10-Q 1 v13803_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 JANUARY 31, 2005 [ ] 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 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 January 31, 2005 was 5,199,538. SBE, INC. INDEX TO JANUARY 31, 2005 FORM 10-Q PART I FINANCIAL INFORMATION ITEM 1 Financial Statements Condensed Consolidated Balance Sheets as of January 31, 2005 (unaudited) and October 31, 2004 (audited)............3 Condensed Consolidated Statements of Operations for the three months ended January 31, 2005 and 2004 (unaudited)...............4 Condensed Consolidated Statements of Cash Flows for the three months ended January 31, 2005 and 2004 (unaudited)...............5 Notes to Condensed Consolidated Financial Statements......................6 ITEM 2 Management's Discussion and Analysis of Financial Condition and Results of Operations.........................10 ITEM 3 Quantitative and Qualitative Disclosures about Market Risk.................................................24 ITEM 4 Controls and Procedures.....................................24 PART II OTHER INFORMATION [DAVE: HAVE YOU CHECKED TO SEE WHETHER YOU HAVE ANY ITEM 2 (SALES OF UNREGISTERED SECURITIES) DISCLOSURES?] ITEM 6 Exhibits and Reports on Form 8-K............................25 SIGNATURES....................................................................28 EXHIBITS......................................................................29 -2- PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS SBE, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands) January 31, October 31, 2005 2004 -------- -------- (unaudited) Current assets: Cash and cash equivalents $ 1,564 $ 1,849 Trade accounts receivable, net 2,048 1,668 Inventories 1,638 1,926 Other 276 227 -------- -------- Total current assets 5,526 5,670 Property, plant and equipment, net 408 427 Capitalized software costs, net 41 48 Other 33 28 -------- -------- Total assets $ 6,008 $ 6,173 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Trade accounts payable $ 526 $ 856 Accrued payroll and employee benefits 377 391 Capital lease obligations - current portion 26 25 Other accrued expenses 260 459 -------- -------- Total current liabilities 1,189 1,731 Capital lease obligations, net of current portion 146 139 -------- -------- Total liabilities 1,335 1,870 -------- -------- Commitments (note 6) Stockholders' equity: Common stock 16,068 15,755 Deferred compensation (120) -- Accumulated deficit (11,275) (11,452) -------- -------- Total stockholders' equity 4,673 4,303 -------- -------- Total liabilities and stockholders' equity $ 6,008 $ 6,173 ======== ======== 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 January 31, 2005 2004 ------- ------- Net sales $ 2,815 $ 2,970 Cost of sales 1,230 1,325 ------- ------- Gross profit 1,585 1,645 ------- ------- Product research and development 473 505 Sales and marketing 559 489 General and administrative 369 364 Loan reserve (benefit) -- (239) ------- ------- Total operating expenses 1,401 1,119 ------- ------- Operating income 184 526 Interest and other income (expense) (2) 1 ------- ------- Income before income taxes 182 527 Provision for income taxes 5 -- ------- ------- Net income $ 177 $ 527 ======= ======= Basic earnings per share $ 0.03 $ 0.11 ======= ======= Diluted earnings per share $ 0.03 $ 0.09 ======= ======= Shares used in per share computations: Basic 5,136 4,888 ======= ======= Diluted 5,869 6,120 ======= ======= See notes to condensed consolidated financial statements. -4- SBE, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)
Three months ended January 31, -------------------- 2005 2004 ------- ------- Cash flows from operating activities: Net income $ 177 $ 527 Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization: Property and equipment 56 53 Capitalized software costs 16 11 Amortization of intellectual property -- 102 Changes in operating assets and liabilities: Trade accounts receivable (380) (1,459) Inventories 288 (184) Other assets (53) (300) Trade accounts payable (330) 721 Other current liabilities (98) (109) Other non-current liabilities 7 (124) ------- ------- Net cash used in operating activities (317) (762) ------- ------- Cash flows from investing activities: Purchases of property and equipment (38) (29) Purchased software (9) -- ------- ------- Net cash used in investing activities (47) (29) ------- ------- Cash flows from financing activities: Repayment of stockholder note -- 142 Proceeds from issuance of common stock and warrants -- 130 Proceeds from stock plans 79 126 ------- ------- Net cash provided by financing activities 79 398 ------- ------- Net decrease in cash and cash equivalents (285) (393) Cash and cash equivalents at beginning of period 1,849 1,378 ------- ------- Cash and cash equivalents at end of period $ 1,564 $ 985 ======= ======= SUPPLEMENTAL SCHEDULE OF NON-CASH FINANCING ACTIVITIES: Non-cash stock portion of Antares purchase price $ 114 $ -- ======= =======
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 (other than the balance sheet as of October 31, 2004), 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 presented. The results of operations for the three month period ended January 31, 2005 are not necessarily indicative of expected results for the full 2005 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, 2004. 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 include matters such as warranty obligations, indemnification obligations, collectibility of accounts receivable, realizability of inventories and recoverability of capitalized software and deferred tax assets. 2. INVENTORIES: Inventories comprise the following (in thousands): January 31, October 31, 2005 2004 -------- -------- Finished goods $ 1,055 $ 1,343 Parts and materials 583 583 -------- -------- $ 1,638 $ 1,926 ======== ======== 3. NET INCOME PER SHARE: Basic net income per common share for the three month periods ended January 31, 2005 and 2004 was computed by dividing the net income for the relevant period by the weighted average number of shares of common stock outstanding. Common stock -6- equivalents for the three month periods ended January 31, 2005 and 2004 were 733,000 and 1,232,000, respectively, and have been included in the calculation of diluted net income per share. Three months ended January 31, 2005 2004 ----------- ----------- (in thousands, except BASIC per share amounts) Weighted average number of common shares outstanding 5,136 4,888 ----------- ----------- Number of shares for computation of net income per share 5,136 4,888 =========== =========== Net income $ 177 $ 527 =========== =========== Net income per share $ 0.03 $ 0.11 =========== =========== DILUTED Weighted average number of common shares outstanding 5,136 4,888 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 733 1,232 ----------- ----------- Number of shares for computation of net income per share 5,869 6,120 =========== =========== Net income $ 177 $ 527 =========== =========== Net income per share $ 0.03 $ 0.09 =========== =========== 4. STOCK BASED COMPENSATION: On January 31, 2005, 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 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 and income per share would have been as follows -7- Three Months Ended January 31, 2005 2004 ------- ------- (in thousands, except per share amounts) Net income, as reported $ 177 $ 527 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 (640) (414) ------- ------- Pro forma net income (loss) $ (463) $ 113 ======= ======= Net income (loss) per share: Basic - as reported $ 0.03 $ 0.11 ======= ======= Basic - pro forma $ (0.09) $ 0.02 ======= ======= Diluted - as reported $ 0.03 $ 0.09 ======= ======= Diluted - pro forma $ (0.09) $ 0.02 ======= ======= Options to purchase 397,500 shares of common stock were granted in the quarter ended January 31, 2005. The assumption regarding the annual vesting of stock options was 25% per year for options granted during the quarter. 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 assumption used for grants in 2005: Dividend yield of 0%; expected volatility of 76.29%; risk-free interest rate of 3.0%; and expected life of five years. In December 2004, the FASB issued SFAS No. 123R that amends SFAS No. 123 Accounting for Stock-Based Compensation, to require public entities (other than those filing as small business issuers) to report stock-based employee compensation in their financial statements. SFAS No. 123R will require us to expense the fair value of unvested options and future grants of options over the remaining vesting period. Unless modified, we will be required to comply with the provisions of SFAS No. 123R as of the first interim period that begins after June 15, 2005 (August 1, 2005 for us). We currently do not record compensation expense related to our stock-based employee compensation plans in our financial statements. 5. CONCENTRATION OF RISK: In the first three months of fiscal 2005 and 2004, most of our sales were attributable to sales of wireless communications products and were derived from a limited number of Original Equipment Manufacturer (OEM) customers. Sales to The Hewlett-Packard Company ("HP") accounted for 36% and 44% of our net sales in the first three months of fiscal 2005 and 2004, respectively, and sales to Data Connection Limited and Nortel Networks accounted for 15% and 14% of our net -8- sales for the quarter ended January 31, 2005, respectively. No other customer accounted for more than 10% of our net sales in either quarter. The three customers combined accounted for 60% of our accounts receivable at January 31, 2005. A significant reduction in orders from any of our OEM customers, or a failure to collect outstanding accounts receivable from any of our OEM customers, could have a material adverse effect on our business, operating results, financial condition and cash flows. 6. WARRANTY OBLIGATIONS AND OTHER GUARANTEES: The following is a summary of our agreements that we have determined are within the scope of Financial Accounting Standards Board ("FASB") Interpretation("FIN") No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others. We accrue the estimated costs to be incurred in performing warranty services at the time of revenue recognition and shipment of the 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 will increase, resulting in decreased gross margin. The following table sets forth an analysis of our warranty reserve (in thousands): January 31, January 31, 2005 2004 ---- ---- Warranty reserve at beginning of period $ 20 $ 58 Less: Cost to service warranty obligations (4) (17) Plus: Increases to reserves 4 -- ---- ---- Total warranty reserve included in other accrued expenses $ 20 $ 41 ==== ==== 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 future amounts 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 January 31, 2005 and October 31, 2004, respectively. We enter into indemnification provisions under our agreements with other companies in the ordinary course of business, typically with business partners, contractors, customers and landlords. Under these provisions we generally 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 include indemnifications relating to representations made by us with regard to intellectual property rights. These -9- 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. We have not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements. 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 January 31, 2005 and October 31, 2004, respectively. As discussed below, we are the secondary guarantor on the sublease of our previous headquarters. We believe we will have no liabilities on this guarantee and have not recorded a liability at January 31, 2005. 7. LOAN TO OFFICER On November 6, 1998, we made a loan to our retiring president and CEO, which was used by him to exercise an option to purchase 139,400 shares of our common stock and pay related taxes. The loan, as amended, was collateralized by shares of our common stock, bore interest at a rate of 2.48% per annum, and 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. 8. DEFERRED COMPENSATION On January 1, 2005, the Company's retiring President and Chief Executive Officer was awarded options to purchase 75,000 shares of the Company's stock at a price of $4.00 per share (closing price on December 31, 2004). The fair value of this option grant is estimated on the date of grant using the Black-Scholes option-pricing model and is included as deferred compensation on the balance sheet. The $120,000 deferred compensation is amortized to general and administrative expense at the rate of $8,000 per month over the 15 month vesting period ending March 2006. 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 -10- 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. 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, 2004. 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 WE DEPEND UPON A SMALL NUMBER OF OEM CUSTOMERS. THE LOSS OF ANY OF THESE CUSTOMERS, OR THEIR FAILURE TO SELL THEIR PRODUCTS, WOULD LIMIT OUR ABILITY TO GENERATE REVENUES. IN PARTICULAR, WE EXPECT HP WILL CEASE TO BE A SIGNIFICANT CUSTOMER OF OURS IN FISCAL 2005, AND OUR SUCCESS DEPENDS ON BEING ABLE TO REPLACE NET SALES PREVIOUSLY ATTRIBUTABLE TO HP WITH SALES TO OTHER CUSTOMERS. In the first quarter of fiscal 2005 and 2004, sales of Versa Module Europa ("VME") products to The Hewlett-Packard Company ("HP") accounted for 36% and 44%, respectively, of our net sales. We shipped the final $1.0 million of the last order for VME products to HP in the first fiscal quarter of fiscal 2005. Our success depends on being able to replace net sales previously attributable to HP with sales to other customers. 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 previously attributable to HP. Even after HP ceases to be a customer, we expect to continue to depend on sales to a small number of OEM customers, including Data Connection Limited and Nortel Networks. Sales to Data Connection Limited and Nortel Networks accounted for 15% and 14% of our net sales for the quarter ended January 31, 2005, respectively. There can be no assurance that we will become a qualified supplier with new OEM customers or that we will remain a qualified supplier with existing 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. -11- Three customers, HP (29%), Data Connection Limited (20%) and Spectel, Inc. (11%), combined accounted for 60% of our accounts receivable at January 31, 2005. A significant reduction in orders from any of our OEM customers, or a failure to collect outstanding accounts receivable from any of our OEM customers, could have a material adverse effect on our business, operating results, financial condition and cash flows. OUR FUTURE CAPITAL NEEDS MAY EXCEED OUR ABILITY TO RAISE CAPITAL OR USE OUR EXISTING CREDIT LINE WITH A BANK. The development and marketing of our products is capital-intensive. 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 assure that this will be the case. Declines in our sales or a failure to keep expenses in line with revenues could require us to seek additional financing or force us to draw down on our existing line of credit with a bank in fiscal 2005. In addition, should we experience a significant growth in customer orders or wish to make strategic acquisitions of business or assets, we may be required to seek additional capital to meet our working capital needs. There can be no assurance that additional financing, if required, will be available on reasonable terms or at all. To the extent that additional capital is raised through the sale of additional equity or convertible debt securities, the issuance of such securities could result in additional dilution to our stockholders. 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, financial condition and cash flows. 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, reduce our cash flow 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 HIGHWIRE, WAN AND LAN ADAPTERS, TOE AND STORAGE PRODUCTS, WE MAY LOSE SALES AND OUR REPUTATION MAY BE HARMED 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 Voice over IP ("VoIP"), 3G Wireless ("Third Generation Wireless Services") SATA ("Serial ATA"), SAS -12- ("Serial Attached SCSI"), Internet Small Computer System Interface ("iSCSI") , Gigabit Ethernet, 10 Gigabit Ethernet and TCP/IP Offload Engine ("TOE"). There can be no assurance that we will be successful in identifying, developing, manufacturing and marketing new products or enhancing our existing products. In addition, there can be no assurance that services, products or technologies developed by others will not render our products noncompetitive or obsolete. We have focused a significant portion of our research and development, marketing and sales efforts on HighWire, WAN and LAN adapters, Encryption, iSCSI and TOE 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, market acceptance of our products and our ability to sell our products. If the TOE, iSCSI, 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 REVENUES AND MARGINS. We compete directly with traditional 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, SCSI, TOE, VoIP 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. 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. 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 -13- 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. 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 do not currently hold any patents and rely 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. RISKS ASSOCIATED WITH OWNERSHIP OF OUR COMMON STOCK 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 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 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. -14- OUR SALES AND OPERATING RESULTS HAVE FLUCTUATED, AND ARE LIKELY TO CONTINUE TO FLUCTUATE SIGNIFICANTLY IN FUTURE PERIODS, WHICH MAY 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, many of our customers may hold excess inventory of our products. A result of the economic downturn is that certain of our customers have cancelled or delayed many of their new design projects and new product rollouts that included our products. Due to the current economic uncertainty, 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. 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. MANAGEMENT'S DISCUSSION AND ANALYSIS OVERVIEW SBE, Inc. designs, develops and sells network communications and storage solutions to original equipment manufacturers ("OEM") in the embedded computing and storage markets. Our solutions enable data communications, telecommunications and storage solution companies, in addition to enterprise class high-end server customers, to rapidly deliver advanced networking and storage products and services. Our products include wide area network ("WAN"), local area network ("LAN"), Internet Small Computer System Interface ("iSCSI") software, SCSI, Fibre Channel, intelligent carrier cards, Encryption and TCP/IP Offload Engine ("TOE") cards. These products perform critical computing, processing offload, Input/Output ("I/O") and storage tasks across both the enterprise server and embedded markets such as high-end enterprise level -15- servers, Linux super computing clusters, workstations, media gateways, routers, internet access devices, home location registers, data messaging applications, network attached storage ("NAS") and remote storage devices and networks. SBE's has partnered with PyX Technologies, a California company, to provide iSCSI software products that strategically support our TOE development plans by offering a high value iSCSI storage software stack that utilizes the TOE hardware to facilitate Internet based storage solutions to large, small and medium sized businesses. iSCSI is an end-to-end protocol for transporting storage I/O block data over an Internet Protocol ("IP") network. The protocol is used on servers (initiators), storage devices (targets), and protocol transfer gateway devices. iSCSI uses standard Ethernet switches and routers to move the data from server to storage. The initiator is typically a host (PC, server, laptop) that is running an iSCSI initiator driver (such as the PyX or Microsoft iSCSI initiator) that will be accessing storage on the IP Storage Area Network ("SAN") and the target is any storage device such as disk drives, raid systems, CDROM's, DVD's, tapes amongst others. Managing storage is universally regarded as one of the most burdensome of IT responsibilities. In direct-attached storage environments that most small to mid-sized companies deploy, the process of managing storage is multiplied by the number of physical connection points and the number of storage systems in an organization. Imagine an environment with ten computers, each with its own storage system. Not only does that create ten point-for-management for the storage systems themselves, it also requires ten times the effort to handle storage expansion, reallocation and repairs. With SANs, storage management is consolidated to a single point from which an IT manager can partition, allocate, expand, reassign, backup and repair storage. By moving to a SAN, small to mid-sized organizations can scale their storage infrastructure much more easily. When additional capacity is needed, simply add additional storage to the SAN. IP SANs such as iSCSI provide higher-speed storage access than internal disks while also enabling load balancing across multiple connections. Remote storage powered by iSCSI also enables on-line data back up, disaster recover and high-speed access to data by remote users. The PyX iSCSI software uses the port aggregation and port failover features of the SBE TOE dual port Gigabit Ethernet card to recover from transmission failures . In addition, the PyX iSCSI software uses the SBE TOE acceleration feature to obtain wire transmission speeds of up to 2 Gigabits per second. Our TOE/iSCSI product has Error Recovery Level 0 ("ERL0") through Error Recovery Level 2 ("ERL2") failure recovery functionality. ERL2 functionality is reached when the TCP/IP and iSCSI transmission can recover from a breakdown in the initiator, the target or the transport medium. When using the PyX ERL2 iSCSI software and SBE TOE hardware, the transmission is resent from the point of failure and not from the beginning of the transmission like other ERL0 iSCSI products. Our business is characterized by a concentration of sales to a small number of OEMs and distributors who provide products and services to the datacom, telecommunications and storage markets in addition to the enterprise high-end server IT markets. Consequently, the timing of significant orders from major customers and their product cycles cause fluctuation in our operating results. HP has historically been the largest of our customers and represented 36% and 44% of net sales in the quarters ended January 31, 2005 and 2004, respectively. We shipped the final order totaling $1.0 million in January 2005 and do not expect to receive any future orders from HP for VME products. Even after HP ceases to be a customer, we expect to continue to depend on sales to a small -16- number of OEM customers, including Data Connection Limited and Nortel Networks. Sales to Data Connection Limited and Nortel Networks accounted for 15% and 14% of our net sales for the quarter ended January 31, 2005, respectively. There can be no assurance that we will become a qualified supplier with new OEM customers or that we will remain a qualified supplier with existing 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. Three customers combined accounted for 59% of our accounts receivable at January 31, 2005. A significant reduction in orders from any of our OEM customers, or a failure to collect outstanding accounts receivable from any of our OEM customers, could have a material adverse effect on our business, operating results, financial condition and cash flows. Our products are distributed worldwide through a direct sales force, distributors, independent manufacturers' representatives and value-added resellers. Our business falls primarily within one industry segment. On January 31, 2005, we had a sales backlog of product orders of approximately $1.4 million compared to a sales backlog of product orders of approximately $2.5 million, including $1.0 million in orders from HP, at October 31, 2004. 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 warranty obligations, indemnification obligations, collectibility of accounts receivable, realizability of inventories and recoverability of capitalized software and deferred tax assets. Our critical accounting policies and estimates include the following: Revenue Recognition: Our policy is to recognize revenues for product sales upon shipment of our products to our customers provided that no significant obligation on our part remains and collection of the receivable is considered probable. Shipping terms are generally FOB shipping point. We defer and recognize service revenues 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 ("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 -17- that collectibility is reasonably assured. Our sales transactions are denominated in U.S. dollars. The software component of our hardware products is considered incidental to our products. We therefore do not recognize software revenues separately from the product sale. Our agreements with OEMs, such as HP and Nortel Networks, typically incorporate clauses reflecting the following understandings: - 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 it places its 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. Reserves for the right of return and restocking are established based on the requirements of SFAS 48, Revenue Recognition when Right of Return Exists because we have visibility into our distributor's inventory and have sufficient history to estimate returns. During the quarters ended January 31, 2005 and 2004, $173,000, or 6% of net sales, and $229,000, or 8% of net sales, were sold to distributors, respectively. 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 -18- 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 its business, we record a specific allowance to reduce the related receivable to the amount we expect to recover. 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 OEMs. Because there is no contractual right of return other than for defective products or stock rotation rights by certain distributors, 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 increased cost of goods sold and decreased gross profit 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. 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 -19- pre-tax income, we have fully reserved our deferred tax assets as of January 31, 2005 and October 31, 2004, 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. New Accounting Pronouncements In December 2004, the FASB issued SFAS No. 123R, which amends SFAS No. 123 Accounting for Stock-Based Compensation, to require public entities (other than those filing as small business issuers) to report stock-based employee compensation in their financial statements. Unless modified, we will be required to comply with the provisions of SFAS No. 123R as of the first interim period that begins after June 15, 2005 (for us, beginning with the quarter ending October 31, 2005). We currently do not record compensation expense related to our stock-based employee compensation plans in our financial statements. RESULTS OF OPERATIONS The following table sets forth, as a percentage of net sales, consolidated statements of operations data for the three month period ended January 31, 2005 and 2004. These operating results are not necessarily indicative of our operating results for any future period. THREE MONTHS ENDED JANUARY 31, 2005 2004 ---- ---- Net sales 100% 100% Cost of sales 44 45 ---- ---- Gross profit 56 55 ---- ---- Product research and development 17 17 Sales and marketing 20 17 General and administrative 13 12 Loan reserve (benefit) -- (8) ---- ---- Total operating expenses 50 38 ---- ---- Operating income 6 17 Interest income and provision for income taxes -- -- ---- ---- Net income 6% 17% ==== ==== NET SALES Net sales for the first quarter of fiscal 2005 was $2.8 million, a 5% decrease from $3.0 million in the first quarter of fiscal 2004. This decrease was primarily attributable to a decrease in shipments to HP offset in part by an increase in shipments of our Highwire products to other customers. Sales to HP were $1.0 million in the first quarter of fiscal 2005, compared to $1.3 million for the first quarter of fiscal 2004. Sales to HP, primarily of VME products, -20- represented 36% of total sales for the first quarter of fiscal 2005 compared to 44% of total sales during the comparable quarter in fiscal 2004. We shipped our final order of VME products to HP in the first fiscal quarter of 2005 and do not expect sales of VME products to HP to be a substantial portion of our net sales in the future. Two other customers combined accounted for 29% of our sales for the quarter ended January 31, 2005. No other customer accounted for over 10% of sales in the first fiscal quarter of 2005 or 2004. Sales of our adapter products were $965,000 for the first quarter of fiscal 2005, as compared to $1.3 million for the same quarter in fiscal 2004. Sales of our HighWire products were $585,000 in the quarter ended January 31, 2005, as compared to $153,000 in the same quarter in fiscal 2004. Our adapter products are used primarily in edge-of-the-network applications such as Virtual Private Network ("VPN") and other routers, Voice over Internet Protocol ("VoIP") gateways and security devices, whereas our HighWire products are primarily targeted at core-of-the-network applications used primarily by telecommunications central offices. During the quarter we shipped a small number of TOE adapters to customers who will use the TOE to facilitate CPU acceleration for use in iSCSI storage applications. We continue to test our TOE and iSCSI products at customer sites and expect customer adoption of these new technologies to begin during fiscal 2005. 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 sale of TOE adapters and iSCSI software storage products. We expect to see a continued increase in the sales of our Highwire products due to some prior design wins in the communications equipment markets going into production. All of our design wins and new customers are for applications using these product families. In addition, we will continue to sell and support our older VME products, but expect them to become a declining portion of our future net sales. Our sales backlog at January 31, 2005 was $1.4 million, compared to $3.6 million at January 31, 2004, which included a $700,000 HP order for VME products. We anticipate an increase in our sales volume for adapter and HighWire products over the course of fiscal 2005 as our customers roll out their new products. We also expect to see an increase in sales of TOE and iSCSI products as these products gain market acceptance; however, there can be no assurances that such an increase or adoption will occur. The communications markets continue to be slow in recovering economically and due to the continuing 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 first quarter of fiscal 2005 was 56% and was 55% during the first quarter of fiscal 2004. Our gross margin on sales of HP products for the quarter was 70% versus 77% in 2004. The slight increase in overall gross profit margin in fiscal 2005 compared to fiscal 2004 -21- is partially due to the inclusion of $100,000 of non-cash intellectual property amortization expense in costs of goods sold in the first quarter of fiscal 2004. Intellectual property was fully amortized in the fiscal year ended October 31, 2004. We expect our gross margin to range between 48% and 50% for fiscal 2005. However, if market and economic conditions, particularly in the telecommunications sector, deteriorate or fail to recover, gross margin may be lower than projected. PRODUCT RESEARCH AND DEVELOPMENT Product research and development expenses representing engineering salaries and benefits, contract services and other costs to develop and enhance our products were $473,000 in the first quarter of fiscal 2004, a decrease of 6% from $505,000 in the first quarter of fiscal 2004. The decrease is primarily due to a decrease in project materials expense. We expect overall spending for our product research and development to range between 17% and 20% of net sales in fiscal 2005 as we remain committed to the development and enhancement of new and existing products, particularly TOE, iSCSI and VoIP products. We did not capitalize any internal software development costs in the first quarter of fiscal 2005. SALES AND MARKETING Sales and marketing expenses for the first quarter of fiscal 2005 were $559,000, an increase of 14% from $489,000 in the first quarter of fiscal 2004. The increase is primarily due to increased marketing program spending for our new TOE and iSCSI products. TOE/iSCSI are at the early stages of storage market acceptance and we will continue to increase our spending on marketing activities to capture market share in the emerging market space. We expect our sales and marketing expenses to range between 20% and 24% of net sales in fiscal 2005 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 were $369,000 for the first quarter of fiscal 2005, virtually unchanged from $364,000 in the first quarter of 2004. We do expect an increase in our general and administrative expense due to compliance work related to the Sarbanes-Oxley Section 404 compliance. General and administrative expenses are expected to range between 14% and 18% of net sales for fiscal 2005. LOAN RESERVE BENEFIT On November 6, 1998, we made a loan to our retiring President and CEO, which was used by him to exercise an option to purchase 139,400 shares of our common stock and pay related taxes. The loan, as amended, was collateralized by shares of our common stock, bore interest at a rate of 2.48% per annum and 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. -22- 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. NET INCOME As a result of the factors discussed above, we recorded net income of $177,000 in the first quarter of fiscal 2005, as compared to net income of $527,000 in the first quarter of fiscal 2004. 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 - the ability to secure credit facilities, if necessary, and - the ability to successfully negotiate merger and partnership agreements to acquire certain intellectual property rights related to the storage and VoIP markets. At January 31, 2005, we had cash and cash equivalents of $1.6 million, as compared to $1.8 million at October 31, 2004. In the first three months of fiscal 2005, $317,000 of cash was used in operating activities primarily as a result of an increase in our trade accounts receivable and a decrease in our accounts payable, partially offset by a decrease in inventory. The increase in trade accounts receivable is due to large shipments made to HP and two other customers during the later part of January. The decrease in accounts payable is related to payments to our contract manufacturers for finished goods inventory received at the end of October 2004. The decrease in inventory is due to the shipment of VME products to HP with an inventory cost of approximately $300,000 was in inventory at October 31, 2004. Working capital, comprised of our current assets less our current liabilities, at January 31, 2005 was $4.3 million, as compared to $3.9 million at October 31, 2004. -23- In the first three months of fiscal 2005, we purchased $38,000 of fixed assets, consisting primarily of computer and engineering equipment. Capital expenditures for each of the remaining quarters of fiscal 2005 are expected to range from $25,000 to $100,000 per quarter. Cash from financing activities in the first three months of fiscal 2005 consisted of $79,000 in payments related to common stock purchases made by employees pursuant to the exercise of employee stock options. We have a working capital line of credit with a Bank that with an annual renew date of May 14. The credit line is secured by a first lien on all our assets and carries a floating annual interest rate equal to the bank's prime rate, plus 1.50%. Draw-downs on the credit line are based on a formula equal to 80% of our domestic accounts receivable. We have not drawn down on this line of credit and have no amounts payable at January 31, 2005. We believe our projected net sales during fiscal 2005 will generate sufficient cash flows to fund our operations through October 31, 2005 and beyond. Our projected future quarterly operational cash flow breakeven point (the point at which we would generate positive cash flow from operations) is expected to be $2.6 million to $2.7 million of net sales, assuming an expected 48% to 50% gross margin. Our projected net sales are based on a combination of increasing demand for existing products and market acceptance of recently released products, such as TOE and iSCSI, 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 the projected sales do not materialize, we will need to reduce expenses further and raise additional capital through customer prepayments or the issuance of debt or equity securities. We have embarked on a strategy of acquiring certain intellectual property rights related to storage and VoIP products and our future liquidity may be affected by our ability to raise additional capital, if necessary. 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 our 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. Our financial instrument holdings at January 31, 2005 were analyzed to determine their sensitivity to interest rate changes. The fair values of these instruments were determined by net present values. In our sensitivity analysis, the same change in interest rate was used for all maturities and all other factors were held constant. 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, 2004, there has been no change in our exposure to market risk. -24- ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures An evaluation as of January 31, 2005 was carried out under the supervision of and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's "disclosure controls and procedures," 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, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective. (b) Changes in Internal Controls over Financial Reporting Our management, including our 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 January 31, 2005, and has concluded that there was no change during such quarter that has materially affected, or is reasonably likely to materially affect our 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 March 29, 2004 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. -25- 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). 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(7) Securities Purchase Agreement, dated July 27, 2003, between SBE, Inc. and purchasers of SBE's common stock thereunder, including form of warrant issued thereunder 10.9(7) Form of warrant issued to associates of Puglisi & Co. ($1.50 exercise price) 10.10(7) Form of warrant issued to associates of Puglisi & Co. ($1.75 and $2.00 exercise price) 10.11 Employment agreement dated January 1, 2005, between SBE and Daniel Grey, President & CEO 10.12 Severance agreement, dated April 12, 2004, between SBE and Daniel Grey, President and CEO 10.13 Severance agreement, dated April 12, 2004, between SBE and David Brunton, Vice President Finance, Secretary, Treasurer & CFO 10.14 Severance agreement dated April 12, 2004, between SBE and Kirk Anderson, Vice President, Operations 10.15 Offer Letter, dated August 7, 2003, between SBE and Carl Munio, Vice President, Engineering 10.16 Termination agreement, dated January 5, 2005, between SBE and William Heye, Jr., retiring President & CEO 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 -26- + 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. (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 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 January 1, 2005. The report provided information regarding the granting of options to purchase common stock to certain officers and directors on January 1, 2005. -27- 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 March 2, 2005. SBE, INC. Registrant Date: March 2, 2005 By: /s/ Daniel B. Grey -------------------------- Daniel B. Grey Chief Executive Officer and President (Principal Executive Officer) Date: March 2, 2005 By: /s/ David W. Brunton -------------------------- David W. Brunton Chief Financial Officer, Vice President, Finance and Secretary (Principal Financial and Accounting Officer) -28-