-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Le4zcW2uHvsXUFFV9nesbaW+bh1kCVeHNeMFO/yqGlpudtUgM8gt2mfIFWTFNZna dbg6l5cOwdd1UQSVlR/rIQ== 0001144204-04-013984.txt : 20040908 0001144204-04-013984.hdr.sgml : 20040908 20040908102119 ACCESSION NUMBER: 0001144204-04-013984 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20040731 FILED AS OF DATE: 20040908 DATE AS OF CHANGE: 20040908 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SBE INC CENTRAL INDEX KEY: 0000087050 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER COMMUNICATIONS EQUIPMENT [3576] IRS NUMBER: 941517641 STATE OF INCORPORATION: DE FISCAL YEAR END: 1031 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-08419 FILM NUMBER: 041019694 BUSINESS ADDRESS: STREET 1: 4550 NORRIS CANYON ROAD CITY: SAN RAMON STATE: CA ZIP: 94583 BUSINESS PHONE: 5103552000 MAIL ADDRESS: STREET 1: 4550 NORRIS CANYON RD CITY: SAN RAMON STATE: CA ZIP: 94583 10-Q 1 v06576_10q.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark one) [X] Quarterly report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 FOR THE QUARTERLY PERIOD ENDED JULY 31, 2004 [_] Transition report pursuant to section 13 or 15(d) of the Securities and Exchange Act of 1934 For the transition period from _______ to ________ Commission file number 0-8419 SBE, INC. ----------------------------------------------------- (Exact name of registrant as specified in its charter) Delaware 94-1517641 ------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2305 Camino Ramon, Suite 200, San Ramon, California 94583 --------------------------------------------------------- (Address of principal executive offices and zip code) (925) 355-2000 ---------------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [_] No [X] The number of shares of Registrant's Common Stock outstanding as of July 31, 2004 was 5,082,918. -1- SBE, INC. INDEX TO JULY 31, 2004 FORM 10-Q PART I FINANCIAL INFORMATION ITEM 1 Financial Statements (unaudited) Condensed Consolidated Balance Sheets as of July 31, 2004 and October 31, 2003..............................3 Condensed Consolidated Statements of Operations for the three and nine months ended July 31, 2004 and 2003..............4 Condensed Consolidated Statements of Cash Flows for the nine months ended July 31, 2004 and 2003........................5 Notes to Condensed Consolidated Financial Statements...............6 ITEM 2 Management's Discussion and Analysis of Financial Condition and Results of Operations......................11 ITEM 3 Quantitative and Qualitative Disclosures about Market Risk..............................................26 ITEM 4 Controls and Procedures..................................26 PART II OTHER INFORMATION ITEM 6 Exhibits and Reports on Form 8-K.........................27 SIGNATURES...........................................................30 EXHIBITS.............................................................31 -2- PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS SBE, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands) July 31, October 31, 2004 2003 --------- --------- (Unaudited) Current assets: Cash and cash equivalents $ 1,497 $ 1,378 Trade accounts receivable, net 2,682 1,818 Inventories 2,535 1,880 Other 272 240 -------- -------- Total current assets 6,986 5,316 Property, plant and equipment, net 314 389 Capitalized software costs, net 189 120 Intellectual property, net 816 1,122 Other 28 28 -------- -------- Total assets $ 8,333 $ 6,975 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Trade accounts payable $ 1,065 $ 696 Accrued payroll and employee benefits 144 184 Other accrued liabilities and deferred revenue 491 491 -------- -------- Total current liabilities 1,700 1,371 Other long-term liabilities 1 217 -------- -------- Total liabilities 1,701 1,588 -------- -------- Commitments Stockholders' equity: Common stock 15,745 15,302 Note receivable from stockholder -- (142) Accumulated deficit (9,113) (9,773) -------- -------- Total stockholders' equity 6,632 5,387 -------- -------- Total liabilities and stockholders' equity $ 8,333 $ 6,975 ======== ======== See notes to condensed consolidated financial statements. -3- SBE, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts) (Unaudited) Three months ended Nine months ended July 31, July 31, 2004 2003 2004 2003 -------- ------- -------- -------- Net sales $ 2,899 $ 1,621 $ 8,846 $ 5,249 Cost of sales 1,359 559 4,101 1,971 -------- ------- -------- -------- Gross profit 1,540 1,062 4,745 3,278 Product research and development 548 334 1,596 913 Sales and marketing 539 361 1,592 1,004 General and administrative 376 381 1,140 1,259 Restructuring costs recovery -- (154) -- (154) Loan loss recovery -- -- (239) -- -------- ------- -------- -------- Total operating expenses 1,463 922 4,089 3,022 -------- ------- -------- -------- Operating income 77 140 656 256 Interest income 2 6 4 21 Other income (expense) -- (4) -- (10) -------- ------- -------- -------- Income before income taxes 79 142 660 267 Income tax provision (benefit) -- 1 -- (17) -------- ------- -------- -------- Net income $ 79 $ 141 $ 660 $ 284 ======== ======= ======== ======== Basic income per share $ 0.02 $ 0.03 $ 0.13 $ 0.07 ======== ======= ======== ======== Diluted income per share $ 0.01 $ 0.03 $ 0.11 $ 0.07 ======== ======= ======== ======== Basic - weighted average shares used in per share computations 5,078 4,288 5,000 4,145 ======== ======= ======== ======== Diluted - weighted average shares used in per share computations 5,866 4,614 6,009 4,276 ======== ======= ======== ======== See notes to condensed consolidated financial statements. -4- SBE, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)
Nine months ended July 31, 2004 2003 -------- -------- Cash flows from operating activities: Net income $ 660 $ 284 Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization: Property and equipment 160 254 Software 42 26 Amortization of intellectual property 306 -- Loss on abandonment of equipment -- 13 Changes in operating assets and liabilities: Accounts receivable (864) (117) Inventories (655) 307 Other assets (32) (62) Trade accounts payable 369 (183) Other accrued liabilities (256) (573) -------- -------- Net cash used in operating activities (270) (51) -------- -------- Cash flows from investing activities: Purchases of property, plant and equipment (85) (77) Capitalized software costs (111) (10) -------- -------- Net cash used in investing activities (196) (87) -------- -------- Cash flows from financing activities: Proceeds from the sale of common stock and the exercise of warrants 202 478 Proceeds from repayment of stockholder note 142 25 Proceeds from exercise of stock options 241 43 -------- -------- Net cash provided by financing activities 585 546 -------- -------- Net increase in cash and cash equivalents 119 408 Cash and cash equivalents at beginning of period 1,378 1,582 -------- -------- Cash and cash equivalents at end of period $ 1,497 $ 1,990 ======== ========
See notes to condensed consolidated financial statements. -5- SBE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. INTERIM PERIOD REPORTING: These condensed consolidated financial statements of SBE, Inc. are unaudited and include all adjustments, consisting of normal recurring adjustments, that are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations and cash flows for the interim periods. The results of operations for the three and nine and months ended July 31, 2004 are not necessarily indicative of expected results for the full 2004 fiscal year. Certain information and footnote disclosures normally contained in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the financial statements and notes contained in our Annual Report on Form 10-K for the year ended October 31, 2003. MANAGEMENT ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles in the U.S. requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, as well as certain disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of net sales and expenses during the reporting period. Actual results could differ from these estimates. Significant estimates and judgments made by us relate to matters such as potential liability for sales allowances, warranty obligations and indemnification obligations, collectibility of accounts receivable, realizability of inventories and recoverability of capitalized software and deferred tax assets. 2. INVENTORIES: Inventories were comprised of the following (in thousands): July 31, October 31, 2004 2003 ------- ------- Finished goods $ 1,568 $ 726 Parts and materials 967 1,154 ------- ------- $ 2,535 $ 1,880 ======= ======= 3. INTANGIBLE ASSETS: Intangible Assets represent intellectual property that consists of the allocation of costs associated with the purchase of current and the design of future products from Antares Microsystems on August 7, 2003. All capitalized intellectual property is amortized to cost of goods expense on a straight line -6- basis over thirty-six months which is the expected useful life and does not materially differ from the expected cash inflow from the sale of the acquired Antares product line. Intangible Assets subject to amortization are as follows (in thousands): Accumulated Gross Amortization Net ------ ------------ ---- Intellectual Property $1,224 $408 $816 ====== ---========= ==== Amortization expense of intellectual property for the three months and nine months ending July 31, 2004 was $102,000 and $306,000 and is included in cost of sales. The estimated aggregate remaining amortization expense for each of the succeeding fiscal years is as follows (in thousands): 2004 $ 102 2005 408 2006 306 ----- Total $ 816 ===== 4. RESTRUCTURING COSTS: The following table sets forth an analysis of the components of our restructuring reserve relating to lease terminations and the payments made against it during the nine-month period ended July 31, 2004 (in thousands): Restructuring accrual at October 31, 2003 $ 58 Less: Cash paid for accrued lease costs (28) ----- Total restructuring accrual included in other accrued liabilities and deferred revenue $ 30 ===== 5. NET INCOME PER SHARE: Basic income per common share for the three and nine months ended July 31, 2004 and 2003 was computed by dividing the net income for such period by the weighted average number of shares of common stock outstanding for such period. Common stock equivalents for the three and nine months ended July 31, 2004 were 788,082 and 1,008,334, respectively, and have been included in the calculation of diluted net income per share. The common stock equivalents for the three and nine months ended July 31, 2004 include the following items: 1) 652,316 and 848,681 vested employee stock options, respectively; 2) 66,821 and 90,708 common stock equivalents subject to warrants, respectively; 3) 68,945 shares of common stock to be issued related to the purchase of Antares, respectively. Common stock equivalents for the three and nine months ended July 31, 2003, were 325,711 and 131,110, respectively, and have been included in the calculation of diluted net income per share. -7- Three months ended Nine months ended July 31, July 31, ------------------ ------------------ 2004 2003 2004 2003 -------- ------- ------- -------- BASIC Weighted average number of common shares outstanding 5,078 4,288 5,000 4,145 -------- ------- ------- -------- Number of shares for computation of net income per share 5,078 4,288 5,000 4,145 ======== ======= ======= ======== Net income $ 79 $ 141 $ 660 $ 284 ======== ======= ======= ======== Net income per share $ 0.02 $ 0.03 $ 0.13 $ 0.07 ======== ======= ======= ======== DILUTED Weighted average number of common shares outstanding 5,078 4,288 5,000 4,145 Shares issuable pursuant to options granted under stock option plans and warrants granted, less assumed repurchase at the average fair market value for the period 788 326 1,009 131 -------- ------- ------- -------- Number of shares for computation of net income per share 5,866 4,614 6,009 4,276 ======== ======= ======= ======== Net income $ 79 $ 141 $ 660 $ 284 ======== ======= ======= ======== Net income per share $ 0.01 $ 0.03 $ 0.11 $ 0.07 ======== ======= ======= ======== 6. STOCK BASED COMPENSATION: At July 31, 2004, we had two stock-based employee compensation plans and one stock-based director compensation plan. We account for these plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, no stock-based employee compensation cost has been recognized in net income for the stock option plans. Had compensation cost for our stock option plans been determined based on the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," our net income (loss) and income (loss) per share would have been as follows (in thousands): -8- Three Months Nine Months Ended July 31, Ended July 31, 2004 2003 2004 2003 ------- ------- ------- ------- Net income, as reported $ 79 $ 141 $ 660 $ 284 Add: Total stock-based compensation expense (benefit) included in the net income determined under the recognition and measurement principles of APB Opinion 25 -- -- -- -- Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects 150 149 316 374 ------- ------- ------- ------- Pro forma net income (loss) $ (71) $ (8) $ 245 $ (239) ======= ======= ======= ======= Income (loss) per share: Basic - as reported $ 0.02 $ 0.03 $ 0.13 $ 0.07 ======= ======= ======= ======= Basic - pro forma $ (0.01) $ 0.00 $ 0.05 $ (0.06) ======= ======= ======= ======= Diluted - as reported $ 0.01 $ 0.03 $ 0.11 $ 0.07 ======= ======= ======= ======= Diluted - pro forma $ (0.01) $ 0.00 $ 0.04 $ (0.06) ======= ======= ======= ======= There were 13,000 stock options granted in the quarter ended July 31, 2004. The assumptions regarding the annual vesting of stock options were 25% per year for options granted in 2004. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2004: Dividend yield of 0%; expected volatility of 111%, risk-free interest rate of 3.17%, and expected life of four years. 7. CONCENTRATION OF RISK: In the three and nine months ended July 31, 2004 and 2003, most of our sales were attributable to sales of communications products and were derived from a limited number of original equipment manufacturer ("OEM") customers. In our third quarter of fiscal 2004, we had sales to two customers that were each greater than 10% of our net sales for the quarter. The sales to these two customers combined totaled 67% of net sales during the third quarter of fiscal 2004. In our third quarter of fiscal 2003, we had sales to one customer that accounted for greater than 10% of our net sales for the quarter. The sales to this customer totaled 50% of our net sales for that quarter. In the first nine months of fiscal 2004, we had sales to two customers that were each greater than 10% of our sales for that period. The sales to these two customers combined totaled 59% of net sales during the first three quarters of fiscal 2004. In the first nine months of fiscal 2003, we had sales to one customer that accounted for greater than 10% of our net sales for that period. The sales to this customer totaled 52% of our net sales for the first three quarters of fiscal 2003. -9- We have two customers that each accounted for more than 10% of our accounts receivable as of July 31, 2004 compared to one customer that accounted for more than 10% of our accounts receivable at July 31, 2003. 8. WARRANTY OBLIGATIONS AND OTHER GUARANTEES: Warranty Reserve: Our products are sold with warranty provisions that require us to remedy deficiencies in quality or performance of our products over a specified period of time, generally 12 months, at no cost to our customers. We accrue the estimated costs to be incurred in performing warranty services at the time of revenue recognition and shipment of our products to our customers. Our estimate of costs to service our warranty obligations is based on historical experience and expectation of future conditions. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, the warranty accrual may increase, resulting in decreased gross margin. The following table sets forth an analysis of our warranty reserve for the nine month period ended July 31, 2004 (in thousands): Warranty reserve at October 31, 2003 $53 Less: Cost to service warranty obligations 33 --- Total warranty reserve included in other accrued expenses $20 === The following is a summary of our agreements that we have determined are within the scope of the Financial Accounting Standards Board's ("FASB") Interpretation No. 45 "Guarantor's Accounting and Disclosure Requirements for Guarantees" ("FIN 45"). Indemnification Agreements: We have agreed to indemnify each of our executive officers and directors for certain events or occurrences arising as a result of the officer or director serving in such capacity. The term of the indemnification period is for the officer's or director's lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. However, we have a directors' and officers' liability insurance policy that should enable us to recover a portion of any future amount paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal and have no liabilities recorded for these agreements as of July 31, 2004 and October 31, 2003. We enter into agreements with other companies containing indemnification provisions in the ordinary course of business, typically with business partners, contractors, customers and landlords. Under these provisions, we generally agree to indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our activities or, in some cases, as a result of the indemnified party's activities under the agreement. These indemnification provisions often relate to representations made by us with -10- regard to our intellectual property rights. These indemnification provisions generally survive termination of the underlying agreement. The maximum potential amount of future payments we could be required to make under these indemnification provisions is unlimited. To date, we have not incurred material costs to defend lawsuits or settle claims related to these indemnification provisions. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of July 31, 2004 and October 31, 2003. Other: We are the secondary guarantor on the lease assignment of our previous headquarters that expires in 2006. We believe we will not have to make any payments as a result of this guarantee and thus have not recorded a liability at July 31, 2004. 9. LOAN TO OFFICER On November 6, 1998, we made a loan to one of our officers and stockholders which was used by the officer/stockholder to exercise an option to purchase 139,400 shares of our common stock and related taxes. The loan, as amended, was collateralized by shares of our common stock, bore interest at a rate of 2.48% per annum, with interest due annually and the entire amount of the principal was due on December 14, 2003. On October 31, 2002, we determined that it was probable that we would be unable to fully recover the balance of the loan on its due date of December 14, 2003. Accordingly, a valuation allowance of $474,000 was recorded against the loan at October 31, 2002. During the fourth quarter of fiscal 2003, the officer repaid $362,800 of the loan and as a result, we recognized a benefit of $235,000 related to the reversal of the loan impairment charge taken by us in fiscal 2002. During the first quarter of fiscal 2004, the officer repaid the remaining loan balance in full and as a result, we recorded a benefit of $239,000 relating to the reversal of the remaining loan impairment charge. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD LOOKING STATEMENTS The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. Words such as "believes," "anticipates," "expects," "intends" and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. Readers are cautioned that the forward-looking statements reflect our analysis only as of the date hereof, and we assume no obligation to update these statements. Actual events or results may differ materially from the results discussed in or implied by the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those risks and uncertainties set forth under the caption "Risk Factors" below. -11- The following discussion should be read in conjunction with the Financial Statements and the Notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and in our Form 10-K for the fiscal year ended October 31, 2003. RISK FACTORS In addition to the other information in this Quarterly Report on Form 10-Q, stockholders or prospective investors should carefully consider the following risk factors: RISKS RELATED TO OUR BUSINESS OUR FUTURE SUCCESS DEPENDS ON OUR ABILITY TO REPLACE NET SALES PREVIOUSLY GENERATED BY SALES OF VME PRODUCTS TO HP. In the first three quarters of fiscal 2004 and 2003, sales of our Versa Module Europa ("VME") products to The Hewlett-Packard Company ("HP") accounted for 47% and 52%, respectively, of our net sales. We shipped $1.6 million of VME products to HP over the first three quarters of fiscal 2003 pursuant to an end-of-life product discontinuation purchase order that is no longer in effect. In September 2003, HP notified us that they would purchase an additional $2.6 million of VME products, with deliveries scheduled for our fourth quarter of fiscal 2003 and the first two quarters of fiscal 2004. In our first two quarters of 2004, we shipped $2.0 million of VME products to HP under the September 2003 purchase order. In April 2004, we received an additional $2.9 million purchase order of VME products from HP and shipped $1.2 million against this purchase order in the third quarter of fiscal 2004 with deliveries for the remaining $1.7 million scheduled for the fourth quarter of fiscal 2004 and first quarter of fiscal 2005. While we have continued to sell VME products to HP pursuant to individual purchase orders, we believe that HP will cease purchasing our VME products in fiscal 2005 as the HP products in which our VME products are embedded are phased out. Our net sales derived from these individual purchase orders have been significant and when HP ceases to purchase VME products we will need to increase our net sales from other sources in order to be successful. We can provide no assurance that we will succeed in obtaining new orders from existing or new customers sufficient to replace or exceed the net sales attributable to HP. WE SELL OUR PRODUCTS TO A SMALL NUMBER OF OEM CUSTOMERS, AND THE LOSS OF ANY OF THEM, OR THEIR FAILURE TO SELL THEIR PRODUCTS, WOULD LIMIT OUR ABILITY TO GENERATE NET SALES. In fiscal 2003 and the first three quarters of fiscal 2004, most of our sales were derived from a limited number of OEM customers, primarily HP. We expect that we will always derive most our sales from a limited number of OEM customers. Orders by our OEM customers are affected by factors such as new product introductions, product life cycles, inventory levels, manufacturing strategies, contract awards, competitive conditions and general economic conditions. Our sales to any single OEM customer are also subject to significant variability from quarter to quarter. Such fluctuations may have a material adverse effect on our operating results. A significant reduction in orders from any of our OEM customers would have a material adverse effect on our operating results, financial condition and cash flows. None of our customers is bound by a long-term purchase contract. Thus, we cannot provide any assurance that we will continue to sell our products at existing levels, if at all, to our existing OEM customers. -12- BECAUSE OF OUR DEPENDENCE ON SINGLE SUPPLIERS FOR SOME COMPONENTS, WE MAY BE UNABLE TO OBTAIN AN ADEQUATE SUPPLY OF SUCH COMPONENTS, OR WE MAY BE REQUIRED TO PAY HIGHER PRICES OR TO PURCHASE COMPONENTS OF LESSER QUALITY. The chipsets used in most of our products are currently available only from Motorola. In addition, certain other components are currently available only from single suppliers. Suppliers may discontinue or upgrade some of the components used in our products, which could require us to redesign a product to incorporate newer or alternative technology. The inability to obtain sufficient key components as required, or to develop alternative sources if and as required in the future, could result in delays or reductions in product shipments or margins that, in turn, would have a material adverse effect on our business, operating results and financial condition. If enough components are unavailable, we may have to pay a premium in order to meet customer demand. Paying premiums for parts, building inventories of scarce parts and obsolesce of existing inventories could lower or eliminate our profit margin, harm our financial condition and otherwise harm our business. To offset potential component shortages, we have in the past, and may in the future, carry an inventory of these components. As a result, our inventory of components parts may become obsolete and may result in write-downs. IF WE FAIL TO DEVELOP AND PRODUCE NEW PRODUCTS, WE MAY LOSE SALES AND OUR REPUTATION MAY BE HARMED. We focus a significant portion of our research and development, marketing and sales efforts on our HighWire, WAN/LAN and TCP/IP Offload Engine ("TOE") Adapter products. The success of these products is dependent on several factors, including timely completion of new product designs, achievement of acceptable manufacturing quality and yields, introduction of competitive products by other companies and market acceptance of our products. If the HighWire and Adapter products or other new products developed by us do not gain market acceptance, our business, operating results, financial condition and cash flows would be materially adversely affected. THE COMMUNICATIONS AND STORAGE PRODUCTS MARKET IS INTENSELY COMPETITIVE, AND OUR FAILURE TO COMPETE EFFECTIVELY COULD REDUCE OUR NET REVENUES AND MARGINS. We compete directly with vendors of terminal servers, modems, remote control software, terminal emulation software and application-specific communications and storage solutions. We also compete with suppliers of routers, hubs, network interface cards and other data communications and storage products. In the future, we expect competition from companies offering client/server access solutions based on emerging technologies such as switched digital telephone services, iSCSI, TCP/IP Offload Engine ("TOE") and other technologies. In addition, we may encounter increased competition from operating system and network operating system vendors to the extent such vendors include full communications and storage capabilities in their products. We may also encounter future competition from telephony service providers (such as AT&T or the regional Bell operating companies) that may offer communications services through their telephone networks. -13- Increased competition with respect to any of our products could result in price reductions and loss of market share, which would adversely affect our business, operating results, financial condition and cash flows. Many of our current and potential competitors have greater financial, marketing, technical and other resources than we do. There can be no assurance that we will be able to compete successfully with our existing competitors or will be able to compete successfully with new competitors. OUR SALES AND OPERATING RESULTS HAVE FLUCTUATED, AND ARE LIKELY TO CONTINUE TO FLUCTUATE SIGNIFICANTLY IN FUTURE PERIODS CAUSING AND MAY CONTINUE TO CAUSE, OUR STOCK PRICE TO FALL AS A RESULT OF FAILURE TO MEET THE EXPECTATIONS OF SECURITIES ANALYSTS OR INVESTORS. Our quarterly operating results have fluctuated significantly in the past and are likely to fluctuate significantly in the future due to several factors, some of which are outside our control and which we may not be able to predict, including the existence or absence of significant orders from OEM customers, fluctuating market demand for, and declines in the average selling prices of our products, success in achieving design wins, delays in the introduction of our new products, competitive product introductions, the mix of products sold, changes in our distribution network, the failure to anticipate changing customer product requirements, the cost and availability of components and general economic conditions. We generally do not operate with a significant order backlog, and a substantial portion of our net sales in any quarter is derived from orders booked in that quarter. Accordingly, our sales expectations are based almost entirely on our internal estimates of future demand and not on firm customer orders. Due to the adverse economic conditions in the telecommunications industry, our customers now typically require a "just-in-time" ordering and delivery cycle where they will place a purchase order with us after they receive an order from their customer. This "just-in-time" inventory purchase cycle by our customers has made forecasting of our future sales volumes very difficult and has required us to build up inventory. Based on the foregoing, we believe that quarterly operating results are likely to vary significantly in the future and that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Further, it is likely that in some future quarter our net sales or operating results will be below the expectations of public market analysts and investors. In such event, the price of our common stock is likely to fall. IF WE ARE UNABLE TO KEEP UP WITH THE RAPID TECHNOLOGICAL CHANGES THAT CHARACTERIZE OUR INDUSTRY, OUR BUSINESS WOULD SUFFER. The markets for our products are characterized by rapidly changing technologies, evolving industry standards and frequent new product introductions. Our future success will depend on our ability to enhance our existing products and to introduce new products and features to meet and adapt to changing customer requirements and emerging technologies such as ACTA form factors with AMC daughter cards, TCP/IP offload engines ("TOE"), Encryption, 10 Gigabit Ethernet ("10Gig"), Voice over Internet Protocol ("VoIP") and Third Generation Wireless -14- Services ("3G"). The development of new and enhanced technology and products is a complex and uncertain process requiring high levels of innovation, highly skilled engineering and development personnel, and the accurate anticipation of technological and marketing trends. There can be no assurance that we will be successful in identifying, developing, manufacturing, marketing or supporting new products or enhancing our existing products on a timely basis, if at all. In addition, there can be no assurance that services, products or technologies developed by others will not render our products noncompetitive or obsolete. WE DEPEND ON OUR KEY PERSONNEL. IF WE ARE UNABLE TO RETAIN OUR CURRENT PERSONNEL AND HIRE ADDITIONAL QUALIFIED PERSONNEL AS NEEDED, OUR BUSINESS WOULD BE HARMED. We are highly dependent on the technical, management, marketing and sales skills of a limited number of key employees. We do not have employment agreements with, or life insurance on the lives of, any of our key employees. The loss of the services of any key employees could adversely affect our business and operating results. Our future success will depend on our ability to continue to attract and retain highly talented personnel to the extent our business grows. Competition for qualified personnel in the networking industry, and in the San Francisco Bay Area, is intense. There can be no assurance that we will be successful in retaining our key employees or that we can attract or retain additional skilled personnel as required. OUR FUTURE CAPITAL NEEDS MAY EXCEED OUR ABILITY TO RAISE CAPITAL. While we believe that our existing cash balances and our anticipated cash flow from operations will satisfy our working capital needs for the next 12 months, we cannot give assurance that this will be the case. Declines in our net sales or a failure to keep expenses in line with net sales could require us to seek additional financing in the future. In addition, should we experience a significant growth in customer orders, we may be required to seek additional capital to meet our working capital needs through the issuance of equity or debt securities and we may not be able to sell these equity or debt securities under then-existing market conditions or on acceptable terms, if at all. If additional funds are raised through the issuance of equity or debt securities, these equity securities could have rights, privileges or preferences senior to those of common stock. If we issue debt securities, we may be forced to pay high interest rates or agree to debt covenants that impose onerous restrictions on our operations. The sale of equity or debt securities could result in additional dilution to current stockholders. WE MAY BE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, WHICH COULD REDUCE ANY COMPETITIVE ADVANTAGE WE HAVE. Although we believe that our future success will depend primarily on continuing innovation, sales, marketing and technical expertise, the quality of product support and customer relations, we must also protect the proprietary technology contained in our products. We currently hold four technology related patents but rely primarily on a combination of copyright, trademark, trade secret laws and contractual provisions to establish and protect proprietary rights in our products. There can be no assurance that steps taken by us in this regard will be adequate to deter misappropriation or independent third-party development of our technology. Although we believe that our products and technology do not infringe on the proprietary rights of others, there can be no assurance that third parties will not assert infringement claims against us. -15- RISKS ASSOCIATED WITH OWNERSHIP OF OUR COMMON STOCK OUR COMMON STOCK HAS BEEN AT RISK FOR DELISTING FROM THE NASDAQ SMALLCAP MARKET. IF IT IS DELISTED, OUR STOCK PRICE AND YOUR LIQUIDITY MAY BE IMPACTED. Our common stock is currently listed on the Nasdaq SmallCap Market. Nasdaq has requirements that a company must meet in order to remain listed on the Nasdaq SmallCap Market. These requirements include maintaining a minimum closing bid price of $1.00 and minimum stockholders' equity of $2.5 million. The closing bid price for our common stock was below $1.00 for more than 30 consecutive trading days during portions of fiscal 2003. Our stockholders' equity as of July 31, 2004 was approximately $6.6 million. Although we currently meet all the minimum continued listing requirements for the Nasdaq SmallCap Market, should our stock price again decline, our common stock could be subject to potential delisting from the Nasdaq SmallCap Market. If we fail to maintain the standards necessary to be quoted on the Nasdaq SmallCap Market and our common stock is delisted, trading in our common stock would be conducted on the OTC Bulletin Board as long as we continue to file reports required by the Securities and Exchange Commission. The OTC Bulletin Board is generally considered to be a less efficient market than the Nasdaq SmallCap Market, and our stock price, as well as the liquidity of our common stock, may be adversely impacted as a result. THE MARKET PRICE OF OUR COMMON STOCK IS LIKELY TO CONTINUE TO BE VOLATILE. YOU MAY NOT BE ABLE TO RESELL YOUR SHARES AT OR ABOVE THE PRICE AT WHICH YOU PURCHASED SUCH SHARES. The trading price of our common stock is subject to wide fluctuations in response to quarter-to-quarter fluctuations in operating results, the failure to meet analyst estimates, announcements of technological innovations or new products by us or our competitors, general conditions in the computer and communications industries and other events or factors. In addition, stock markets have experienced extreme price and trading volume volatility in recent years. This volatility has had a substantial effect on the market price of the securities of many high technology companies for reasons frequently unrelated to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of our common stock. Our common stock has historically had relatively small trading volumes. As a result, small transactions in our common stock can have a disproportionately large impact on the quoted price of our common stock. OUR CERTIFICATE OF INCORPORATION AND BYLAWS AND THE DELAWARE GENERAL CORPORATION LAW CONTAIN PROVISIONS THAT COULD DELAY OR PREVENT A CHANGE IN CONTROL. Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be materially adversely affected by, the rights of the holders of any preferred stock that may -16- be issued in the future. The issuance of preferred stock could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. Furthermore, certain other provisions of our certificate of incorporation and bylaws may have the effect of delaying or preventing changes in control or management, which could adversely affect the market price of our common stock. In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, an anti-takeover law. MANAGEMENT'S DISCUSSION AND ANALYSIS OVERVIEW We architect and provide board-level network communications solutions for OEMs in both the embedded and enterprise-level information technology ("IT") computing markets. Our solutions enable both data communications and telecommunications companies, in addition to enterprise-class high-end server clients, to rapidly deliver advanced networking and storage products and services. We offer a broad selection of wide area network ("WAN") such as T1/T3, local area network ("LAN") such as Gigabit Ethernet, SCSI, Fibre Channel, and intelligent carrier cards across both the enterprise and embedded server markets. Our products have been integrated into a variety of applications, including storage area networks and mission-critical data centers. Our products, with Linux and Solaris drivers and software, include WAN and LAN interface adapters, storage network interface cards ("NICs") products such as SCSI and Fibre Channel, and high performance intelligent communications controllers for high-end enterprise level servers, workstations, media gateways, routers, internet access devices, home location registers and data messaging applications. Our products are distributed worldwide through a direct sales force, distributors, independent manufacturers' representatives and value-added resellers. We continue to operate in a single business segment. CONCENTRATIONS Our business is characterized by a concentration of sales to a small number of OEMs and, consequently, the timing of significant orders from major customers and their product cycles causes fluctuations in our operating results. HP is the largest of our customers. Sales to HP accounted for 55% and 47% of our net sales in the three and nine months ended July 31, 2004, respectively, and 50% and 52% for the same periods in fiscal 2003, respectively. In the third quarter of fiscal 2004, sales to Data Connection Limited accounted for 11% of net sales, in addition, Nortel Networks contributed 11% of our revenue for the nine month period ended July 31, 2004. No other customer accounted for greater than 10% of net sales in the three or nine months ended July 31, 2004 or 2003. HP accounted for 58% and 30% of our accounts receivable as of July 31, 2004 and 2003, respectively. At July 31, 2004, one other customer accounted for greater that 10% of our accounts receivable compared to one other customer as of July 31, 2003. No other customers accounted for more than 10% of our accounts receivable as of July 31, 2004 or 2003, respectively. Orders by our OEM customers are affected by factors such as new product introductions, product life cycles, inventory levels, manufacturing strategy, contract awards, competitive conditions and general economic conditions. If any of our major customers reduces orders for our products, we would lose revenues and could suffer damage to our business reputation. -17- BACKLOG On July 31, 2004, we had a sales backlog of product orders of approximately $3.9 million compared to a sales backlog of product orders of approximately $0.2 million one year ago. Of the July 31, 2004 backlog approximately $1.6 million relates to sales of VME products for HP compared to no backlog as of July 31, 2003. We have begun to see a slight recovery in certain segments of our markets, such as, wireless, VoIP, voice conferencing among others and customers in those markets have been increasing their ordering levels. As a result we have begun to increase our headcount in our engineering and production departments. Although we are responding to current and future customer design and support needs, we continue to focus on cost containment and cash preservation and monitor our expense levels very closely. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of consolidated financial statements in conformity with generally accepted accounting principles in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates and judgments made by us include matters such as indemnifications obligations, accounts receivable, realizability of inventories and recoverability of capitalized software and deferred tax assets. Actual results could differ from those estimates. Our critical accounting policies and estimates include the following: Revenue Recognition: Our policy is to recognize revenue for product sales when title transfers and risk of loss has passed to the customer, which is generally upon shipment of our products to our customers. We defer and recognize service revenue over the contractual period or as services are rendered. We estimate expected sales returns and record the amount as a reduction of revenue and cost of goods sold ("COGS") at the time of shipment. Our policy complies with the guidance provided by Staff Accounting Bulletin No. 104, "Revenue Recognition in Financial Statements," issued by the Securities and Exchange Commission. Judgments are required in evaluating the credit worthiness of our customers. Credit is not extended to customers and revenue is not recognized until we have determined that collectibility is reasonably assured. Our sales transactions are denominated in U.S. dollars. The software component of our products is considered incidental. We, therefore do not recognize software revenue separately from the product sale. Our agreements with OEMs, such as HP, Nortel Networks Corp. and Lockheed Martin, typically incorporate clauses reflecting the following understandings: -18- - all prices are fixed and determinable at the time of sale; - title and risk of loss pass at the time of shipment (FOB shipping point); - collectibility of the sales price is probable (the OEM is obligated to pay and such obligation is not contingent on the ultimate sale of the OEM's integrated solution); - the OEM's obligation to us will not be changed in the event of theft or physical destruction or damage of the product; - we do not have significant obligations for future performance to directly assist in the resale of the product by the OEMs; and - there is no contractual right of return other than for defective products. Our agreements with our distributors include certain product rotation and price protection rights. All distributors have the right to rotate slow moving products once each fiscal quarter. The maximum dollar value of inventory eligible for rotation is equal to 25% of our products purchased by the distributor during the previous quarter. In order to take advantage of their product rotation rights, the distributors must order and take delivery of additional SBE products equal to at least the dollar value of the products that they want to rotate. Each distributor is also allowed certain price protection rights. If and when we reduce or plan to reduce the price of any of our products and the distributor is holding any of the affected products in inventory, we will credit the distributor the difference in price when they place their next order with us. We record an allowance for price protection, reducing our net sales and accounts receivable. The allowance is based on the price difference of the inventory held by our stocking distributors at the time we expect to reduce selling prices. We believe we are able to fully evaluate potential returns and adjustments and continue to recognize the sale based on shipment to our distributors. Reserves for the right of return and restocking are established based on the requirements of SFAS 48, "Revenue Recognition when Right of Return Exists." During the quarter ended July 31, 2004, $168,000 or 6% of our sales were sold to distributors compared to $0 in the same quarter of fiscal 2003. During the nine months ended July 31, 2004, $706,000 or 8% of our sales were sold to distributors compared to $0 in the same period of fiscal 2003. Our reserves for distributor programs total approximately $40,000 as of July 31, 2004. Allowance for Doubtful Accounts: Our policy is to maintain allowances for estimated losses resulting from the inability of our customers to make required payments. Credit limits are established through a process of reviewing the financial history and stability of each customer. Where appropriate, we obtain credit rating reports and financial statements of the customer when determining or modifying their credit limits. We regularly evaluate the collectibility of our trade receivable balances based on a combination of factors. When a customer's account balance becomes past due, we initiate dialogue with the customer to determine the cause. If it is determined that the customer will be unable to meet its financial obligation to us, such as in the case of a bankruptcy filing, deterioration in the customer's operating results or financial position or other material events impacting their business, we record a specific allowance to reduce the related receivable to the amount we expect to recover. -19- We also record an allowance for all customers based on certain other factors including the length of time the receivables are past due and historical collection experience with customers. We believe our reported allowances are adequate. If the financial conditions of those customers were to deteriorate, however, resulting in their inability to make payments, we may need to record additional allowances which would result in additional general and administrative expenses being recorded for the period in which such determination was made. Warranty Reserves We accrue the estimated costs to be incurred in performing warranty services at the time of revenue recognition and shipment of the products to the OEMs. Because there is no contractual right of return other than for defective products, we can reasonably estimate such returns and record a warranty reserve at the point of shipment. Our estimate of costs to service our warranty obligations is based on historical experience and expectation of future conditions. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, the warranty accrual will increase, resulting in decreased gross margin. Inventories We are exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage, or subject to lower of cost or market issues. These factors include, but are not limited to, technological changes in our markets, our ability to meet changing customer requirements, competitive pressures in products and prices, and the availability of key components from our suppliers. Our policy is to establish inventory reserves when conditions exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon our assumptions about future demand for our products and market conditions. We regularly evaluate our ability to realize the value of our inventory based on a combination of factors including the following: historical usage rates, forecasted sales or usage, product end-of-life dates, estimated current and future market values and new product introductions. Purchasing practices and alternative usage avenues are explored within these processes to mitigate inventory exposure. When recorded, our reserves are intended to reduce the carrying value of our inventory to its net realizable value. If actual demand for our products deteriorates, or market conditions are less favorable than those that we project, additional inventory reserves may be required. Inventories are stated at the lower of cost, using the first-in, first-out method, or market value. Deferred Taxes We record a valuation allowance to reduce our deferred taxes to the amount that is more likely than not to be realized. Based on the uncertainty of future pre-tax income, we have fully reserved our deferred tax assets as of July 31, 2004 and October 31, 2003, respectively. In the event we were to determine that we would be able to realize our deferred tax assets in the future, an adjustment to the deferred tax asset would increase income in the period such determination was made. -20- Intangible Assets: We adopted the Financial Accounting Standards Board ("FASB") Statements of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets" on accounting for business combinations and goodwill as of the beginning of fiscal year 2002. Accordingly, we will not amortize goodwill from acquisitions, but will continue to amortize other acquisition-related intangibles and costs. All of the intangible assets that we currently own are intellectual property acquired in the Antares acquisition. As required by these rules, we will perform an impairment review annually, or earlier if indicators of potential impairment exist. This annual impairment review was completed during the fourth quarter of fiscal year 2003, and no impairment was found. The impairment review is based on a discounted cash flow approach that uses estimates of future market share and revenues and costs for our segments as well as appropriate discount rates. The estimates used are consistent with the plans and estimates that we use to manage the underlying business. However, if we fail to deliver new products, if the products fail to gain expected market acceptance, or if market conditions are unfavorable, revenue and cost forecasts may not be achieved, and we may incur charges for impairment of goodwill. For identifiable intangible assets, we amortize the cost over the estimated useful life and assess any impairment by estimating the future cash flow from the associated asset in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". If the estimated undiscounted cash flow related to these assets decreases in the future or the useful life is shorter than originally estimated, we may incur charges for impairment of these assets. The impairment is based on the estimated discounted cash flow associated with the asset. An impairment could result if the underlying technology fails to gain market acceptance, we fail to deliver new products related to these technology assets, the products fail to gain expected market acceptance or if market conditions are unfavorable. Intellectual property costs consist of the allocation of costs associated with the purchase of current and the design of future products from Antares Microsystems on August 7, 2003. All capitalized intellectual property is amortized to expense over thirty-six months which is the expected useful life. The quarterly amortization expense is approximately $102,000. RESULTS OF OPERATIONS The following table sets forth, as a percentage of net sales, consolidated statements of operations data for the three and nine months ended July 31, 2004 and 2003. These operating results are not necessarily indicative of our operating results for any future period. -21- THREE MONTHS ENDED NINE MONTHS ENDED JULY 31, JULY 31, 2004 2003 2004 2003 ------- -------- -------- ------- Net sales 100% 100% 100% 100% Cost of sales 47 34 46 38 ------- -------- -------- ------- Gross profit 53 66 54 62 ------- -------- -------- ------- Product research and development 19 21 18 17 Sales and marketing 19 22 18 19 General and administrative 13 24 13 24 Restructuring (benefit) -- (10) -- (3) Loan loss recovery -- -- (3) -- ------- -------- -------- ------- Total operating expenses 51 57 46 57 ------- -------- -------- ------- Operating income 3 9 8 5 Interest income -- -- -- -- Income tax benefit -- -- -- -- ------- -------- -------- ------- Net income 3% 9% 8% 5% ======= ======== ======== ======= NET SALES Net sales for the third quarter of fiscal 2004 were $2.9 million, an 81% increase from $1.6 million in the third quarter of fiscal 2003. For the first nine months of fiscal 2004, net sales were $8.8 million, which represented a 69% increase over net sales of $5.2 million for the same period in fiscal 2003. This increase was primarily attributable to an increase in shipments to HP combined with an increase in shipments in our WAN and LAN adapter products plus an increase in our Highwire business. Sales to HP were $1.6 million and $4.2 million in the three and nine months ending July 31, 2004, respectively, compared to $804,000 and $2.7 million for the same periods of fiscal 2003, respectively. Sales to HP, primarily of VME products, represented 55% and 47% of total sales for the three and nine months ending July 31, 2004 compared to 50% and 52% of total sales during the comparable periods in fiscal 2003. We shipped $1.2 million of VME products in the third fiscal quarter of 2004 against a $2.9 million purchase order from HP that we received in April 2004 with deliveries for the remaining $1.7 million scheduled for the fourth quarter of fiscal 2004 and the first quarter of fiscal 2005. We can provide no assurance that we will receive any further purchase orders for VME products from HP or succeed in obtaining new orders from existing or new customers sufficient to replace or exceed the net sales attributable to HP. Data Connection Limited was our only other customer that accounted for over 10% of sales in the three-month period ended July 31, 2004. Sales of our products acquired in the Antares acquisition on August 7, 2007 were $203,000 for the quarter ended July 31, 2004 compared to $517,000 in the prior quarter and $1.0 million for the nine months ended July 31, 2004 compared to $0 in the same period in fiscal 2003. Sales of our adapter products were $1.1 million and $3.6 million for the three and nine months ending July 31, 2004, respectively, as compared to $423,000 and $1.4 million for the same periods in fiscal 2003, respectively. Sales of our HighWire products were $401,000 and $876,000 for the three and nine months ending July 31, 2004, respectively, as compared to $165,000 and $799,000 for the same periods in fiscal 2003, respectively. Our adapter products are used primarily in edge-of-the-network applications such as VPN and in routers, VoIP gateways and security devices, whereas our HighWire products are primarily targeted at core-of-the-network -22- applications used primarily by telecommunications central offices. The Gigabit Ethernet and other adapter products we acquired in the Antares acquisition are used primarily in enterprise applications such as high-end servers and storage arrays using both Solaris and Linux software. In the future, we expect our net sales to be generated predominantly by sales of our adapter products with Linux and Solaris software, followed by the Antares SCSI and Fibre Channel storage products. We have seen an upturn in the sales of our Highwire products that is primarily related to one customer beginning to deploy VoIP systems that includes our HW400CR intelligent carrier grade communication controller card. We expect to continue to see strong demand for this product for the foreseeable future. We will continue to sell and support our older VME products, but expect them to decline significantly as the OEM products in which they are embedded are phased out. Our sales backlog at July 31, 2004 was $3.9 million, including an HP order of VME products of $1.7 million to be shipped over our next two fiscal quarters, compared to $0.2 million at July 31, 2003, with no HP backlog. While we anticipate an increase in our sales volume over the remainder of fiscal 2004 and into fiscal 2005 as our customers deploy new product designs and as we release new products, there can be no assurances that such an increase will occur. Due to the current economic uncertainty, our customers typically require a "just-in-time" ordering and delivery cycle where they will place a purchase order with us after they receive an order from their customer. This "just-in-time" inventory purchase cycle by our customers has made forecasting of our future sales volumes very difficult. Because our sales are generally concentrated with a small group of OEM customers, we could experience significant fluctuations in our quarterly sales volumes due to fluctuating demand from any major customer or delay in the rollout of any significant new product by a major customer. GROSS MARGIN Gross margin as a percentage of sales in the third quarter of fiscal 2004 was 53% compared to 66% for the third quarter of fiscal 2003. For the first nine months of fiscal 2004 our gross margin was 54% compared to 62% for the same period in fiscal 2003. Our gross margin on sales of HP products for the quarter was 70% versus 100% in 2003 due, in part, to the sales of previously written down inventory to HP. The decrease in the gross margin is due primarily to a combination of the reduction in the gross margin attributable to the sale of products to HP as previously mentioned and an increase in our cost of goods that resulted from the addition of approximately $102,000 of non-cash quarterly amortization of the intellectual property acquired from Antares. We will continue to amortize this intellectual property at the rate of $102,000 per quarter for the next 8 quarters. We have also seen some erosion in gross margin due to slightly higher raw material and manufacturing costs. To help counteract component delivery lead-time and price increase issues, we have decided to purchase certain critical components ahead of our customer's orders, thereby increasing our on-hand inventory. Although we continue to have limited visibility into our customer's product demand, our critical inventory purchase plan is based on our best estimate of current customer demand and their past ordering patterns. Including this non-cash amortization expense, we expect our gross margin to range between 52% and 55% for the remainder of fiscal 2004. -23- However, if market and economic conditions, particularly in the telecommunications sector deteriorate and raw material pricing continues to escalate, gross margin may be lower than projected. PRODUCT RESEARCH AND DEVELOPMENT Product research and development expenses for the three and nine month periods ended July 31, 2004 were $548,000 and $1.6 million, respectively, an increase from $334,000 and $913,000 for the same periods in fiscal 2003. The increase resulted primarily from engineering staffing increases. When we acquired the Antares assets in August 2003, we hired a Vice President of Engineering and three design engineers to enhance our product development and support activities. We expect overall spending for our product research and development to range between 15% and 18% of net sales in fiscal 2004 as we remain committed to the development and enhancement of new and existing products. We did not capitalize any internal software development costs in the nine-month period ending July 31, 2004. SALES AND MARKETING Sales and marketing expenses for the three and nine month periods ended July 31, 2004 were $539,000 and $1.6 million, respectively, an increase from $361,000 and $1.0 million for the same periods in fiscal 2003. The increase is primarily due to increased marketing program spending for products, in addition to new marketing and sales personnel hired during the latter part of fiscal 2003. We hired a Vice President of Marketing, a product manager and a technical support engineer in conjunction with the acquisition of the Antares products. We expect our sales and marketing expenses to range between 16% and 18% of net sales in fiscal 2004 as we continue to accelerate our product marketing efforts and attend an increasing number of industry-specific trade shows. GENERAL AND ADMINISTRATIVE General and administrative expenses for the three and nine months periods ended July 31, 2004 were $376,000 and $1.1 million, respectively, a decrease from $381,000 and $1.3 million for the same periods of fiscal 2003. This decrease was due to the effect of a continued focus on controlling spending, primarily legal and employee benefit expense, during the first three quarters of fiscal 2004. The decrease in general and administrative expenses is also a result of decreased depreciation expense as we have fully depreciated certain equipment. General and administrative expenses are expected to range between 14% and 18% of net sales for fiscal 2004. LOAN LOSS RECOVERY On November 6, 1998, we made a loan to one of our officers and stockholders which was used by the officer/stockholder to exercise an option to purchase 139,400 shares of our common stock and related taxes. The loan, as amended, was collateralized by shares of our common stock, bore interest at a rate of 2.48% per annum, with interest due annually and the entire amount of the principal was due on December 14, 2003. -24- On October 31, 2002, we determined that it was probable that we would be unable to fully recover the balance of the loan on its due date of December 14, 2003. Accordingly, a valuation allowance of $474,000 was recorded against the loan at October 31, 2002. During the fourth quarter of fiscal 2003, the officer repaid $362,800 of the loan, and as a result, we recognized a benefit of $235,000 related to the reversal of the loan impairment charge taken by us in fiscal 2002. During the first quarter of fiscal 2004, the officer repaid the remaining loan balance in full, and as a result, we recorded a benefit of $239,000 resulting from the reversal of the remaining loan impairment charge. NET INCOME As a result of the factors discussed above, we recorded net income of $79,000 and $660,000 in the three and nine month periods ended July 31, 2004, as compared to net income of $141,000 and $284,000 for the same periods in fiscal 2003. OFF-BALANCE SHEET ARRANGEMENTS We do not have any transactions, arrangements, or other relationships with unconsolidated entities that are reasonably likely to affect our liquidity or capital resources. We have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support. We also do not engage in leasing, hedging, research and development services, or other relationships that could expose us to liability that is not reflected on the face of the financial statements. LIQUIDITY AND CAPITAL RESOURCES Our liquidity is dependent on many factors, including sales volume, operating profit and the efficiency of asset use and turnover. Our future liquidity will be affected by, among other things: - the actual versus anticipated increase in sales of our products; - ongoing cost control actions and expenses, including for example, research and development and capital expenditures; - timing of product shipments which occur primarily during the last month of the quarter; - the gross profit margin; - the ability to raise additional capital, if necessary; and - the ability to secure credit facilities, if necessary. At July 31, 2004, we had cash and cash equivalents of $1.5 million, as compared to $1.4 million at October 31, 2003. In the first nine months of fiscal 2004, $270,000 of cash was used in operating activities primarily as a result of generating net income for the nine months ended July 31, 2004 of $660,000 that was reduced by an increase in our inventory, trade accounts receivable and liabilities that was partially offset by an increase in trade accounts payable. The increase in inventory is reflective of the purchase of bulk raw materials to partially offset vendor price increases and to meet "just-in-time" customer demands. The increase in trade accounts receivable is due the shipment of significant amounts of product to HP during the last two weeks of the quarter. The increase in trade accounts payable was primarily due to the receipt of finished goods from our contract manufacturers during the last two weeks of the quarter with payment in the first month of the following quarter. Working capital, comprised of our current assets less our current liabilities, at July 31, 2004 was $5.3 million, as compared to $3.9 million at October 31, 2003. -25- In the first nine months of fiscal 2004, we purchased $85,000 of fixed assets, consisting primarily of computer and engineering equipment and $111,000 in software primarily for engineering and product design activities. Capital expenditures for the remaining quarter of fiscal 2004 are expected to approximate $100,000. We received $241,000 in the first nine months of fiscal 2004 from payments related to common stock purchases made by employees pursuant to our employee stock purchase plan and the exercise of employee stock options. During the nine month period, we also received cash proceeds of $116,000 from an investor for the purchase of 70,000 shares of our common stock pursuant to a warrant the investor received in conjunction with a private placement of common stock transaction that was completed in fiscal 2003. In November 2003, we received a loan payment from an officer of $142,000. Our projected quarterly operational cash flow break-even point is approximately $2.4 million to $2.6 million in net sales if gross margin is 53% to 55%. Our projected sales are to a limited number of new and existing OEM customers and are based on internal and customer-provided estimates of future demand, not firm customer orders. If our projected sales do not materialize, we may need to reduce expenses and raise additional capital through customer prepayments or the issuance of debt or equity securities. If additional funds are raised through the issuance of preferred stock or debt, these securities could have rights, privileges or preferences senior to those of common stock, and debt covenants could impose restrictions on our operations. The sale of equity or debt could result in additional dilution to current stockholders, and such financing may not be available to us on acceptable terms, if at all. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our cash and cash equivalents are subject to interest rate risk. We invest primarily on a short-term basis, maturity of less than three months, principally money market instruments. We have no other investments with significant interest rate risks. If interest rates increased by 10%, the expected effect on net income related to our financial instruments would be immaterial. We hold no assets or liabilities denominated in a foreign currency. Since October 31, 2003, there has been no change in our exposure to market risk. ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures An evaluation as of July 31, 2004 was carried out under the supervision of and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's "disclosure controls and procedures," -26- which are defined under SEC rules as controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files under the Securities Exchange Act of 1934 (the "Exchange Act") is recorded, processed, summarized and reported within required time periods. Based upon that evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective. (b) Changes in Internal Controls over Financial Reporting The Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, has evaluated any changes in the company's internal control over financial reporting that occurred during the quarter ended July 31, 2004, and has concluded that there was no change during such quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. PART II. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a)(3) List of Exhibits Exhibit Number Description ------ ----------- 2.1 (1) Asset Purchase Agreement dated August 8, 2003, by and between D.R. Barthol & Company and SBE, Inc. 3.1(2) Certificate of Incorporation, as amended through December 15, 1997. 3.2(3) Bylaws, as amended through December 8, 1998. 10.1(4)* 1996 Stock Option Plan, as amended. 10.2(4)* 1991 Non-Employee Directors' Stock Option Plan, as amended. 10.3(4) 1992 Employee Stock Purchase Plan, as amended. 10.4(4) 1998 Non-Officer Stock Option Plan as amended. 10.5(5) Lease for 4550 Norris Canyon Road, San Ramon, California dated November 2, 1992 between the Company and PacTel Properties. 10.6(6) Amendment dated June 6, 1995 to lease for 4550 Norris Canyon Road, San Ramon, California, between the Company and CalProp L.P. (assignee of PacTel Properties). -27- 10.7(4)* Full Recourse Promissory Note executed by William B. Heye, Jr. in favor of the Company dated November 6, 1998, as amended and restated on December 14, 2001. 10.8(4)+ Letter Agreement, dated October 30, 2001, amending (i) Amendment No. S/M018-4 dated April 3, 2001, and (ii) Purchase Agreement dated May 6, 1991, each between SBE, Inc. and Compaq Computer Corporation 10.9(7) Stock subscription agreement and warrant to purchase 111,111 of SBE, Inc. Common Stock dated April 30, 2002 between SBE, Inc. and Stonestreet Limited Partnership. 10.10(8) Amendment dated August 22, 2002 to stock subscription agreement dated April 20, 2002 between SBE, Inc. and Stonestreet LP. 10.11(9) Securities Purchase Agreement, dated July 27, 2003, between SBE, Inc. and purchasers of SBE's common stock thereunder, including form of warrant issued thereunder 10.12(9) Form of warrant issued to associates of Puglisi & Co. ($1.50 exercise price) 10.13(9) Form of warrant issued to associates of Puglisi & Co. ($1.75 and $2.00 exercise price) 31.1 Certification of Chief Executive Officer 31.2 Certification of Chief Financial Officer 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 * Indicates management contract or compensation plans or arrangements filed pursuant to Item 601(b)(10) of Regulation SK. + Certain confidential information has been deleted from this exhibit pursuant to a confidential treatment order that has been granted. (1) Filed as an exhibit to Current Report on Form 8-K, dated April 30, 2002 and incorporated herein by reference. (2) Filed as an exhibit to Annual Report on Form 10-K for the year ended October 31, 1997 and incorporated herein by reference. (3) Filed as an exhibit to Annual Report on Form 10-K for the year ended October 31, 1998 and incorporated herein by reference. -28- (4) Filed as an exhibit to Annual Report on Form 10-K for the year ended October 31, 2002 and incorporated herein by reference. (5) Filed as an exhibit to Annual Report on Form 10-K for the year ended October 31, 1993 and incorporated herein by reference. (6) Filed as an exhibit to Annual Report on Form 10-K for the year ended October 31, 1995 and incorporated herein by reference. (7) Filed as an exhibit to Registration Statement on Form S-3 dated May 23, 2002 and incorporated herein by reference. (8) Filed as an exhibit to Quarterly Report on Form 10-Q for the quarter ended July 31, 2002 and incorporated herein by reference. (9) Filed as an exhibit to Registration Statement on Form S-3 dated July 11, 2003 and incorporated herein by reference. (b) REPORTS ON FORM 8-K A report on Form 8-K was filed with the Securities and Exchange Commission on May 19, 2004. The report furnished our press release announcing our financial results for the quarter ended April 30, 2004. -29- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, on September 7, 2004. SBE, INC. --------- Registrant Date: September 7, 2004 By: /s/ William B. Heye, Jr. ------------------------------ William B. Heye, Jr. Chief Executive Officer and President (Principal Executive Officer) Date: September 7, 2004 By: /s/ David W. Brunton ------------------------------ David W. Brunton Chief Financial Officer, Vice President, Finance and Secretary (Principal Financial and Accounting Officer) -30- EX-31.1 2 v06576_ex31-1.txt EXHIBIT 31.1 CERTIFICATIONS I, William B. Heye, Jr., certify that: 1. I have reviewed this quarterly report on Form 10-Q of SBE, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13(a)-15(e) and 15(d)-15(e)) for the registrant and we have: a) Designed such disclosure controls and procedures or caused such disclosure controls and procedures to be designed under the supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during registrant's most recent fiscal quarter (the registrant's fourth quarter in the case of an annual report) that has materially affected or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal controls over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: September 7, 2004 /s/ William B. Heye, Jr. - ------------------------ William B. Heye, Jr. Chief Executive Officer and President EX-31.2 3 v06576_ex31-2.txt EXHIBIT 31.2 CERTIFICATIONS I, David W. Brunton certify that: 1. I have reviewed this quarterly report on Form 10-Q of SBE, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13(a)-15(e) and 15(d)-15(e)) for the registrant and we have: a) Designed such disclosure controls and procedures or caused such disclosure controls and procedures to be designed under the supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during registrant's most recent fiscal quarter (the registrant's fourth quarter in the case of an annual report) that has materially affected or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal controls over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: September 7, 2004 /s/ David W. Brunton - -------------------- David W. Brunton Chief Financial Officer, Vice President, Finance and Secretary EX-32.1 4 v06576_ex32-1.txt EXHIBIT 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 Pursuant to the requirement set forty in Rule 13a-14(b) of the Securities Act of 1934, as amended(the "Exchange Act"), and Section 1350 of Chapter 63 of Title 18 of the United States Code ("18 U.S.C. Section 1350"), William B. Heye, Jr., the Chief Executive Officer of SBE, Inc. (the "Company") hereby certifies that, to the best of his knowledge: 1. The Company's Quarterly Report on Form 10-Q for the quarter ended July 31, 2004, to which this Certification is attached as Exhibit 32.1 (the "Quarterly Report"), fully complies with the requirements of Section 13(a) or Section 15(d) of the Exchange Act, as amended; and 2. The information contained in the Quarterly Report fairly presents, in all material respects, the financial condition and results of operation of the Company. Dated: September 7, 2004 /s/ William B. Heye Jr. - ----------------------- William B. Heye Jr. Chief Executive Officer "This certification accompanies the Form 10-Q to which it relates, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference to any filing of SBE, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (whether made before of after the date of the Form 10-Q), irrespective of any general incorporation language contained in such filing." EX-32.2 5 v06576_ex32-2.txt EXHIBIT 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 Pursuant to the requirement set forty in Rule 13a-14(b) of the Securities Act of 1934, as amended(the "Exchange Act"), and Section 1350 of Chapter 63 of Title 18 of the United States Code ("18 U.S.C. Section 1350"), David W. Brunton, the Chief Financial Officer of SBE, Inc. (the "Company") hereby certifies that, to the best of his knowledge: 1. The Company's Quarterly Report on Form 10-Q for the quarter ended July 31, 2004, to which this Certification is attached as Exhibit 32.1 (the "Quarterly Report"), fully complies with the requirements of Section 13(a) or Section 15(d) of the Exchange Act, as amended; and 2. The information contained in the Quarterly Report fairly presents, in all material respects, the financial condition and results of operation of the Company. Dated: September 7, 2004 /s/ David W. Brunton - -------------------- David W. Brunton Chief Financial Officer "This certification accompanies the Form 10-Q to which it relates, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference to any filing of SBE, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (whether made before of after the date of the Form 10-Q), irrespective of any general incorporation language contained in such filing." -----END PRIVACY-ENHANCED MESSAGE-----