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U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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AMENDMENT NO. 2
TO
FORM 10-KSB
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended March 31, 1997
Commission file number 0-20462
CHATCOM, INC.
(Name of Small Business Issuer in Its Charter)
CALIFORNIA 95-3746596
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
9600 TOPANGA CANYON BOULEVARD, CHATSWORTH, CALIFORNIA 91311
(Address of principal executive offices)
818/709-1778
(Issuer's telephone number)
Securities registered under Section 12(b) of the Exchange Act:
Name of Each Exchange
Title of Each Class on Which Registered
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None None
Securities registered under Section 12(g) of the Exchange Act:
Common Stock, no par value
(Title of Class)
Check whether the issuer: (1) filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 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
--- ---
Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of Registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [_]
State issuer's revenues for its most recent fiscal year: $9,103,000.
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PART I
EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED HEREIN, THE MATTERS
DISCUSSED IN THIS ANNUAL REPORT ARE FORWARD LOOKING STATEMENTS THAT INVOLVE
RISKS AND UNCERTAINTIES, INCLUDING BUT NOT LIMITED TO, ECONOMIC, COMPETITIVE,
GOVERNMENTAL AND TECHNOLOGICAL FACTORS AFFECTING THE COMPANY'S OPERATIONS,
MARKETS, PRODUCTS, SERVICES AND PRICES, AND OTHER FACTORS DISCUSSED IN ITEMS I
AND VI BELOW AND THE COMPANY'S VARIOUS OTHER FILINGS WITH THE SECURITIES AND
EXCHANGE COMMISSION.
ITEM 1. DESCRIPTION OF BUSINESS
Overview
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During the past fiscal year, ChatCom, Inc. ("ChatCom" or the "Company") has
actively repositioned itself into the fast growing consolidated server market
and has recently won a major industry award for the excellence of its product
line in meeting consolidated server requirements (LAN Times - Best of Times
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Award for Consolidated Servers, February 1997). In recent years, the Company's
products had been geared primarily toward the remote control segment of the
remote access market. However, increased competition from alternative
technologies, lower demand and changes in access topology caused by increased
dominance of the Internet have led to declining revenues in the remote control
segment of the remote access market and increased operating losses that have
significantly impaired the Company's liquidity and capital resources, and caused
the Company to transition itself into the new and rapidly growing domain of the
consolidated server market.
The Company has taken significant steps to position itself as an
important force in the consolidated server, network simulation, clustering,
multi-user remote access and telecom Internet service markets, refocusing its
product development and marketing efforts to achieve this goal. The Company has
undergone major organizational changes to improve both its skills mix and modus
operandii. The Company believes that the quality and effectiveness of its sales
and marketing teams have been greatly improved, and the Company is taking steps
to increase gross margins through the use of outsourced "turn-key" manufacturing
of subassemblies for the Company's products and focusing a solutions approach on
the higher-end server marker.
The Company's primary product line is the well known ChatterBox(TM) family
of server consolidation and clustering platforms, a fully open OSI (Open Systems
Interconnect) architecture that supports all major network operating systems.
The Company's major strength is its proven ability to deliver high and ultra-
high density platforms, which deploy the latest in processor and bus technology.
Recognized by LAN Times as the benchmark for consolidated server performance,
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the Company's product line features a highly scaleable architecture,
unparalleled power efficiency, fully functioned management software and low
Mean-Time-To-Recover (MTTR).
The Company's top-down commitment to Open Standards and ISO9000 Quality and
a rededication to "Excellence by Design," have helped the Company in making the
transition to an emerging and technically challenging marketplace, while
supplying the bedrock on which revenue growths may be based. In furtherance of
the move into the consolidated server market, the Company has overhauled its
operations and procedures to comply with the requirements of ISO9000 Quality
Standards. The first round of internal audits were completed in June and the
formal approval process will be undertaken in the third quarter of this fiscal
year.
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In order to generate additional working capital to fund the Company's
marketplace transition, and its recent operating losses, the Company has
completed several private placements of its equity securities during the prior
fiscal year. Encouraged by both industry and customer reception of its
repositioned product offerings during the current fiscal year, the Company
anticipates that revenues can be significantly increased. However, there can be
no assurance that the Company will be able to generate increased revenues or
achieve profitability even if revenues do increase. Although the Company
currently has no debt, the Company at present has insufficient liquidity to
support its current level of operations or any significant increase in revenues,
and is actively seeking additional financing to meet its immediate needs as well
as its anticipated requirements for the balance of the fiscal year.
Description of Products
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ChatterBox. With five different models in the family, the ChatterBox
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series has been designed to meet the needs of the consolidated server market,
and thereby satisfies the needs of the high-density applications server,
Internet server and network simulation markets as well. Each ChatterBox model
is built around a selection of common server modules, which makes the whole
product line both functionally compatible and fully scaleable. The ChatterBox
family exhibits the following significant advantages
. High to ultra-high platform density in compact industry-standard
enclosures. Current ultra-high density systems can support fully
configured Pentium(R) systems in one 19" rack enclosure. For high-end
server requirements, up to 28 dual SMP Pentium Pro(R) platforms can be
accommodated in one enclosure.
. State of the art power distribution using load balancing power supply
modules in a highly fault tolerant and efficient N+1 configuration
. High availability/low MTTR design with all system components being fully
hot-swappable and with no single point of system failure, achieved through
the deployment of a "multiple instance" architecture.
. Super scaleable fault tolerant clusters using advanced load-balancing
software to provide "processor bandwidth on demand" systems with near
linear efficiency.
. Systems management through ChatCom's Intelli-Management(TM) integrated
management system, which provides full monitoring and control capabilities
either locally or to a remote location using standards-based remote
management (SNMP).
. Ultra-high performance and data integrity is delivered through the
Company's ChatRAID(TM) Intelligent Disk Subsystem.
The Company believes the clustering technology will permeate the networking
industry where mission critical applications are being deployed. The Company has
trademarked "RAINS" which stands for Redundant Array of Inexpensive Network
Servers and is partnered with Microsoft and Vinca Corporation ("Vinca") to
provide turnkey solutions.
The open architecture of ChatterBox server platforms supports the latest
Pentium and Pentium Pro technology of Intel Corporation ("Intel"), including the
recently introduced Dual SMP Pentium Pro, which provides the highest power to
density ratio yet achieved with this technology. Processor speeds up to 200MHz
and memory sizes up to 512MB in both single and dual processor designs are
available, making these platforms comparable to the most advanced stand-alone
servers available today.
Designed from the outset for mission-critical applications, the ChatterBox
family performs in an arena where system failures or unrecoverable loss of data
are considered unacceptable. The addition of the integrated ChatRAID level
7 disk storage architecture provides multiple server access to a self-healing,
fault-tolerant storage subsystem offering up to 1.1 Terabyte of high-
availability data across multiple redundant paths.
ChatterBox systems are in service worldwide supporting diverse applications
including Internet, intranet and web server functions, database and Groupware
(E-mail, etc.) server systems from Lotus Notes(R) and Microsoft(R) Exchange(TM)
to Oracle environments, file servers, applications servers, gateways, remote
access, Citrix servers
<PAGE>
and many more. They are also in service with a number of major peripheral
manufacturers in support of their various development and test programs.
Configurations range in price from approximately $5,000 up to approximately
$30,000 for the Office series, while the more powerful Corporate series range
from $7,500 to over $300,000.
Sources and Availability of Raw Materials. The Company purchases from
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various independent suppliers numerous parts, including computer chips, power
supplies, printed circuit boards, chassis, resistors, capacitors, and various
electronic components that the Company assembles into products. Although there
are at least dual suppliers for many of such parts, supplies and components, the
Company currently relies on single sources of supply for certain parts and
components, and the Company is vulnerable to product changes by and variances in
product quality from these suppliers. The Company's primary sources for these
items, which are readily available, are electronics distributors, including
Arrow Electronics, Inc., Bell Industries Inc., Hamilton/ Hallmark, and Intel.
The Company purchases certain components (the Cirrus VGA integrated
circuit, Intel processors, Opti integrated circuits, Omega power supply modules
and 3Com application specific integrated circuits), which contain technology
that is proprietary to its manufacturer and is therefore unavailable from other
manufacturers. The Company has no written supply agreements covering any of
these components. The Omega power supply module is purchased directly from
Omega Power Systems, Inc. ("Omega") and this module is an integral portion of
one of the power supply options offered by the Company.
The Company is required to carry significant amounts of inventory to meet
the rapid delivery requirements of its customers. Inventories held by the
Company are subject to obsolescence and the Company reports inventories net of a
reserve for obsolescence.
Markets and Marketing
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The Networking Market. Products that serve as the building blocks for
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data/voice networks have traditionally fallen into two categories -- those that
utilize the same underlying technology as standard desktop personal computers
("PCs"), and those that require specialized hardware and software. Included in
the former group are Internet/intranet servers, fileservers, database servers,
and E-mail gateways, while the latter group includes products such as routers,
bridges, remote access systems, and telephone switching systems.
Companies such as Compaq Computer Corporation ("Compaq"), Hewlett-Packard
Company ("HP"), IBM, Sun Microsystems, Inc., Dell Computer Corporation ("Dell")
and others have been the traditional leaders in providing hardware for the
server market, whereas companies such as Cisco Systems, Inc., 3Com Corporation,
Bay Networks, Inc., and Ascend Communications, Inc. have grown to multimillion
dollar or billion dollar corporations with products that address 'specialized'
networking functions.
The Marketing Approach. Today, with the extraordinary power of
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technologies utilizing Intel's Pentium processors and Digital Equipment
Corporation's Alpha(R) processors, virtually all networking functions can be
performed on PC-based hardware. Since ChatterBox integrates multiple server
modules that are based on such PC-based technology into compact, power
efficient, highly-reliable and highly-manageable systems for mission critical
applications, it is well-positioned to become an ideal platform for network
server consolidation. The advantages of having a common, low-cost 'engine' for
all networking applications are only now becoming apparent, and ChatCom believes
that it is poised to make significant inroads into this emerging market.
<PAGE>
The Company will continue to pursue its objective of providing
powerful, reliable, scalable, fault-tolerant and feature-rich products for the
mission critical market. While not the highest priced products of their kind,
the Company believes that ChatterBox systems will nonetheless rank among the
products with the best price/performance characteristics available, when the
ChatterBox's numerous value-added capabilities are considered.
Trade Shows and Advertising. The Company plans to exhibit at the following
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national trade shows during fiscal year 1998:
. NetWorld+InterOp, Las Vegas - April
. PC Expo, New York - June
. NetWorld+InterOp, Atlanta - September
. Comnet, Washington D.C. - January
These shows offer the opportunity for broad exposure of the Company's
products to both end-users and resellers, and are among the best-attended of the
numerous shows that now serve the networking industry. At these four large
shows, the Company will present its updated ChatterBox product line. In
addition, the Company will maintain some presence at certain regional trade
shows that address focused aspects of the industry, such as those put on by
Novell and Microsoft user groups.
In February 1997, the Company launched a new advertising campaign,
expanding its demographic coverage to address information technology (IT)
executives as well as the LAN management personnel covered in previous
campaigns. New solutions-oriented messages convey the benefits of deploying the
Company's products in several key markets, including remote access, Internet and
web servers and Microsoft NT/Backoffice(R) servers. LAN Times was selected as
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the core advertising vehicle based upon price, research and previous lead
generation performance.
Sales Channel Development. The Company has traditionally sold its products
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through value-added resellers ("VAR"s), and will continue to do so for a
significant portion of its sales. However, the Company intends to continue to
evaluate its VAR network, attract larger and technically skilled VARs, and train
existing VARs to ensure high-quality service and response to end-users. The
Company perceives its VAR channel as a family of partners, and as such expects
to work in close cooperation with them.
Direct Sales. The Company has begun a direct sales program to large
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corporate users of ChatCom equipment as testing platforms for quality assurance.
Direct Sellers have the advantage of superior knowledge and control of what will
be a mission-critical application in a production environment.
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Engineering and Customer Service
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This new department has recently been created to help the Company pursue
its stated objective of providing superior quality in both its products and
service. A Vice President position has been created and filled to head-up the
department.
Engineering. Engineering reviews Marketing Requirement Documents to ensure
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that the Company's products meet customer requirements. Engineering will
research component resources to ensure that the Company's products use state-of-
the-art components resulting in reliable, competitive and cost effective
products. Engineering will ensure all design processes follow established
procedures in conformance with ISO9000 requirements. The department will execute
designs using in-house engineering resources, as well as outsourcing engineering
workload to ISO9000 certified third-party development sources. Engineering will
transition products to Manufacturing and provide engineering support at the
onset of release through product end-to-life to ensure that the Company's
products are manufactured in strict comformance with specifications. Engineering
will also provide a high level of support to Customer Service to ensure that its
customer base receives full levels of support. Finally, Engineering will provide
documentation of all products to ensure embedded quality goes in before the name
goes on.
Customer Service. The Customer Service organization is responsible for
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processing all incoming service calls, managing in-warranty and out-of-warranty
repair returns/shipments, and tracking all reported product problems. The
Company is in the process of building its Customer Service group into a premier
organization, capable of ensuring either immediate response to a call for
service, or a return call within two hours.
Sales and Distribution
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The Sales Organization. The Sales organization reports to the Company's
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President, and is currently divided into four regions - Eastern, Central,
Western and International. The Company has sales offices in New York, New
Jersey, Virginia, Chicago, Dallas, Ottawa, Seattle, Washington and
Chatsworth, California, each staffed by a regional sales representative. There
are also four sales staff located at headquarters who provide inside support for
the regions.
Significant Customers. During the fiscal year ended March 31, 1997 the
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Company received approximately 13% of its gross revenues from sales to US
Robotics Access Corp., an end-user of the Company's products. No other single
customer accounted for more than 10% of the Company's revenues for the fiscal
years ended March 31, 1996 and March 31, 1997.
Manufacturing
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The Company contracts for various electronic and mechanical components from
vendors and other manufacturers. Some are complete subassemblies, such as power
supplies or custom-built chassis, while others are individual items such as bare
circuit boards and chips. Rather than manufacture the actual electronic circuit
boards and mount the components used in its products, the Company subcontracts
the mounting and soldering of these assemblies and then performs assembly,
integration, and final testing.
<PAGE>
Because no heavy manufacturing such as wave soldering of circuit boards or
sheet metal fabrication is performed by the Company at its leased premises, the
Company would be able, if it became necessary, to quickly increase its
production levels with relatively little disruption to current operations. This
also allows the Company to incorporate the latest technology without having to
retool its manufacturing. The Company believes that it is capable of doubling
its present output with the addition of more assemblers and testers.
OEM Agreements. The Company currently has agreements with original
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equipment manufacturers ("OEMs") to manufacture the Company's RAID subsystem
products and 3 Com Corporation to incorporate their chips into the Company's
products and to market failover (clustering) software in conjunction with its
consolidated servers under the ChatCom name. Other than the foregoing, the
Company does not have any significant agreements with OEMs.
Competition
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Products that are competitive with ChatterBox fall into two main
categories:
. 'Racked-and-stacked' stand-alone servers
. Integrated, purpose-designed rack-mounted systems (similar to
ChatterBox)
The racked and stacked stand-alone server category is comprised of many
stand-alone servers (e.g., from manufacturers such as Compaq, HP, IBM, Dell,
etc.) placed on custom metal racks. Metal rack systems are available from
numerous companies such as Wright Line, Ergotron, Inc., American Network
Products, Engineered Data Products (NetCom3), Kewaunee and others. While this
approach does allow a user to maintain some degree of order and a neat
appearance, it does not significantly reduce space requirements, nor does it
reduce power or cabling requirements. Furthermore, it does nothing to
consolidate the manageability of the separate systems. Nonetheless, the Company
considers its major competition to come from these 'racked-and-stacked' server
systems.
Among the second group of competitors (purpose-designed systems) is Cubix
Corporation ("Cubix"), a manufacturer that has been traditionally considered
among the Company's key competitors. Cubix is a strong player in managed
systems-level platforms for communications and application servers. Cubix
manufactures a platform with similar functionality to ChatCom's product line.
Cubix manufacturers proprietary motherboards whereas ChatCom use industry
standard motherboards in most of its products. The form factor of the two
product lines is different and the Company's believe that its product lines will
prevail due to the greater flexibility of its architecture.
In order to position itself as the superior choice in its marketplace,
ChatCom plans to increase its efforts to convey a consistent message regarding
those problems that the ChatterBox product line solves in ways that no other
manufacturer can. Additionally, ChatCom will embrace a philosophy of "Customer
Awareness." This philosophy combined with a clear, consistent message of product
and service superiority will enable ChatCom to reclaim its deserved recognition
among potential users.
New Product Development
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The Computer Industry. The Company's business is, as is the business of
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all of the computer hardware and software industry, extremely competitive and
rapidly changing. Without continued refinement of existing products, and the
development of new products, the Company could easily lose any competitive
advantage it may possess. It is therefore essential that substantial resources
be devoted to research and new product development.
<PAGE>
Recent Developments. As described previously, the Company is in the
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process of repositioning its products as a family of systems, rather than a
collection of building blocks. In creating the Corporate and Office Series
product lines, significant new system management features have been introduced.
These are composed of ChatCom's Intelli-Management monitoring and control
system, coupled with a major new version of the Company's ChatView(TM)
management software. Version 3 of this software operates in Microsoft's Windows
NT environment, and allows a ChatterBox system to be managed through industry-
standard SNMP-based products such as HP's OpenView(R) or IBM's Netview (TM).
Pentium Pro 200(R) -- A line of servers featuring the Intel Pentium Pro
CPU was introduced by the Company in March 1997 and is positioned for high-
speed, high-bandwidth applications, such as Internet/intranet/web servers,
groupware applications and traditional file serving.
Pentium ChatTwin(TM) -- In fiscal year 1996, the Company introduced its
ChatTwin line of server modules. The ChatTwin contains two complete processing
units on a single board, and fourteen such boards can be housed in a single card
cage. The Corporate Series Model 2040 can house up to four card cages, which
provides capacity for up to 112 processors in a six and a half foot tall cabinet
that occupies approximately five square feet of floor space. In March 1997, the
Company introduced significant performance enhancements to its ChatTwin server
module. The ChatTwin server module is now available with two fully functional,
completely independent Pentium servers integrated on a single card. This
configuration has proven useful and is expected to generate significant revenue
within the manufacturing sector that requires non-simulated network load and
network product test/measurement equipment.
In fiscal year 1996, the Company also introduced the ChatPowerPlus(TM)
redundant, hot-swappable module power supply unit for its processing systems.
The ChatPowerPlus unit is based on the "N+1" concept, whereby the user populates
the unit with the number of power modules needed to provide power to the
processor units plus an additional power module. As the power modules can be
exchanged without powering down other power modules, a power module failure does
not result in the failure of any processing units and the failed power module
may be replaced without the interruption of any processing. Because the
ChatPowerPlus holds up to four power modules that are individually exchangeable,
the user may obtain true fault tolerance and redundancy by employing power
modules with 133% of the user's maximum power needs, as opposed to the 200%
required by most redundant power systems. The Company knows of no systems
offered by its competitors that provide the processing power density of its
systems utilizing the ChatTwin and ChatPowerPlus units.
Future Developments The Company has and will continue to develop products
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for the server consolidation and remote applications markets, with emphasis on
those products that involve hardware as well as software. The Company feels that
with its current server module designs, the introduction of the next generation
of processor chips can be accommodated into certain of the Company's products
with little or no redesign required. The Company expects this characteristic of
the Company's products to reduce the time to market for future technology
upgrades. The Company believes that its server products are elements of a total
consolidated server solution consisting of hardware and software, which it
intends to develop internally or acquire under OEM agreements.
Research and Development The Company has spent approximately $1,246,000,
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$914,000 and $877,000 on company-sponsored research and development activities
during the fiscal years ended March 31, 1997, 1996, and 1995, respectively.
<PAGE>
Environmental Laws
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Compliance with federal, state and local provisions that have been enacted
or adopted regulating the discharge of materials into the environment, or
otherwise relating to the protection of the environment, likely will not have a
significant effect upon the capital expenditures, earnings, or competitive
position of the Company.
Organization and Business Development
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The Company was incorporated under the laws of the State of California in
March 1982. The Company originally was named "Astro Systems and Engineering,
Inc." and changed to "Astro Sciences Corporation" in 1985. On February 9, 1996,
the Company changed its name to "ChatCom, Inc."
Originally an engineering and technical consulting services company, the
Company acquired the assets of J&L Information Systems, Inc., a California
corporation ("J&L") in 1988. From 1982 (prior to J&L's incorporation) through
late 1985, J&L's primary activity consisted of the manufacturing and marketing
of remote access products for TeleVideo Systems, Inc.'s multi-user systems. As
the use of personal computer-based local area networks ("LANs") increased in
1986, J&L expanded its line of remote user access products to include
Novell(R) networks and networks of other emerging vendors. At the same time,
J&L evolved into a publisher of asynchronous communications software for LANs.
After the acquisition of J&L, the Company terminated its engineering
services business and concentrated completely on the J&L product business.
Currently, the Company's primary business activity is developing, integrating,
manufacturing and marketing highly-efficient centralized servers and storage
management systems.
Employees
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The Company currently employs approximately 78 full-time employees, of
which 21 are in manufacturing, 18 are in sales, 12 are in research and product
development, nine are classified as officers, general and administrative, eight
are in technical support, five are in quality assurance, three are in sustaining
engineering and two are in marketing.
RISK FACTORS
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Documents and press releases prepared by the Company, including this report on
Form 10-KSB, may from time to time contain forward looking statements. The
Company, its assets, operations, and financial condition and such forward
looking statements made by the Company are subject to various risks and
uncertainties, including without limitation, the following:
Ability to Continue as a Going Concern
--------------------------------------
As a result of the Company's net losses in recent periods and the Company's
negative cash flow from operating activities in recent periods, the Company's
independent auditors have included in their report on the Company's March 31,
1997 financial statements an explanatory paragraph regarding the ability of the
Company to continue as a going concern. The Company has obtained conditional
commitments for equity funds in one or more private placements in order to
obtain the funds necessary to meet its immediate working capital needs. There
can be no
<PAGE>
assurance that the Company will be able to successfully complete the private
placements or otherwise obtain the necessary funds to continue operations or
fund the Company's projected growth.
Liquidity
---------
The Company's continuing losses and negative cash flow from operations have
created a liquidity problem for the Company. As of March 31, 1997, the Company
had working capital of $3,195,000, as compared to working capital of $3,501,000
as of March 31, 1996. Notwithstanding the Company's working capital position as
of March 31, 1997, the Company must provide additional liquidity to support its
current level of operations or any significant future increase in revenues and
is actively seeking additional financing to meet its immediate needs as well as
its anticipated requirements for the balance of the current fiscal year. The
Company, which currently does not have any bank debt, has received a conditional
commitment for a credit line and is in the process of finalizing the
implementation of the credit line and is negotiating an equity investment from
one of several strategic partners. The Company has not received a firm
commitment for any of the foregoing debt or equity financing, and there can be
no assurance that it will be able to obtain these commitments for a sufficient
amount of financing. If the Company does not raise sufficient financing to meet
its short term needs, it intends to implement a plan, pursuant to which it will
significantly reduce its current advertising and marketing activities, and make
significant reductions in its sales, engineering, customer service and
manufacturing work force. Although the Company believes that it should be able
to maintain operations at a reduced level under the plan for the foreseeable
future, it may be required to raise capital to continue operations at this
reduced level and it would be necessary to raise additional capital to restore
operations to their prior level. There can be no assurance that the Company
would be able to obtain this financing.
The Company has incurred operating losses in each of its last three fiscal
years and in the first quarter of its current fiscal year. Even if the Company
successfully completes the debt and equity financings it is currently attempting
to place, if the Company continues to experience operating losses in the future
that results in a significant utilization of its liquid resources, the Company's
liquidity and its ability over the long-term to sustain operations at current
levels could be materially, adversely affected.
The Company may seek additional public or private financing to meet its
longer term capital needs if market conditions are favorable. If additional
funds are raised through the issuance of equity securities, it is likely that
the Company will be required to sell such securities at a substantial discount
to the current market price for the Company's Common Stock (the "Common Stock"),
the percentage ownership of the then current shareholders of the Company will be
reduced, and such equity securities may have rights, preferences or privileges
senior to those of the holders of the Common Stock. No assurance can be given
that additional financing will be available or that, if available, it will be
available on terms favorable to the Company or its shareholders. Any increase in
the outstanding number of shares of Common Stock or options and warrants may
have an adverse effect on the market price of the Common Stock and may hinder
efforts to arrange future financing. If adequate funds are not available to
satisfy capital requirements, the Company may be required to curtail its
operations significantly or to obtain funds through arrangements with strategic
partners or others that may require the Company to relinquish material rights to
certain of its technologies or potential markets.
<PAGE>
Prior Operating Losses; Fluctuations in Operating Results
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The Company has reported net losses of $4,601,000 and $1,968,000 for the
fiscal years ended March 31, 1997 ("fiscal 1997") and 1996 ("fiscal 1996"),
respectively, due primarily to a decrease in revenue during fiscal 1997, flat
revenues during fiscal 1996 and increases in operating expenses and cost of
goods sold, including inventory obsolescence reserves. The Company also
incurred an operating loss for the three-month period ended June 30, 1997.
There can be no assurance that the Company's operations will be profitable in
the future.
The Company's reported results of operations are subject to considerable
fluctuations due to changes in demand for the Company's products and other
factors, and there can be no assurance that the Company will be profitable in
any particular period. Demand for the Company's products in each of the markets
it serves can vary significantly from quarter to quarter due to revisions in
budgets or schedules for customer projects requiring the Company's products,
changes in demand for systems that incorporate the Company's products, general
business and economic factors and other factors beyond the control of the
Company.
Dependence on New Product Development
-------------------------------------
The markets served by the Company are characterized by rapid technological
advances, downward price pressure in the marketplace as technologies mature,
changes in customer requirements, frequent new product introductions and
enhancements, and price erosion. The Company's business requires substantial
ongoing research and development efforts and expenditures, and its future
success will depend on its ability to enhance its current products, reduce
product costs and develop and introduce new products that both keep pace with
technological developments in response to evolving customer requirements and
that also achieve market acceptance.
The consolidated server market in particular is characterized by the
continuing advancement of technology, including technologies relating to the
increased efficiency of systems level management and the speed and efficiency of
microprocessors. The Company's strategy is to update its products to
accommodate new technologies; however, there can be no assurance that the new
technologies will not render the Company's products obsolete. The Company
believes that it must continue to respond quickly to the needs of its customers
for broad product functionality and must respond to advances in hardware,
generic operating system software, applications software, and emerging
technologies and markets, such as Internet services, groupware services,
enterprise-wide remote communications and the test measurement and emulation
markets. There can be no assurance that the Company will be able to respond
effectively to technological changes or product announcements by its
competitors. If the Company is unable, for technological or other reasons, to
develop and introduce products and applications in a timely manner in response
to changing market conditions or customer requirements, the Company's operating
results and financial condition could be materially, adversely affected.
Additionally, the marketability of the Company's products is influenced to
a significant degree by the management capabilities and efficiency of
proprietary software that is an integral component of the remote access
solutions that are offered by the Company. The Company's strategy is to
continually update its consolidated server product line and technology to
increase its capabilities and efficiency as well as to maintain its
compatibility with application and operating software and network protocols that
proliferate in the marketplace. There can be no
<PAGE>
assurance that the Company's competitors will not introduce functionally similar
consolidated server platforms or proprietary management software that could
render the Company's products obsolete or that the Company will be able to
improve and advance its consolidated server technology and management software
so that it is compatible with applications software, operating software and
network protocols and market demands that may be introduced in the future or
that the Company's technology and products will continue to be accepted in the
marketplace. If the Company is unable to develop new, or improve its current,
products and technology in response to changes in its operating environment or
customer requirements, the Company's operating results and financial condition
could be materially, adversely affected.
Need to Manage Product Transitions
----------------------------------
The introduction of new and enhanced products requires the Company to
manage the transition from older products in order 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 demand. There can be no assurance that the Company will successfully
manage the transition to selling new products, and the failure to do so could
have a materially adverse effect on the Company's operating results and
financial condition.
Highly Competitive Environment
------------------------------
The market for consolidated servers, including PC-based server technology
is highly competitive. The Company competes with leading vendors who provide
both desktop PCs and high-end server products. Such competitors, including but
not limited to HP, Compaq, Dell, and to a lesser extent, Cubix, who offers a
functionally similar consolidated server solution, have greater financial,
marketing, technical, and other resources than the Company. In the future, the
Company expects several of these companies to enter the consolidated server
market, or increase their presence, with their own additional consolidated
server products and solutions, and such competitive products and solutions could
have a materially adverse effect on the Company's results of operations.
In July 1995, the Company changed its pricing strategy for commodity-type
subassemblies (e.g. disk drives, fax servers, and random access memory)
purchased by the Company and incorporated into its products. Sales prices and
published list prices on these items were lowered by the Company in order to
discourage resellers and end-users from purchasing such products elsewhere and
installing them on systems provided by the Company. The installation of
components purchased from other vendors into systems sold by the Company had
caused compatibility problems in certain cases, potentially impacting the
Company's reputation for marketing reliable products. This change in pricing
strategy has resulted in lower margins on such subassemblies.
Increased competition could result in price reductions and loss of market
share, which would adversely affect the Company's results of operations. Many
of the Company's current and potential competitors have greater financial,
marketing, technical and other resources than the Company. There can be no
assurance that the Company will be able to compete successfully with its
existing competitors or any new competitors.
<PAGE>
Reliance on Consolidation Server Market; Early Stage of Market
--------------------------------------------------------------
The Company currently devotes a majority of its product development,
manufacturing, marketing and sales resources to providing product and services
to the enterprise consolidated server market. Although the Company believes
that its concentrated focus provides it with certain competitive advantages in
this market, this focus may also leave the Company more vulnerable to any future
decline in the demand for the Company's consolidated servers. In addition, the
Company's future financial performance will depend in large part on continued
growth of the consolidated server market, which in turn will depend in part on
the number of organizations utilizing such products and the number of
applications developed for use with those products. There can be no assurance
that these markets will continue to grow or that the Company will be able to
respond effectively to the evolving requirements of these markets. Any
significant decline in, or significant decrease in the growth rate of, the
consolidated server market could have a materially adverse effect on the
Company's results of operations and financial condition. Additionally, many of
the Company's customers do not yet have a standard consolidated server solution,
and there can be no assurance that the Company's products will be the standard
adopted by its customers.
Product Defects
---------------
New products, when first released by the Company, may contain undetected
design faults and software errors, or "bugs" that, despite testing by the
Company, are discovered only after a product has been installed and used by
customers. There can be no assurance that faults or errors in the Company's
existing products or in new products introduced by the Company will not be
discovered in the future, causing delays in product introductions and shipments
or requiring design modifications that could adversely affect the Company's
competitive position and results of operations. In addition, there can be no
assurance that new products or product enhancements developed by the Company
will achieve market acceptance or, if successful, will not adversely impact the
sales of the Company's existing products. On several occasions, the Company has
discovered minor design defects in its products that have caused delays in the
introduction of products. To date, however, the Company has not experienced any
significant problems in this regard and has not recalled products as a result of
a product defect.
Dependence on Key Personnel
---------------------------
The Company's future success depends in large part on the continued service
of its key marketing, sales and management personnel. The Company is dependent
upon its ability to identify, hire, train, retain and motivate high quality
personnel, especially highly skilled engineers involved in the ongoing hardware
and software development required to refine the existing products to introduce
enhancements for future applications and to develop new products. The Company
is particularly dependent on the skills and contributions of certain of its
management personnel, although the Company does not have long-term employment
agreements within many of these individuals. Competition for personnel in the
Company's industry, as well as in the computer hardware and software industry,
is characterized by a high level of employee mobility and aggressive recruiting
of skilled personnel. There can be no assurance that the Company's current
employees will continue to work for the Company or that the Company will be able
to obtain the services of additional personnel necessary for the Company's
growth.
<PAGE>
Dependence on Timely Receipt of Acceptable Components
-----------------------------------------------------
The Company depends on the timely receipt of non-defective components to
meet its manufacturing schedule. The Company's operating results or financial
condition could be adversely affected by the receipt of a significant number of
defective components or a delay in component delivery, an increase in component
prices or the inability of the Company to obtain lower component prices in
response to competitive pressures on the pricing of the Company's products.
Reliance on Certain Suppliers
-----------------------------
The Company purchases from various independent suppliers numerous parts,
supplies and other components, which the Company assembles into products.
Although there are at least dual suppliers for many of such parts, supplies and
components, the Company currently relies on single sources of supply for certain
parts and components, and the Company is vulnerable to product changes by and
variances in product quality from these suppliers. Although the Compant believes
that such changes and quality fluctuations could be accommodated by it, they may
necessitate changes in the Company's product design or manufacturing methods,
and the Company could experience temporary delays or interruptions in supply
while such changes are incorporated or a new source of supply is procured. Any
future disruptions in supply of suitable parts and components from the Company's
principal suppliers could have a materially adverse effect on the Company's
operating results and financial condition.
The Company purchases certain components (the Cirrus VGA integrated
circuits, Intel processors, Opti integrated circuits, Omega power supply modules
and 3Com application specific integrated circuits), which contain technology
that is proprietary to its manufacturer and is therefore unavailable from other
manufacturers. The Company has no written supply agreements covering any of
these components. Although the Company purchases the components manufactured by
Cirrus, Opti and 3Com from only a single distributor each, and these components
are available through numerous distributors, the Company could experience
additional development costs and production delays while developing alternate
solutions should any of these manufacturers cease to produce the components.
The Omega power supply module is purchased directly from Omega and this
module is an integral portion of one of the power supply options offered by the
Company. Should Omega cease its production of this component or cease sales of
the component to the Company, a total redesign of the particular power supply in
which the component is utilized would be required. While the Company's processor
units may be sold with other power supply systems, the sales of the affected
model, and possibly a portion of the Company's sales of other products, would be
lost or delayed during the redesign and production start-up period.
The Company licenses remote access related software from Symantec
Corporation ("Symantec"). Although the software licensed from Symantec contains
proprietary features, other companies offer similar software that is compatible
with the Company's products. Accordingly, the Company believes that termination
of the Company's ability to license software directly from Symantec would not
have a material adverse effect upon the Company's operations.
<PAGE>
Management of Inventory; Risk of Inventory Obsolescence
-------------------------------------------------------
The marketplace dictates that many of the Company's products be shipped
very quickly after an order is received. Since purchased component and
manufacturing lead times are typically much longer than the short order
fulfillment times allowed by the marketplace, the Company is required to
maintain adequate inventories of both components and finished goods, and must
accurately forecast demand for finished products. Historically, the Company has
been unable to accurately forecast specific future demand, requiring it to
maintain relatively large inventory levels, which has had an adverse effect on
its financial condition. The relatively high levels of inventories have also
contributed to the Company experiencing costs relating to obsolescence of
inventories, which has had an adverse effect on the Company's results of
operations and financial condition.
Engineering refinements to the Company's new hardware and software products
are relatively common. These changes can result in the disruption of the
manufacturing operation and delays in delivery dates. These changes also can
cause the finished goods inventory to enjoy a relatively short shelf life or may
require the Company to incur additional costs to rework the finished goods or
work-in-process inventories that were produced prior to the engineering change.
These and other circumstances, including inaccurate forecasts of customer
demand, poor availability of purchased components, supplier quality problems,
allocation limitations of key components by their manufacturer, carrier strikes
or damage to products during manufacture could result in a buildup of excess
components of finished goods on the one hand or an inability to deliver product
on a timely basis on the other hand, either of which could have a materially
adverse effect on the Company's operating results and financial condition.
The Company has incurred inventory writedowns in the past. While the
Company maintains valuation allowances for excess and obsolete inventories,
which it believes to be adequate, significant changes in the technology
prevailing in the industry could require the Company to record additional
valuation reserves. During fiscal 1997 and fiscal 1996, the Company recorded
additions to its valuation allowance for obsolete and excess inventories in the
amounts of $794,000, and $162,000, respectively, which adversely affected gross
profit and net income in the periods in which additional valuation allowances
were recorded. The Company believes that its allowance for obsolete and excess
inventories that are currently recorded are sufficient to properly state
inventories at their net realizable value. Material additions to such allowance
might be required in the future if market conditions affecting the Company's
product sales mix change significantly. Should future writedowns become
necessary, such writedowns could have a materially adverse effect on the
Company's operating results and financial condition.
Dependence on Proprietary Technology
------------------------------------
The Company's future success and competitive position is dependent partly
upon its proprietary technology, and the Company relies to a limited degree on
trademark and copyright law and, may in the future rely on patent law to
protect its intellectual property. There can be no assurance that any patent
owned by the Company will not be invalidated, circumvented or challenged, that
the rights granted thereunder will provide competitive advantages to the Company
or that any of the Company's future patent applications will be issued within
the scope of the claims sought by the Company, if at all. Furthermore, there
can be no assurance that others will not develop technologies that are similar
or superior to the Company's technology, duplicate the Company's technology or
design around the patents owned by the Company. In addition, effective
copyright and trade secret protection may be unavailable or limited in certain
<PAGE>
foreign countries. The Company has been issued two patents for its "Phone Busy
Circuit" and "Hardware Remote Reset Circuit." Although products marketed by
third parties may infringe on these patents, the Company may not proceed to
enjoin the marketing of those products by others in light of technological
changes that are on-going and the substantial expense that the Company may be
required to incur to enforce these patents with no certainty of success.
Potential Erosion of Profit Margins
-----------------------------------
As a result of competitive pressures and technological changes, the sales
price of the Company's current products may decrease over time. As markets
develop for the Company's products, the Company expects that the average selling
price will decrease, which will adversely affect gross profit margins to the
extent that such decreases are not offset by new higher-margin products or
product cost reductions. In addition, certain of the Company's competitors have
significantly greater resources than the Company, and the market for the
Company's primary products is relatively new and undeveloped. There can be no
assurance that a competitor will not enter the Company's markets and devote
substantial resources to the introduction of competing products at lower prices,
which could require the Company to reduce the price of its products. Such a
price reduction could have an adverse effect on the Company's profit margins,
and accordingly, on its operating results and financial condition.
Dividends on Common Stock Unlikely
----------------------------------
The Company has never declared or paid dividends on its Common Stock. The
provisions of the Company's Series D Preferred Stock (the "Series D Preferred
Stock") prohibit the payment of dividends on the Common Stock while shares of
the Series D Preferred Stock are outstanding. The Company does not currently
intend to pay dividends in the foreseeable future so that it may reinvest its
earnings, if any, in the development of its business. The payment of dividends
in the future will be at the discretion of its Board of Directors.
Possible Dilutive Effect of Outstanding Options, Warrants and Preferred
-----------------------------------------------------------------------
Stock
- -----
AS OF JUNE 30, 1997, there were 5,832,967 shares of Common Stock
reserved for issuance upon exercise of stock options and warrants that have been
granted or issued. 1,886,683 of the outstanding options and all of the
3,131,284 warrants are currently exercisable at exercise prices ranging from
$0.60 to $5.00 per share. An additional 337,817 shares of Common Stock are
reserved for issuance upon the exercise of options available for future grant
under the Company's 1994 Stock Option Plan, and 1,700,000 shares of Common Stock
are reserved for issuance upon the conversion or redemption of the 2,496
outstanding shares of the Company's Series D Preferred Stock and the accrued but
unpaid dividends related thereto that may be paid in shares of Common Stock.
Because the Company anticipates that the trading price of Common Stock at the
time of exercise of any such options or warrants will exceed the exercise price,
such exercise will have a dilutive effect on the Company's shareholders. As the
number of shares issuable upon the conversion or redemption of the Series D and
dividends related thereto may increase based on a decline in the market price of
the Common Stock on the date of conversion or redemption, such conversions or
redemptions may have a dilutive effect on the Company's shareholders.
Market Price Fluctuations and Effect of Registration of Shares
--------------------------------------------------------------
The trading price of the Common Stock has from time to time fluctuated
widely and in the future may be subject to similar fluctuations in response to
quarter-to-quarter variations in
<PAGE>
the Company's operating results, announcements of innovations or new products by
the Company or its competitors, general conditions in the computer or computer
network industries and other events or factors. In addition, in recent years
broad stock market indices, in general, and the securities of technology
companies, in particular, have experienced substantial price fluctuations. Such
broad market fluctuations may adversely affect the future trading price of the
Common Stock.
The Company has filed registration statements that became effective in
February 1996 and June 1996, respectively, covering the potential public resale
of a number of shares of its Common Stock that were issued in connection with
private placements by the Company or that may be publicly resold upon the
conversion or exercise of outstanding options, warrants or other convertible
securities. The Company anticipates filing additional registration statements
in the future covering the Company's 1994 Stock Option Plan and shares of Common
Stock issuable upon conversion of the Series D Preferred Stock or upon exercise
of warrants issued in connection with the sale of the Series D Preferred Stock
and may also file registration statements from time to time in the future
covering the public resale of Common Stock issued or issuable upon conversion of
securities issued in any future private placements by the Company. Sales, or
even the possibility of sales, of a substantial number of shares of Common Stock
by the holders thereof could adversely affect the market price of the Common
Stock and could impair the Company's ability to raise capital through the sales
of equity securities.
The warrants to purchase Common Stock that were issued in conjunction with
the Company's 1994 private placement of Common Stock and the Company's 1995
private placement of Common Stock provide the Company the ability to force the
exercise of the warrants if the Common Stock underlying the warrants has been
registered and if the market price of the Common Stock equals or exceeds a
specified level for a period of ten consecutive business days. Should these
conditions be satisfied and should the Company elect to exercise its right to
force the warrants to be exercised, there is a possibility that the warrant
holders may sell some or all of the Common Stock that they purchased during the
private placements in order to obtain the funds necessary to exercise the
warrants. The Company cannot predict what effect, if any, such actions would
have on the market price of the Company's Common Stock.
Loss on Liquidation and Dissolution
-----------------------------------
In the event of a dissolution and termination of the Company, distribution
of the proceeds realized from liquidation will be made according to the relative
priority on liquidation of the Company's creditors. The Company anticipates
that any line of credit it may obtain will be secured by the Company's accounts
receivable and inventory and, therefore, the lender will have a claim to the
Company's assets on liquidation, which is prior to that of the Company's
shareholders. Additionally, holders of the Series D Preferred Stock have
liquidation preference over holders of Common Stock, whereby any proceeds from
liquidation or dissolution remaining after repayment of creditors would be used
to repay holders of Series D Preferred Stock their entire initial investment
plus any accrued but unpaid dividends prior to distributing excess proceeds, if
any, among holders of Common Stock. Accordingly, the ability of a shareholder to
recover all or a portion of his investment under such circumstances will depend
on the net amount of funds available after senior creditors and holders of
Series D Preferred Stock are satisfied.
<PAGE>
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS
Overview
- --------
During the past fiscal year, the Company has actively repositioned itself
into the fast growing consolidated server market and has recently won a major
industry award for the excellence of its product line in meeting consolidated
server requirements (LAN Times - Best of Times Award for Consolidated Servers,
---------
February 1997). In recent years, the Company's products had been geared
primarily toward the remote control segment of the remote access market.
However, increased competition from alternative technologies, lower demand and
changes in access topology caused by increased dominance of the Internet have
led to declining revenues in the remote control segment of the remote access
market and increased operating losses that have adversely affected the Company's
liquidity and capital resources, and caused the Company to transition itself
into the new and rapidly growing domain of the consolidated server market.
The Company has taken significant steps to position itself as an
important force in the consolidated server, network simulation, clustering,
multi-user remote access and telecom Internet service markets, refocusing its
product development and marketing efforts to achieve this goal. The Company has
undergone major organizational changes to improve both its skills mix and modus
operandii. The Company believes that the quality and effectiveness of its sales
and marketing teams have been greatly improved, and the Company is taking steps
to increase gross margins through the use of outsourced "turn-key" manufacturing
of subassemblies for the Company's products and focusing a solutions approach on
the higher-end server market.
The Company's primary product line is the well known ChatterBox family of
server consolidation and clustering platforms, a fully open OSI (Open Systems
Interconnect) architecture that supports all major network operating systems.
The Company's major strength is its proven ability to deliver high and ultra-
high density platforms, which deploy the latest in processor and bus technology.
Recognized by LAN Times as the benchmark for consolidated server performance,
----------
the Company's product line features a highly scaleable architecture,
unparalleled power efficiency, fully functioned management software and low
Mean-Time-To-Recover (MTTR).
The Company's top-down commitment to Open Standards and ISO9000 Quality and
a rededication to "Excellence by Design," have helped the Company in making the
transition to an emerging and technically challenging marketplace, while
supplying the bedrock on which revenue growths may be based. In furtherance of
the move into the consolidated server market, the Company has overhauled its
operations and procedures to comply with the requirements of ISO9000 Quality
Standards. The first round of internal audits were completed in June and the
formal approval process will be undertaken in the third quarter of this fiscal
year.
In order to generate additional working capital to fund the Company's
marketplace transition, and its recent operating losses, the Company has
completed several private placements of its equity securities during the prior
fiscal year. Encouraged by both industry and customer reception of its
repositioned product offerings during the current fiscal year, the Company
anticipates that revenues can be significantly increased. However, there can be
no assurance that the Company will be able to generate increased revenues or
achieve profitability even if revenues do increase. Although the Company
currently has no debt, the Company at present has insufficient liquidity to
support its current level of operations or any significant increase in revenues,
and is actively seeking additional financing to meet its immediate needs as well
as its anticipated requirements for the balance of the fiscal year.
<PAGE>
Results of Operations for the Fiscal Year Ended March 31, 1997 Compared to the
- ------------------------------------------------------------------------------
Fiscal Year Ended March 31, 1996
- --------------------------------
The Company recorded a net loss of $4,601,000 for the fiscal year ended
March 31, 1997 ("fiscal 1997"), on revenues of $9,103,000 as compared to a net
loss of $1,968,000 on revenues of $14,790,000 for the year ended March 31, 1996
("fiscal 1996").
Sales and Costs of Goods Sold
-----------------------------
Sales decreased $5,687,000, or 39%, from $14,790,000 to $9,103,000. The
Company believes that the decrease in revenues was attributable in part to a
constraint on the number of Pentium Pro chips allocated by Intel (which problem
is now corrected), a large volume of orders received late in the fiscal year,
which could not be manufactured in time to ship during the fiscal year, and
delays in foreign government orders, a declining demand for remote control type
remote access solutions, decreased marketing efforts during the last quarter of
fiscal 1996 due to cash flow constraints and the redirection of marketing
efforts toward the server consolidation and network emulation markets during
fiscal 1997. The Company believes that its efforts to penetrate these new
markets will begin to positively affect revenue levels during the first half of
the fiscal year ending March 31, 1998 ("fiscal 1998").
Cost of goods sold decreased $2,988,000, or 30%, from $9,882,000 to
$6,894,000. The decrease was attributable to decreased product sales. The
percentage decrease in cost of sales was less than the percentage decrease in
revenues due to fixed costs contained in cost of sales that did not decrease
proportionately with revenues and a $632,000 increase in additions to inventory
reserves for product obsolescence. The Company is in the process of attempting
to improve its margins and intends to try to obtain higher margins on its new
product offerings, however competitive market forces and new product
introductions by competitors may hamper the Company's attempts.
Rapidly changing technology and engineering refinements to the Company's
hardware and software products are relatively common. These changes can cause
the finished goods inventory to enjoy a relatively short shelf life. The
Company has incurred inventory writedowns in the past. While the Company
maintains valuation allowances for excess and obsolete inventories, which it
believes to be adequate, significant changes in the technology prevailing in the
industry could require the Company to record additional valuation reserves.
During fiscal 1997 and fiscal 1996, the Company recorded additions to its
valuation allowance for obsolete and excess inventories in the amounts of
$794,000 and $162,000, respectively, which adversely affected gross profit and
net income in the periods in which additional valuation allowances were
recorded. The Company believes that its allowance for obsolete and excess
inventories that are currently recorded are sufficient to properly state
inventories at their net realizable value. However, material additions to such
allowance might be required in the future if technology or market conditions
affecting the Company's product sales mix change significantly.
Selling Expense
---------------
Selling expense decreased $167,000, or 5%, from $3,429,000 to $3,262,000.
The decrease was attributable to a decrease in sales department salaries of
$93,000, a decrease in sales commissions of $38,000 and a decrease in
advertising expenditures of $172,000. These decreases were partially offset by
an increase in marketing salary of $85,000. The decrease in sales salaries
was attributable to the resignations of the Vice President of Sales and a
regional
<PAGE>
sales manager during the first two quarters of fiscal 1997. The decrease in
sales commissions was primarily attributable to the decrease in revenues.
Advertising expense decreased as a result of cash flow constraints during the
last quarter of fiscal 1996 and the Company's lack of a marketing director
during the first quarter of fiscal 1997. Marketing department salaries
increased as a result of the hiring of a marketing director and a marketing
communications manager in the first quarter of fiscal 1997. The Company
anticipates that the sales department salaries and advertising expense levels
experienced in fiscal 1997 will increase during fiscal 1998 as the Company
expects to generate increased revenues and has increased its sales staff to
provide increased sales coverage and customer support and has launched a
marketing campaign to penetrate the server consolidation market.
General and Administrative Expense
----------------------------------
General and administrative expense increased $335,000, or 17%, from
$2,004,000 to $2,339,000. The increase consisted of a $139,000 increase in
salaries, an $84,000 increase in officers' travel, a $112,000 increase in bad
debt expense and the recording of $62,000 in restructuring expenses related to
the elimination of certain positions during August 1996. These increases were
partially offset by a $92,000 decrease in legal fees. The increase in salaries
was primarily attributable to the creation of an "Office of the President" that
involved the hiring of a Senior Vice President for Business Development and the
transfer of the Senior Vice President of Technology from the research and
development cost center to the general and administrative cost center. The
increase in officers' travel was attributable to an increased number of officers
and a concerted effort by the Company to keep its executive officers in close
contact with its customers. The increase in bad debts was primarily attributable
to the financial failure of a large reseller of the Company's products.
Severance Expense
-----------------
During fiscal 1996, the Company recorded a severance expense of $322,000
related to the payments that the Company has agreed to pay to former executive
officers of the Company pursuant to the remaining terms of their employment
contracts. There were no terminations during fiscal 1997 that involved similar
agreements.
Research and Development Expense
--------------------------------
Research and development expense increased $332,000, or 36%, from $914,000
for fiscal 1996 to $1,246,000 for fiscal 1997. The increase was primarily
attributable to a concerted effort by the Company to decrease development time
and increase pre-production product testing. The increase included net workforce
increases in the Company's engineering staff and a $178,000 increase in
prototyping and consulting expenses.
Interest Expense
----------------
Interest expense decreased $171,000, or 93%, from $183,000 to $12,000, due
to the retirement of virtually all of the Company's debt financing during the
first quarter of fiscal 1997.
<PAGE>
Results of Operations for the Fiscal Year Ended March 31, 1996 Compared to the
- ------------------------------------------------------------------------------
Fiscal Year Ended March 31, 1995
- --------------------------------
The Company recorded a net loss of approximately $1,968,000 for fiscal
1996, on revenues of approximately $14,790,000 as compared to net loss of
$1,928,000 on revenues of $14,962,000 for the fiscal year ended March 31, 1995
("fiscal 1995").
Sales and Costs of Goods Sold
-----------------------------
Sales decreased $172,000, or 1%, from $14,962,000 to $14,790,000. The
decrease in sales was entirely due to decreased fourth quarter sales. Sales for
the quarter ended March 31, 1996 were $2,383,000 as compared to $5,163,000 for
the quarter ended March 31, 1995, which represents a $2,780,000, or 54%,
decrease. The Company believes that the decrease was due at least in part to
decreased marketing expenditures in the third and fourth quarters of fiscal 1996
due to cash constraints, the lack of a federal budget during that period, which
slowed government purchases of durable goods and the proliferation of alternate
remote access solutions that offer lower performance at a lower cost.
Cost of goods sold increased $214,000, or 2%, from $9,668,000 to
$9,882,000. The increase was due entirely to an increase in manufacturing labor
and overhead of $220,000. The manufacturing labor and overhead increased
primarily due to increased volume of production that was experienced during the
first nine months of the fiscal year.
Selling Expense
---------------
Selling expenses increased $199,000, or 6%, from $3,230,000 to $3,429,000.
The increase was primarily attributable to an increase of $140,000 in
advertising and business promotion related expenses and a $42,000 increase in
marketing consulting.
General and Administrative Expense
----------------------------------
General and administrative expense increased $551,000, or 38%, from
$1,453,000 to $2,004,000. The increase was attributable to the consulting
expenses of $85,000 related to the utilization of an interim president and chief
executive officer from July 1995 to March 1996, approximately $100,000 related
to officers' and directors' liability insurance premiums for a policy that was
initiated in June 1995, approximately $120,000 in management consulting fees
related to the restructuring of the Company's management and the search for the
Company's permanent president and chief executive officer, an increase of
approximately $93,000 in legal and accounting fees relating to transition costs
for the change in corporate counsel and the filing of registration statements,
an increase of consulting fees of $43,000 related to financial public relations
and a $40,000 increase in sales tax expense that resulted from an audit of
fiscal 1992, 1993 and 1994 sales taxes.
Compensation Expense due to Stock Options
-----------------------------------------
Compensation expense recorded in connection with the extension of stock
options decreased $929,000, or 98%, from $949,000 to $20,000. The compensation
expense recorded in
<PAGE>
fiscal 1996 related to options granted to directors pursuant to the formula
option provision of the 1994 Stock Option Plan, which then provided for the
grant of options at 75% of the market price. Subsequent to that grant the
formula option provision of the 1994 Stock Option Plan was amended, whereby
future grants of options will be exercisable at market price as of the date of
grant. The compensation expense recorded in fiscal 1995 related to the
extension of the exercise terms of options to purchase 744,000 shares of Common
Stock.
Severance Expense
-----------------
The Company recorded a severance expense of $322,000 related to payments
that the Company agreed to pay to former executive officers of the Company
pursuant to the remaining terms of their employment contracts.
Research and Development Expense
--------------------------------
Research and development expense increased $38,000, or 4%, from $876,000 to
$914,000. The increase was primarily due to salary increases awarded to
employees and an increase in materials for prototypes.
Interest Expense
----------------
Interest expense decreased $175,000, or 49%, from $358,000 to $183,000, due
to the lower levels of debt financing throughout the year, which was made
possible by the proceeds of a private placement of Common Stock and warrants at
the end of fiscal 1995.
Income Taxes
------------
Income taxes decreased $352,000, or 99%, from $356,000 to $4,000. The
decrease was due to an addition to the valuation reserve for deferred tax assets
in the fiscal year ended March 31, 1995, which effectively reserved all amounts
previously recorded as deferred tax assets.
Financial Condition as of March 31, 1997
- ----------------------------------------
Liquidity and Capital Resources
-------------------------------
During fiscal 1997, the Company had a negative cash flow from operations of
$3,573,000. Additionally, $343,000 of cash was expended for the purchase of
capital assets that are used in operations. The negative operating cash flow
was primarily the result of the net loss of $4,601,000, which was partially
mitigated by noncash charges for accounts receivable and inventory obsolescence
reserves, which comprised part of the net loss, and by a decrease in accounts
receivable. Financing activities provided a positive cash flow of $4,018,000
primarily due to the private placement of Series C 6% Convertible Preferred
Stock, $20,000 stated value per share (the "Series C Preferred Stock") in the
amount of $1,325,000, the private placement of Series D 10% Voting Convertible
Preferred Stock, $1,000 stated value per share(the "Series D Preferred Stock")
and warrants for net proceeds of $2,322,000, and the exercise of stock options
and stock purchase warrants that resulted in proceeds to the Company of
$850,000.
The proceeds from the sale of securities was partially offset by the
repayment of $938,000 of outstanding borrowings under a line of credit agreement
that was terminated in the first quarter of fiscal 1997.
<PAGE>
Liquidity
---------
The Company's continuing losses and negative cash flow from operations have
created a liquidity problem for the Company. As of March 31, 1997, the Company
had working capital of $3,195,000, as compared to working capital of $3,501,000
as of March 31, 1996. Notwithstanding the Company's working capital position as
of March 31, 1997, the Company must provide additional liquidity to support its
current level of operations or any significant future increase in revenues and
is actively seeking additional financing to meet its immediate needs as well as
its anticipated requirements for the balance of the current fiscal year. The
Company, which currently does not have any long-term or bank debt, has received
a conditional commitment for a credit line and is in the process of finalizing
the implementation of the credit line and is negotiating an equity investment
from one of several strategic partners. The Company has not received a firm
commitment for any of the foregoing debt or equity financing, and there can be
no assurance that it will be able to obtain these commitments for a sufficient
amount of financing. If the Company does not raise sufficient financing to meet
its short term needs, it intends to implement a plan, pursuant to which it will
significantly reduce its current advertising and marketing activities, and make
significant reductions in its sales, engineering, customer service and
manufacturing work force. Although the Company believes that it should be able
to maintain operations at a reduced level under the plan for the foreseeable
future, it may be required to raise capital to continue operations at this
reduced level and it would be necessary to raise additional capital to restore
operations to their prior level.
The Company has incurred operating losses in each of its last three fiscal
years and in the first quarter of its current fiscal year. Even if the Company
successfully completes the debt and equity financings it is currently attempting
to place, if the Company continues to experience operating losses in the future
that results in a significant utilization of its liquid resources, the Company's
liquidity and its ability over the long-term to sustain operations at current
levels could be materially, adversely affected.
The Company may seek additional public or private financing to meet its
longer term capital needs if market conditions are favorable. If additional
funds are raised through the issuance of equity securities, it is likely that
the Company will be required to sell such securities at a substantial discount
to the current market price for the Common Stock, the percentage ownership of
the then current shareholders of the Company will be reduced, and such equity
securities may have rights, preferences or privileges senior to those of the
holders of the Company's Common Stock. No assurance can be given that
additional financing will be available or that, if available, it will be
available on terms favorable to the Company or its shareholders. Any increase
in the outstanding number of shares of the Common Stock or options and warrants
may have an adverse effect on the market price of the Common Stock and may
hinder efforts to arrange future financing.
The Company has no material commitments for capital expenditures as of the
date hereof. The Company anticipates, however, acquiring additional equipment
and fixtures from time to time as considered necessary by the Company's
management
ITEM 7. FINANCIAL STATEMENTS
The Company's financial statements appear on pages 34 to 53 of this Annual
Report on Form 10-KSB, following Part IV.
<PAGE>
FINANCIAL STATEMENTS
<PAGE>
INDEPENDENT AUDITORS' REPORT
- ----------------------------
To the Board of Directors of
ChatCom, Inc.
Chatsworth, California:
We have audited the accompanying balance sheets of ChatCom, Inc., (the
"Company") as of March 31, 1997 and 1996, and the related statements of
operations, stockholders' equity, and cash flows for each of the three years in
the period ended March 31, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of ChatCom, Inc. as of March 31,
1997 and 1996, and the results of its operations and its cash flows for each of
the three years in the period ended March 31, 1997 in conformity with generally
accepted accounting principles.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 1 to the
financial statements, the Company's recurring losses and negative cash flows
from operations raise substantial doubt about its ability to continue as a going
concern. Management's plans concerning these matters are also described in Note
1. The financial statements do not include any adjustments that might result
from the outcome of this uncertainty.
DELOITTE & TOUCHE LLP
Los Angeles, California
JUNE 20, 1997
<PAGE>
CHATCOM, INC.
- -------------
<TABLE>
<CAPTION>
BALANCE SHEETS
MARCH 31, 1997 AND 1996 (in thousands)
- ----------------------------------------------------------------------------------------------
Notes 1997 1996
----- ---- ----
<S> <C> <C> <C>
ASSETS 5
- ------
CURRENT ASSETS:
Cash and cash equivalents $ 1,169 $ 1,067
Restricted cash 5 500
Accounts receivable, net of allowances of
$109,000 (1997) and $262,000 (1996) 1,334 1,968
Inventories 2 2,721 3,481
Prepaid expenses and other current assets 108 202
-------- -------
Total current assets 5,332 7,218
EQUIPMENT AND FIXTURES, Net 3,6 651 539
DEPOSITS 24 21
-------- -------
TOTAL $ 6,007 $ 7,778
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable 12 $ 1,427 $ 1,843
Accrued expenses 4 687 906
Short-term borrowings 5 938
Current portion of capital lease obligations 6 23 30
-------- -------
Total current liabilities 2,137 3,717
CAPITAL LEASE OBLIGATIONS -
less current portion 6 12 19
STOCKHOLDERS' EQUITY: 9
Preferred Stock, no par value, authorized 1,000,000 shares: 8
Series B Preferred Stock, $20,000 stated value per share,
authorized 1,000 shares, issued and outstanding
75 shares (1996) 1,294
Series D Preferred Stock, $1,000 stated value per share,
authorized 5,000 shares, issued and outstanding
2,496 shares (1997) 1,407
Common stock, no par value, authorized, 25,000,000 shares,
issued and outstanding, 9,826,892 (1997) and
7,536,629 (1996) shares 10,090 5,860
Additional paid-in capital 2,404 1,436
Accumulated deficit (10,043) (4,548)
-------- -------
Total stockholders' equity 3,858 4,042
-------- -------
TOTAL $ 6,007 $ 7,778
======== =======
</TABLE>
See notes to financial statements
<PAGE>
CHATCOM, INC.
- -------------
<TABLE>
<CAPTION>
STATEMENTS OF OPERATIONS
YEARS ENDED MARCH 31, 1997, 1996 AND 1995 (in thousands, except share and per share data)
- ------------------------------------------------------------------------------------------------------------------
Notes 1997 1996 1995
----- ---- ---- ----
<S> <C> <C> <C> <C>
SALES $ 9,103 $ 14,790 $ 14,962
COST OF GOODS SOLD 6,894 9,882 9,668
---------- ---------- ----------
GROSS PROFIT 2,209 4,908 5,294
---------- ---------- ----------
OPERATING EXPENSES: 12
Selling expense 3,262 3,429 3,230
General and administrative expense 2,339 2,004 1,453
Compensation expense related to stock options 9 20 949
Research and development expense 1,246 914 876
Severance expense 10 322
---------- ---------- ----------
Total operating expenses 6,847 6,689 6,508
---------- ---------- ----------
LOSS FROM OPERATIONS (4,638) (1,781) (1,214)
INTEREST INCOME 49
INTEREST EXPENSE 5, 12 12 183 358
---------- ---------- ----------
LOSS BEFORE PROVISION FOR INCOME TAXES (4,601) (1,964) (1,572)
PROVISION FOR INCOME TAXES 11 4 356
---------- ---------- ----------
NET LOSS (4,601) (1,968) (1,928)
DIVIDENDS ON PREFERRED STOCK 894
---------- ---------- ----------
NET LOSS AVAILABLE TO COMMON STOCKHOLDERS $ (5,495) $ (1,968) $ (1,928)
========== ========== ==========
NET LOSS PER SHARE $(0.61) $(0.26) $(0.34)
========== ========== ==========
Weighted average number of common shares 8,965,743 7,536,629 5,675,999
</TABLE>
See notes to financial statements
<PAGE>
<TABLE>
<CAPTION>
CHATCOM, INC.
- -------------
STATEMENTS OF STOCKHOLDERS' EQUITY
- --------------------------------------------------------------------------------------------------------------
YEARS ENDED MARCH 31, 1997, 1996 AND 1995 (in thousands, except share data)
- --------------------------------------------------------------------------------------------------------------
Preferred Stock Common Stock
--------------- ------------
Number of Number of
Notes Shares Amount Shares Amount
----- ------ ------ ------ ------
<S> <C> <C> <C> <C> <C>
BALANCE, April 1, 1994 5,429,629 $ 2,162
Extension of convertible
subordinated debt 7 27,500 55
Options granted for services
Extension of stock options 9
Issuance of Common Stock and 9
warrants 2,077,500 3,642
Net loss
----- ------ ------ ---------- -------
BALANCE, March 31, 1995 7,534,629 5,859
Exercise of stock options 9 2,000 1
Grant of stock options
Payment of subscription receivable
Issuance of Series B Preferred Stock 8 75 $ 1,294
Net loss
------ ------ ---------- -------
BALANCE, March 31, 1996 75 1,294 7,536,629 5,860
Issuance of Series C Preferred Stock 8 75 1,277
Issuance of Series D Preferred Stock 8 2,496 1,407
Issuance of stock purchase warrants 8
Conversion of Series B Preferred Stock 8 (75) (1,294) 1,024,768 1,294
Conversion of Series C Preferred Stock 8 (75) (1,277) 907,098 1,277
Preferred Stock dividends 38,041 809
Exercise of stock options 9 30,000 37
Exercise of stock purchase warrants 9 290,356 813
Net loss
------ ------ ---------- -------
BALANCE, March 31, 1997 2,496 $ 1,407 9,826,892 $10,090
====== ====== ========== =======
</TABLE>
<TABLE>
<CAPTION>
Additional
Subscription Paid-in Accumulated Stockholders'
Receivable Capital Deficit Equity
------------ ---------- ----------- ------------
<S> <C> <C> <C> <C>
BALANCE, April 1, 1994 $ 348 $ (652) $ 1,858
Extension of convertible
subordinated debt 55
Options granted for services 119 119
Extension of stock options
Issuance of common stock and 949 949
warrants $(100) 3,542
Net loss (1,928) (1,928)
------------ ---------- ----------- ------------
BALANCE, March 31, 1995 (100) 1,416 (2,580) 4,595
Exercise of stock options 1
Grant of stock options 20 20
Payment of subscription receivable 100 100
Issuance of Series B Preferred Stock 1,294
Net loss (1,968) (1,968)
------------ ---------- ----------- ------------
BALANCE, March 31, 1996 1,436 (4,548) 4,042
Issuance of Series C Preferred Stock 1,277
Issuance of Series D Preferred Stock 1,407
Issuance of Stock Purchase Warrants 968 968
Conversion of Series B Preferred Stock
Conversion of Series C Preferred Stock
Preferred Stock dividends (894) (85)
Exercise of stock options 37
Exercise of stock purchase warrants 813
Net loss (4,601) (4,601)
------------ ---------- ----------- ------------
BALANCE, March 31, 1997 $2,404 $(10,043) $3,858
============ ========== =========== ============
</TABLE>
See notes to financial statments
<PAGE>
<TABLE>
<CAPTION>
CHATCOM, INC.
- -------------
STATEMENTS OF CASH FLOWS
YEARS ENDED MARCH 31, 1997, 1996 AND 1995 (in thousands)
- ----------------------------------------------------------------------------------------------------------------------
1997 1996 1995
------- ------- -------
CASH FLOWS FROM OPERATING
ACTIVITIES:
<S> <C> <C> <C>
Net loss $(4,601) $(1,968) $(1,928)
Adjustments to reconcile net loss
to net cash used in operating activities:
Grant/extension of stock options 20 949
Depreciation and amortization 253 312 309
Loss on disposal of assets 57 7
Deferred income taxes 354
Provision for losses on accounts receivable 166 37 57
Provision for inventory obsolescence 794 162 324
Changes in operating assets and liabilities:
Accounts receivable 468 1,455 (1,368)
Inventories (34) (521) (763)
Prepaid expenses and other current assets 94 119 (201)
Deposits (3) (1) (1)
Accounts payable (416) (768) 1,144
Accrued expenses (294) 171 213
------- ------- -------
Net cash used in operating
activities (3,573) (925) (904)
------- ------- -------
CASH FLOWS FROM INVESTING
ACTIVITIES - Capital expenditures (343) (190) (192)
------- ------- -------
CASH FLOWS FROM FINANCING
ACTIVITIES:
Proceeds from short-term borrowings 938
Repayments of short-term borrowings (938) (1,075) (875)
Change in restricted cash 500 (500)
Principal payments on capital leases (35) (33) (28)
Payment of preferred stock dividends (10)
Proceeds from issuance of Common Stock and
warrants 3,242
Collection of subscription receivable 100
Proceeds from issuance of Series B Preferred Stock 1,294
Proceeds from issuance of Series C Preferred Stock 1,325
Proceeds from issuance of Series D Preferred Stock 2,322
Proceeds from issuance of stock purchase warrants 4
Proceeds from issuance of convertible subordinated
debt 550
Repayment of convertible subordinated debt (250)
Repayment of notes payable to officers (88)
Proceeds from exercise of stock purchase warrants 813
Proceeds from exercise of stock options 37 1
------- ------- -------
Net cash provided by financing
activities 4,018 725 2,551
------- ------- -------
NET INCREASE (DECREASE) IN
CASH AND CASH EQUIVALENTS 102 (390) 1,455
CASH AND CASH EQUIVALENTS,
BEGINNING OF YEAR 1,067 1,457 2
------- ------- -------
CASH AND CASH EQUIVALENTS,
END OF YEAR $ 1,169 $ 1,067 $ 1,457
======= ======= =======
See notes to financial statements
(Continued)
</TABLE>
<PAGE>
CHATCOM, INC.
STATEMENTS OF CASH FLOWS
YEARS ENDED MARCH 31, 1997, 1996 AND 1995
- --------------------------------------------------------------------------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
----- ----- ------
<S> <C> <C> <C>
Cash paid (refunded) for income taxes $ $ 2 $(65)
Cash paid for interest $12 $196 $292
</TABLE>
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
During the years ended March 31, 1997 and 1995, the Company acquired office
equipment under capital leases in the amount of $22,000 and $15,000,
respectively.
During fiscal 1997, the Company accrued dividends related to the Series D
Preferred stock of $75,000.
During fiscal 1997, 75 shares of Series B Preferred Stock and 75 shares of
Series C Preferred Stock were converted into 1,024,768 and 907,098 shares
of the Company's Common Stock (the "Common Stock"), respectively.
During fiscal 1997, the Company issued 38,041 shares of Common Stock in
payment of accrued dividends of $59,000 relating to Series B Preferred
Stock and Series C Preferred Stock.
During fiscal 1997, the Company recognized preferred stock dividends of
$750,000 as a result of the beneficial conversion features of the Series B
Preferred Stock and Series C Preferred Stock, which resulted in an increase
in accumulated deficit of $750,000 and an increase in Common Stock of
$750,000. (See note 8).
During fiscal 1997, the Company granted warrants to purchase 100,000 shares
of Common Stock to SGI International, Inc. as partial compensation pursuant
to a finders fee agreement in connection with the placement of the Series D
preferred Stock. The transaction resulted in an increase in additional
paid-in capital of $1,000 and a decrease in Series D Preferred Stock of
$1,000.
During fiscal 1996, the Company granted 15,000 options to purchase the
Common Stock to directors at an exercise price of $4.03 per share. The
market price on the date of grant was $5.37. The grant of the options
resulted in the recording of compensation expense and additional paid-in
capital of $20,000.
During March 1995, the Company issued Common Stock and warrants in exchange
for the receipt of a personal check in the amount of $100,000. Subsequent
to the issuance of the securities, the check proved to be drawn on an
account with insufficient funds. During fiscal 1996, the Company received
the $100,000 subscription receivable.
During March 1995, convertible subordinated debt with a principal balance
of $300,000 was converted into 150,000 shares of Common Stock and warrants
to purchase 150,000 shares of Common Stock.
During December 1994, the Company agreed to issue 27,500 shares of Common
Stock and warrants to purchase 27,500 shares of Common Stock as
consideration for the extension of the due dates of the convertible
subordinated debt. Interest expense for the year ended March 31, 1995, and
Common Stock at March 31, 1995, each contain an amount of $55,000 related
to this transaction.
During November 1994, the Company granted options to purchase 200,000
shares of Common Stock to a consulting firm in exchange for investor
relations services for the period from November 15, 1994, through November
14, 1995. The granting of the options resulted in an increase of
additional paid-in capital of $119,000. The balance of prepaid expenses as
of March 31, 1995, included $74,000 in prepaid consulting fees and general
and administrative expense for the years ended March 31, 1996 and 1995,
included amounts of $74,000 and $45,000, respectively, related to this
transaction.
During August 1994, the Company extended the exercise terms of all non-
qualified stock options then outstanding resulting in the recording of
compensation expense and additional paid-in capital in the amount of
$949,000.
See notes to financial statements.
<PAGE>
CHATCOM, INC.
NOTES TO FINANCIAL STATEMENTS
YEARS ENDED MARCH 31, 1997, 1996 AND 1995
- -----------------------------------------
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Business - ChatCom, Inc., a California corporation, is engaged in the
--------
business of developing, integrating, manufacturing and marketing highly-
efficient centralized server and storage management systems.
The accompanying financial statements have been prepared assuming the
Company will continue as a going concern. During the years ended March 31,
1997, 1996 and 1995 the Company incurred net losses of $4,601,000,
$1,968,000 and $1,928,000, respectively, and negative cash flows from
operations of $3,573,000, and $925,000 and $904,000, respectively, which
raise substantial doubt about its ability to continue as a going concern.
Additionally, revenues during the fourth quarter of fiscal 1997 were lower
than that of the fourth quarter of the previous year and of the first three
quarters of fiscal 1997. As of March 31, 1997, the Company had working
capital of $3,195,000, as compared to working capital of $3,501,000 as of
March 31, 1996. Notwithstanding the Companys working capital position as
of March 31, 1997, the Company must provide additional liquidity to support
its current level of operations or any significant future increase in
revenues and is actively seeking additional financing to meet its immediate
needs as well as its anticipated requirements for the balance of the
current fiscal year. The Company, which currently does not have any bank
debt, has received a conditional commitment for a credit line and is in the
process of finalizing the implementation of the credit line and is
negotiating an equity investment from one of several strategic partners.
The Company has not received a firm commitment for any of the foregoing
debt or equity financing, and there can be no assurance that it will be
able to obtain these commitments for a sufficient amount of financing. If
the Company does not raise sufficient financing to meet its short term
needs, it intends to implement a plan, pursuant to which it will
significantly reduce its current advertising and marketing activities, and
make significant reductions in its sales, engineering, customer service and
manufacturing work force. Although the Company believes that it should be
able to maintain operations at a reduced level under the plan for the
foreseeable future, it may be required to raise capital to continue
operations at this reduced level and it would be necessary to raise
additional capital to restore operations to their prior level. There can be
no assurance that the Company would be able to obtain this financing. The
financial statements do not include any adjustments that might result
should the Company be unable to continue as a going concern.
Use of Estimates - 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.
Cash and Cash Equivalents - The Company considers cash on hand, demand
-------------------------
deposits and short-term investments with original maturities of 90 days or
less to be cash
<PAGE>
equivalents. At March 31, 1997 and 1996, the balance of cash and cash
equivalents consisted of cash on hand, demand deposits, and a certificate
of deposit.
Financial Instruments - The carrying value of cash and cash equivalents,
---------------------
restricted cash, accounts receivable, accounts payable and short-term
borrowings approximate fair value due to the short maturities of such
instruments.
The Companys financial instruments that are exposed to concentration of
credit risk consist primarily of its cash and cash equivalents, restricted
cash and accounts receivables. The Company restricts its investment of
cash and cash equivalents and restricted cash to financial institutions
with high credit standing. Credit risk on accounts receivables is
minimized to a certain extent as a result of the large number and
geographic dispersion of the Companys nationwide customer base. The
Company performs ongoing credit evaluations of its customers financial
condition and maintains an allowance for potential credit losses.
Inventories - Inventories are stated at the lower of cost (first-in, first-
-----------
out) or market. The Company reviews its inventories and assesses the
reserve for obsolete and excess inventories required to state inventories
at the lower of cost or market approximately quarterly. The charges to
cost of sales for the valuation of obsolete and excess inventories were
$794,000, $162,000 and $324,000 for the years ended March 31, 1997, 1996
and 1995, respectively.
Equipment and Fixtures - Equipment and fixtures are stated at cost.
----------------------
Depreciation and amortization are computed on the straight-line method over
the following estimated useful lives of the assets:
Equipment 5 years
Software 3 years
Furniture and fixtures 5 years
Leasehold improvements Lesser of lease
term or 5 years
Software Costs - The Company capitalizes the cost of purchased software.
--------------
These costs are amortized over three years.
Research and Development - All research and development costs are expensed
------------------------
as incurred.
Revenue Recognition - The Company records revenue for sales of hardware
-------------------
and software products at the time the title to the product is transferred
to the customer. The Company does not have significant obligations to
provide hardware or software upgrades or service beyond a standard warranty
period of one year. The cost to provide standard warranty services for
previously sold products is estimated quarterly and accrued.
At the time an extended warranty agreement is sold, the proceeds are
recorded as deferred revenue and amortized to income on a straight-line
basis over the extended warranty period. Sales of extended warranty
agreements began in February 1994. Extended warranty agreements in the
amounts of $139,000, $94,000 and $44,000 were sold during the years ended
March 31, 1997, 1996 and 1995, respectively. Deferred revenue related to
extended warranty agreements of $147,000 and $91,000 was included in
accrued expenses at March 31, 1997 and 1996, respectively.
<PAGE>
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of -
-----------------------------------------------------------------------
The Company adopted the provisions of SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of,"
on April 1, 1996. This Statement requires that long-lived assets and
certain identifiable intangibles be reviewed for impairment whenever events
or changes in circumstances indicates that the carrying amount of the asset
may not be recoverable. Recoverability of assets to be held and used in the
future is measured by a comparison of the carrying amount of the asset to
future net cash flows expected to be generated by the asset. If such assets
are considered to be impaired, the impairment to be recognized is measured
by the amount by which the carrying amount of the assets exceeds the fair
value of the assets. Assets to be disposed of are reported at the lower of
the carrying amount or fair value less costs to sell. Adoption of this
statement did not have a material impact on the Companys financial position
or results of operations.
Major Customers - The Company had sales to individual customers in the
---------------
amounts of $1,177,000, $853,000 and $3,055,000 during the years ended March
31, 1997, 1996 and 1995, respectively.
Income Taxes - Deferred income tax assets and liabilities are computed
------------
annually for differences between the financial statement and income tax
bases of assets and liabilities. Such deferred income tax asset and
liability computations are based on enacted tax law and rates applicable in
periods in which the differences are expected to reverse. If necessary, a
valuation allowance is established to reduce deferred tax assets to the
amount expected to be realized. Income tax expense is the tax payable or
refundable for the year and the change in deferred income tax assets and
liabilities during the year.
Earnings per Share - Earnings per share are computed based on the weighted
------------------
average number of common shares and dilutive common share equivalents
(consisting of convertible preferred stock, stock warrants and stock
options) outstanding during the periods. The computation of fully diluted
loss per share was antidilutive; therefore the amounts reported for primary
and fully diluted loss per share were the same.
Reclassification - Certain amounts in the accompanying 1996 and 1995
----------------
financial statements have been reclassified to conform with the 1997
presentation.
Stock Options - The Company adopted SFAS No. 123, "Accounting for Stock-
-------------
Based Compensation," on April 1, 1996. SFAS No. 123 requires expanded
disclosures of stock-based compensation arrangements with employees and
encourages (but does not require) compensation cost to be measured based on
fair value of the equity instrument awarded. Companies are permitted,
however, to continue to apply APB Opinion No. 25, which recognizes
compensation cost based on the intrinsic value of the equity instrument
awarded. The Company continues to apply APB Opinion No. 25 to its stock-
based compensation awards to employees and has disclosed the required pro
forma effect on net loss and loss per share. (See note 9).
<PAGE>
2. INVENTORIES
Inventories consist of the following:
<TABLE>
<CAPTION>
March 31,
-------------------------
1997 1996
---- ----
<S> <C> <C>
Raw materials $1,508,000 $1,548,000
Work-in process 1,056,000 1,004,000
Finished goods 1,121,000 1,320,000
---------- ----------
Inventory at cost 3,685,000 3,872,000
Less: Reserve for obsolescence 964,000 391,000
---------- ----------
$2,721,000 $3,481,000
========== ==========
</TABLE>
3. EQUIPMENT AND FIXTURES
Equipment and fixtures consist of the following:
<TABLE>
<CAPTION>
March 31,
-------------------------
1997 1996
---- ----
<S> <C> <C>
Equipment $1,006,000 $ 755,000
Software 137,000 84,000
Furniture and fixtures 181,000 154,000
Leasehold improvements 74,000 40,000
---------- ----------
1,398,000 1,033,000
Less accumulated depreciation
and amortization 747,000 494,000
---------- ----------
$ 651,000 $ 539,000
========== ==========
</TABLE>
4. ACCRUED EXPENSES
Accrued expenses consisted of the following:
<TABLE>
<CAPTION>
March 31,
-----------------------
1997 1996
---- ----
<S> <C> <C>
Accrued payroll and related expenses $252,000 $219,000
Accrued bonuses and commissions 29,000 32,000
Accrued dividends on preferred stock 75,000
Reserve for severance 54,000 317,000
Reserve for stock registration 36,000
Accrued royalties 35,000 35,000
Deferred rent 26,000 39,000
Deferred revenue 147,000 91,000
Accrued warranty expense 15,000 15,000
Other liabilities 54,000 122,000
-------- --------
$687,000 $906,000
======== ========
</TABLE>
<PAGE>
5. SHORT TERM BORROWINGS
On May 26, 1995, the Company entered into a $3,500,000 working capital
line-of-credit facility with a commercial finance corporation that bore
interest at the prime rate (8.25% at March 31, 1996) plus 1.75%. The line-
of-credit was collateralized by substantially all of the assets of the
Company and contained covenants requiring the Company to maintain a
prescribed level of earnings and certain financial ratios. The maximum
amount of borrowing that was allowed under the line-of-credit agreement was
equal to 80% of eligible accounts receivable.
The Company failed to comply with the maintenance of earnings covenant
contained in the line-of-credit agreement for the fiscal quarters ended
September 30, 1995 and December 31, 1995. The lender waived compliance
with the covenant for the quarter ended September 30, 1995 upon the Company
securing the facility with a $500,000 six-month irrevocable standby letter
of credit. The lender waived compliance with the covenant for the quarter
ended December 31, 1995 upon the agreement by the Company to repay all
amounts owing under the line by May 3, 1996. On May 2, 1996, the Company
repaid all amounts then outstanding and all accrued interest owed under the
line-of-credit agreement and the agreement was terminated.
6. LEASE OBLIGATIONS
The Company leases its primary operating facility in Chatsworth, California
under an operating lease expiring on November 30, 1998. The Company leases
sales offices in Seattle, New York City, San Francisco and West Orange, New
Jersey under operating lease agreements that expire at various times during
fiscal year 1998 and a vehicle and certain equipment under operating lease
agreements that expire at various times during the fiscal year ending March
31, 2000. Rent expense under such lease agreements in fiscal years 1997,
1996 and 1995 was $172,000, $153,000 and $136,000, respectively.
The Company has financed the purchase of office equipment through
capital lease agreements. The obligations are collateralized by the leased
equipment, which had a net book value of $41,000 and $42,000 at March 31,
1997 and 1996, respectively.
Future minimum lease payments are as follows:
<TABLE>
<CAPTION>
Year Ending Operating Capital
March 31, Leases Leases
------------- ---------- --------
<S> <C> <C>
1998 $183,000 $25,000
1999 99,000 12,000
2000 2,000 1,000
-------- -------
$284,000 38,000
========
Less interest 3,000
Less current portion 23,000
-------
$12,000
=======
</TABLE>
<PAGE>
7. CONVERTIBLE SUBORDINATED DEBT
On May 4, 1994, the Company issued 9% convertible subordinated debt with
principal of $550,000, maturing on November 4, 1994. Upon maturity, the
Company negotiated extensions of the due dates of the convertible
subordinated debt until March 4, 1995. During the extension period,
interest at the rate of 12% per annum was paid by the Company. As
additional consideration for the extension, the noteholders were issued
27,500 shares of common stock and warrants to purchase 27,500 shares of
common stock at an exercise price of $3.00 per share. In March 1995, the
Company repaid $250,000 of the convertible subordinated debt and the
remaining $300,000 was converted into 150,000 shares of common stock and
warrants to purchase 150,000 shares of Common Stock at an exercise price of
$3.00 per share.
8. PREFERRED STOCK
In March 1996, the Company sold 75 shares of Series B Preferred Stock,
$20,000 stated value per share (the "Series B Preferred Stock"), for gross
proceeds of $1,500,000. Offering costs of $206,000, consisting of finders
fees, legal fees, accounting fees, listing fees and registration costs,
were incurred by the Company. Dividends were payable in cash or common
stock, at the option of the Company, at a rate of 6% per annum. The shares
were convertible into Common Stock with a conversion price equal to the
lesser of the average closing bid price for the five trading days prior to
the date of sale or 75% of the average closing bid price for the five
trading days prior to the date of conversion or redemption. As a result of
this beneficial conversion feature, $375,000 was charged to additional
paid-in capital and reflected as a preferred stock dividend during fiscal
1997. During fiscal 1997, the holders of the Series B Preferred Stock
converted all of the outstanding shares into 1,024,768 shares of Common
Stock. The Company paid dividends of $10,000 and 15,535 shares of Common
Stock related to the Series B Preferred Stock.
In May 1996, the Company sold 75 shares of Series C Preferred Stock,
$20,000 stated value per share (the "Series C Preferred Stock"), for gross
proceeds of $1,500,000. Offering costs of $175,000, consisting of finders
fees, legal fees, accounting fees, listing fees and registration costs,
were incurred by the Company. Dividends were payable in cash or Common
Stock, at the option of the Company, at a rate of 6% per annum. The shares
were convertible into Common Stock with a conversion price equal to the
lesser of the average closing bid price for the five trading days prior to
the date of sale or 75% of the average closing bid price for the five
trading days prior to the date of conversion or redemption. As a result of
this beneficial conversion feature, $375,000 was charged to additional
paid-in capital and reflected as a preferred stock dividend during fiscal
1997. During fiscal 1997, the holders of the Series C Preferred Stock
converted all of the outstanding shares into 907,098 shares of Common
Stock. The Company paid dividends of 22,506 shares of Common Stock related
to the Series C Preferred Stock.
In December 1996, the Company sold 2,496 shares of Series D Voting
Convertible Preferred Stock, $1,000 stated value per share (the "Series D
Preferred Stock") and warrants to purchase 400,000 shares of common stock
(the "Warrants"), for gross proceeds of $2,500,000. Offering costs of
$178,000, consisting of cash finders fees, warrants issued as finders fees,
legal fees, accounting fees, listing fees and registration costs, were
incurred by the Company. Dividends are payable in cash or Common Stock, at
the option of the Company, at a rate of 10% per annum. The Company can
require the holders of the Series D Preferred Stock to convert these shares
into shares of Common Stock at any time prior to December 14, 1997. The
Series D Preferred Stock is also convertible at the election of the holders
into shares of Common Stock during the one-year period commencing on
December 14,
<PAGE>
1997. The actual number of shares of Common Stock into which of the Series
D Preferred Stock and any dividends that are payable in shares of Common
Stock are convertible is variable, with the conversion value of the shares
being equal to the market price of the Common Stock (determined based on
the closing sale price of the Common Stock for the ten trading days
preceding the date of conversion). The conversion value of the Common Stock
will have a cap of $4.50 per share and, commencing on December 14, 1997,
will have a floor of $1.50 per share. The Company has agreed to register
the shares issuable upon conversion of Series D Preferred Stock or upon
exercise of the Warrants. The purchasers of the Series D Preferred Stock
have voting rights for each share of the Series D preferred Stock
outstanding equivalent to that of 380 shares of Common Stock. Holders of
the Series D Preferred Stock also have the right to elect a majority of the
Company's directors in the event of default by the Company in the payment
of dividends on the Series D Preferred Stock or upon certain other defined
events of default.
9. STOCK OPTIONS AND WARRANTS
Stock Options
-------------
The Company applies APB Opinion 25 in accounting for its Stock Options
Plans (the "Plans"). Had the Company determined compensation cost based on
the fair value at the grant date for its stock options under SFAS No. 123,
the Companys net loss would have increased to the pro forma amounts
indicated below.
<TABLE>
<CAPTION>
Year Ended March 31,
-------------------------------
1997 1996
---- ----
<S> <C> <C>
Net loss As reported $(4,601,000) $(1,968,000)
per share $ (0.61) $ (0.26)
Pro Forma $(6,209,000) $(2,546,000)
per share $ (0.69) $ (0.34)
</TABLE>
Pro forma net loss reflects only options granted subsequent to March 31,
1995. Therefore, the full impact of calculating compensation cost for
stock options under SFAS 123 is not reflected in the pro forma net loss
amounts presented above because compensation cost is reflected over the
vesting period of up to 4 years and compensation cost for options granted
prior to April 1, 1995 is not considered.
The Company had an incentive stock option plan that expired in April 1995
(the "1985 Plan"), under which options to purchase 400,000 shares of Common
Stock could be granted to officers and employees. Options granted were at
100% of the estimated fair market value on the dates of grant. On November
22, 1994, the shareholders of the Company approved and adopted the Companys
1994 Stock Option Plan (the "1994 Plan") to replace the expiring 1985 Plan.
Under the 1994 Plan, options to purchase up to 2,000,000 shares of the
Common Stock may be granted to officers, employees, directors and
consultants of the Company. On February 8, 1996, and on November 21, 1996
the shareholders of the Company approved and adopted amendments to the 1994
Plan, which revised the provision for the granting of formula options to
non-employee directors of the Company. The following summarizes the
transactions relating to stock options granted pursuant to the terms of the
stock option plans:
<PAGE>
<TABLE>
<CAPTION>
Weighted
Shares Average
Under Price Price
Option Per Share Range
------ --------- -----
<S> <C> <C> <C>
Balance at April 1, 1994 153,000 $2.47 $0.45-$5.00
Granted 186,100 $2.16 $1.67-$2.22
---------
Balance at March 31, 1995 339,100 $2.30 $0.45-$5.00
Granted 798,750 $2.19 $1.75-$3.63
Exercised 2,000 $0.45 $ 0.45
Canceled and expired 132,250 $2.27 $0.45-$3.63
---------
Balance at March 31, 1996 1,003,600 $2.22 $1.67-$5.00
Granted 392,500 $2.33 $2.19-$2.63
Canceled and expired 151,750 $2.20 $2.13-$2.63
---------
Balance at March 31, 1997 1,244,350 $2.26 $1.67-$5.00
=========
</TABLE>
The fair value of the options granted during the year ended March 31, 1997
was estimated using the Black-Scholes option pricing model based on groups
of options with identical terms (including actual contractual lives ranging
from 3 to 10 years) assuming a volatility rate of 93% and zero dividend
yield, and a discount rate of 6 to 6.5%.
At March 31, 1997 and 1996, 767,600 and 419,600 stock options,
respectively, were exercisable under the 1994 Plan, and 35,500 and 40,000
employee incentive stock options were exercisable under the 1985 Plan at
March 31, 1997 and 1996, respectively. Pursuant to the terms of the 1994
Stock Option Plan, the options granted to employees have an exercise price
equal to the market value of the Common Stock on the date of grant.
Accordingly, no compensation expense was recorded with respect to the
granting of employee options. The 541,250 options that were not exercisable
at March 31, 1997 consist of 31,250 options granted to directors, 360,000
options granted to an officer and 150,000 options granted to two key
employees. All of the options granted to directors become exercisable
during the fiscal year ending March 31, 1998. The options granted to an
officer become exercisable over six years, the timing of which is dependent
upon the Company achieving certain performance criteria. 120,000 of such
options vested as of March 31, 1997. During each of the years ending March
31, 1998, 1999 and 2000, 50,000 of the options granted to employees become
exercisable.
In November 1994, the Company granted options to purchase 200,000 shares of
common stock for $1.50 per share to a group of consultants as consideration
for investor relations consulting services for the period from November 15,
1994 through November 14, 1995. The options expire November 15, 1997.
Although the closing market price for Common Stock on the date of grant
exceeded the exercise price of the options, as the optionees were not
employees or directors of the Company, the Company recorded a prepaid
consulting fee and additional paid-in capital in the amount of $119,000
based on an estimate of fair market value of the options. The prepaid
expense was amortized to consulting expense on a straight line basis over
the term of the agreement.
In August 1994, the Company extended the exercise terms of 744,000 non-
qualified options (which consisted of 44,000 options granted to directors
in fiscal 1992 for service
<PAGE>
on the Board of Directors, 400,000 options granted to officers of the
Company in fiscal 1992 pursuant to the terms of their employment
agreements, and 300,000 options that were granted to directors in fiscal
1991 in connection with loan guarantees) to expire at a date ten years from
the original grant date. All of the options were originally granted to
directors and officers, some of whom are major shareholders, of the Company
prior to the end of fiscal 1992. As the market price of the Common Stock on
the date that the option terms were extended exceeded the exercise price of
the options, the Company recorded compensation expense of $949,000 relating
to the extension of the exercise terms.
In fiscal 1993, the Company granted options to purchase 30,000 shares of
Common Stock to a consultant, which were exercisable at a price of $1.25
per share. On April 15, 1996, the consultant exercised all of the options.
In fiscal 1992, the Board of Directors authorized the Company to grant
options to purchase 99,000 shares of Common Stock to three directors
(33,000 for each director) for $0.60 per share. One third of the options
become exercisable after each of the three fiscal year-ends following the
date of grant, provided that the Company's income before taxes exceeded
$200,000 for the fiscal year then ended. As of March 31, 1996, 22,000 of
these options had been exercised, 33,000 had been canceled and 44,000 of
these options were exercisable. These options originally were to expire on
March 31, 1995. As described above, in August 1994, the Company extended
the exercise terms of 44,000 options then outstanding to expire on March 5,
2002. The Company recorded $56,100 in compensation expense related to the
extension of the exercise terms of these options.
In fiscal 1992, the Board of Directors granted options to purchase 400,000
shares of Common Stock for $0.60 per share to two of the officers of the
Company pursuant to their employment agreements. The timing of the vesting
of the stock options was dependent on the achievement of specified net
income goals. At March 31, 1996, all of the options were exercisable and
outstanding. These options were originally to expire on January 31, 1997.
As described above, in August 1994, the Company extended the exercise terms
of these options to expire on January 31, 2002. The Company recorded
$510,000 in compensation expense related to the extension of the exercise
terms of these options.
In fiscal 1991, the Company granted major stockholders and directors stock
options to purchase 350,000 shares of Common Stock at exercise prices of
$0.60 per share. These options were originally to expire on February 1,
1996. As described above, in August 1994, the Company extended the exercise
terms of the 300,000 of these options then outstanding to expire on January
1, 2002. The Company recorded $382,500 in compensation expense related to
the extension of the exercise terms of these options. The stock options
were granted in connection with loan guarantees on the Company's borrowings
provided by the stockholders and directors. As of March 31, 1997, 50,000 of
these options had been exercised and the remaining 300,000 options were
exercisable.
Stock Purchase Warrants
-----------------------
In connection with the private placement of Series D Preferred Stock, the
Company issued warrants to purchase 400,000 shares of Common Stock at a
price of $3.125 per share and the Company issued warrants to purchase
100,000 shares of Common Stock at a price of $3.125 per share pursuant
to a finders fee agreement. All of the foregoing warrants expire on
December 21, 2001.
In connection with the private placement of Series C Preferred Stock, the
Company issued warrants to purchase 30,000 shares of Common Stock at a
price of $3.00 per share pursuant to a finders fee agreement The warrants
expire on May 31, 2000.
From December 1994 through March 1995, the Company sold units consisting of
Common Stock and warrants through a private placement. In conjunction with
this offering, warrants to purchase 1,877,500 shares at an exercise price
of $3.00 per share were issued. The warrants expire on December 31, 1997
and may be called by the
<PAGE>
Company if certain conditions are met in the future. The warrants become
callable by the Company after the Common Stock underlying the warrants is
registered and the Common Stock has had a closing bid price of at least
$3.60 for the most recent ten consecutive trading days. In May 1996, a
private placement of preferred stock by the Company caused the exercise
price and the number of shares subject to such warrants to be adjusted
pursuant to the antidilution provisions contained in the warrant
agreements. The adjustments increased the number of shares subject to the
warrants to 2,011,604 and decreased the exercise price to $2.80 per share.
Subsequent to the adjustment pursuant to the antidilution provisions,
290,356 warrants were exercised.
In December 1994, the Company issued warrants to purchase 27,500 shares of
Common Stock at an exercise price of $3.00 per share in connection with the
negotiation of the extension of maturity dates for the convertible
subordinated debt that was outstanding for a portion of fiscal 1995. The
warrants expire on December 31, 1997. The warrants become callable by the
Company after the Common Stock underlying the warrants is registered and
the Common Stock has had a closing bid price of at least $3.60 for the most
recent ten consecutive trading days. In May 1996, a private placement of
preferred stock by the Company caused the exercise price and the number of
shares subject to such warrants to be adjusted pursuant to the antidilution
provisions contained in the warrant agreements. The adjustments increased
the number of shares subject to the warrants to 29,465 and decreased the
exercise price to $2.80 per share.
In December 1994, the Company sold units consisting of Common Stock and
warrants through a private placement. In conjunction with this offering,
warrants to purchase 200,000 shares at an exercise price of $2.00 per share
were issued. The warrants expire on January 1, 1998. The warrants become
callable by the Company after June 30, 1995 if the Common Stock has had a
closing bid price of at least $4.00 for the most recent five consecutive
trading days. In May 1996, a private placement of preferred stock by the
Company caused the exercise price and the number of shares subject to such
warrants to be adjusted pursuant to the antidilution provisions contained
in the warrant agreements. The adjustments increased the number of shares
subject to the warrants to 213,904 and decreased the exercise price to
$1.87 per share.
In fiscal 1992, the Company issued warrants to purchase 625,000 shares of
common stock at $0.80 per share in connection with the private placement of
1,250,000 shares of Common Stock. The warrants expire on March 5, 1999. In
May 1996, a private placement of preferred stock by the Company caused the
exercise price and the number of shares subject to such warrants to be
adjusted pursuant to the antidilution provisions contained in the warrant
agreements. The adjustments increased the number of shares subject to the
warrants to 666,667 and decreased the exercise price to $0.75 per share.
<PAGE>
10. SEVERANCE EXPENSE
During the fourth quarter of fiscal 1996, the Company recorded severance
expense in the amount of $322,000 relating to a change in the executive
officers of the Company. The amount charged as severance expense relates
to the required payments remaining on the contracts of the former executive
officers of the Company.
11. INCOME TAXES
The components of income tax expense (benefit) are as follows:
<TABLE>
<CAPTION>
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Current:
Federal $0 $ 0 $ 0
State 0 4,000 1,000
-- ------ --------
Total current 0 4,000 1,000
-- ------ --------
Deferred:
Federal 0 0 287,000
State 0 0 68,000
-- ------ --------
Total deferred 0 0 355,000
-- ------ --------
Total income tax expense $0 $4,000 $356,000
== ====== ========
</TABLE>
The reasons for the differences between income tax expense and the amount
computed by applying the federal statutory income tax rate to income before
income taxes are as follows:
<TABLE>
<CAPTION>
1997 1996 1995
----- ----- -----
<S> <C> <C> <C>
Tax expense at federal
statutory rate 35% 35% 35%
State franchise tax, net of
federal income tax benefit 7 7 7
Extension of stock options (24)
Addition of deferred income tax asset
valuation reserves (42) (42) (39)
Other (2)
--- --- ---
Actual tax expense 0% 0% (23)%
=== === ===
</TABLE>
<PAGE>
The components of deferred income tax assets (liabilities) at March 31 are
as follows:
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Deductible:
Net operating loss carryforward $ 2,498,000 $ 974,000
Reserve for severance 0 109,000
Alternative minimum tax credits 21,000 21,000
Uniform capitalization rules 33,000 33,000
Reserve for bad debts 37,000 49,000
Inventory reserves 328,000 133,000
Vacation accrual 29,000 38,000
Warranty reserves 5,000 5,000
State taxes (net of federal taxes) 479,000 237,000
----------- -----------
$ 3,430,000 $ 1,599,000
=========== ===========
1997 1996
---- ----
Taxable:
Depreciation $ (9,000) $ (28,000)
State taxes (net of federal taxes) (2,000) (7,000)
----------- -----------
$ (11,000) $ (35,000)
=========== ===========
The net deferred tax asset at March 31 are as follows:
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Deferred tax assets $ 3,430,000 $ 1,599,000
Deferred tax liabilities (11,000) (35,000)
----------- -----------
3,419,000 1,564,000
Valuation allowance (3,419,000) (1,564,000)
----------- -----------
$ 0 $ 0
=========== ===========
</TABLE>
The deferred tax asset valuation allowance increased $1,855,000, $761,000
and $609,000 in the fiscal years ended March 31, 1997, 1996 and 1995,
respectively.
At March 31, 1997, the Company had net operating loss carryforwards of
approximately $7,348,000 and $3,879,000 for federal income tax and state
franchise tax purposes, respectively. The federal net operating loss
carryforwards expire in the fiscal years ending March 31, 2004 through
2012, and state net operating loss carryforwards expire in the fiscal years
ending March 31, 1997 through 2002.
12. RELATED PARTY TRANSACTIONS
A former director of the Company is also a principal in a law firm that
provides legal consultation to the Company, and was a principal in another
law firm, which has been dissolved, that provided services to the Company.
At March 31, 1997 and 1996, the Company owed the current law firm $3,000
and $10,000, respectively, and $74,000 and $10,000 of legal fees relating
to this firm were included in general and administrative
<PAGE>
expense for the years ended March 31, 1997 and 1996, respectively. In
fiscal 1996 and 1995 legal fees relating to the dissolved law firm in the
amounts of $237,000 and $199,000, respectively, were included in general
and administrative expense. Additionally, in fiscal 1995, legal expenses
for the dissolved law firm related to the private placement of securities
in the amount of $40,000 were offset against the proceeds of the placement.
In fiscal 1996, the Company paid Maximum Partners, Ltd. a finders fee in
the amount of $150,000 related to the placement of the Series B Preferred
Stock. The son of the Companys then-Vice Chairman is a principal of Maximum
Partners, Ltd. In fiscal 1997, Maximum Partners, Ltd. also received
$150,000 and warrants to purchase 30,000 shares of Common Stock at an
exercise price of $3.00 per share as a finders fee for the placement of the
Series C Preferred Stock.
13. RESTATEMENT OF QUARTERLY NET LOSS PER SHARE
Quarter Ended
-------------
June 30, September 30, December 31
1996 1996 1996
---- ---- ----
Net loss per share as
previously reported $(0.08) $(0.13) $(0.06)
As restated $(0.18) $(0.14) $(0.06)
Net loss per share data for the fiscal quarters ended June 30, September
30, and December 31, 1996, has been restated to reflect the amortization as
preferred stock dividends of the beneficial conversion features of the
Series B Preferred Stock and the Series C Preferred Stock as discussed in
note 8.
14. SUBSEQUENT EVENTS
During May 1997, the Company was advanced $350,000 by an investor upon the
Companys agreement to issue shares of a to be authorized Series E Preferred
Stock (the "Series E Preferred Stock") or a 10% convertible subordinated
note. Although the terms of the Series E Preferred Stock have not been
finalized, the Company anticipates that the Series E Preferred Stock, if
issued, is likely to have terms similar to the Series D Preferred Stock,
but with different conversion and repurchase options and different
conversion and exercise prices.
<PAGE>
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the Registrant
has caused this Amendment to its Report on Form 10-KSB to be signed on its
behalf by the undersigned, thereunto duly authorized.
CHATCOM, INC.
a California corporation
Dated July 17, 1997 By: /s/ James B. Mariner
----------------------------
James B. Mariner, President,
Chief Executive Officer and
Chief Financial Officer
Dated July 17, 1997 By: /s/ Cheryl A. Smithey
----------------------------
Cheryl A. Smithey
Controller and Principal
Accounting Officer
