-----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, KTignyvp5My+cE1mhafgu0PLe/9Ei9rll5BQpz7QXAQ1+8nv5/4SN4Nqp+Dvyg4I C5Ob9M0Lmky3zb1XbMRpJA== 0000908605-05-000054.txt : 20050805 0000908605-05-000054.hdr.sgml : 20050805 20050805153717 ACCESSION NUMBER: 0000908605-05-000054 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20050630 FILED AS OF DATE: 20050805 DATE AS OF CHANGE: 20050805 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CASTELLE \CA\ CENTRAL INDEX KEY: 0000908605 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER PERIPHERAL EQUIPMENT, NEC [3577] IRS NUMBER: 770164056 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-22020 FILM NUMBER: 051002676 BUSINESS ADDRESS: STREET 1: 855 JARVIS DRIVE CITY: MORGAN HILL STATE: CA ZIP: 95037 BUSINESS PHONE: 408-852-8000 MAIL ADDRESS: STREET 1: 855 JARVIS DRIVE CITY: MORGAN HILL STATE: CA ZIP: 95037 FORMER COMPANY: FORMER CONFORMED NAME: CASTELLE INC DATE OF NAME CHANGE: 19930702 10-Q 1 cstl10q_2q.txt CASTELLE Q2 05 FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2005 |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 0-220-20 CASTELLE (Exact name of Registrant as specified in its charter) California 77-0164056 (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 855 Jarvis Drive, Suite 100, Morgan Hill, California 95037 (Address of principal executive offices, including zip code) (408) 852-8000 (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 the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| The number of shares of Common Stock outstanding as of July 25, 2005 was 3,914,060. Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes|_| No |X| CASTELLE Table of Contents PAGE PART I - FINANCIAL INFORMATION...............................................3 ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.....................3 CONDENSED CONSOLIDATED BALANCE SHEETS...........................3 CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS...................4 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS.................5 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS............6 SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS...............................13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..........................................14 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK......27 ITEM 4. CONTROLS AND PROCEDURES.........................................28 PART II - OTHER INFORMATION.................................................29 ITEM 1. LEGAL PROCEEDINGS..............................................29 ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS......................29 ITEM 3. DEFAULTS UPON SENIOR SECURITIES................................29 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............29 ITEM 5. OTHER INFORMATION..............................................29 ITEM 6. EXHIBITS.......................................................29 SIGNATURES..................................................................30 AMENDMENT TO SILICON VALLEY BANK LOAN AGREEMENT............................E-1 RULE 13A-14(A)/15D-14(A) CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER......E-4 RULE 13A-14(A)/15D-14(A) CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER......E-5 SECTION 1350 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER..................E-6 SECTION 1350 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER..................E-7 2 PART I - FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
CASTELLE CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) June 30, 2005 December 31, 2004 (unaudited) ------------------ -------------------- Assets: Current assets: Cash and cash equivalents $ 6,350 $ 5,599 Accounts receivable, net of allowance for doubtful accounts of $40 and $30, respectively 723 857 Inventories 1,553 1,785 Prepaid expenses and other current assets 178 130 Deferred taxes 231 231 ------------------ -------------------- Total current assets 9,035 8,602 Property and equipment, net 203 203 Other non-current assets 46 50 Deferred taxes, non-current 1,292 1,292 ------------------ -------------------- Total assets $ 10,576 $ 10,147 ================== ==================== Liabilities and Shareholders' Equity: Current liabilities: Long-term debt, current portion $ 15 $ 15 Accounts payable 277 511 Accrued liabilities 1,098 1,073 Deferred revenue 1,334 1,253 ------------------ -------------------- Total current liabilities 2,724 2,852 Long term debt, net of current portion 5 14 ------------------ -------------------- Total liabilities 2,729 2,866 ------------------ -------------------- Shareholders' equity: Common stock, no par value: Authorized: 25,000 shares Issued and outstanding: 3,904 and 3,799 shares, 27,783 27,668 respectively Accumulated deficit: (19,936) (20,387) ------------------ -------------------- Total shareholders' equity 7,847 7,281 ------------------ -------------------- Total liabilities and shareholders' equity $ 10,576 $ 10,147 ================== ====================
See accompanying notes to condensed consolidated financial statements. 3
CASTELLE CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS (in thousands, except per share amounts) (unaudited) Three months ended Six months ended ................................ ............................... June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004 ---------------- -------------- --------------- --------------- Net sales: Products $ 2,116 $ 2,090 $ 4,009 $ 4,102 Services 730 601 1,431 1,128 ---------------- -------------- --------------- --------------- Total net sales 2,846 2,691 5,440 5,230 Cost of sales: Products 674 592 1,216 1,231 Services 258 216 528 414 ---------------- -------------- --------------- --------------- Total cost of sales 932 808 1,744 1,645 ---------------- -------------- --------------- --------------- Gross profit 1,914 1,883 3,696 3,585 Operating expenses: Research and development 418 428 857 842 Sales and marketing 618 675 1,216 1,270 General and administrative 582 508 1,217 973 ---------------- -------------- --------------- --------------- Total operating expenses 1,618 1,611 3,290 3,085 ---------------- -------------- --------------- --------------- Income from operations 296 272 406 500 Interest income, net 35 5 60 8 Other expense, net (15) (10) (15) (14) ---------------- -------------- --------------- --------------- Income before provision for income taxes 316 267 451 494 Provision for income taxes - 121 - 219 ---------------- -------------- --------------- --------------- Net income $ 316 $ 146 $ 451 $ 275 ================ ============== =============== ===============
Net Income per share: Net income per common share - basic $ 0.08 $ 0.04 $ 0.12 $ 0.08 Net income per common share - diluted $ 0.07 $ 0.03 $ 0.10 $ 0.06 Shares used in per share calculation - basic 3,871 3,573 3,843 3,536 Shares used in per share calculation - diluted 4,460 4,428 4,463 4,439
See accompanying notes to condensed consolidated financial statements. 4
CASTELLE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited) Six months ended ...................................... June 30, 2005 June 30, 2004 ----------------- ------------------ Cash flows from operating activities: Net income $ 451 $ 275 Adjustment to reconcile net income to net cash provided by operating activities: Depreciation and amortization 95 103 Provision for doubtful accounts 10 (3) Provision for excess and obsolete inventory (474) (210) Allowance for sales returns and stock rotation (55) 16 Loss on disposal of fixed assets - 1 Deferred taxes - 219 Changes in assets and liabilities: Accounts receivable 179 (115) Inventories 706 (78) Prepaid expenses and other current assets (44) (122) Accounts payable (234) 104 Accrued liabilities 25 (242) Deferred revenue 81 132 ----------------- ------------------ Net cash provided by operating activities 740 80 ----------------- ------------------ Cash flows from investing activities: Acquisition of equipment (95) (15) ----------------- ------------------ Net cash used in investing activities (95) (15) ----------------- ------------------ Cash flows from financing activities: Repayment of long-term debt (9) (9) Proceeds from exercise of stock options 115 172 ----------------- ------------------ Net cash provided by financing activities 106 163 Net increase in cash and cash equivalents 751 228 Cash and cash equivalents at beginning of period 5,599 4,614 ----------------- ------------------ Cash and cash equivalents at end of period $ 6,350 $ 4,842 ================= ==================
See accompanying notes to condensed consolidated financial statements. 5 CASTELLE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) 1. Basis of Presentation: The accompanying unaudited condensed consolidated financial statements include the accounts of Castelle and its wholly-owned subsidiary in the United Kingdom. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. All intercompany balances and transactions have been eliminated. In our opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of our financial position, results of operations and cash flows at the dates and for the periods indicated have been included. Because all of the disclosures required by accounting principles generally accepted in the United States of America are not included in the accompanying condensed consolidated financial statements and related notes, they should be read in conjunction with the audited consolidated financial statements and related notes included in the Company's Form 10-K for the year ended December 31, 2004. The condensed consolidated balance sheet data as of December 31, 2004 was derived from our audited financial statements and does not include all of the disclosures required by accounting principles generally accepted in the United States of America. The results of operations for the periods presented are not necessarily indicative of results that we expect for any future period, or for the entire year. The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We believe that our existing cash balances and anticipated cash flows from operations will be sufficient to meet our anticipated capital requirements for the next 12 months. If we have a need for additional capital resources, we may be required to sell additional equity or debt securities, secure additional lines of credit or obtain other third party financing. The timing and amount of such capital requirements cannot be determined at this time and will depend on a number of factors, including demand for our existing and new products, if any, and changes in technology in the networking industry. There can be no assurance that such additional financing will be available on satisfactory terms when needed, if at all. Failure to raise such additional financing, if needed, may result in us not being able to achieve our long-term business objectives. To the extent that additional capital is raised through the sale of additional equity or convertible debt securities, the issuance of such securities would result in additional dilution to our shareholders. In addition, because we are dependent on a small number of distributors for a significant portion of the sales of our products, the loss of any of our major distributors or their inability to satisfy their payment obligations to us could have a significant adverse effect on our business, operating results and financial condition. In the first six months of 2005 and 2004, our two largest distributors collectively represented approximately 43% and 48% of our net sales, respectively. We do not currently have any material long-term supply contracts with any of our manufacturing subcontractors or component suppliers. We purchase finished products and components on a purchase order basis. We own all engineering, sourcing documentation, functional test equipment and tooling used in the manufacturing of our products and believe that we could shift product assembly to alternate suppliers if necessary. Certain key components of our products, including a 6 modem chip set from Conexant, microprocessors from Motorola, integrated circuits from Intel and Kendin, are currently available from single sources. Other components of our products are currently available from only a limited number of sources. In addition, certain manufacturers have announced the end-of-life of certain standard off-the-shelf components which are being used by us in the manufacture of our FaxPress Products. However, we have purchased what we believe to be at least two years worth of supplies of these end-of-life components in an effort to guarantee an uninterrupted supply of FaxPress Products to our customers for the next two years, while we decide whether to re-engineer our Products with the manufacturers' suggested replacement parts, or develop new replacement products. We believe that most of these end-of-life components will be utilized in the following two years, resulting in insignificant amounts of excessive inventory, or none at all. We believe that Castelle's liquidity continues to be strong despite these purchases, as our cash reserves have increased during the periods when the parts were purchased. 2. Revenue Recognition: We recognize revenue based on the provisions of Staff Accounting Bulletin No. 104 "Revenue Recognition," AICPA Statement of Position No. 97-2 ("SOP 97-2") "Software Revenue Recognition," as amended by SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions," and Statement of Financial Accounting Standards ("SFAS") No. 48 "Revenue Recognition When Right of Return Exits." The Company uses the residual method to recognize revenue when an agreement includes one or more elements to be delivered at a future date. If there is an undelivered element under the arrangement, the Company defers revenue based on vendor-specific objective evidence of the fair value of the undelivered element, as determined by the price charged when the element is sold separately. If vendor-specific objective evidence of fair value does not exist for all undelivered elements, the Company defers all revenue until sufficient evidence exists or all elements have been delivered. Product revenue is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred; the fee is fixed and determinable; collection is probable; and returns can be reasonably estimated. If an acceptance period or other contingency exists, revenue is recognized upon satisfaction of the contingency, customer acceptance or expiration of the acceptance period. Shipment generally occurs and title and risk of loss is transferred when the product is delivered to a common carrier. We evaluate product sales through our distribution channels and the related reserve requirement to establish an estimate for our sales returns reserve by reviewing detailed point-of-sales and on-hand inventory reports provided to us by our channel partners. Based on a combination of historical return experience, the sales activities to end-user customers by our channel partners and the level of inventories on hand at the channel partners, we determine our returns reserve at the end of each financial period, and increases or reduce the reserve balance accordingly. We provide standard support to our customers for an initial period of sixty days, which includes advance swap of the defective hardware and software, bug fixes, software upgrades and technical support. In addition to standard support, we also offer our customers the option to purchase extended support at the time of product purchase or anytime thereafter. Extended support covers hardware and software for a period of one year. We have established vendor-specific objective evidence with respect to the fair value of the standard support contracts based on standalone sales and renewals of our one-year extended support contracts. The fair value of our sixty day support contracts included with product sales is determined by pro-rating the related one-year extended support contracts. We recognize revenue from extended support contracts ratably over the period of the contract based on 7 contract service dates. 3. Net Income Per Share: Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding for such period. Diluted net income per share reflects the potential dilution from the exercise or conversion of other securities into common stock that were outstanding during the period. Diluted net income per share excludes shares that are potentially dilutive if their effect is antidilutive. Dilutive potential shares consist of incremental common shares issuable upon exercise of stock options. Basic and diluted net income per share is calculated as follows for the first two quarters of 2005 and 2004 (Unaudited, in thousands, except per share amounts):
(in thousands, except per share amounts) ........................................................ (Unaudited) ........................................................ Three months ended Six months ended ........................... ............................ June 30, 2005 June 30, June 30, June 30, 2004 2004 2005 --------------------------- ------------- -------------- Basic: Weighted average common shares outstanding 3,871 3,573 3,846 3,536 =========================== ============= ============== Net income $ 316 $ 146 $ 451 $ 275 =========================== ============= ============== Net income per common share - basic $ 0.08 $ 0.04 $ 0.12 $ 0.08 =========================== ============= ============== Diluted: Weighted average common shares outstanding 3,871 3,573 3,846 3,536 Common equivalent shares from stock options 589 855 617 903 --------------------------- ------------- -------------- Shares used in per share calculation - diluted 4,460 4,428 4,463 4,439 =========================== ============= ============== Net income $ 316 $ 146 $ 451 $ 275 =========================== ============= ============== Net income per common share - diluted $ 0.07 $ 0.03 $ 0.10 $ 0.06 =========================== ============= ==============
The calculation of diluted shares outstanding for all periods presented excludes 123,000 shares of common stock issuable upon exercise of outstanding stock options, as their effect was antidilutive in the period. 4. Stock-Based Compensation We account for our stock-based compensation plans using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." Compensation cost for stock options, if any, is measured by the excess of the quoted market price of our stock at the date of grant over the amount an employee must pay to acquire the stock. SFAS No. 123, "Accounting for Stock-Based Compensation," established accounting and disclosure requirements using a fair-value based method of accounting for stock-based employee compensation plans. Had compensation costs been determined consistent with SFAS No. 123, our net income, net of income taxes, would have been changed to the amounts indicated below (unaudited, in thousands, except per share data): 8
Three months ended Six months ended ............................. ................................. June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004 -------------- -------------- --------------------------------- Net Income - as reported $ 316 $ 146 $ 451 $ 275 Fair value of stock-based compensation, net (99) (159) (297) (255) of taxes Net income (loss) - pro forma 217 (13) 154 20 Net income per share - basic - as reported $ 0.08 $ 0.04 $ 0.12 $ 0.08 Net income per share - diluted - as reported $ 0.07 $ 0.03 $ 0.10 $ 0.06 Net income (loss) per share - basic - pro forma $ 0.06 $ 0.00 $ 0.04 $ 0.01 Net income (loss) per share - diluted - pro $ 0.05 $ 0.00 $ 0.03 $ 0.00 forma
We account for stock-based compensation arrangements with non-employees in accordance with Emerging Issues Task Force ("EITF") Abstract No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Accordingly, unvested options and warrants held by non-employees are subject to revaluation at each balance sheet date based on the then current fair market value. 5. Inventories: Inventories are stated at the lower of standard cost (which approximates cost on a first-in, first-out basis) or market. Inventory details are as follows (unaudited, in thousands):
June 30, 2005 December 31, 2004 ----------------------- ----------------------- Raw material $ 853 $ 1,202 Work in process 81 118 Finished goods 619 465 ----------------------------------------------- Total inventory $ 1,553 $ 1,785 ===============================================
After the announcement by our component suppliers that new components are available to replace certain of their end-of-life components currently used in our FaxPress products, we purchased approximately two years worth of these end-of-life components in an effort to guarantee a smooth supply of our FaxPress Products to our customers. As of June 30, 2005, we have approximately $470,000 worth of end-of-life components as compared to $675,000 at the end of December 31, 2004. We believe that most of these end-of-life components will be utilized in the following two years, resulting in insignificant amounts of excessive inventory, or none at all. Inventories are reduced for excess and obsolete inventories. These write-downs are based on management's review of inventories on hand on a quarterly basis, compared to management's assumptions about future demand, market conditions and anticipated timing of the release of product upgrades or next generation products. If actual market conditions for future demand are less favorable than those projected by us or if product upgrades or next generation products are released earlier than anticipated, additional inventory write-downs may be required. Obsolete products removed from gross inventory are physically scrapped. 9 6. Segment Information: We have determined that we operate in one segment. Revenues by geographic area are determined by the location of the customer and are summarized as follows (unaudited, in thousands):
Three months ended Six months ended ......................... ........................ June 30, June 30, June 30, June 30, 2005 2004 2005 2004 ------------------------- ------------------------ United States $ 2,170 $ 2,279 $ 4,360 $ 4,390 Europe 119 148 212 332 Pacific Rim 290 153 531 335 Rest of Americas, excluding United States 267 111 337 173 ------------------------- ------------------------ Total Revenues $ 2,846 $ 2,691 $ 5,440 $ 5,230 ========================= ========================
Customers that individually accounted for greater than 10% of net sales are as follows (unaudited, in thousands):
.................................................................................................... Quarter Ended Six Months Ended ................................................. .................................................. June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004 Customer Amount Percentage Amount Percentage Amount Percentage Amount Percentage -------- ------ ---------- ------ ---------- ------ ---------- ------ ---------- A $ 415 15% $ 562 21% $ 870 16% $ 1,439 28% B $ 773 27% $ 701 26% $ 1,475 27% $ 1,076 20% C $ 256 9% * * $ 520 10% * *
* This customer accounted for less than 10% in 2004. 7. Comprehensive Income: Comprehensive income is the change in equity from transactions and other events and circumstances other than those resulting from investments by owners and distributions to owners. There are no significant components of comprehensive income excluded from net income, therefore, no separate statement of comprehensive income has been presented. 8. Commitments and Contingencies: Contingencies From time to time, we are involved in various legal proceedings in the ordinary course of business. We are not currently involved in any litigation, which, in our opinion, would have a material adverse effect on our business, operating results, cash flows or financial condition; however, there can be no assurance that any such proceeding will not escalate or otherwise become material to our business in the future. Lease Commitments The following represents combined aggregate maturities for all of our financing and commitments under operating and capital leases as of June 30, 2005 (unaudited, in thousands): 10
Capital Lease Total Operating Leases Obligations Commitments ---------------------------------------------------- Six months ending December 31, 2005 $ 103 $ 15 $ 118 Year ending December 31, 2006 207 5 212 Year ending December 31, 2007 207 - 207 Year ending December 31, 2008 207 - 207 Year ending December 31, 2009 86 - 86 ---------------------------------------------------- Total Commitments $ 810 $ 20 $ 830 ====================================================
We have extended our building lease for a term of five years commencing on June 1, 2004 and expiring on May 31, 2009, with one conditional three-year renewal option, which if exercised, would extend the lease to May 31, 2012 commencing with rent at ninety-five percent of fair market value. We lease certain of our equipment under various operating and capital leases that expire at various dates through 2006. The lease agreements frequently include renewal, escalation clauses and purchase provisions, and require us to pay taxes, insurance and maintenance costs. As of June 30, 2005, we had $20,000 outstanding under a loan and security agreement, which is subject to an interest rate of 12.8%. In September, 2004, we entered into a $4.0 million collateralized revolving line of credit with a bank. This line of credit has been extended through August of 2006. The revolving line of credit provides for borrowings of up to $4.0 million. Borrowings under this line of credit agreement are collateralized by all of our assets and bear interest at the bank's prime rate plus 0.50%. Under the new facility we are required to maintain certain minimum cash and investment balances with the bank and meet certain other financial covenants. As of June 30, 2005, we have not drawn down on the line of credit and were in compliance with the terms of the agreement. Product Warranties and Guarantor Arrangements We offer warranties on certain products and record a liability for the estimated future costs associated with warranty claims, which is based upon historical experience and our estimate of the level of future costs. Warranty costs are reflected in the Statement of Operations as a Cost of Sales. A reconciliation of the changes in our warranty liability is as follows (unaudited, in thousands):
(Unaudited) .................................................... Three months ended Six months ended ......................... ........................ June 30, June 30, June 30, June 30, 2005 2004 2005 2004 ------------------------- ------------------------ Balance at beginning of period $ 18 $ 23 $ 13 $ 24 Accruals for warranties issued during the - 1 5 1 period Actual warranty expense - (2) - (3) ------------------------- ------------------------ Balance at end of period $ 18 $ 22 $ 18 $ 22 ========================= ========================
As permitted under California law, and under the provisions of our articles of incorporation and by-laws, we are obligated to indemnify our officers and directors for certain events or occurrences while the officer or director is, or was, serving at our request 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 the Company could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy that limits our exposure and 11 enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is insignificant. We enter into standard indemnification agreements with our customers in the ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual following execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have never incurred claims or costs to defend lawsuits or settle claims related to these indemnification agreements. 9. Recent Accounting Pronouncements: In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment," a revision of SFAS No. 123, "Accounting for Stock-Based Compensation" and superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS No. 123R requires the Company to expense grants made under the Company's stock option program. That cost will be recognized over the vesting period of the plans. SFAS No. 123R is effective for fiscal years beginning after June 15, 2005. The Company is evaluating the alternatives allowed under the standard, which the Company is required to adopt effective for its first quarter of fiscal 2006. In December 2004, the FASB issued Staff Position SFAS No. 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes (FSP No. 109-1) to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 which was signed into law by the President of the United States on October 22, 2004. Companies that qualify for the recent tax law's deduction for domestic production activities must account for it as a special deduction under SFAS No. 109 and reduce their tax expense in the period or periods the amounts are deductible, according to FSP No. 109-1, effective for the Company in its fiscal year 2005. The FASB's guidance is not expected to have a material impact to the Company's financial results. 12 SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS This document contains forward-looking statements that involve risks and uncertainties. Our operating results may vary significantly from quarter to quarter due to a variety of factors, including changes in our product and customer mix, constraints in our manufacturing and assembling operations, shortages or increases in the prices of raw materials and components, changes in pricing policy by us or our competitors, a slowdown in the growth of the networking market, seasonality, timing of expenditures, and economic conditions in the United States, Europe and Asia. 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. Unless the context otherwise requires, references in this Form 10-Q to "we," "us," or the "Company" refer to Castelle. Readers are cautioned that the forward-looking statements reflect management's 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 the forward-looking statements. Factors that might cause such a difference include, but are not limited to the risks and uncertainties discussed herein, as well as other risks set forth under the caption "Risk Factors" below and in our Annual Report on Form 10-K for the year ended December 31, 2004. 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that are subject to many risks and uncertainties that could cause actual results to differ significantly from expectations. For more information on forward-looking statements, refer to the "Special Note on Forward-Looking Statements" prior to this section. The following discussion should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and the Notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and our Form 10-K for the year ended December 31, 2004. Critical Accounting Policies Castelle's financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, sales and expenses. These estimates and assumptions are affected by management's application of accounting policies. Critical accounting policies for us include revenue recognition; distributor programs and incentives; warranty; credit, collection and allowances for doubtful accounts; inventories and related allowance for obsolete and excess inventory; and income taxes, which are discussed in more detail under the caption "Critical Accounting Policies" in our 2004 Annual Report on Form 10-K. Consolidated Statements of Operations - As a Percentage of Net Sales
Three months ended Six months ended ................................ ................................ June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004 ---------------- -------------- ---------------- -------------- Net sales: Products 74% 78% 74% 78% Services 26% 22% 26% 22% ---------------- -------------- ---------------- -------------- Total net sales 100% 100% 100% 100% Cost of sales: Products 24% 22% 22% 23% Services 9% 8% 10% 8% ---------------- -------------- ---------------- -------------- Total cost of sales 33% 30% 32% 31% Gross profit 67% 70% 68% 69% Operating expenses: Research and development 15% 16% 16% 17% Sales and marketing 22% 25% 22% 24% General and administrative 20% 19% 23% 18% ---------------- -------------- ---------------- -------------- Total operating expenses 57% 60% 61% 59% Income from operations 10% 10% 7% 10% Interest income, net 1% * 1% * Other expense, net * (1%) * * ---------------- -------------- ---------------- -------------- Income before provision for income taxes 11% 10% 8% 9% Provision for income taxes - 5% - 4% ---------------- -------------- ---------------- -------------- Net income 11% 5% 8% 5% ================ ============== ================ ==============
* Less than 1% 14 Results of Operations Net Sales
Three months ended Six months ended ................................. ................................. June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004 ----------------- -------------- --------------- ---------------- Net sales Products $ 2,116 $ 2,090 $ 4,009 $ 4,102 Services 730 601 1,431 1,128 ----------------- -------------- --------------- ---------------- Total Net sales $ 2,846 $ 2,691 $ 5,440 $ 5,230 ================= ============== =============== ================
Net sales for the second quarter of 2005 increased 6% to $2.8 million from $2.7 million in the same period in 2004. Net sales for the first six months of 2005 increased 4% to $5.4 million from $5.2 million for the same period in 2004. Product sales of $2.1 million for the second quarter of 2005 were relatively unchanged as compared to the same period in 2004. Product sales of $4.0 million for the first six months of 2005 represent a slight decrease of $93,000 compared to the first six months of 2004, or a 2% decrease for that period. Service revenues are comprised primarily of extended warranty and support programs as well as 60-days of maintenance bundled with initial product sales. Revenue related to these arrangements is recognized ratably over the period of the arrangement. Service revenues in the second quarter of 2005 increased 21% to $730,000 from $601,000 in the same period in 2004. For the first six months of 2005, service revenues increased 27% to $1.4 million from $1.1 million in the same period in 2004. The increase in service revenues was primarily due to increased sales of extended warranty contracts due to an increase in our installed customer base resulting from the launch of our FaxPress Premier fax server products in the second half of 2003.
Three months ended Six months ended ......................... ........................ June 30, June 30, June 30, June 30, 2005 2004 2005 2004 ------------------------- ------------------------ United States $2,170 $ 2,279 $ 4,360 $ 4,390 Europe 119 148 212 332 Pacific Rim 290 153 531 335 Rest of Americas, excluding United States 267 111 337 173 ------------------------- ------------------------ Total Revenues $2,846 $ 2,691 $ 5,440 $ 5,230 ========================= ========================
Sales in the United States in the second quarter of 2005 were $2.2 million, as compared to $2.3 million for the same period in 2004, representing 76% and 85% of total net sales in the second quarter of 2005 and 2004, respectively. The reduction in percentage of net sales in the second quarter of 2005 is mostly due to increases in sales to distribution channels outside of the United States. Sales for the first six months of 2005 and 2004 were $4.4 million, which represents 80% and 84% of total net sales in 2005 and 2004, respectively. The decrease in sales is mostly due to lower sales for the FaxPress family of products offset partially by higher service revenues. 15 International sales (excluding sales to the rest of the Americas) for the second quarter of 2005 were $409,000 as compared to $301,000 in the second quarter of 2004. This represents 14% and 11% of net sales for 2005 and 2004, respectively. International sales were $743,000 for the first six months of 2005, as compared to $667,000 for the same period in 2004, which represents 14% and 13% of total net sales for 2005 and 2004, respectively. The increase in international sales is due to increased sales of the FaxPress and FaxPress Premier fax server products to Japan as a result of the FaxPress Premier fax server launch in Japan in the first quarter of 2005. Sales to the rest of the Americas (excluding the United States) in the second quarter of 2005 were $267,000 as compared to $111,000 in the year-ago quarter, representing 9% of total net sales for 2005 and 4% for 2004, respectively. The increase in sales was mostly due to sales of our FaxPress Premier products to Latin America. For the six months ended June 30, sales to the Rest of the Americas were $337,000 and $173,000 for 2005 and 2004, respectively. This represents 6% and 3% of net sales for 2005 and 2004, respectively. Cost of Sales; Gross Profit
Three months ended Six months ended .................................. .................................... June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004 ----------------- ---------------- ---------------- ----------------- Products: Revenue $ 2,116 $ 2,090 $ 4,009 $ 4,102 Cost of product sales 674 592 1,216 1,231 ----------------- ---------------- ---------------- ----------------- Gross profit 1,442 1,498 2,793 2,871 Gross profit % 68% 72% 70% 70% Services: Revenue 730 601 1,431 1,128 Cost of service sales 258 216 528 414 ----------------- ---------------- ---------------- ----------------- Gross profit 472 385 903 714 Gross profit % 65% 64% 63% 63% Total gross profit $1,914 $1,883 $ 3,696 $ 3,585 Gross profit % 67% 70% 68% 69%
Gross profit was $1.9 million for the second quarter of 2005 and 2004, or 67% and 70% of net sales, respectively. Gross profit for the first six months of 2005 and 2004 was $3.7 million and $3.6 million, or 68% and 69% of net sales, respectively. The increase in gross profit was mainly due to higher service revenue in the three and six months ended June 30, 2005 as compared to the same periods in 2004. Research & Development Research and development expenses for the second quarter of 2005 were $418,000, or 15% of net sales, as compared to $428,000 or 16% of net sales for the same period in 2004. For the first six months of 2004, research and development expenses were $857,000, as compared to $842,000 in the same period of 2004, or 16% of net sales for both periods. Research and development expenses are not expected to change significantly for fiscal year 2005. 16 Sales & Marketing Sales and marketing expenses for the second quarter of 2005 were $618,000, or 22% of net sales, as compared to $675,000, or 25% of net sales, for the same period in 2004. Sales and marketing expenses were $1.2 million for the first six months of 2005, and $1.3 million for the same period of 2004, which represents 22% and 24%, respectively, of net sales for the period. The decrease for the quarter of $55,000 is due to reduced use of outside consultants due to a completion of short-term projects, and the decrease of $53,000 is due to lower advertising costs for the six month period. General & Administrative General and administrative expenses were $582,000 for the second quarter of 2005 as compared to $508,000 for the same period in 2004. This represents 20% and 19% of net sales of the second quarter of 2005 and 2004, respectively. For the first six months of 2004, general and administrative expenses were $1.2 million, or 23% of net sales, as compared to $973,000, or 18% of net sales for the first six months of 2004. The increase of $74,000 for the second quarter and $244,000 for the six month period ended June 30, 2005, is primarily due to increases in accounting and legal fees related to the restatement of the Company's historical financial statements included in the Company's December 31, 2004 Annual Report on Form 10-K and Castelle's response to a series of comment letters issued by the Division of Corporate Finance of the Securities and Exchange Commission during the first quarter of fiscal 2005. These restatements are discussed in detail in the Company's December 31, 2004 Form 10-K. General and administrative expenses are also expected to increase in fiscal 2005 as the Company begins to prepare for Sarbanes-Oxley internal control compliance. Provision for Income Tax We account for income taxes in accordance with the liability method. Under the liability method, deferred assets and liabilities are recognized based upon anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. The provision for income taxes is comprised of the current tax liability and the change in deferred tax assets and liabilities. We establish a valuation allowance to the extent that all or some portion of the deferred tax assets will not be recoverable against future taxable income. Significant management judgment is required in determining the provision for income taxes, and in particular, any valuation allowance recorded against our deferred tax assets. During 2004 and 2003, we recorded tax benefits of $1,067,000 and $537,000, respectively. This portion of the valuation allowance was reversed because we determined that it was more likely than not that certain future tax benefits will be realized as a result of projected future income. Due to our limited history of generating taxable income, we recorded a tax provision at an effective rate of approximately 40% during the first three quarters of fiscal 2004. Based in large part on our projected future taxable income we did not record income tax provision in the second quarter of 2005. We will record a tax provision in future periods when all available non-operating losses and tax credit carryforwards are fully utilized or the remaining deferred tax assets are deemed to be unrealizable. At December 31, 2004, we had net operating loss carryforwards of approximately $12,955,000 and $2,296,000 available to offset future federal and California taxable income, respectively. These loss carryforwards will expire in varying amounts beginning in 2005 through 2021. In addition, at December 31, 2004, we had federal and California Research and Development credit and alternative minimum tax credit carryforwards of approximately $1,152,000 and $728,000, 17 respectively. The federal Research and Development credits expire in varying amounts beginning in 2007. The California Research and Development credits carry-forward indefinitely. Liquidity and Capital Resources
June 30, 2005 December 31, 2004 (unaudited) (dollars inthousands) Cash and cash equivalents $ 6,350 $ 5,599 Working capital $ 6,311 $ 5,750 Working capital ratio 3.3 3.0
Since our initial public offering of common stock in December 1995, our principal source of funding has been cash from our operations, with some funding from capital equipment lease lines. As of June 30, 2005, we had $6.4 million of cash and cash equivalents, an increase of $751,000 from December 31, 2004. The increase in cash and cash equivalents was primarily attributable to cash provided by operating activities of $740,000 and $115,000 in proceeds from the exercise of employee stock options, off-set by the purchase of $95,000 of equipment. Our operating activities generated cash of $740,000 in the first six months of 2005 primarily due to our increased net income, reduction of inventories as our usage of some of the end-of-life parts and other components purchased last year more than offset purchases during the first quarter, and a decrease in accounts receivable achieved by greater collection efforts. Net cash provided by financing activities was $106,000 and $163,000 in the first two quarters of 2005 and 2004, respectively, primarily from proceeds from issuance of common stock. In September, 2004, we entered into a $4.0 million collateralized revolving line of credit with a bank. This line of credit has been extended through August of 2006. The revolving line of credit provides for borrowings of up to $4.0 million. Borrowings under this line of credit agreement are collateralized by all of our assets and bear interest at the bank's prime rate plus 0.50%. Under the new facility we are required to maintain certain minimum cash and investment balances with the bank and meet certain other financial covenants. As of June 30, 2005, we have not drawn down on the line of credit and were in compliance with the terms of the agreement. We lease certain of our equipment under various operating and capital leases that expire at various dates through 2006. The lease agreements frequently include renewal, escalation clauses and purchase provisions, and require us to pay taxes, insurance and maintenance costs. As of June 30, 2005, we had $20,000 outstanding under a loan and security agreement, which is subject to an interest rate of 12.8%. We lease our headquarters in Morgan Hill, California. We have extended our building lease for a term of five years commencing on June 1, 2004 and expiring on May 31, 2009, with one conditional three-year renewal option, which if exercised, would extend the lease to May 31, 2012 commencing with rent at ninety-five percent of fair market value. As of June 30, 2005, future minimum payments under the lease were $810,000. The following represents combined aggregate maturities for all our financing and commitments as of June 30, 2005 (unaudited, in thousands): 18
Payments Due by Period -------------------------------------------------------------------- Contractual Obligations Total 1 Year 2 - 3 Years 4 - 5 Years More than 5 Years --------- ------------- -------------- ------------- --------------- Capital (Finance) Lease Obligations $ 20 $ 15 $ 5 - - Operating Lease Obligations $ 810 $ 103 $ 414 $ 207 $ 86 --------- ------------- -------------- ------------- --------------- Total contractual cash obligations $ 830 $ 118 $ 419 $ 207 $ 86 ========= ============= ============== ============= ===============
In addition, because we are dependent on a small number of distributors for a significant portion of the sales of our products, the loss of any of our major distributors or their inability to satisfy their payment obligations to us could have a significant adverse effect on our business, operating results and financial condition. We believe that, for the periods presented, inflation has not had a material effect on our operations. Recent Accounting Pronouncements: In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment," a revision of SFAS No. 123, "Accounting for Stock-Based Compensation" and superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS No. 123R requires the Company to expense grants made under the Company's stock option program. That cost will be recognized over the vesting period of the plans. SFAS No. 123R is effective for fiscal years beginning after June 15, 2005. The Company is evaluating the alternatives allowed under the standard, which the Company is required to adopt effective in fiscal 2006. In December 2004, the FASB issued Staff Position SFAS No. 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes (FSP No. 109-1) to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 which was signed into law by the President of the United States on October 22, 2004. Companies that qualify for the recent tax law's deduction for domestic production activities must account for it as a special deduction under SFAS No. 109 and reduce their tax expense in the period or periods the amounts are deductible, according to FSP No. 109-1, effective for the Company in its fiscal year 2005. The FASB's guidance is not expected to have a material impact to the Company's financial results. RISK FACTORS Shareholders or investors considering the purchase of shares of our common stock should carefully consider the following risk factors, in addition to other information in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2004. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations Our revenue and operating results have fluctuated in the past and are likely to fluctuate significantly in the future, particularly on a quarterly basis. 19 Our operating results may vary significantly from quarter to quarter due to many factors, some of which are outside our control. For example, the following conditions could all affect our results: o changes in our product sales and customer mix; o constraints in our manufacturing and assembling operations; o shortages or increases in the prices of raw materials and components; o changes in pricing policy by us or our competitors; o a slowdown in the growth of the networking market; o seasonality; o timing of expenditures; and o economic conditions in the United States, Europe and Asia. Our sales often reflect orders shipped in the same quarter in which they are received. In addition, significant portions of our expenses are relatively fixed in nature, and planned expenditures are based primarily on sales forecasts. Therefore, if we inaccurately forecast demand for our products, the impact on net income may be magnified by our inability to adjust spending quickly enough to compensate for the net sales shortfall. Other factors contributing to fluctuations in our quarterly operating results include: o changes in the demand for our products; o customer order deferrals in anticipation of new versions of our products; o the introduction of new products and product enhancements by us or our competitors; o the effects of filling the distribution channels following introductions of new products and product enhancements; o potential delays in the availability of announced or anticipated products; o the mix of product and revenue derived from the sale of extended warranty contracts; o the commencement or conclusion of significant development contracts; o changes in foreign currency exchange rates; and o the timing of significant marketing and sales promotions. 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 viewed as indications of future performance. We have a history of losses and a large accumulated deficit. We have experienced significant operating losses and, as of June 30, 2005, had an accumulated deficit of $19.9 million. Our development and marketing of current and new products will continue to require substantial expenditures. We incurred of losses in 2001 but since the third quarter of 2001, we have been profitable. There can be no assurance that growth in net sales will be achieved or profitability sustained in future years. Recent FASB Exposure Draft on Share-Based Payments may have a significant effect on our Results of Operations, if adopted. In December 2004, the Financial Accounting Standards Board (FASB) issued Statement No. 123 (revised 2004), "Share-Based Payment" (SFAS 123R). SFAS 123R addresses the accounting for transactions in which an enterprise receives employee services in exchange for (i) equity instruments of the enterprise or (ii) liabilities that are based on the fair value of the enterprises' equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123R supersede APR No. 25 and will require that such transactions be accounted for using a fair-value based method and that companies recognize an expense for compensation cost related to share-based payment arrangements, 20 including stock option and employee stock purchase plans. SFAS 123R is effective for the first annual period after June 15, 2005 and, therefore, we will be implementing SFAS 123R on January 1, 2006. As permitted by Statement 123R, we currently account for share-based payments to employees using APB 25's intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123R fair value method will have an impact on our result of operations, although it will not have an impact on our overall financial or cash position. The impact of SFAS 123R on our operation results cannot be predicted at this time, because that will depend on levels of share-based payments granted in the future. Should we adopt the proposed statement, it may have a significant impact on our consolidated statement of operations as we will be required to expense the fair value of our stock options rather than disclosing the impact on our consolidated net income within our footnotes (See Note 4 of the notes to the condensed consolidated financial statements). The proposed standard would require the modified prospective method be used, which would require that the fair value of new awards granted from the beginning of the year of adoption plus unvested awards at the date of adoption be expensed over the vesting term. In addition, the proposed statement encourages companies to use the "binomial" approach to value stock options, as opposed to the Black-Scholes option pricing model that is currently being used for the fair value of our options. Substantially all of our revenue comes from the sale of fax server products, and a decline in demand for those products would harm our business, operating results and financial condition. We derive substantially all of our product revenue from the sale of fax and print server products, with fax server products accounting for 100% of total sales in 2004 and the first six months of 2005. We expect that our current products will continue to account for most of our sales in the near future. A decline in demand for our fax server products as a result of competition, technological change, shortages of components or other factors, or a delay in the development and market acceptance of new features and products, would have a material adverse effect on our business, operating results and financial condition. We sell our products through a limited number of distributors, and any deterioration in our relationship with those distributors would harm our business, operating results and financial condition. We sell our products primarily through a two-tier domestic and international distribution network. Our distributors sell our products to VARs, e-commerce vendors and other resellers. The distribution of personal computers and networking products has been characterized by rapid change, including consolidations due to the financial difficulties of distributors and the emergence of alternative distribution channels. An increasing number of companies are competing for access to these channels. Our distributors typically represent other products that are complementary to, or compete with, our products. Our distributors are not contractually committed to future purchases of our products and could discontinue carrying our products at any time for any reason. In addition, because we are dependent on a small number of distributors for a significant portion of the sales of our products, the loss of any of our major distributors or their inability to satisfy their payment obligations to us could have a significant adverse effect on our business, operating results and financial condition. We have a stock rotation policy with certain of our distributors that allows them to return marketable inventory against offsetting orders. If we reduce our prices, we credit certain distributors for the difference between the purchase price of products remaining in their inventory and our reduced price for these products. In addition, inventory levels of our products held by distributors could become excessive due to industry conditions or the actions of competitors, resulting in product returns and inventory write-downs. 21 The market for our products is affected by rapidly changing technology and if we fail to predict and respond to customers' changing needs, our business, operating results and financial condition may suffer. The market for our products is affected by rapidly changing networking technology, evolving industry standards and the Internet and other new communication technologies. We believe that our future success will depend upon our ability to enhance our existing products and to identify, develop, manufacture and introduce new products that: o conform to or support emerging network telecommunications standards; o are compatible with a growing array of computer and peripheral devices; o support popular computer and network operating systems and applications; o meet a wide range of evolving user needs; and o achieve market acceptance. There can be no assurance that we will be successful in these efforts. We have incurred, and expect to continue to incur, substantial expenses associated with the introduction and promotion of new products. There can be no assurance that the expenses incurred will not exceed research and development cost estimates or that new products will achieve market acceptance and generate sales sufficient to offset development costs. In order to develop new products successfully, we are dependent upon timely access to information about new technological developments and standards. There can be no assurance that we will have such access or will be able to develop new products successfully and respond effectively to technological change or new product announcements by others. Complex products such as those offered by us may contain undetected or unresolved hardware defects or software errors when they are first introduced or as new versions are released. Changes in our or our suppliers' manufacturing processes or the inadvertent use of defective components could adversely affect our ability to achieve acceptable manufacturing yields and product reliability. We have in the past discovered hardware defects and software errors in certain of our new products and enhancements after their introduction. Replacement of discontinued components used in our products could lead to further defects and errors. There can be no assurance that despite testing by us and by third-party test sites, errors and defects will not be found in future releases of our products, which would result in adverse product reviews and negatively affect market acceptance of these products. The introduction of new or enhanced products requires us to manage the transition from the older products to the new or enhanced products or versions, both internally and for customers. We must manage new product introductions so as to minimize disruption in customer ordering patterns, avoid excessive levels of older product inventories and ensure that adequate supplies of new products can be delivered to meet customer demands. We have from time to time experienced delays in the shipment of new products. There can be no assurance that we will successfully manage future product transitions. Our success depends upon the continued contributions of our key management, marketing, product development and operational personnel. Our success will depend, to a large extent, upon our ability to retain and continue to attract highly skilled personnel in management, marketing, product development and operations. Competition for employees in the computer and electronics industries is intense, and there can be no assurance that we will be able to attract and retain enough qualified employees. Volatility or lack of positive performance in our stock price may also adversely affect our ability to retain and continue to attract key employees, many of whom have been granted stock options. Our inability to retain and attract key employees could 22 have a material adverse effect on our product development, business, operating results and financial condition. We do not carry key person life insurance with respect to any of our personnel. The markets for our products are highly competitive and may become more competitive in the future. The network enhancement products and computer software markets are highly competitive, and we believe that competition will intensify in the future. The competition is characterized by rapid change and improvements in technology along with constant pressure to reduce the prices of products. We currently compete principally in the market for network fax servers, network print servers and fax-on-demand software. Both direct and indirect competition could adversely affect our business and operating results through pricing pressure, loss of market share and other factors. In particular, we expect that, over time, average selling prices for our print server products will continue to decline, as the market for these products becomes increasingly competitive. Any material reduction in the average selling prices of our products would adversely affect gross margins. There can be no assurance we will be able to maintain the current average selling prices of our products or the related gross margins. The principal competitive factors affecting the market for our products include: o product functionality; o performance; o quality; o reliability; o ease of use; o quality of customer training and support; o name recognition; o price; and o compatibility and conformance with industry standards and changing operating system environments. Several of our existing and potential competitors have substantially greater financial, engineering, manufacturing and marketing resources than us. We also experience competition from a number of other software, hardware and service companies. In addition to our current competitors, we may face substantial competition from new entrants into the network enhancement market, including established and emerging computer, computer peripheral, communications and software companies. In the fax server market we compete with companies such as Captaris Inc., Omtool, Ltd. and Esker Software. There can be no assurance that competitors will not introduce products incorporating technology more advanced than the technology used by us in our products. In addition, certain competing methods of communications such as the Internet or electronic mail could adversely affect the market for fax products. Certain of our existing and potential competitors in the print server market are manufacturers of printers and other peripherals, and these competitors may develop closed systems accessible only through their own proprietary servers. There can be no assurance that we will be able to compete successfully or that competition will not have a material adverse effect on our business, operating results and financial condition. We depend on sales in foreign markets, and political or economic changes in these markets could affect our business, operating results and financial condition. Sales to customers located outside the United States accounted for approximately 18%, 19% and 21% of our net sales for the years ended December 31, 2004, 2003 and 2002, respectively. We sell our products in approximately 44 foreign countries through approximately 89 distributors. Our principal Japanese distributor accounted for approximately 39%, 38% and 27% of our international sales in 2004, 2003 and 2002, respectively, and 7%, 7% and 6% of our total net sales in 2004, 2003 and 2002, 23 respectively. We expect that international sales will continue to represent a significant portion of our product revenues and that we will be subject to the normal risks of international sales, such as export laws, currency fluctuations, longer payment cycles, greater difficulties in accounts receivable collections and the requirement of complying with a wide variety of foreign laws. There can be no assurance that we will not experience difficulties resulting from changes in foreign laws relating to the export of our products in the future. In addition, because we primarily invoice foreign sales in U.S. dollars, fluctuations in exchange rates could affect demand for our products by causing prices to be out of line with products priced in the local currency. Additionally, any such difficulties would have a material adverse effect on our international sales and a resulting material adverse effect on our business, operating results and financial condition. We may experience fluctuations in European sales on a quarterly basis because European sales may be weaker during the third quarter than the second quarter due to extended holiday shutdowns in July and August. There can be no assurance that we will be able to maintain the level of international sales in the future. Any fluctuations in international sales will significantly affect our operating results and financial condition. The introduction of new products may reduce the demand for our existing products and increase returns of existing products. From time to time, we may announce new products, product versions, capabilities or technologies that have the potential to replace or shorten the life cycles of existing products. The release of a new product or product version may result in the write-down of products in inventory if this inventory becomes obsolete. We have in the past experienced increased returns of a particular product version following the announcement of a planned release of a new version of that product. There can be no assurance that product returns will not exceed our allowance for these returns in the future and will not have a material adverse effect on our business, operating results and financial condition. If we fail to obtain components of our products from third-party suppliers and subcontractors, our business could suffer. Our products require components procured from third-party suppliers. Some of these components are available only from a single source or from limited sources. In addition, we subcontract a substantial portion of our manufacturing to third parties, and there can be no assurance that these subcontractors will be able to support our manufacturing requirements. We purchase components on a purchase order basis, and generally have no long-term contracts for these components. If we are unable to obtain a sufficient supply of high-quality components from our current sources, we could experience delays or reductions in product shipments. From time to time, component manufacturers announce the end of life of certain of their products and may or may not have replacement products. If we are unable to secure enough inventories of the end-of-life components or their replacements, we might not be able to deliver our products to our customers and could adversely affect our revenue and net income. Furthermore, a significant increase in the price of one or more of these components or our inability to lower component or sub-assembly prices in response to competitive price reductions could adversely affect our gross margin. We depend on proprietary technology, and inability to develop and protect this technology or license it from third parties could adversely affect our business, operating results and financial condition. Our success depends to a certain extent upon our technological expertise and proprietary software technology. We rely upon a combination of contractual rights and copyright, trademark and trade secret laws to establish and protect our technologies. Despite the precautions taken by us, it may be possible for unauthorized third parties to copy our products or to reverse engineer or obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries either do not protect our 24 proprietary rights or offer only limited protection. Given the rapid evolution of technology and uncertainties in intellectual property law in the United States and internationally, there can be no assurance that our current or future products will not be subject to third-party claims of infringement. Any litigation to determine the validity of any third-party claims could result in significant expense and divert the efforts our technical and management personnel, whether or not any litigation is determined in favor of us. In the event of an adverse result in litigation, we could be required to expend significant resources to develop non-infringing technology or to obtain licenses to the technology that is the subject of the litigation. There can be no assurance that we would be successful in this development or that any such licenses would be available on commercially reasonable terms. We also rely on technology licensed from third parties. There can be no assurance that these licenses will continue to be available upon reasonable terms, if at all. Any impairment or termination of our relationship with third-party licensors could have a material adverse effect on our business, operating results and financial condition. There can be no assurance that our precautions will be adequate to deter misappropriation or infringement of our proprietary technologies. We have received, and may receive in the future, communications asserting that our products infringe the proprietary rights of third parties or seeking indemnification against the alleged infringement. There can be no assurance that third parties will not assert infringement claims against us with respect to current or future products or that any assertion may not require us to enter into royalty arrangements or result in costly litigation. Any claims, with or without merit, can be time consuming and expensive to defend. There can be no assurance that any intellectual property litigation will not have a material adverse effect on our business, operating results and financial condition. Our common stock is listed on the Nasdaq SmallCap Market, and we have had difficulty satisfying the listing criteria to avoid the delisting of our common stock. Our common stock has been listed on the Nasdaq SmallCap Market since April 1999. In order to maintain our listing on the Nasdaq SmallCap Market, we must maintain total assets, capital and public float at specified levels, and our common stock generally must maintain a minimum bid price of $1.00 per share. If we fail to maintain the standards necessary to be quoted on the Nasdaq SmallCap Market, our common stock could become subject to delisting. There can be no assurance that we will be able to maintain the $1.00 minimum bid price per share of our common stock and thus maintain our listing on the Nasdaq SmallCap Market. We have traded below $1.00 as recently as December 2002. If our common stock is delisted, trading in our common stock could be conducted on the OTC Bulletin Board or in the over-the-counter market in what is commonly referred to as the "pink sheets." If this occurs, a shareholder will find it more difficult to dispose of our common stock or to obtain accurate quotations as to the price of our common stock. Lack of any active trading market would have an adverse effect on a shareholder's ability to liquidate an investment in our common stock easily and quickly at a reasonable price. It might also contribute to volatility in the market price of our common stock and could adversely affect our ability to raise additional equity or debt financing on acceptable terms or at all. Failure to obtain desired financing on acceptable terms could adversely affect our business, financial condition and results of operations. Our stock price has been volatile, and is likely to continue to be volatile in the future. The price of our common stock has fluctuated widely in the past. Sales of substantial amounts of our common stock, or the perception that sales could occur, could adversely affect prevailing market prices for our common stock. Our management believes past fluctuations may have been caused by the factors identified above, and that these factors may continue to affect the market price of our common stock. Additionally, stock markets have experienced extreme price volatility in recent years. This volatility has had a substantial effect on the market price of the common stock of us and other high 25 technology companies, often for reasons unrelated to operating performance. We anticipate that prices for our common stock may continue to be volatile. Future stock price volatility may result in the initiation of securities litigation against us, which may divert substantial management and financial resources and have an adverse effect on our business, operating results and financial condition. We may require additional capital in the future, and may be unable to obtain this capital at all or on commercially reasonable terms. The development and marketing of products requires significant amounts of capital. If we need additional capital resources, we may be required to sell additional equity or debt securities, secure additional lines of credit or obtain other third party financing. The timing and amount of such capital requirements cannot be determined at this time and will depend on a number of factors, including demand for our existing and new products and changes in technology in the networking industry. There can be no assurance that additional financing will be available on satisfactory terms when needed, if at all. Failure to raise such additional financing, if needed, may result in our inability to achieve our long-term business objectives. The issuance of equity or convertible debt securities to raise additional capital would result in additional dilution to our shareholders. Government regulation could increase our costs of doing business and adversely affect our gross margin. Certain aspects of the networking industry in which we compete are regulated both in the United States and in foreign countries. Imposition of public carrier tariffs, taxation of telecommunications services and the necessity of incurring substantial costs and expenditure of managerial resources to obtain regulatory approvals, or the inability to obtain regulatory approvals within a reasonable period of time, could have a material, adverse effect on our business, operating results and financial condition. This is particularly true in foreign countries where telecommunications standards differ from those in the United States. Our products must comply with a variety of equipment, interface and installation standards promulgated by communications regulatory authorities in different countries. Changes in government policies, regulations and interface standards could require the redesign of products and result in product shipment delays which could have a material, adverse impact on our business, operating results and financial condition. The costs of compliance with recent developments in corporate governance regulation may affect our business, operating results and financial condition in ways that presently cannot be predicted. Beginning with the enactment of the Sarbanes-Oxley Act of 2002, a significant number of new corporate governance requirements have been adopted or proposed through legislation and regulation by the Securities and Exchange Commission and Nasdaq National Stock Market. We may not be successful in complying with these requirements at all times in the future. Additionally, we expect these developments to increase our legal compliance and accounting costs, and to make some activities more difficult, such as stockholder approval of new stock option plans. We expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments could make it more difficult for us to attract and retain qualified members of our Board of Directors, or qualified executive officers. We are presently evaluating and monitoring regulatory developments and cannot estimate the timing or magnitude of additional costs we may incur as a result, or the effect that these increased costs may have on our operating results. 26 Recent terrorist activity in the United States and the military action to counter terrorism could adversely impact our business. Terrorist acts or acts of war (wherever located around the world) could significantly impact our revenue, costs and expenses, and financial condition. The terrorist attacks that took place in the United States on September 11, 2001 have created many economic and political uncertainties, some of which may materially harm our business, operating results and financial condition. The long-term effects on our business of the September 11, 2001 attacks and the ensuing war on terror are unknown. The potential for future terrorist attacks, the national and international responses to terrorist attacks or perceived threats to national security, and other actual or potential conflicts, acts of war or hostility, including the United States' activities in Iraq, have created many economic and political uncertainties that could adversely affect our business, operating results and financial condition in ways that cannot presently be predicted. Provisions in our charter documents might deter a company from acquiring us, which could inhibit your ability to receive an acquisition premium for your shares. Our Board of Directors has authority to issue shares of preferred stock and to fix the rights, including voting rights, of these shares without any further vote or action by the shareholders. The rights of the holders of our common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock, thereby delaying, deferring or preventing a change in control. Furthermore, such preferred stock may have other rights, including economic rights, senior to the common stock, and as a result, the issuance thereof could have a material adverse effect on the market. Voting control by officers, directors and affiliates may delay, defer or prevent a change of control. At July 25, 2005, our officers and directors and their affiliates beneficially owned approximately 24% of the outstanding shares of common stock. Accordingly, together they had the ability to significantly influence the election of our directors and other corporate actions requiring shareholder approval. Such concentration of ownership may have the effect of delaying, deferring or preventing a change in control. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK We had no holdings of derivative financial or commodity instruments at June 30, 2005. However, we are exposed to financial market risks, including changes in interest rates and foreign currency exchange rates. While much of our revenue is transacted in U.S. dollars, some revenues and capital spending are transacted in Pounds Sterling. These amounts are not currently material to our financial statements. Therefore, we believe that foreign currency exchange rates should not materially affect our overall financial position, results of operations or cash flows. The fair value of our money market accounts or related income would not be significantly impacted by increases or decreases in interest rates due mainly to the highly liquid nature of this investment. However, sharp declines in interest rates could seriously harm interest earnings. 27 ITEM 4. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures Regulations under the Securities Exchange Act of 1934 require public companies, including our company, to maintain "disclosure controls and procedures," which are defined to mean a company's controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. Our Chief Executive Officer and our Chief Financial Officer, based on their evaluation of our disclosure controls and procedures as of the end of the period covered by this report, concluded that our disclosure controls and procedures were effective for this purpose. Regulations under the Securities Exchange Act of 1934 require public companies, including our company, to evaluate any change in our "internal control over financial reporting," which is defined as a process to provide reasonable assurance regarding the reliability of financial reporting and preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States. In connection with their evaluation of our disclosure controls and procedures as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer did not identify any change in our internal control over financial reporting during the three-month period ended June 30, 2005 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and our management necessarily applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. 28 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS We held our Annual Meeting of Shareholders on May 27, 2005. At the meeting, our shareholders voted on the following two proposals and cast their votes as follows: Proposal 1: To elect the following nominees as directors:
Nominee For Withheld ---------------------------- ---------------- ----------------- Donald L. Rich 3,147,434 65,300 Scott C. McDonald 3,197,389 15,345 Peter R. Tierney 3,155,569 57,165 Robert H. Hambrecht 3,149,434 63,300 Robert O. Smith 3,204,523 8,211
Proposal 2: To ratify the appointment of Grant Thornton LLP as our independent registered public accounting firm for the 2005 fiscal year:
For Against Abstain --------------------- --------------------- -------------------- 3,193,934 17,200 1,600
ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS In accordance with SEC Release No. 33-8212, Exhibits 32.1 and 32.2 are to be treated as "accompanying" this report rather than "filed" as part of the report. 10.1 Amendment to Silicon Valley Bank Loan Agreement 31.1 Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer 31.2 Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer 32.1 Section 1350 Certification of Principal Executive Officer 32.2 Section 1350 Certification of Principal Financial Officer 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. CASTELLE By: /s/ Scott C. McDonald Date: August 5, 2005 Scott C. McDonald Chief Executive Officer and President (Principal Executive Officer) By: /s/ Paul Cheng Date: August 5, 2005 Paul Cheng Vice President of Finance and Administration Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) 30
EXHIBIT INDEX Exhibit Description Number - -------------------------------------------------------------------------------------------------- 10.1 Amendment to Silicon Valley Bank Loan Agreement 31.1 Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer 31.2 Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer 32.1 Section 1350 Certification of Principal Executive Officer 32.2 Section 1350 Certification of Principal Financial Officer
31 EX-10 2 cstl10q_2qex101.txt EXHIBIT 10.1 AMENDED LOAN AGREEMENT Exhibit 10.1 FIRST AMENDMENT TO LOAN AND SECURITY AGREEMENT This FIRST AMENDMENT to Loan and Security Agreement (this "Amendment") is entered into this 1st day of August, 2005, by and between Silicon Valley Bank ("Bank") and Castelle, a California corporation ("Borrower") whose address is 855 Jarvis Drive Suite 100, Morgan Hill, CA 95037. RECITALS A. Bank and Borrower have entered into that certain Loan and Security Agreement dated as of August 2, 2004 (as the same may from time to time be amended, modified, supplemented or restated, the "Loan Agreement"). Bank has extended credit to Borrower for the purposes permitted in the Loan Agreement. B. Bank has extended credit to Borrower for the purposes permitted in the Loan Agreement. C. Borrower has requested that Bank amend the Loan Agreement to (1) extend the maturity date and (2) waive the testing of deposit requirement covenant from April 1, 2005 through October 31, 2005. D. Bank has agreed to so amend certain provisions of the Loan Agreement, but only to the extent, in accordance with the terms, subject to the conditions and in reliance upon the representations and warranties set forth below. AGREEMENT NOW, THEREFORE, in consideration of the foregoing recitals and other good and valuable consideration, the receipt and adequacy of which is hereby acknowledged, and intending to be legally bound, the parties hereto agree as follows: 1. Definitions. Capitalized terms used but not defined in this Amendment shall have the meanings given to them in the Loan Agreement. 2. Amendments to Loan Agreement. 2.1 Section 2.3 (Interest Rate, Payments). Section 2.3(b) is amended in part to provide that interest due on the Committed Revolving Line is payable on the last day of each month. 2.2 Section 6.6 (Primary Accounts). Notwithstanding anything to the contrary set forth in Section 6.6, Borrower shall not be required to be in compliance with the deposit requirement covenant from April 1, 2005 through October 31, 2005. E-1 2.3 Section 13 (Definitions). The following term and its respective definition set forth in Section 13.1 is amended in its entirety and replaced with the following: "Revolving Maturity Date" is July 31, 2006. 3. Limitation of Amendments. 3.1 The amendments set forth in Section 2, above, are effective for the purposes set forth herein and shall be limited precisely as written and shall not be deemed to (a) be a consent to any amendment, waiver or modification of any other term or condition of any Loan Document, or (b) otherwise prejudice any right or remedy which Bank may now have or may have in the future under or in connection with any Loan Document. 3.2 This Amendment shall be construed in connection with and as part of the Loan Documents and all terms, conditions, representations, warranties, covenants and agreements set forth in the Loan Documents, except as herein amended, are hereby ratified and confirmed and shall remain in full force and effect. 4. Representations and Warranties. To induce Bank to enter into this Amendment, Borrower hereby represents and warrants to Bank as follows: 4.1 Immediately after giving effect to this Amendment (a) the representations and warranties contained in the Loan Documents are true, accurate and complete in all material respects as of the date hereof (except to the extent such representations and warranties relate to an earlier date, in which case they are true and correct as of such date), and (b) no Event of Default has occurred and is continuing; 4.2 Borrower has the power and authority to execute and deliver this Amendment and to perform its obligations under the Loan Agreement, as amended by this Amendment; 4.3 The organizational documents of Borrower delivered to Bank on the Effective Date remain true, accurate and complete and have not been amended, supplemented or restated and are and continue to be in full force and effect; 4.4 The execution and delivery by Borrower of this Amendment and the performance by Borrower of its obligations under the Loan Agreement, as amended by this Amendment, have been duly authorized; 4.5 The execution and delivery by Borrower of this Amendment and the performance by Borrower of its obligations under the Loan Agreement, as amended by this Amendment, do not and will not contravene (a) any law or regulation binding on or affecting Borrower, (b) any contractual restriction with a Person binding on Borrower, (c) any order, judgment or decree of any court or other governmental or public body or authority, or subdivision thereof, binding on Borrower, or (d) the organizational documents of Borrower; E-2 4.6 The execution and delivery by Borrower of this Amendment and the performance by Borrower of its obligations under the Loan Agreement, as amended by this Amendment, do not require any order, consent, approval, license, authorization or validation of, or filing, recording or registration with, or exemption by any governmental or public body or authority, or subdivision thereof, binding on either Borrower, except as already has been obtained or made; and 4.7 This Amendment has been duly executed and delivered by Borrower and is the binding obligation of Borrower, enforceable against Borrower in accordance with its terms, except as such enforceability may be limited by bankruptcy, insolvency, reorganization, liquidation, moratorium or other similar laws of general application and equitable principles relating to or affecting creditors' rights. 5. Counterparts. This Amendment may be executed in any number of counterparts and all of such counterparts taken together shall be deemed to constitute one and the same instrument. 6. Effectiveness. This Amendment shall be deemed effective upon (a) the due execution and delivery to Bank of this Amendment by each party hereto and (b) Borrower's payment of an amendment fee in an amount equal to $4,000. IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be duly executed and delivered as of the date first written above. BANK BORROWER SILICON VALLEY BANK CASTELLE By: ________________________ By: _________________________ Name: ________________________ Name: _________________________ Title: ________________________ Title:_________________________ E-3 EX-31 3 cstl10q_2qex311.txt EXHIBIT 31.1 RULE 13A-14(A)/15D-14(A) CERT EXHIBIT 31.1 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO EXCHANGE ACT RULE 13A-14(A)/15D-14(A) AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, SCOTT C. MCDONALD, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Castelle; 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(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our 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 the registrant's most recent fiscal quarter (the registrant's fourth fiscal 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(s) and I have disclosed, based on our most recent evaluation of internal control 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: August 05, 2005 By: /s/ Scott C. McDonald Scott C. McDonald Chief Executive Officer and President (Principal Executive Officer) E-4 EX-31 4 cstl10q_2qex312.txt EXHIBIT 31.2 RULE 13A-14(A)/15D-14(A) CERT EXHIBIT 31.2 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO EXCHANGE ACT RULE 13A-14(A)/15D-14(A) AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, PAUL CHENG, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Castelle; 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(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our 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 the registrant's most recent fiscal quarter (the registrant's fourth fiscal 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(s) and I have disclosed, based on our most recent evaluation of internal control 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: August 05, 2005 By: /s/ Paul Cheng Paul Cheng Chief Financial Officer (Principal Financial Officer) E-5 EX-32 5 cstl10q_2qex321.txt EXHIBIT 32.2 SECTION 1350 CERTIFICATION EXHIBIT 32.1 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Castelle (the "Company") on Form 10-Q for the period ended June 30, 2005, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Scott C. McDonald, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge: (1) The Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Scott C. McDonald Name: Scott C. McDonald Title: Chief Executive Officer and President (Principal Executive Officer) Date: August 05, 2005 This certification accompanies this report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed to be filed by Castelle for purposes of Section 18 of the Securities Exchange Act of 1934. E-6 EX-32 6 cstl10q_2qex322.txt EXHIBIT 32.2 SECTION 1350 CERTIFICATION EXHIBIT 32.2 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Castelle (the "Company") on Form 10-Q for the period ended June 30, 2005, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Paul Cheng, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge: (1) The Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Paul Cheng Name: Paul Cheng Title: Chief Financial Officer (Principal Financial Officer) Date: August 05, 2005 This certification accompanies this report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed to be filed by Castelle for purposes of Section 18 of the Securities Exchange Act of 1934. 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