10-Q 1 d51497_10-q.txt 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, 2002 |_| 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, CA 95037 (Address of principal executive offices, including zip code) (408) 852-8000 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, NO PAR VALUE 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 the Registrant's Common Stock outstanding as of August 2, 2002 was 4,754,795. CASTELLE FORM 10-Q TABLE OF CONTENTS PAGE SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS 2 PART I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements: 3 Condensed Consolidated Balance Sheets 3 Condensed Consolidated Statements of Operations 4 Condensed Consolidated Statements of Cash Flows 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3. Quantitative and Qualitative Disclosure About Market Risk 22 PART II. OTHER INFORMATION Item 1. Legal Proceedings 23 Item 2. Changes in Securities and Use of Proceeds 23 Item 3. Defaults Upon Senior Securities 23 Item 4. Submission of Matters to a Vote of Security Holders 23 Item 5. Other Information 23 Item 6. Exhibits and Reports on Form 8-K 23 Signatures 24 Exhibit 99.1 - Certification pursuant to Section 906 of the Public Company Accounting Reform and Investor Protection Act of 2002 (18 U.S.C.ss. 1350, as adopted) E-1 Exhibit 99.2 - Press Release dated July 29, 2002 E-2 1 SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS This document contains forward-looking statements that involve risks and uncertainties. The Company's operating results may vary significantly from quarter to quarter due to a variety of factors, including changes in the Company's product and customer mix, constraints in the Company's manufacturing and assembling operations, shortages or increases in the prices of raw materials and components, changes in pricing policy by the Company or its 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 the Company assumes 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" in the Company's Annual Report on Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2001. 2 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CASTELLE CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) (Unaudited)
June 30, 2002 December 31, 2001 ------------- ----------------- Assets: Current assets: Cash and cash equivalents $ 4,311 $ 4,568 Accounts receivable, net of allowances for doubtful accounts of $189 in 2002 and $206 in 2001 649 680 Inventories, net 842 926 Prepaid expense and other current assets 121 130 ---------- ---------- Total current assets 5,923 6,304 Property, plant & equipment, net 510 598 Other assets, net 108 108 ---------- ---------- Total assets $ 6,541 $ 7,010 ========== ========== Liabilities and Shareholders' Equity: Current liabilities: Long-term debt, current portion $ 19 $ 18 Accounts payable 149 280 Accrued liabilities 2,019 2,446 ---------- ---------- Total current liabilities 2,187 2,744 Long-term debt, net of current portion 55 64 ---------- ---------- Total liabilities 2,242 2,808 Shareholders' equity: Common stock, no par value: Authorized: 25,000 shares Issued and outstanding: 4,755 and 4,745, respectively 28,980 28,977 Deferred compensation (1) (1) Accumulated deficit (24,680) (24,774) ---------- ---------- Total shareholders' equity 4,299 4,202 ---------- ---------- Total liabilities and shareholders' equity $ 6,541 $ 7,010 ========== ==========
See accompanying notes to condensed consolidated financial statements. 3 CASTELLE CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) (Unaudited)
Three months ended Six months ended ------------------------------ ------------------------------- June 30, 2002 June 29, 2001 June 30, 2002 June 29, 2001 ------------- ------------- ------------- ------------- Net sales $ 2,261 $ 2,313 $ 4,629 $ 4,606 Cost of sales 669 842 1,446 1,540 ------------- ------------- ------------- ------------- Gross profit 1,592 1,471 3,183 3,066 ------------- ------------- ------------- ------------- Operating expenses: Research and development 349 481 762 866 Sales and marketing 780 982 1,543 2,052 General and administrative 450 255 854 699 Restructuring charges (40) 58 (40) 238 ------------- ------------- ------------- ------------- Total operating expenses 1,539 1,776 3,119 3,855 ------------- ------------- ------------- ------------- Income (loss) from operations 53 (305) 64 (789) Interest income, net 12 25 22 58 Other income (expense), net (3) 12 8 55 ------------- ------------- ------------- ------------- Income (loss) before provision for income taxes 62 (268) 94 (676) Provision for income taxes -- -- -- -- ------------- ------------- ------------- ------------- Net income (loss) $ 62 $ (268) $ 94 $ (676) ============= ============= ============= ============= Income (loss) per share: Net income (loss) per common share - basic $ 0.01 $ (0.06) $ 0.02 $ (0.14) Shares used in per share calculation - basic 4,749 4,744 4,747 4,742 Net income (loss) per common share - diluted $ 0.01 $ (0.06) $ 0.02 $ (0.14) Shares used in per share calculation - diluted 4,765 4,744 4,769 4,742
See accompanying notes to condensed consolidated financial statements. 4 CASTELLE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (Unaudited)
Six months ended ------------------------------- June 30, 2002 June 29, 2001 ------------- ------------- Cash flows from operating activities: Net income (loss) $ 94 $ (676) Adjustment to reconcile net income (loss) to net cash used in operating activities: Loss on disposal of fixed assets 1 9 Depreciation and amortization 108 144 Provision for doubtful accounts and sales returns 81 52 Provision for excess and obsolete inventory (79) 89 Compensation expense related to grant of stock options -- 4 Changes in assets and liabilities: Accounts receivable (50) 839 Inventories 163 (313) Prepaid expenses and other current assets 9 (161) Other assets -- 9 Accounts payable (131) (192) Accrued liabilities (427) (151) ------------- ------------- Net cash used in operating activities (231) (347) ------------- ------------- Cash flows from investing activities: Return of restricted cash -- 125 Purchase of property and equipment (21) (66) ------------- ------------- Net cash provided by (used in) investing activities (21) 59 ------------- ------------- Cash flows from financing activities: Repayment of long-term debt (8) (5) Proceeds from issuances of common stock, net of repurchases 3 -- ------------- ------------- Net cash used in financing activities (5) (5) ------------- ------------- Net decrease in cash and cash equivalents (257) (293) Cash and cash equivalents at beginning of period 4,568 3,893 ------------- ------------- Cash and cash equivalents at end of period $ 4,311 $ 3,600 ============= =============
See accompanying notes to condensed consolidated financial statements. 5 CASTELLE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Basis of Presentation and Significant Accounting Policies: The accompanying unaudited condensed consolidated financial statements include the accounts of Castelle and its wholly-owned subsidiaries in the United Kingdom and The Netherlands, and 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 the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the Company's 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 unaudited 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 and Form 10-K/A for the fiscal year-ended December 31, 2001. The December 31, 2001 condensed balance sheet data 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 statements of operations for the periods presented are not necessarily indicative of results that we expect for any future period, nor for the entire year. Certain prior year amounts have been reclassified to conform with the current presentation. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company believes that its existing cash balances, anticipated cash flows from operations and available lines of credit will be sufficient to meet its anticipated capital requirements for the next 12 months. However, a decline in future orders and revenues might require us to seek additional capital to meet our working capital needs during or beyond the next 12 months if we are unable to reduce expenses to the degree necessary to avoid incurring negative operating cash flow. 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 the Company's 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. 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 the Company is dependent on a small number of distributors for a significant portion of the sales of its products, the loss of any of the Company's major distributors or their inability to satisfy their payment obligations to the Company could have a significant adverse effect on the Company's business, operating results and financial condition. Revenue Recognition Castelle recognizes revenue based on the provisions of Staff Accounting Bulletin ("SAB") No. 101 "Revenue Recognition in Financial Statements" and Statement of Financial Accounting Standards ("SFAS") No. 48 "Revenue Recognition When Right of Return Exists." 6 Product revenue is recognized upon shipment if persuasive evidence of an arrangement exists, the fee is fixed and determinable, collection of the resulting receivables is probable and product returns are reasonably estimable. Shipment generally occurs when product is delivered to a common carrier. The Company enters into agreements with certain of its distributors which permit limited stock rotation rights. These stock rotation rights allow the distributor to return products for credit but require the purchase of additional products of equal value. Customers who purchase products directly from Castelle also have limited return rights, which expire 30 days from the date of product shipment. Revenues subject to stock rotation rights are reduced by management's estimates of anticipated exchanges. Castelle establishes its returns allowance for distributors and direct customers based on historic return rates from these customers. Pursuant to the Company's distributor agreements, the Company also protects its distributors' exposure related to the impact of price reductions. Price adjustments are recorded at the time products are shipped. The Company recognizes revenue from support or maintenance contracts, including extended warranty programs and post contract support, ratably over the period of the contract. Castelle recognizes royalties on the sale of LANpress products by a Japanese distributor. Royalties are not recognized as revenue until the products are sold by the distributor. Provisions for estimated warranty costs are recorded at the time products are shipped. 2. Accounting Changes Effective January 1, 2002, Castelle has redefined its fiscal quarter and year end for financial reporting purposes to conform with calendar month ends, i.e., ending on March 31, June 30, September 30 and December 31. Previously, Castelle set its fiscal quarter as ending on the Friday of the thirteenth week into the quarter. The results of this change did not have a significant impact on The Company's financial position, results of operations or cash flows for the 2002 periods presented herein. Effective January 1, 2002, Castelle implemented Emerging Issues Task Force No. 01-9, "Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products)" ("EITF 01-9"), which presumes consideration from a vendor to a customer or reseller of the vendor's products to be a reduction of the selling prices of the vendor's products which, therefore, should be characterized as a reduction of revenue when recognized in the vendor's income statement and could lead to negative revenue under certain circumstances. Revenue reduction is required unless consideration relates to a separate identifiable benefit and the benefit's fair value can be established. Since Castelle was unable to clearly separate the benefits received from certain marketing development funds it paid to its resellers, these costs have been reclassified as a reduction of sales, and the financial statements for prior periods presented for comparative purposes have been reclassified to comply with the new accounting standard. The effect of the implementation of this new accounting standard was a reduction of sales of $45,000 and $133,000 in the three and six months ended June 30, 2002, respectively, with an equivalent reduction in operating expenses. This compares to a reduction in sales of $57,000 and $113,000 in the three and six months ended June 29, 2001, respectively, with an equivalent reduction in operating expenses. The new accounting standard has no impact on the Company's operating margin, net income or earnings per share. The table below reflects the impact of this new accounting standard on fiscal 2001 revenues. 7
2001 SALES - RESTATED FOR EITF 01-9 (in thousands, unaudited) QUARTER ENDED Mar 30 Jun 29 Sep 28 Dec 31 TOTAL YEAR -------------- ------------ ------------ ------------- ---------------- Original $2,349 $2,370 $2,559 $2,342 $9,620 Restated $2,293 $2,313 $2,500 $2,248 $9,354 Difference ($56) ($57) ($59) ($94) ($266)
3. Income (loss) Per Share Basic net income (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding for that 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 loss per share excludes shares that are potentially dilutive as their effect is anti-dilutive. Shares that are potentially dilutive to the Company's basic income per share consist of incremental shares of common stock issuable upon exercise of stock options and warrants. Basic and diluted earnings per share are calculated as follows for the second quarter and first six months of 2002 and 2001, respectively:
(in thousands, except per share amounts) ----------------------------------------------------- (Unaudited) ----------------------------------------------------- Three months ended Six months ended ------------------------ ------------------------ June 30, June 29, June 30, June 29, 2002 2001 2002 2001 ---------- ---------- ---------- ---------- Basic: Weighted average common shares outstanding 4,749 4,744 4,747 4,742 ========== ========== ========== ========== Net income (loss) $ 62 $ (268) $ 94 $ (676) ========== ========== ========== ========== Net income (loss) per common share - basic $ 0.01 $ (0.06) $ 0.02 $ (0.14) ========== ========== ========== ========== Diluted: Weighted average common shares outstanding 4,749 4,744 4,747 4,742 Common equivalent shares from stock options and warrants 16 -- 22 -- ---------- ---------- ---------- ---------- Shares used in per share calculation - diluted 4,765 4,744 4,769 4,742 ========== ========== ========== ========== Net income (loss) $ 62 $ (268) $ 94 $ (676) ========== ========== ========== ========== Net income (loss) per common share - diluted $ 0.01 $ (0.06) $ 0.02 $ (0.14) ========== ========== ========== ==========
The calculation of diluted shares outstanding for the three months ended June 29, 2001 excludes options to purchase 1,327,089 shares of the Company's common stock, as their effect was antidilutive in the period. The calculation of diluted shares outstanding for the six months ended June 29, 2001, excludes options to purchase 1,319,089 shares of the Company's common stock, as their effect was antidilutive in the period. 4. Inventories: Inventories are stated at the lower of standard cost (which approximates cost on a first-in, first-out basis) or market and net of reserves for excess and obsolete inventory. Inventory details are as follows (in thousands): 8
(Unaudited) June 30, 2002 December 31,2001 ------------- ---------------- Raw material $ 178 $ 283 Work in process 229 182 Finished goods 435 461 -------- -------- Total inventories $ 842 $ 926 ======== ========
5. Segment Disclosure and Geographic Information: The Company has determined that it operates in one segment. Revenues by geographic area are determined by the location of the customer and are summarized as follows (in thousands): (Unaudited) --------------------------------------------- Three months ended Six months ended -------------------- -------------------- June 30, June 29, June 30, June 29, 2002 2001 2002 2001 -------- -------- -------- -------- Americas $ 1,841 $ 1,796 $ 3,819 $ 3,565 Europe 172 158 404 542 Pacific Rim 248 359 406 499 -------- -------- -------- -------- Total Revenues $ 2,261 $ 2,313 $ 4,629 $ 4,606 ======== ======== ======== ======== 6. Comprehensive Income: Under Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income," disclosure of comprehensive income and its components is required in financial statements. 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, and therefore, no separate statement of comprehensive income has been presented. 7. Restructuring: In April 2001, the Company terminated 17 regular, temporary and contractor positions, which at the time, constituted approximately 25% of its workforce. This action resulted in a severance charge of $58,000 in the second quarter of fiscal 2001. This severance charge was in addition to the restructuring charge of $180,000 recorded in the first quarter of fiscal 2001, which included an asset write-off and other direct expenses associated with the consolidation of our operations in the United Kingdom and El Dorado Hills, California. In the second quarter of fiscal 2002, a non-recurring benefit of $40,000 arising from the reversal of previously recorded restructuring charges was included in the results of operations, following the completion of the Company's 2001 restructuring programs for less than previously anticipated. 8. Commitments and contingencies: The Company has been contacted by a third party claiming that the Company needs to obtain licenses of certain patents held by that party for certain of the Company's fax server products. The Company is continuing to assess the validity and strength of the claims, believes it has adequate legal defenses and that the ultimate outcome of any possible action will not have a material effect on the Company's financial position, results of operations or cash flows although there can be no assurance as to the outcome of any possible litigation. 9 From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of its business activities. The Company accrues contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. No estimate of the amount of any potential loss upon resolution of these matters can be made at this time. However, depending of the amount and timing of such resolution, an unfavorable resolution of some or all of these matters could materially affect the Company's financial position 9. New Accounting Pronouncements: In April 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections". SFAS No. 145 rescinds Statement 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in APB Opinion 30 will now be used to classify those gains and losses. SFAS 145 also amends Statement 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. The Company does not believe that the adoption of this statement will have a material impact on its results of operations, financial position or cash flows. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 eliminates the definition and requirement for recognition of exit costs in Emerging Issues Task Force Issue No. 94-3 where a liability for an exit cost was recognized at the date of an entity's commitment to an exit plan. This statement is effective for exit or disposal activities initiated after December 31, 2002. The Company does not believe that the adoption of this statement will have a material impact on its results of operations, financial position or cash flows. 10 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" at the front on this Form 10-Q. The following discussion should be read in conjunction with the Financial Statements and the Notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and in the Company's Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2001. Critical Accounting Policies Castelle's financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles 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 Castelle include revenue recognition; credit, collection and allowances for doubtful accounts; inventories and related allowance for obsolete and excess inventory, which are discussed in more detail in Item 7, "Management's Discussion and Analysis of Financial Conditions and Results of Operations," and Note 2 of "Notes to Consolidated Financial Statements" in the Company's Annual Report on Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2001. Consolidated Statements of Operations - As a Percentage of Net Sales
(Unaudited) Three months ended Six months ended -------------------------------- -------------------------------- June 30, 2002 June 29, 2001 June 30, 2002 June 29, 2001 ------------- ------------- ------------- ------------- Net sales 100% 100% 100% 100% Cost of sales 30% 36% 31% 33% ------------- ------------- ------------- ------------- Gross profit 70% 64% 69% 67% ------------- ------------- ------------- ------------- Operating expenses: Research and development 15% 21% 17% 19% Sales and marketing 35% 42% 33% 45% General and administrative 20% 11% 19% 15% Restructuring charges (2%) 3% (1%) 5% ------------- ------------- ------------- ------------- Total operating expenses 68% 77% 68% 84% ------------- ------------- ------------- ------------- Income (loss) from operations 2% (13%) 1% (17%) Interest income, net 1% 1% 1% 1% Other income, net * * * 1% ------------- ------------- ------------- ------------- Income (loss) before provision for income taxes 3% (12%) 2% (15%) Provision for income taxes -- -- -- * ------------- ------------- ------------- ------------- Net income (loss) 3% (12%) 2% (15%) ============= ============= ============= =============
* Less than 1% 11 Results of Operations Net Sales Net sales for the second quarter of fiscal 2002 were $2.3 million, as compared to $2.3 million for the same period in fiscal 2001. Net sales for first the six months of fiscal 2002 were $4.6 million, as compared to $4.6 million for the same period in fiscal 2001. Domestic sales in the second quarter of fiscal 2002 were $1.8 million, or 81% of total net sales, as compared to $1.8 million, or 78% of total net sales, in the same period in fiscal 2001. For the first six months of fiscal 2002, domestic sales were $3.8 million, or 83% of total net sales, an increase of $254,000 as compared to $3.6 million, or 77% of total net sales, in fiscal 2001, primarily due to higher sales in the FaxPress fax server products. International sales in the second quarter of fiscal 2002 decreased to $420,000 from $517,000 for the same period in fiscal 2001, representing 19% and 22%, respectively, of total net sales. International sales for the first six months of fiscal 2002 and 2001 were $810,000 and $1.0 million, representing 17% and 23%, respectively, of total net sales. These declines in international sales were mainly the result of reduced demand for our print server products in the Asia Pacific region. Cost of Sales; Gross Profit Gross profit increased to $1.6 million, or 70% of net sales, for the second quarter of fiscal 2002, as compared to $1.5 million, or 64% of net sales, for the same period in fiscal 2001. The improvement was primarily due to the mix of products sold and product cost reductions. Gross profits for the first six months of fiscal 2002 and 2001 were $3.2 million, or 69% of net sales and $3.1 million, or 67% of net sales, respectively. The increase in gross profit for the six months of fiscal 2002 was primarily due to higher sales of our fax server products, which carry higher gross margins. The reduction in gross profit as a percentage of sales resulting from the implementation of EITF No. 01-9 was insignificant for the three and six month periods ended June 30, 2002 and June 29, 2001. Research & Development Research and product development expenses were $349,000, or 15% of net sales, for the second quarter of fiscal 2002, as compared to $481,000, or 21% of net sales, for the same period in fiscal 2001, due to decreases in outside consulting expenses of $50,000 and other support costs of $74,000. Research and product development expenses for the first six months of fiscal 2002 were $762,000, or 17% of net sales, as compared to $866,000, or 19% of net sales, for the same period in fiscal 2001. This reduction of $104,000 in the six-month period was primarily due to decreases in outside consulting expenses of $70,000 and other support costs of $116,000, offset in part by higher compensation costs of $92,000. Sales & Marketing Sales and marketing expenses were $780,000, or 35% of net sales, for the second quarter of fiscal 2002, as compared to $982,000, or 42% of net sales, for the same period in fiscal 2001. The reduction of $202,000 was primarily attributable to reduced payroll and related costs. For the first six months of fiscal 2002, sales and marketing expenses were $1.5 million, or 33% of 12 net sales, as compared to $2.1 million, or 45% of net sales, for the same period in fiscal 2001. This reduction of sales and marketing spending by $509,000 was primarily due to lower compensation and other payroll related expenses of $331,000 and reduced promotional expenses of $178,000. General & Administrative General and administrative expenses were $450,000, or 20% of net sales, for the second quarter of fiscal 2002, as compared to $255,000, or 11% of net sales, for the same period in fiscal 2001. The increase in general and administrative expenses in the second quarter of fiscal 2002 was principally due to the increase in legal and accounting fees of $44,000, outside consulting expenses of $53,000 and the absence of benefit obtained from the collection of previously written-off bad debts during the quarter ended June 29, 2001. General and administrative expenses for the first six months of fiscal 2002 were $854,000, or 18% of net sales, as compared to $699,000, or 15% of net sales for the same period in fiscal 2001. The increase in general and administrative expenses of $155,000 was primarily due to higher legal and accounting expenses of $69,000, an increase in the allowance for doubtful accounts from customers of $40,000 and an increase in outside consulting expenses of $53,000. Restructuring In April 2001, we terminated 17 regular, temporary and contractor positions, which constituted approximately 25% of our workforce. This action resulted in a severance charge of $58,000 in the second quarter of fiscal 2001. This severance charge is in addition to the restructuring charge of $180,000 recorded in the first quarter of fiscal 2001, which included an asset write-off and other direct expenses associated with the consolidation of our operations in the United Kingdom and El Dorado Hills, California. In the second quarter of fiscal 2002, a non-recurring benefit of $40,000 arising from the reversal of previously recorded restructuring charges was included in the results of operations, following the completion of the Company's 2001 restructuring programs for less than previously anticipated. Liquidity and Capital Resources As of June 30, 2002, we had approximately $4.3 million of cash and cash equivalents, as compared to $4.6 million at December 31, 2001. The decrease in cash and cash equivalents of $257,000 was primarily due to employees cashing out unused vacation of $140,000 and the payment of $105,000 of incentive compensation earned in fiscal 2001 and the first quarter of fiscal 2002 to our former Chief Executive Officer who retired in April 2002. The Company leases its corporate headquarters in Morgan Hill, California. The lease on the Morgan Hill facility has an initial term of five years, expiring in December 2005, with one conditional three-year option, which if exercised, would extend the lease to December 2008 commencing with rent at 95% of fair market value. As of June 30, 2002, the future minimum payments under the lease were approximately $917,000. In December 2000, as a source of capital asset financing, we entered into a loan and security agreement with a finance company for an amount of $75,000. This loan is subject to interest of 12.8% per annum and is repayable by December 2006. As of June 30, 2002, the future minimum payments were $77,000. In April 2001, as a source of capital asset financing, we entered into a loan and security agreement with a finance company for an amount of $25,000. This loan is subject to interest of 12.5% per annum and is repayable by April 2004. As of June 30, 2002, the future minimum payments were $17,000. 13 In addition to the commitments shown above, we have a $3.0 million collateralized revolving line of credit with a bank, which expires in March 2003, pursuant to which we may borrow 100% against pledges of cash at the bank's prime rate. Borrowings under this line of credit agreement are collateralized by all of our assets. We are in compliance with the terms of the agreement, and as of June 30, 2002, had no borrowings under the line of credit. As of June 30, 2002, net accounts receivable were $649,000, down from $680,000 at December 31, 2001. The decrease in net accounts receivable was largely attributable to improved collection of outstanding balances in the first six months of fiscal 2002. Net inventory as of June 30, 2002 was $842,000, a decrease from the $926,000 at December 31, 2001. The lower inventory was primarily due to more components being used in production than purchases in the same period. Although we believe that our existing capital resources, anticipated cash flows from operations and available lines of credit will be sufficient to meet our capital requirements for at least the next 12 months, we may be required to seek additional equity or debt financing. The timing and amount of such additional 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 the pace of technological change in the networking industry. There can be no assurance that such additional financing will be available on satisfactory terms when needed, if at all. We believe that, for the periods presented, inflation has not had a material effect on our operations. New Accounting Pronouncements: In April 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections". SFAS No. 145 rescinds Statement 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in APB Opinion 30 will now be used to classify those gains and losses. SFAS 145 also amends Statement 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. The Company does not believe that the adoption of this statement will have a material impact on its results of operations, financial position or cash flows. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 eliminates the definition and requirement for recognition of exit costs in Emerging Issues Task Force Issue No. 94-3 where a liability for an exit cost was recognized at the date of an entity's commitment to an exit plan. This statement is effective for exit or disposal activities initiated after December 31, 2002. The Company does not believe that the adoption of this statement will have a material impact on its results of operations, financial position or cash flows. 14 RISK FACTORS The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties not presently known to the Company or that the Company currently deems immaterial also may impair the Company's business operations. If any of the following risks or such other risks actually occur, our business could be adversely affected. Fluctuations in Operating Results The Company's revenue and operating results have fluctuated in the past and the Company's future revenues and operating results are likely to fluctuate significantly in the future, particularly on a quarterly basis. The Company's operating results may vary significantly from quarter to quarter due to a variety of factors, some of which are outside the control of the Company, including changes in the Company's product and customer mix, constraints in the Company's manufacturing and assembling operations, shortages or increases in the prices of raw materials and components, changes in pricing policy by the Company or its competitors, a slowdown in the growth of the networking market, seasonality, timing of expenditures and economic conditions in the United States, Europe and Asia. The Company's sales will often reflect orders shipped in the same quarter in which they are received. The Company's backlog at any given time is not necessarily indicative of actual sales for any succeeding period. In addition, significant portions of the Company's expenses are relatively fixed in nature, and planned expenditures are based primarily on sales forecasts. Therefore, if the Company inaccurately forecasts demand for its products, the impact on net income may be magnified by the Company's inability to adjust spending quickly enough to compensate for the net sales shortfall. Other factors contributing to fluctuations in the Company's quarterly operating results include changes in the demand for the Company's products, customer order deferrals in anticipation of new versions of the Company's products, the introduction of new products and product enhancements by the Company or its competitors, the effects of filling the distribution channels following such introductions, potential delays in the availability of announced or anticipated products, the mix of product revenue, the commencement or conclusion of significant development projects, changes in foreign currency exchange rates, the timing of acquisitions and associated costs, and the timing of significant marketing and sales promotions. Based on the foregoing, the Company believes that quarterly operating results are likely to vary significantly in the future and that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be viewed upon as indications of future performance. History of Losses; Accumulated Deficit The Company has experienced significant operating losses and, as of June 30, 2002, had an accumulated deficit of $24.7 million. The development and marketing by the Company of its current and new products will continue to require substantial expenditures. There can be no assurance that growth in net sales or profitability will be achieved or sustained in future years. Related risk factors are discussed elsewhere in the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Quarterly Report on Form 10-Q and in the Annual Report on Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2001. Nasdaq SmallCap Listing; Risk associated with Limited Market The Company's Common Stock has been listed on the Nasdaq SmallCap Market since April 1999. In order to maintain its listing on the Nasdaq SmallCap Market, the Company must maintain total assets, capital and public float at specified levels and generally must maintain a minimum bid 15 price of $1.00 per share. If the Company fails to maintain the standard necessary to be quoted on the Nasdaq SmallCap Market, the Company's Common Stock could become subject to delisting. On March 12, 2002, the Company received a notice from the Nasdaq Stock Market that its common stock had failed to maintain the minimum bid price of $1.00 per share required for continued listing on the Nasdaq SmallCap Market. If the Company's Common Stock fails to meet the $1.00 bid price per share for a minimum of ten consecutive trading days prior to September 9, 2002, the Company's Common Stock will be delisted from the Nasdaq SmallCap Market. If the Common Stock is delisted, trading in the 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 the Common Stock or to obtain accurate quotations as to the price of the Common Stock. Lack of any active trading market would have an adverse effect on a shareholder's ability to liquidate an investment in the Company's Common Stock easily and quickly at a reasonable price. It might also contribute to volatility in the market price of the Company's Common Stock and could adversely affect the Company's 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 the Company's business, financial condition and results of operations. Rapid Technological Change; Risks Associated with New Products The market for the Company's products is affected by rapidly changing networking technology, evolving industry standards, increasing internet usage and the emergence of other new communication technologies. The Company believes that its future success will depend upon its ability to enhance its existing products and to identify, develop, manufacture and introduce new products which conform to or support emerging network telecommunications standards, are compatible with a growing array of computer and peripheral devices, support popular computer and network operating systems and applications, meet a wide range of evolving user needs and achieve market acceptance. There can be no assurance that the Company will be successful in these efforts. The Company has incurred, and the Company expects 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, the Company is dependent upon timely access to information about new technological developments and standards. There can be no assurance that the Company will have such access or that it will be able to develop new products successfully and respond effectively to technological change or new product announcements by others. Furthermore, the Company expects that printer and other peripheral manufacturers will add features to their products that make them more network accessible, which may reduce demand for the Company's print servers. There can be no assurance that products or technologies developed by others will not render the Company's products non-competitive or obsolete. The fax-on-demand market in general has been negatively affected by the growth of the Internet. Although the Company has new Web/fax/email products in development, there can be no assurance these products will compete successfully. Complex products such as those offered by the Company may contain undetected or unresolved hardware defects or software errors when they are first introduced or as new versions are released. Changes in the Company's or its suppliers' manufacturing processes or the inadvertent use of defective components by the Company or its suppliers could adversely affect the Company's ability to achieve acceptable manufacturing yields and product reliability. The Company has in the past discovered hardware defects and software errors in certain of its new products and enhancements after their introduction. There can be no assurance that despite testing by the Company and by third-party test sites, errors will not be found in future releases of the Company's products, which would result in adverse product reviews and negatively affect market acceptance of these products. The introduction of new or enhanced products requires the Company to manage the transition, both internally and for customers, from the older products to the new or enhanced 16 products or versions. The Company 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. The Company has from time to time experienced delays in the shipment of new products. There can be no assurance that future product transitions will be managed successfully by the Company. Key Personnel The Company's success depends to a significant degree upon the continued contributions of the Company's key management, marketing, product development and operational personnel. The success of the Company will depend to a large extent upon its ability to retain and continue to attract highly skilled personnel. Competition for employees in the technology sector is intense, and there can be no assurance that the Company will be able to attract and retain enough qualified employees. The Company's inability to retain and attract key employees could have a material adverse effect on the Company's product development, business, operating results and financial condition. The Company does not carry key person life insurance with respect to any of its personnel. Competition and Price Erosion The network enhancement products and computer software markets are highly competitive, and the Company believes that such 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. The Company currently competes principally in the market for network fax servers and network print servers and fax-on-demand software. Increased competition, direct and indirect, could adversely affect the Company's business and operating results through pricing pressure, loss of market share and other factors. In particular, the Company expects that, over time, average selling prices for its 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 the Company's products would adversely affect gross margins. There can be no assurance the Company will be able to maintain the current average selling prices of its products or the related gross margins. The principal competitive factors affecting the market for the Company's products include product functionality, performance, quality, reliability, ease of use, quality of customer training and support, name recognition, price, and compatibility and conformance with industry standards and changing operating system environments. Several of the Company's existing and potential competitors, most notably the Hewlett-Packard Company ("Hewlett-Packard") and Intel Corporation ("Intel"), have substantially greater financial, engineering, manufacturing and marketing resources than the Company. The Company also experiences competition from a number of other software, hardware and service companies. In addition to its current competitors, the Company may face substantial competition from new entrants into the network enhancement market, including established and emerging computer, computer peripherals, communications and software companies. In the fax server market the Company competes with companies such as Captaris Inc., Omtool, Ltd. and Computer Associates International, Inc. There can be no assurance that competitors will not introduce products incorporating technology more advanced than the technology used by the Company in its products. In addition, certain competing methods of communication such as the Internet or electronic mail could adversely affect the market for fax products. Certain of the Company's 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 the Company will be able to compete successfully or that competition will not have a material adverse effect on the Company's business, operating results and financial condition. 17 International Sales Sales to customers located outside Canada and the United States accounted for approximately 20%, 25% and 31% of the Company's net sales in fiscal 2001, 2000 and 1999, respectively, and 18% for the six months ended June 30, 2002. The Company sells its products in approximately 40 foreign countries through approximately 50 international distributors. Macnica, the Company's principal Japanese distributor, accounted for approximately 46%, 60% and 60% of the Company's international sales in fiscal 2001, 2000 and 1999, respectively, and 10%, 15% and 18% of the Company's total net sales in fiscal 2001, 2000 and 1999, respectively. Sales to Macnica accounted for approximately 8% of the Company's total net sales in the six months ended June 30, 2002. The Company expects that international sales will continue to represent a significant portion of the Company's product revenues and that the Company 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 the Company will not experience difficulties resulting from changes in foreign laws relating to the export of its products in the future. In addition, because the Company primarily invoices its foreign sales in U.S. dollars, fluctuations in exchange rates could affect demand for the Company's products by causing its prices to be out of line with products priced in the local currency. Additionally, any such difficulties would have a material adverse effect on the Company's international sales and a resulting material adverse effect on the Company's business, operating results and financial condition. In fiscal 2001, the Company downsized its operations in the United Kingdom and entered into an agreement with a distributor to service the region. In addition, the Company entered into a separate agreement in fiscal 2001 with a Japanese distributor to sell the Company's LANpress products in Japan, from which the Company is entitled to receive a royalty on sales of these products. The Company 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 the Company will be able to maintain the historical level of international sales in the future. Any fluctuations in international sales will greatly affect the Company's operating results and financial condition. Lack of Product Revenue Diversification The Company derives substantially all of its sales from its fax and print server products, with its fax server products accounting for 91% of its total sales in fiscal 2001 and 93% of its total sales for the six months ended June 30, 2002. The Company is leveraging its expertise in these areas to develop new messaging features and products to support greater integration into corporate network environments and with Internet communications. The Company expects that its current products will continue to account for a majority of the Company's sales in the near future. A decline in demand for these products as a result of competition, technological change or other factors, or a delay in the development and market acceptance of new features and products, would have a material adverse effect on the Company's business, operating results and financial condition. Product Transition; Risk of Product Returns and Inventory Obsolescence From time to time, the Company 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 such inventory becomes obsolete. The Company has 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 the Company's allowance for such returns in the future and will not have a material adverse effect on the Company's business, operating results and financial condition. 18 Concentration of Distributors; Distribution Risks The Company sells its products primarily through a two-tier domestic and international distribution network. The Company's distributors sell Castelle's 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. In addition, an increasing number of companies are competing for access to these channels. The Company's distributors typically represent other products that are complementary to, or compete with, those of the Company. In particular, certain of the Company's competitors, including Hewlett-Packard and Intel, sell a substantially higher dollar volume of products through several of the Company's large U.S. distributors, and as a result, the Company believes such distributors give higher priority to products offered by such competitors. The Company's distributors are not contractually committed to future purchases of the Company's products and could discontinue carrying the Company's products at any time for any reason. In addition, because the Company is dependent on a small number of distributors for a significant portion of the sales of its products, the loss of any of the Company's major distributors or their inability to satisfy their payment obligations to the Company could have a significant adverse effect on the Company's business, operating results and financial condition. The Company has a stock rotation policy with certain of its distributors that allows them to return marketable inventory against offsetting orders. Should the Company reduce its prices, the Company credits certain of its distributors for the difference between the purchase price of products remaining in their inventory and the Company's reduced price for such products. In addition, due to industry conditions or the actions of competitors, inventory levels of the Company's products held by distributors could become excessive, resulting in product returns and inventory write-downs. Although the Company provides an allowance for anticipated returns and for price protection, and believes its existing policy results in the establishment of an allowance that is adequate, there can be no assurance that in the future returns and price protection will not have a material adverse effect on the Company's business, operating results and financial condition. Dependence on Third-Party Suppliers and Subcontractors The Company's products incorporate or require components or sub-assemblies procured from third-party suppliers. Certain of these components or sub-assemblies are available only from a single source, and others are available only from limited sources. Certain key components of the Company's products, including a modem chip set from Conexant Systems, Inc. and a microprocessor from Motorola, Inc., are currently available from single sources. Other product components are currently available from only a limited number of sources. In addition, the Company subcontracts a substantial portion of its manufacturing to third parties, and there can be no assurance that these subcontractors will be able to support the manufacturing requirements of the Company. Other than an agreement with Sercomm Corporation to manufacture certain print server products, the Company does not have material long-term supply contracts with third parties or any other sole or limited source vendors and subcontractors. The Company purchases components or sub-assemblies on a purchase order basis. The Company's ability to obtain these components and sub-assemblies is dependent upon its ability to accurately forecast customer demand for its products and to anticipate shortages of critical components or sub-assemblies created by competing demands upon suppliers. If the Company were unable to obtain a sufficient supply of high-quality components or sub-assemblies from its current sources, the Company could experience delays in obtaining such components or sub-assemblies from other sources. Resulting delays or reductions in product shipments could adversely affect the Company's business, operating results and financial condition and damage customer relationships. Furthermore, a significant increase in the price of one or more of these components or sub-assemblies or the Company's inability to lower component or sub-assembly prices in response to competitive price reductions could adversely affect the Company's business, operating results and financial condition. 19 The Company augments its product offerings by obtaining access to third-party products and technologies in areas outside of its core competencies or where the Company believes internal development of products and technologies is not cost-effective. The Company's third-party supplier of certain print server products is SerComm. There can be no assurance that these products will produce gross margins comparable to those of the Company's internally generated products or that the parties with which the Company contracts will continue to provide the quantities and quality of products needed by the Company or that they will upgrade their respective products on a timely basis. The termination of the Company's relationships with third-party product suppliers and with SerComm, in particular, could result in delays or reductions in product shipments, which could have a material adverse effect on the Company's business, operating results and financial condition. Government Regulation Certain aspects of the telecommunications industry in which the Company competes 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, particularly in foreign countries where telecommunications standards differ from those in the United States of America, or the inability to obtain regulatory approvals within a reasonable period of time, could have a material, adverse effect on the Company's business, operating results and financial condition. The Company's 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 the Company's business, operating results and financial condition. Dependence on Proprietary Rights; Uncertainty of Obtaining Licenses The Company's success depends to a certain extent upon its technological expertise and proprietary software technology. The Company relies upon a combination of contractual rights and copyright, trademark and trade secret laws to establish and protect its technologies. Despite the precautions taken by the Company, it may be possible for unauthorized third parties to copy the Company's products or to reverse engineer or obtain and use information that the Company regards as proprietary. In addition, the laws of some foreign countries either do not protect the Company's proprietary rights or offer only limited protection. Given the rapid evolution of technology and uncertainties in intellectual property law in the United States of America and internationally, there can be no assurance that the Company's 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 to the Company and divert the efforts of the Company's technical and management personnel, whether or not such litigation is determined in favor of the Company. In the event of an adverse result in any such litigation, the Company 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 the Company would be successful in such development or that any such licenses would be available. The Company also relies on technology licenses from third parties. There can be no assurance that these licenses will continue to be available to the Company upon reasonable terms, if at all. Any impairment or termination of the Company's relationship with third-party licensors could have a material adverse effect on the Company's business, operating results and financial condition. There can be no assurance that the Company's precautions will be adequate to deter misappropriation or infringement of its proprietary technologies. Furthermore, while the Company has obtained federal registration for many of its trademarks in the United States of America, certain of its trademarks have not been registered in the United States of America or foreign jurisdictions. There can be no assurance that the Company's use of such registered trademarks will not be contested by third parties in the future. 20 The Company has received, and may receive in the future, communications asserting that its products infringe the proprietary rights of third parties or seeking indemnification against such infringement. There can be no assurance that third parties will not assert infringement claims against the Company with respect to current or future products or that any such assertion may not require the Company to enter into royalty arrangements or result in costly litigation. As the number of software products in the industry increases and the functionality of these products further overlap, the Company believes that software developers may become increasingly subject to infringement claims. Any such claims, with or without merit, can be time consuming and expensive to defend. There can be no assurance that any such intellectual property litigation that may be brought in the future will not have a material adverse effect on the Company's business, operating results and financial condition. As a result of such claims or litigation, it may become necessary or desirable in the future for the Company to obtain licenses relating to one or more of its products or relating to current or future technologies, and there can be no assurance that it would be able to do so on commercially reasonable terms. Possible Volatility of the Company's Common Stock Price The price of the Company's Common Stock has fluctuated widely in the past. Sales of substantial amounts of the Company's Common Stock, or the perception that such sales could occur, could adversely affect prevailing market prices for the Company's Common Stock. The management of the Company believes that such past fluctuations may have been caused by the factors identified above as well as announcements of new products, quarterly fluctuations in the results of operations and other factors, including changes in the condition of the personal computer industry in general. These fluctuations, as well as general economic, political and market conditions, such as recessions or international currency fluctuations, may adversely affect the market price of the Company's Common Stock. Stock markets have experienced extreme price volatility in recent years. This volatility has had a substantial effect on the market prices of securities issued by the Company and other technology companies, often for reasons unrelated to the operating performance of the specific companies. The Company anticipates that prices for Castelle Common Stock may continue to be volatile. Such future stock price volatility for Castelle Common Stock may provoke the initiation of securities litigation, which may divert substantial management resources and have an adverse effect on the Company's business, operating results and financial condition. Future Capital Requirements The development and marketing of the Company's products requires significant amounts of capital. The Company believes that its existing cash balances, anticipated cash flows from operations and available lines of credit will be sufficient to meet its anticipated capital requirements for the next 12 months. However, a decline in future orders and revenues might require us to seek additional capital to meet our working capital needs during or beyond the next twelve months if we are unable to reduce expenses to the degree necessary to avoid incurring losses. 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 additional capital requirements cannot be determined at this time and will depend on a number of factors, including demand for the Company's existing and new products 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. 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. Related risk factors are discussed elsewhere in this Quarterly Report on Form 10-Q and in the Annual Report on Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2001. 21 Voting Control by Officers, Directors and Affiliates As of August 5, 2002, to the Company's knowledge and based on public filings, the Company's officers and directors and their affiliates beneficially owned approximately 28% of the outstanding shares of the Company's Common Stock. Accordingly, together they had the ability to significantly influence the election of the Company's 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 of the Company. Certain Charter Provisions The Company's Board of Directors has authority to issue up to 2,000,000 shares of Preferred Stock and to fix the rights, preferences, privileges and restrictions, including voting rights, of these shares without any further vote or action by the shareholders. The rights of the holders of the Company's 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 the outstanding voting stock of the Company, thereby delaying, deferring or preventing a change in control of the Company. 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 value of the Company's Common Stock. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK We had no holdings of derivative financial or commodity instruments at June 30, 2002. However, we are exposed to financial market risks, including changes in interest rates and foreign currency exchange rates. While most of our sales are 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, and therefore we believe that fluctuations in 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 account and related interest income would not be significantly impacted by changes in interest rates due mainly to the highly liquid nature of this investment. The Company believes that there have been no material changes in the reported market risks faced by the Company since the fiscal year ended December 31, 2001. These and other risk factors are discussed above under the caption "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q and in our Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2001 under the section "Risk Factors." 22 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company has been contacted by a third party claiming that the Company needs to obtain licenses of certain patents held by that party for certain of the Company's fax server products. The Company is continuing to assess the validity and strength of the claims, believes it has adequate legal defenses and that the ultimate outcome of any possible action will not have a material effect on the Company's financial position, results of operations or cash flows although there can be no assurance as to the outcome of any possible litigation. 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 None. ITEM 5. OTHER INFORMATION In April 2002, Donald L. Rich, retired as the CEO, a post he has held since November of 1998 and Scott C. McDonald, a member of the Board of Directors since April of 1999, was appointed President and CEO and continues to serve on the Board. Mr. Rich will continue as Chairman of the Board, a post he has held since May 1999, and will stay active with the Company in that role. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: 99.1 Certification pursuant to Section 906 of the Public Company Accounting Reform and Investor Protection Act of 2002 (18 U.S.C.ss. 1350, as adopted) 99.2 Press Release dated July 29, 2002 (b) Reports on Form 8-K On April 23, 2002, we filed a report on Form 8-K announcing the appointment of Scott C. McDonald as our Chief Executive Officer replacing Donald L. Rich who was retiring. 23 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 13, 2002 ------------------------------------------ Scott C. McDonald Chief Executive Officer and President (Principal Executive Officer) By: /s/ Paul Cheng Date: August 13, 2002 ------------------------------------------ Paul Cheng Vice President of Finance and Administration Chief Financial Officer (Principal Financial and Chief Accounting Officer) Secretary 24