10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q

( Mark One )

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

For the quarterly period ended November 30, 2001

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

For the transition period from ______________________ to ______________________

Commission file number 0-14843
 
DPAC TECHNOLOGIES CORP.
(Exact Name of Registrant Issuer as Specified in Its Charter)

CALIFORNIA	33-0033759
( State or other Jurisdiction of Incorporation or Organization)	( IRS Employer Identification No.)

7321 LINCOLN WAY
GARDEN GROVE, CALIFORNIA 92841
( Address of Principal Executive Offices )
(714) 898-0007
Issuer’s Telephone Number, Including Area Code
 
Dense-Pac Microsystems, Inc.
( Former Name, Former Address and Former Fiscal Year
if Changed Since Last Report )

     Check whether the issuer: (1) 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 issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES [X]                NO [   ]
 
APPLICABLE ONLY TO CORPORATE ISSUERS

     The number of shares of common stock, no par value, outstanding as of January 10, 2002 was 20,924,374.

TABLE OF CONTENTS

PART I- FINANCIAL INFORMATION
	ITEM 1. Financial Statements
		Consolidated Balance Sheets
		Consolidated Statements of Operations
		Consolidated Statements of Cash Flows
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	ITEM 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations.
	ITEM 3. Quantitative and Qualitative Disclosures About Market Risk.
PART II — OTHER INFORMATION
	Item 1 — Legal Proceedings
	Item 6 — Exhibits and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX
EXHIBIT 99.1

PART I - FINANCIAL INFORMATION

ITEM 1. Financial Statements

DPAC Technologies Corp.
Consolidated Balance Sheets

			November 30,			February 28,
			2001			2001
			(unaudited)
ASSETS
Current Assets:
	Cash and cash equivalents		$	5,638,419		$	5,346,525
	Accounts receivable, net			3,428,550			3,300,702
	Inventories, net			1,203,117			1,444,063
	Other current assets			288,761			281,504
		Total current assets		10,558,847			10,372,794
Property, net				4,892,426			5,380,800
Goodwill, net				4,977,921			5,630,944
Other assets				375,789			378,565
			$	20,804,983		$	21,763,103
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Current portion of long-term debt		$	506,121		$	456,683
	Accounts payable			1,705,674			1,153,548
	Income taxes payable			—			1,545,649
	Accrued compensation			456,204			551,623
	Other accrued liabilities			306,595			684,540
	Deferred revenue			—			363,000
		Total current liabilities		2,974,594			4,755,043
Long-term debt, net of current portion				527,709			786,828
Stockholders’ equity
	Common stock			24,770,733			24,871,477
	Accumulated deficit			(7,468,053	)		(8,650,245	)
		Total stockholders’ equity		17,302,680			16,221,232
			$	20,804,983		$	21,763,103

See accompanying notes to condensed consolidated financial statements.

DPAC Technologies Corp.
Consolidated Statements of Operations
( Unaudited )

			For the quarter ended:						For the nine months ended:
			November 30,			November 30,			November 30,			November 30,
			2001			2000			2001			2000
NET SALES			$	6,260,637		$	9,649,326		$	21,915,100		$	27,834,477
COST OF SALES				3,892,869			6,842,403			14,817,637			19,540,254
GROSS PROFIT				2,367,768			2,806,923			7,097,463			8,294,223
COSTS AND EXPENSES:
	Selling, general and administrative			1,112,238			1,554,432			4,028,225			4,530,033
	Amortization of goodwill			195,000			66,024			582,939			66,024
	Research and development			460,877			397,392			1,352,332			1,256,336
		Total costs and expenses		1,768,115			2,017,848			5,963,496			5,852,393
INCOME FROM OPERATIONS				599,653			789,075			1,133,967			2,441,830
OTHER INCOME:
	Interest income			42,868			72,624			151,274			181,971
	Interest expense			(32,386	)		(24,008	)		(103,049	)		(94,421	)
	Gain on sale of TypeHaus assets			—			16,998			—			16,998
		Total other income		10,482			65,614			48,225			104,548
INCOME BEFORE INCOME TAX PROVISION				610,135			854,689			1,182,192			2,546,378
INCOME TAX PROVISION				—			2,000			—			55,000
NET INCOME			$	610,135		$	852,689		$	1,182,192		$	2,491,378
NET INCOME PER SHARE:
	Basic		$	0.03		$	0.04		$	0.06		$	0.13
	Diluted		$	0.03		$	0.04		$	0.06		$	0.12
WEIGHTED AVERAGE SHARES OUTSTANDING:
	Basic			20,934,041			20,261,036			20,945,056			19,828,373
	Diluted			21,176,764			20,436,622			21,198,168			20,597,218

See accompanying notes to condensed consolidated financial statements.

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

			For the nine months ended
			November 30,			November 30,
			2001			2000
CASH FLOWS FROM OPERATING ACTIVITIES:
		Net income	$	1,182,192		$	2,491,378
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
	Gain on sale of TypeHaus assets			—			(16,998	)
	Depreciation and amortization			1,676,372			1,158,097
	Amortization of unearned compensation			—			110,376
Changes in operating assets and liabilities (net of effects of acquisition and disposition):
		Accounts receivable		(127,848	)		1,086,479
		Inventories		240,945			326,028
		Other current assets		(4,481	)		(10,166	)
		Accounts payable		552,127			(722,972	)
		Accrued compensation		(95,419	)		(432,986	)
		Other accrued liabilities		(377,945	)		(207,699	)
		Deferred revenue		(363,000	)		(375,000	)
Net cash provided by operating activities:				2,682,943			3,406,537
CASH FLOWS FROM INVESTING ACTIVITIES:
		Property additions		(417,840	)		(393,413	)
		Proceeds from sale of TypeHaus assets		—			25,000
		Cash paid for acquisition, net of cash acquired		—			(525,348	)
		Acquired income tax obligation		(1,545,649	)		—
Net cash (used by) investing activities:				(1,963,489	)		(893,761	)
CASH FLOWS FROM FINANCING ACTIVITIES:
		Principal payments on other long-term debt		(387,661	)		(557,849	)
		Proceeds from issuance of common stock		66,589			861,045
		Repurchase of common stock		(106,488	)		—
Net cash used in financing activities				(427,560	)		303,196
NET INCREASE IN CASH				291,894			2,815,972
CASH, BEGINNING OF YEAR				5,346,525			2,949,562
CASH, END OF PERIOD			$	5,638,419		$	5,765,534
SUPPLEMENTAL CASH FLOW INFORMATION:
		Interest paid	$	103,049		$	94,421
		Income taxes paid	$	1,545,000		$	63,000
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
	Acquisition of property under capital leases		$	177,980		$	—

See accompanying notes to condensed financial statements.

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

NOTE 1 — DPAC Technologies Corp.(formerly Dense-Pac Microsystems), including its wholly owned subsidiary (collectively called “we,” “us,” “DPAC” or the “Company”), is a technology company that provides products and services for the Integration Age. DPAC was founded in 1982 and provides component packaging technology to create high-density, space saving surface mount electronic components. The Company also provides engineering design services to its customers, helping them realize cost-savings through improved circuitry designs. DPAC also provides design and manufacturing capability for ceramic and plastic high-density, high-reliability memory modules. The Company also offers manufacturing services for value-added circuit boards and assemblies. DPAC’s products are used in network servers, workstations, computer storage devices, medical and communication devices, as well as high-reliability electronics in the industrial, defense and aerospace industries. DPAC is ISO 9001 compliant. The DPAC Web site is at www. DPACtech.com

NOTE 2 — Basis of Presentation — The accompanying unaudited interim consolidated financial statements of DPAC as of November 30, 2001 and for the three and nine months ended November 30, 2001 and 2000 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 generally accepted accounting principles 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 generally accepted accounting principles 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-KSB for the year ended February 28, 2001. Effective March 1, 2001, the Company no longer qualifies as a “small business issuer” under Rule 12b-2 and is required to file under the application of Regulation S-K for its quarterly and annual reports.

Operating results for the three and nine months ended November 30, 2001 are not necessarily indicative of the results that may be expected for the full year ending February 28, 2002.

NOTE 3 —Recent Accounting Pronouncements — In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141 (“SFAS 141”), “Business Combinations.” SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. SFAS 141 also requires reclassification of certain identifiable assets to a separate financial statement line to the extent they meet certain criteria. At this time, the Company does not believe that the adoption of SFAS 141 will have a significant impact on its financial statements.

In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets”, which will become effective for the Company in March 2002. SFAS No. 142 requires that goodwill and other intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually. The Company will continue to assess its recorded goodwill and other intangible assets under current generally accepted accounting principles at each reporting period until the standard is adopted. The adoption of SFAS No. 142 in March 2002 will eliminate charges to operations for goodwill amortization and require employment of a method for determining impairment at least on an annual basis. The effect on the financial statements has not been determined. Currently, the Company’s amortization of goodwill is approximately $200,000 per quarter.

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NOTE 4 — Acquisitions — The results of operations of Productivity Enhancement Products, Inc. acquired in the third quarter of fiscal year 2002, are included in the consolidated financial statements from the date of acquisition. The following unaudited pro forma information assumes that the acquisition had occurred on the first day of the Company’s fiscal year ended February 28, 2001. The pro forma information is based on historical information and does not necessarily reflect the actual results that would have occurred, nor is it necessarily indicative of future results of the combined enterprise.

Nine months ended November 30, 2000
Net sales		$	33,256,000
Net income		$	1,412,000
Net income per share:
	Basic and diluted	$	0.06

NOTE 5 — The following table summarizes stock option activity under DPAC’s 1985 and 1996 Stock Option Plans for the nine months ended November 30, 2001:

		Number of			Price per		Number of
		Shares			Share		Options Exercisable
Balance, February 28, 2001			2,187,000		$	.94-$7.56		598,726
	Granted		612,500			1.00-3.50
	Exercised		(50,750	)		1.00-1.50
	Canceled		(154,875	)		1.00-8.63
Balance, November 30, 2001			2,593,875		$	.94-$7.56		1,040,286

NOTE 6 — 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 potential dilution of securities by including other common stock equivalents, such as stock options, in the weighted average number of shares outstanding, if dilutive.

6

The table below sets forth the reconciliation of the denominator of the earnings per share calculations: (000’s)

Three months ended	November 30,
	2001		2000
Shares used in computing basic net income per share		20,934		20,261
Dilutive effect of stock options		243		176
Shares used in computing diluted net income per share		21,177		20,437

Nine Months Ended	November 30,
	2001		2000
Shares used in computing basic net income per share		20,945		19,828
Dilutive effect of stock options		253		769
Shares used in computing diluted net income per share		21,198		20,597

NOTE 7- 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 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 CEO 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, and sales, production, and development personnel. As a result, the Company has discontinued the preparation of separate financial information for the three segments and 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 single operating segment as of November 30, 2001 and expects such reporting structure to continue in future periods.

The Company had export sales (primarily to Western European customers) accounting for approximately 9% and 2% of net sales for the three months ended November 30, 2001 and 2000, respectively, and approximately 4% and 3% of net sales for the nine months ended November 30, 2001 and 2000, respectively.

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ITEM 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations.

FORWARD-LOOKING STATEMENTS

     Included in the Notes to Consolidated 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, 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-KSB for the year ended February 28, 2001 under the heading “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 three months ended November 30, 2001 decreased $3,389,000 or 35% compared to the quarter ended November 30, 2000. The decrease in net sales for the quarter ended November 30, 2001, when compared to the same quarter in the prior year, was primarily due to the decrease in value of the memory content we purchased. This decrease was caused by the rapid decline in DRAM component prices experienced throughout the current fiscal year as well as a reduction in the percentage of orders containing purchased memory components opposed to consigned memory from the customer. For the commercial high-density product, the revenues of products containing the memory components we purchase on the customer’s behalf decreased to 33% of total revenues as compared to 45% from the third quarter in the prior fiscal year. In cases where the memory components are included in sales of products, the Company will purchase material for the commercial order and will determine the final sales price thereof, in order to avoid any price volatility in the components. See “Forward-Looking Statements.”

     Additionally, the overall revenue created from the stacking of memory decreased as competitive pricing pressures increased, resulting in a reduction of sales price by approximately 15% to 20% from the comparable quarter in the prior year. The number of units of commercial stacks shipped during the quarter ended November 30, 2001 increased by 84% from the comparable quarter in the prior year.

     Net sales for the nine months ended November 30, 2001 decreased $5,919,000 or 21% compared to the comparable period ended November 30, 2000. The decrease in net sales for the nine-month period ended November 30, 2001, when compared to the comparable period in the prior year was due primarily to the decline in the material price of the DRAM components. For the commercial high-density product, the revenue of products containing memory components we purchased decreased to 39% of total revenue as compared to 46% in the same period in the prior fiscal year. Additionally, the overall revenue created from the stacking of memory decreased as competitive pricing pressures increased, resulting in a reduction of sales price by approximately 10% to 15% from the comparable period in the prior year. The overall units in commercial stacks

8

shipped during the nine-month period ended November 30, 2001 increased by 25% from the comparable nine-month period of the previous fiscal year. Additionally, the product mix within the commercial business changed as to the relationship between consigned material and material purchased on behalf of the customer.

     Gross profit as a percentage of sales was 38% for the three-month period ended November 30, 2001, as compared to 29% for the three-month period ended November 30, 2000. For the nine-month periods ended November 30, 2001 and 2000, gross profit as a percentage of sales was 32% and 30% respectively. The increase in the gross margins for the three and nine month periods ended November 30, 2001 can be attributed to the decreased percentage of revenues from commercial products for which we purchased the memory components, partially offset by competitive pressure on pricing. During the third quarter ended November 30, commercial orders with memory included, accounted for $2,066,000 compared to $4,388,000 in the comparable period of the previous year. For the nine months ended November 30, 2001, approximately $8,577,000 of commercial orders contained procured memory as compared to $12,765,000 in the comparable period of the previous year. The balance of the commercial orders had consigned memory associated with the sale.

     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 third quarter of fiscal year 2002, 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 decreased in the third quarter of fiscal year 2002 by $442,000 or 28% from the third quarter of the prior fiscal year. For the nine-month period in fiscal year 2002, selling general and administrative expenses decreased $502,000 or 11% from the same period in the prior fiscal year. The decrease in general and administrative expenses for the third quarter and nine-month period ended November 30, 2001 versus the same periods in the prior year can be mainly attributed to the consolidation of the facility obtained during the previous year’s acquisition into the Garden Grove facility, eliminating or reducing redundant expenses. Additionally, the TypeHaus subsidiary was sold at the end of the third quarter of 2001, eliminating the associated general and administrative expenses. Legal fees associated with defending the lawsuit brought by SimpleTech, Inc., decreased by $235,000 for the nine-month period.

     Amortization of goodwill was $195,000 for the three months ended November 30, 2001, and $66,000 for the three months ended November 30, 2000. For the nine months ended November 30, 2001 and 2000, amortization of goodwill was $583,000 and $66,000 respectively. The amortization is related to the acquisition of Productivity Enhancement Products, Inc. completed in the third quarter of fiscal year 2001. The current net balance of the goodwill is $4,978,000 and is being amortized over a seven-year period. See “NOTE 3” to the Financial Statements included in this Report.

     Research and development costs increased by $63,000 and $96,000 for the quarter and nine-month periods ended November 30, 2001, respectively. For the quarter ended November 30, 2001, the research and development expense represented 7.3% of net sales as compared to 4.1% of net sales from the same quarter in the previous fiscal year. For the nine-month period ended November 30, 2001, research and development represented 6.2% of net sales as compared to 4.5% in the same period of the prior 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”.

9

     For the three months ended November 30, 2001, interest income decreased $30,000 from the same period last year and decreased $31,000 for the nine-month period. These changes primarily relate to the impact of interest rates and cash reserves. Interest expense decreased slightly for the same periods.

     For the three and nine months ended November 30, 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 nine-month period ended November 30, 2001 was from cash generated from 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 November 30, 2001a credit facility for three million dollars from a financial institution, which we 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 November 30, 2001. See “Forward-Looking Statements.”

     Net cash provided by operations was approximately $2,683,000 during the nine-month period consisting of net income plus depreciation and amortization offset by changes in operating assets and liabilities.

     The Company purchased for cash approximately $418,000 in new equipment during the first nine months of fiscal year 2002. The Company is expecting that it may incur additional lease debt with the acquisition of additional equipment during the next six months. The Company expects that it will not acquire more than one million dollars in additional equipment for the remainder of the fiscal year. See “Forward-Looking Statements”. The Company also paid a $1.5 million tax liability assumed in the Productivity Enhancement Products acquisition.

     Net cash used in financing activities was approximately $428,000 during the nine months ended November 30, 2001 and principally relates to debt repayments of $388,000, repurchase of common stock of $106,000, offset by proceeds from stock issuance of $67,000.

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.

10

PART II — OTHER INFORMATION

     Item 1 — Legal Proceedings

     The information is incorporated herein by reference to Form 10-KSB filed May 25, 2001. There have been no significant changes in the status of these legal proceedings.

     Item 6 — Exhibits and Reports on Form 8-K

          (a)  Exhibits

               99.1      Cautionary Statements are incorporated by reference to pages 17 through 23, inclusive, of the Registrant’s Form 10-KSB filed May 25, 2001 with the Securities and Exchange Commission.

(b) Reports on Form 8-K — No reports on Form 8-K were filed during the third quarter of fiscal year 2002 covered by this Form 10-Q.

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)

January 14, 2002	By:	/s/     Ted Bruce
Date	Ted Bruce, Chief Executive Officer
January 14, 2002	By:	/s/     William M. Stowell
Date	William M. Stowell, Chief Financial Officer

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EXHIBIT INDEX

Exh. No.	Description
99.1	Cautionary Statements

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.

     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, DST, Cubic Memory and Thompson CSF in France. 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 five thousand dollars 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. The Company also expects that its business may experience significant seasonality to the extent it sells a material portion of its products in Europe and to the extent its exposure to the personal computer market remains significant.

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’s customer’s 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 and Euroventures 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:

• Problems assimilating the purchased operations, technologies or products;

• Costs associated with the acquisition;

• Adverse effects on existing business relationships with suppliers and customers;

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

• Potential loss of key employees of purchased organizations; and

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

     Our inability to overcome problems encountered in connection with such acquisitions could invert 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 ICs. 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, has 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. -----END PRIVACY-ENHANCED MESSAGE-----