencies associated with the start-up of new product introductions, and the Company's semiconductor customers manufacturing memory modules, internally or with other third parties, outside of the United States due to concerns about United States antidumping investigations and laws.

        The Company's operating results may also be affected by the timing of new product announcements and releases by the Company or its competitors, the timing of significant orders, the ability to produce products in volume, delays, cancellations or rescheduling of orders due to customer financial difficulties or other events, inventory obsolescence, including the reduction in value of the Company's inventories due to price declines, unexpected product returns, the timing of expenditures in

anticipation of increased sales, cyclicality in the Company's targeted markets, and expenses associated with acquisitions. In particular, declines in DRAM, SRAM and Flash semiconductor prices could affect the valuation of the Company's inventory which could result in adverse changes in the Company's business, financial condition and results of operations.

        Sales of the Company's individual products and product lines toward the end of a product's life cycle are typically characterized by steep declines in sales, pricing and gross margin, the precise timing of which may be difficult to predict. The Company has experienced, and could continue to experience, unexpected reductions in sales of products as customers anticipate new product purchases. In addition, to the extent that the Company manufactures products in anticipation of future demand that does not materialize, or in the event a customer cancels outstanding orders during a period of either declining product selling prices or decreasing demand, the Company could experience an unanticipated decrease in sales of products. These factors could give rise to charges for obsolete or excess inventory, returns of products by distributors, or substantial price protection charges or discounts. In the past, the Company has had to write-down and write-off excess or obsolete inventory. To the extent that the Company is unsuccessful in managing product transitions, its business, financial condition and results of operations could be materially and adversely affected.

        The need for continued significant expenditures for capital equipment purchases, research and development and ongoing customer service and support, among other factors, will make it difficult for the Company to reduce its operating expenses in any particular period if the Company's expectations for net sales for that period are not met. Accordingly, there can be no assurance that the Company will be able to continue to be profitable. The Company believes that period-to-period comparisons of the Company's financial results are not necessarily meaningful and should not be relied upon as indications of future performance. Due to the foregoing factors, it is likely that in some future period the Company's operating results will be below the expectations of public market analysts or investors. In such event, the market price of the Company's securities would be materially and adversely affected.

International Sales

        International sales may be subject to certain risks, including changes in regulatory requirements, tariffs and other barriers, timing and availability of export licenses, political and economic instability, difficulties in accounts receivable collections, natural disasters, difficulties in staffing and managing foreign subsidiary and branch operations, difficulties in managing distributors, difficulties in obtaining governmental approvals for telecommunications and other products, foreign currency exchange fluctuations, the burden of complying with a wide variety of complex foreign laws and treaties, potentially adverse tax consequences and uncertainties relative to regional, political and economic circumstances. Moreover and as a result of currency changes and other factors, certain of the Company's competitors may have the ability to manufacture competitive products in Asia at lower costs than the Company.

        The Company is also subject to the risks associated with the imposition of legislation and regulations relating to the import or export of high technology products. The Company cannot predict whether quotas, duties, taxes or other charges or restrictions upon the importation or exportation of the Company's products will be implemented by the United States or other countries. Because sales of the Company's products have been denominated to date in United States dollars, increases in the value of the United States dollar could increase the price of the Company's products, so that they become relatively more expensive to customers in the local currency of a particular country, leading to a reduction in sales and profitability in that country. Future international activity may result in increased foreign currency denominated sales. Gains and losses on the conversion to United States dollars of accounts receivable, accounts payable and other monetary assets and liabilities arising from international operations may contribute to fluctuations in the Company's results of operations. Some of the Company customers purchase orders and agreements are governed by foreign laws, which may differ significantly from United States laws. Therefore, the Company may be limited in its ability to enforce its rights under such agreements and to collect damages, if awarded. There can be no

assurance that any of these factors will not have a material adverse effect on the Company's business, financial condition and results of operations.

Substantial Influence of Existing Shareholders

        Euroventures I B.V. and Euroventures II B.V. beneficially own approximately 11% of our common stock. As a result, they have the ability to exert significant or controlling influence on all matters requiring approval by our shareholders, including the election and removal of directors, approval of significant corporate transactions, and the decision of whether a change in control will occur.

Limited Experience in Acquisition

        While we have no agreements or negotiations currently underway, we intend to pursue selective acquisitions to complement our internal growth. If we make any future acquisitions, we could issue stock that would dilute our shareholders' percentage ownership, incur substantial debt, or assume contingent liabilities. We have limited experience in acquiring other businesses, product lines and technologies. In addition, the attention of our small management team may be diverted from our core business if we undertake an acquisition. Potential acquisitions also involve numerous risks, including, among others:

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Problems assimilating the purchased operations, technologies or products;



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Costs associated with the acquisition;



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Adverse effects on existing business relationships with suppliers and customers;



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Risks associated with entering markets in which we have no or limited prior experience;



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Potential loss of key employees of purchased organizations; and



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Potential litigation arising from the acquired company's operations before the acquisition.

        Our inability to overcome problems encountered in connection with such acquisitions could divert the attention of management, utilize scarce corporate resources and harm our business. In addition, we are unable to predict whether or when any prospective acquisition candidate will become available or the likelihood that any acquisition will be completed.

Cyclical Nature of Semiconductor Industry

        The semiconductor industry, including the memory markets in which we compete, is highly cyclical and is characterized by constant and rapid technological change, rapid product obsolescence and price erosion, evolving standards, short product life cycles and wide fluctuations in product supply and demand. The industry has experienced significant downturns, often connected with, or in anticipation of, maturing product cycles of both semiconductor companies' and their customers' products and declines in general economic conditions. These downturns have been characterized by diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices. Any future downturns could have a material adverse effect on our business and operating results. Furthermore, any upturn in the semiconductor industry could result in increased demand for, and possible shortages of, components we use to manufacture and assemble our intregrated circuits. Such shortages could have a material adverse effect on our business and operating results.

Product Returns and Order Cancellation

        To the extent we manufacture products in anticipation of future demand that does not materialize, or in the event a customer cancels outstanding orders, we could experience an unanticipated increase in our inventory. A majority of our sales through aftermarket channels include limited rights to return unsold inventory. In addition, while we may not be contractually obligated to accept returned products, we may determine that it is in our best interest to accept returns in order to maintain good relations with our customers. Product returns would increase our inventory and reduce our revenues. We have

had to write-down inventory in the past for reasons such as obsolescence, excess quantities and declines in market value below our costs.

        We have no long-term volume commitments from our customers, except those subject to cancellation by the customer. Sales of our products are made through individual purchase orders and, in certain cases, are made under master agreements governing the terms and conditions of the relationships. Customers may change, cancel or delay orders with limited or no penalties. We have experienced cancellations of orders and fluctuations in order levels from period-to-period, and we expect to continue to experience similar cancellations and fluctuations in the future, which could result in fluctuations in our revenues.

Additional Capital Funding to Impair Value of Investment

        If we expand more rapidly than currently anticipated or if our working capital needs exceed our current expectations, we may need to raise additional capital through public or private equity offerings or debt financings. Our future capital requirements depend on many factors including our research, development, sales and marketing activities. We do not know whether additional financing will be available when needed, or will be available on terms favorable to us. If we cannot raise needed funds on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities, or respond to competitive pressures or unanticipated requirements. To the extent we raise additional capital by issuing equity securities, our shareholders may experience substantial dilution and the new equity securities may have greater rights, preferences, or privileges than our existing common stock.

Geographic Concentration of Operation

        All of our manufacturing operations are located in our facility in Garden Grove, California. Due to this geographic concentration, a disruption of our manufacturing operations, resulting from sustained process abnormalities, human error, government intervention, or natural disasters such as earthquakes, fires or floods could cause us to cease or limit our manufacturing operations, and consequently harm our business, financial condition and results of operations.

Compliance with Environmental Laws and Regulations

        We are subject to a variety of environmental laws and regulations governing, among other things, air emissions, waste water discharge, waste storage, treatment and disposal, and remediation of releases of hazardous materials. Our failure to comply with present and future requirements could harm our ability to continue manufacturing our products. Such requirements could require us to acquire costly equipment or to incur other significant expenses to comply with environmental regulations. The imposition of additional or more stringent environmental requirements, the results of future testing at our facilities, or a determination that we are potentially responsible for remediation at other sites where problems are not presently known to us, could result in expenses in excess of amounts currently estimated to be required for such matters.

Stock Price Volatility

        The stock market in general, and the market for shares of technology companies in particular, have experienced extreme price fluctuations. These price fluctuations are often unrelated to the operating performance of the affected companies. Many technology companies, including the Company, have experienced dramatic volatility in the market prices of their common stock. If our future operating results are below the expectations of stock market analysts and investors, our stock price may decline. We cannot be certain that the market price of our common stock will remain stable in the future. Our stock price may undergo fluctuations that are material, adverse, and unrelated to our performance.

Customer Consolidation

        DPAC's customer base is largely comprised of DRAM manufacturers, memory module manufacturers, and related businesses. These businesses are subject to volatility and the cyclical nature of the DRAM marketplace. There is risk of a significant impact to DPAC's revenues if one of our major customers was to be acquired, merge, consolidate, or close. There is no guarantee that current business relationships will prevail in the event of one of the above occurrences.