SOCKET MOBILE, INC. - Quarter Report: 2001 June (Form 10-Q)

NOTE 1 - Basis of Presentation

NOTE 3 - Inventories

NOTE 4 - Bank Financing Arrangements

NOTE 5 - Income Taxes

Revenue

We are a leading supplier of connectivity plug-in card products to the handheld and notebook computing markets. Total revenue for the three and six months ended June 30, 2001 of $2.8 million and $5.7 million, respectively, increased 17% and 30% over revenue of $2.4 million and $4.4 million for the corresponding periods a year ago.

Our core technologies are in transferring data into and out of Windows-powered mobile computing devices through the PC Card or CompactFlash slots. Our products are designed to achieve high data transfer speeds with low power consumption. Our primary marketing and sales focus is on connection products for Windows CE handheld computers, the largest category being Pocket PCs. Our connection products generally also work in Windows-powered notebooks.

Our plug-in connection card products are grouped into five product families. Our peripheral connection cards are designed to connect one or more peripheral devices such as a keyboard, monitor or another computer, to a mobile computer. Our data collection cards are designed to connect bar code scanners such as a bar code wand, scanning gun, or a bar code printer to a mobile computer. Our digital phone cards are designed to connect a data-enabled mobile phone to a mobile computer, providing access to email, to the Internet, or to corporate intranets while mobile. Our Ethernet cards are designed to connect a mobile computer to an Ethernet network. And our Bluetooth Personal Network Cards and modules are designed to wirelessly connect other Bluetooth-enabled electronic devices such as mobile phones, printers, bar code scanner and printers, and local area network access points to a mobile computer within a personal area network radius of approximately thirty feet. Our connection product strategy has been to create a broad family of low-power connection products in the PC card and CompactFlash form factor, with standard (removable cable), ruggedized (fixed cable), or with Bluetooth wireless connection designs that work with Windows-powered handheld and notebook computers.

We also earn revenue from the sale of our interface chips to third parties, from the licensing of our software to others, and from non-recurring engineering services relating to embedded design services for third parties, including embedding our Bluetooth modules into third party products.

Revenues from the sale of peripheral connection cards were $1.1 million and $2.3 million, respectively, for the three and six month periods ended June 30, 2001, compared to $0.8 million and $2.0 million for the same periods one year ago. Moderate increases in the volumes of PC card sales for notebooks in 2001 were partially offset by lower sales of custom labeled products to OEM customers in 2001 resulting from the completion in the first quarter of 2000 of an OEM contract.

Revenue from the sale of data collection cards were $0.7 million and $1.2 million, respectively, for the three and six month periods ended June 30, 2001, compared to $0.6 million and $1.0 million for the same periods one year ago. Increases in 2001 were due to increased shipments of our CompactFlash In-Hand Scan Card.

Revenue from the sale of digital phone cards were $0.3 million and $0.8 million, respectively, for the three and six month periods ended June 30, 2001, compared to $0.5 million and $0.6 million for the same periods one year ago. Higher retail sales in 2001 were partially offset by moderately lower sales in 2001 to phone network carriers and to customers through our distribution channels. Sales levels during the first quarter and part of the second quarter of 2001 were adversely affected by lower Pocket PC computer sales due to supply shortages of Pocket PCs in the retail channel.

Revenue from the sale of Ethernet cards were $0.3 million and $0.8 million, respectively, for the three and six month periods ended June 30, 2001, compared to $0.5 million and $0.8 million for the same periods one year ago. Sales levels during the first quarter and part of the second quarter of 2001 were adversely affected by lower Pocket PC computer sales due to supply shortages of Pocket PCs in the retail channel.

Revenue from the sale of Bluetooth cards were $0.1 million and $0.2 million, respectively, for the three and six month periods ended June 30, 2001, compared to zero for the same periods one year ago. Bluetooth product sales in 2001 were primarily from sales of developer evaluation kits.

Revenue from funded engineering services were $0.2 million and $0.4 million, respectively, for the three and six month periods ended June 30, 2001, compared to zero for the same periods one year ago. We have offered engineering design services to third parties since our acquisition of 3rd Rail Engineering, a engineering design and services company early in the fourth quarter of 2000.

Revenue from the sale of our custom interface chips to third parties were $0.1 million for the three and six month periods ended June 30, 2001, compared to zero for the same period one year ago. We began selling our interface chips in the third quarter of 2000.

We distribute our products primarily through third-party distribution channels. In the United States, our largest distributor is Ingram Micro, which accounted for approximately 25% and 26% of worldwide revenues in the three and six month periods ended June 30, 2001 compared to 31% and 28% for the same periods one year ago. We also sell our products internationally through 35 distributors in 27 countries in Europe, Asia and the Pacific Rim. Our distributors resell to computer retail stores, electronic products catalog companies and value added resellers. During 2000, we also began selling our Digital Phone Cards in the U.S. through mobile phone network carriers. Recognition of revenue on shipments to distributors and the related cost of sales are deferred until such distributors resell the products to their customers. Recognition of revenue on shipments to customers other than distributors occurs generally at the time of shipment. We also sell our products directly to selected large customers, particularly for custom products sold to original equipment manufacturers.

Revenue outlook for the second half of 2001

Current economic slowdown and temporary manufacturing shortages of Pocket PCs during the first quarter of 2001 continued into the second quarter but sufficient supplies of Pocket PCs became available from the Pocket PC manufacturers by June to meet increasing demand, and Pocket PC manufacturers have announced that they expect to continue to manufacture sufficient quantities of Pocket PCs to meet expected demand levels. In addition, we anticipate additional Pocket PCs models, many with popular bright outdoor screens, will be available in time for the fall holiday buying season. Long manufacturing lead times for the bright outdoor screens were a major factor contributing to the Pocket PC supply shortages in the first half of 2001. Sales of Pocket PCs are a major driver of sales for our CompactFlash connection cards. In addition to anticipated growth in the available supply of Pocket PC's, factors driving increased demand will include our planned introduction of new products including Bluetooth CompactFlash connection cards and combination input/output and memory cards, expansion of our markets with the introduction of phone card products for the newest handheld units from Palm, Inc. that have expansion options, the broadening of our distribution channels into additional electronic retail store outlets, and additional engineering revenue anticipated from our offering embedded engineering services for new Bluetooth modules as our research and development workload decreases. Based on these expected developments, we anticipate moderate revenue growth in the 3rd quarter, increasing in the 4th quarter. If any of these anticipated developments do not occur, our revenue outlook will be adversely affected.

Gross Margins

Gross margins for the three and six month periods ended June 30, 2001 were 55% and 54%, respectively, compared to margins of 58% for same periods in 2000. Factors reducing gross margins in 2001 included higher fixed manufacturing costs as we increased staffing to manage anticipated growth, and growth in lower margin nonrecurring engineering services revenue and moderately lower margin CompactFlash product sales.

Gross Margin outlook for the balance of 2001. We expect the Company's CompactFlash products to continue to drive revenue growth during the balance of 2001, with more sales qualifying for volume purchase discounts. As our sales mix continues to shift toward higher volume sales, and increases in lower-margin engineering services revenues, we expect our margins to continue to decline by a few percentage points. We also expect to achieve cost reductions on our products from volume manufacturing efficiencies and engineering improvements which will partially mitigate the effects of lower unit pricing. We expect our pricing model during 2001 to maintain our margins at or above fifty percent. However, future unanticipated inventory write-offs and write-downs and other factors could adversely impact our margin results.

Research and Development Expense

Research and development expense in the three and six month periods ended June 30, 2001 was $1.1 million and $2.1 million, respectively, an increase of 84 percent and 95 percent, respectively, over research and development expense for the corresponding periods in the previous year. This increase was due primarily to increases in engineering resources beginning with the fourth quarter of 2000 from our acquisition of 3rd Rail Engineering in October 2000. The additional engineering resources have enabled us to undertake and sustain three major engineering development programs. These programs are:

• wireless plug-in Bluetooth CompactFlash cards, embedded modules and Bluetooth software;
• combination CompactFlash memory and input/output cards with removable memory including development of a new ASIC interface chip; and
• development work on a smaller SD form factor for all of our CompactFlash connection products.

Research and development expense also included $0.1 million and $0.2 million of third party software development expense during the three and six months periods ended June 30, 2001, respectively, compared to zero in the same periods of the previous year. During 2001, we also incurred higher occupancy and administrative support costs, partially offset by reductions in outside services.

Outlook for Research and Development Costs for the balance of 2001: We believe that we have the resources we need to sustain our development programs during the balance of 2001. Quarterly development expense is expected to moderately decline quarter over quarter from second quarter 2001 levels as we complete major phases of our Bluetooth development programs during the third quarter of 2001 and begin to shift our engineer efforts to providing more customer-funded engineering and design services for embedded Bluetooth modules where the costs are accounted for as costs of revenue. We also completed in the first half of 2001 expenses associated with our investments in third party software development.

Sales and Marketing Expense

Sales and marketing expense for the three and six month periods ended June 30, 2001 was $1.3 million and $2.7 million, respectively, an increase of 43 percent and 63 percent compared to sales and marketing expense in the corresponding periods of 2000. During the first half of 2001, we nearly doubled the number of sales, marketing and customer service personnel over personnel staffing levels in the first half of 2000, allowing us to commit sales and marketing personnel to each product family, and we added a Vice President of Sales midway through the first quarter of 2000. During the first and second quarters of 2001, we also expanded our international sales and marketing presence in Europe and Asia. Approximately 80 percent and 70 percent, respectively, of the growth in sales and marketing expense for the three and six month periods ended June 30, 2001 over the corresponding periods in the previous year was due to higher personnel costs resulting from increases in our personnel. We also expanded our advertising and increased our attendance at trade shows in 2001 to reach new markets for our newer products.

Sales and Marketing expense outlook for the balance of 2001: Quarterly sales and marketing expense is expected to remain substantially level with first and second quarter 2001 levels during the third quarter ending September 30, 2001, and to grow moderately in the fourth quarter ending December 31, 2001 to support anticipated revenue growth and fall trade show activities.

General and Administrative Expense

General and administrative expense for the three and six month periods ended June 30, 2001 was $0.6 million and $1.2 million, an increase of 84 percent and 69 percent, respectively, compared to the same periods in 2000. Approximately 40 percent and 50 percent of the increase in the three and six month periods ended June 30, 2001, respectively, related to increased administrative staffing and from the appointment of Kevin Mills as CEO in late March 2000, replacing Charlie Bass who served from April 1997 to March 2000 without cash remuneration. In July 2000, we were listed on the Nasdaq National Market System, and our expenses reflect the higher fees associated with that listing along with higher audit and insurance costs during 2001 associated with growth compared to the same periods one year earlier.

General and administrative expense outlook for the balance of 2001. We expect our quarterly general and administrative expenses to remain flat in the third quarter ending September 30, 2001 compared to the previous quarter ended June 30, 2001 and to moderately increase in the fourth quarter ending December 31, 2001. We expect to moderately increase our public relations activities in the fourth quarter of the year, anticipating increased investor interest following release of our Bluetooth wireless products during the third quarter.

Charges related to compensatory stock option grants

We reported stock-based compensation expense of $22 thousand and $34 thousand for the three and six month periods ended June 30, 2001 compared to expense of $0.7 million and $0.7 million for the same periods in 2000. Charges in 2001 related to the vesting of stock option grants awarded to consultants. The higher charges in 2000 were due to higher vesting levels primarily attributed to a stock grant awarded in 1998 to Charlie Bass for his services as CEO from April 1997 that became accountable as a compensatory grant at the end of March 2000 when Kevin Mills was promoted to CEO, to the accelerated vesting of stock grants to two directors who completed their terms of service in June 2000, and to higher market stock prices applicable to shares vesting during the period. Mr. Bass' grant was accelerated to fully vest during the third quarter of 2000 and no additional charges relating to this grant were incurred in 2001.

Outlook for the balance of 2001: We have terminated our stock option grant arrangements with consultants, and no additional charges related to compensatory stock option grants are expected to be incurred during the second half of 2001.

Amortization of goodwill and intangibles

On October 5, 2000, the Company acquired 3rd Rail Engineering, an engineering services firm specializing in embedded systems engineering design and integration services for Windows CE and other operating system environments. The acquisition was valued at $11.3 million of which approximately $1.1 million was attributed to intangible intellectual property and approximately $10.0 million was attributed to goodwill. Goodwill will be amortized through 2001 in accordance with SFAS Nos. 141 and 142. The Company will test goodwill for impairment under the new rules during the reminder of 2001 and from 2002 onward and make adjustments accordingly. Other intangible assets will be amortized over their estimated useful lives of 3 to 8 years. Amortization charges of $0.4 million and $0.8 million during the three and six month periods ended June 30, 2001 represents the amortization of goodwill and other intangibles relating to the acquisition of 3rd Rail.

Outlook for 2001: Amortization of goodwill and intangible assets for the 3rd Rail acquisition will continue during 2001 at a quarterly rate of $0.4 million. The net unamortized investment balance is classified on the balance sheet as a noncurrent asset.

Interest Income, Interest Expense, Net

Interest income reflects interest earned on cash balances. Cash balances increased during the first half of 2000 due to the exercise of public warrants, and have declined since June 2000 primarily due to the funding of net operating losses and working capital investments in inventory and receivables. Interest income of $49 thousand and $120 thousand for the three and six month periods ended June 30, 2001 compared to interest income of $104 thousand and $168 thousand in the same periods one year ago. Interest expense in the three and six month periods ended June 30, 2001 was $4 thousand and $8 thousand and related primarily to interest on equipment lease financing obligations assumed from 3rd Rail Engineering in October 2000.

Income Taxes

There were no provisions for Federal or state income taxes as the Company incurred net operating losses in all periods.

Preferred Stock Dividend; Accretion of Preferred Stock

Preferred stock dividends in the three and six months ended June 30, 2000 reflected dividends accrued at a rate of 8% per annum on unconverted Series B convertible preferred stock issued during the first quarter of 1998 (first quarter only), on Series C convertible preferred stock issued during the first and second quarters of 1998, and on Series D convertible preferred stock issued during the fourth quarter of 1998. Preferred shares were convertible into common stock at the discretion of the holder. All preferred shares were converted by the end of the third quarter of 2000, and no dividends were earned or accrued during 2001.

Liquidity and Capital Resources

We have historically financed our operations through the sale of equity securities, equipment financing, and revolving bank lines of credit. Since our inception we have raised over $42 million in equity capital. We have incurred significant quarterly and annual operating losses in every fiscal period since our inception, and we expect to continue to incur quarterly operating losses at least through the end of 2001 and possibly longer. We have historically needed to raise capital to fund our operating losses. Although we believe that we have sufficient cash to fund our operations during the next twelve months, continuing use of cash in operations could make it necessary to raise additional capital in the future and there are no assurances that such capital would be available on acceptable terms, if at all.

Cash used in operating activities was $2.8 million in the first half of 2001 compared to $0.7 million in the first half of 2000. The use of cash resulted from financing our net loss (as adjusted for non-cash charges that are included in the operating loss) of $2.6 million in the first half of 2001 and $0.6 million in the first half of 2000, and from net working capital changes requiring the use of cash in the amount of $0.2 million in the first half of 2001 and $0.1 million in the first half of 2000. Changes in working capital balances in the first half of 2001 were primarily related to decreases in receivables due to higher collections and flat revenues compared to the previous quarter, and decreases in accounts payable as we reduced our inventory purchases. Changes in working capital balances in the first half of 2000 were due to increases in accounts receivable and inventories associated with revenue growth offset by increases in accounts payable and deferred revenue accounts.

Cash used in investing activities was $0.15 million in the first half of 2001 compared to $0.25 million in the first half of 2000. Investing activities primarily reflect the cost of test equipment, tooling costs for new products, and furniture, new computers and purchased software for new employees.

Cash provided by financing activities was $2.0 million in the first half of 2001 and $5.9 million during the first half of 2000. Financing activities in 2001 consisted of the use of our bank credit line facility at June 30, 2001 and the exercise of employee stock options. Cash from financing activities in 2000 included $5.0 million from the exercise of warrants, $0.5 million from the sale of common stock and $0.4 million from the exercise of employee stock options.

Our cash balances as of June 30, 2001 were $6.5 million. We may seek additional funding in 2001 to fund our operations and to strengthen our working capital balances, which we would intend to accomplish through the issuance of additional equity securities, through increased borrowings on our bank lines as the levels of receivables permit, and through development funding from development partners. At June 30, 2001 the amounts drawn under our $4.0 million bank lines of credit of $1.5 million were approximately the amounts available under the line.

Risk Factors

We have a history of operating losses and we cannot assure you that we will achieve ongoing profitability

We have incurred significant operating losses since our inception in 1992. We expect to continue to incur quarterly operating losses at least through the end of 2001 and possibly longer. Profitability, if any, will depend upon:

• increased market acceptance of products including new products being introduced into the market;
• our ability to obtain additional capital to fund our working capital requirements;
• market acceptance and increased availability of mobile computers that use Microsoft's Windows-powered operating system for handheld computers (formerly Windows CE);
• the expansion of development and OEM customer relationships to increase development and product sales revenues;
• the development of successful new products for new and existing markets;
• our ability to increase or maintain gross margins through higher sales volumes and contract manufacturing efficiencies;
• our ability to expand our distribution capability;
• our ability to perform on development contracts; and
• our ability to manage our operating expenses.

We have historically relied on our ability to raise equity capital to fund our operating losses and working capital requirements

Since our inception, we have issued more than $42 million in equity capital and at June 30, 2001, we had an accumulated deficit of more than $26 million. Although we believe that our cash balances as of June 30, 2001 of $6.5 million are adequate to fund our operations during the next twelve months, continued losses could make it necessary for us to raise additional capital in 2001 or in the future. We may not be able to raise additional capital on acceptable terms, if at all. If we do, the additional capital may be on terms that are dilutive to existing stockholders. If we are unable to raise sufficient capital, we may not be able to remain competitive or continue our operations at present levels, or at all.

We depend significantly on the market for mobile computers, particularly those that use the Windows-powered operating system for handheld computers (formerly Windows CE)

Substantially all of our products are designed for use in mobile computers, including notebooks, handheld PCs, Palm-size PCs, tablet PCs, and H/PC Professionals (mini notebooks). The market for mobile computers is characterized by rapidly changing technology, evolving industry standards, frequent new product introductions and significant price competition. These characteristics result in short product life cycles and regular reductions of average selling prices over the life of a specific product. Accordingly, growth in demand for mobile computers is uncertain. If such growth does not occur, demand for our products would be reduced.

Our ability to generate increased revenue depends significantly on the commercial success of Windows-powered handheld devices, particularly the Pocket PC, and other devices such as the new line of handhelds with expansion options announced by Palm. As a result, our future success depends on factors outside of our control, including market acceptance of Pocket PC devices generally and other factors affecting the commercial success of Pocket PCs devices, including availability of critical components such as processors, changes in industry standards or the introduction of new or competing technologies. For instance, our revenue for the first half of fiscal 2001 fell below prior expectations because of delays in shipment of Pocket PC devices by one of the Pocket PC manufacturers. Any delays in or failure of Pocket PC and other Windows-powered devices or the new Palm devices to ship on schedule, or to achieve or maintain market acceptance would reduce the number of potential customers of our products.

Our ability to comply with industry standards is critical to our business

We must continue to identify and ensure compliance with evolving industry standards to remain competitive. For instance, to avoid being out of compliance with newly emerging SD input/output standards, we are dependent upon approval of the standard for SD I/O cards by the SD standards committee before we complete our development of such products. Unanticipated changes in industry standards could render our products incompatible with products developed by major hardware manufacturers and software developers. We could be required, as a result, to invest significant time and resources to redesign our products to ensure compliance with relevant standards. If our products are not in compliance with prevailing industry standards for a significant period of time, we would miss opportunities to have our products specified as standards for new hardware components designed by mobile computer manufacturers and OEMs. The failure to achieve any such design win would result in the loss of any potential sales volume that could be generated by such newly designed hardware component.

We depend on alliances and other business relationships with a small number of third parties

Our strategy is to establish strategic alliances and business relationships with leading participants in various segments of the communications and mobile computer markets. In accordance with this strategy, we have entered into alliances or relationships with Axis Communications, Bell Mobility, Cambridge Silicon Radio, Compaq Computer Corporation, Hewlett-Packard Company, Hitachi, Intermec, Microsoft, Palm, SanDisk Corporation, Sprint PCS, Symbol Technologies, Targus Group International, Toshiba Corporation and Welch Allyn. Our success will depend not only on our continued relationships with these parties, but also on our ability to enter into additional strategic arrangements with new partners on commercially reasonable terms. We believe that, in particular, relationships with application software developers are important in creating commercial uses for our products. Any future relationships may require us to share control over our development, manufacturing and marketing programs or to relinquish rights to certain versions of our technology. Also, our strategic partners may revoke their commitment to our products or services at any time in the future, or may develop their own competitive products or services. Also, the hardware or software of such companies that is integrated into our products may contain defects or errors. Accordingly, our strategic relationships may not result in sustained business alliances, successful product or service offerings or the generation of significant revenues. Failure of one or more of such alliances could result in delay or termination of product development projects, reduction in market penetration, decreased ability to win new customers or loss of confidence by current or potential customers.

We have devoted significant research and development resources to design activities for Windows-powered mobile products and, more recently, to design activities for products to work with Palm devices, diverting financial and personnel resources from other development projects. These design activities are not undertaken pursuant to any agreement under which Microsoft or Palm are obligated to continue the collaboration or to support resulting products. Consequently, Microsoft or Palm may terminate their collaborations with us for a variety of reasons including our failure to meet agreed-upon standards or for reasons beyond our control, including changing market conditions, increased competition, discontinued product lines and product obsolescence.

The market for our products changes rapidly, and our success depends upon our ability to develop new and enhanced products

The market for our products is characterized by rapidly changing technology, evolving industry standards and short product life cycles. Accordingly, to remain competitive we must:

• identify emerging standards in the field of mobile computing products,
• enhance our products by adding additional features to differentiate our products from those of our competitors, and
• maintain superior or competitive performance in our products and bring products to market quickly.

Given the emerging nature of the mobile computing products market, our products or technology may be rendered obsolete by alternative technologies. Further, short product life cycles expose our products to the risk of obsolescence and require frequent new product introductions. If we fail to develop or obtain access to advanced mobile communications technologies as they become available, or if we fail to develop and introduce competitive new products on a timely basis, our future operating results will be adversely affected.

Our products may contain undetected flaws and defects

Although we perform testing prior to new product introductions, our hardware and software products may contain undetected flaws, which may not be discovered until the products have been used by customers. From time to time, we may temporarily suspend or delay shipments or divert development resources from other projects to correct a particular product deficiency. Such efforts to identify and correct errors and make design changes may be expensive and time consuming. Failure to discover product deficiencies in the future could delay product introductions or shipments, require us to recall previously shipped products to make design modifications or cause unfavorable publicity, any of which could adversely affect our business.

Our quarterly operating results may fluctuate in future periods and our future results are difficult to predict because we typically have little order backlog

We expect to experience quarterly fluctuations in operating results in the future. We generally ship orders as received and as a result typically have little or no backlog. Quarterly revenues and operating results therefore depend on the volume and timing of orders received during the quarter, which are difficult to forecast. Historically, we have often recognized a substantial portion of our revenues in the last month of the quarter. This subjects us to the risk that even modest delays in orders adversely affect our quarterly operating results. Our operating results may also fluctuate due to factors such as:

• the demand for our products;
• the size and timing of customer orders;
• unanticipated delays or problems in the introduction of our new products and product enhancements;
• the introduction of new products and product enhancements by our competitors;
• changes in the proportion of revenues attributable to royalties and engineering development services;
• product mix;
• timing of software enhancements;
• changes in the level of operating expenses; and
• competitive conditions in the industry including competitive pressures resulting in lower average selling prices.

Because we base our staffing and other operating expenses on anticipated revenue, delays in the receipt of orders can cause significant variations in operating results from quarter to quarter. As a result of any of the foregoing factors, our results of operations in any given quarter may be below the expectations of public market analysts or investors, in which case the market price of our common stock would be adversely affected.

We depend on key employees and we need to attract and retain them

Our future success will depend upon the continued service of certain key technical and senior management personnel. Competition for such personnel is intense, and there can be no assurance that we will be able to retain our existing key managerial, technical or sales and marketing personnel. The loss of key personnel could adversely affect our business.

We believe our ability to achieve increased revenues and to develop successful new products and product enhancements will depend in part upon our ability to attract and retain highly skilled sales and marketing and product development personnel. Competition for such personnel is intense, and we may not be able to retain such key employees, and there are no assurances that we will be successful in attracting and retaining such personnel in the future. In addition, our ability to hire and retain such personnel will depend upon our ability to raise capital or achieve increased revenue levels to fund the costs associated with such personnel. Failure to attract and retain key personnel will adversely affect our business.

We depend on distributors, resellers and OEMs to sell our products

We sell our products primarily through distributors, resellers and original equipment manufacturers, or OEMs. Our largest distributor, Ingram Micro in the United States, accounted for approximately 26% of our revenue in 2000 and approximately 26% of our revenue for the first half of 2001. Our agreements with OEMs, distributors and resellers, in large part, are nonexclusive and may be terminated on short notice by either party without cause. Our OEMs, distributors and resellers are not within our control, are not obligated to purchase products from us and may represent other lines of products. A reduction in sales effort or discontinuance of sales of our products by our OEMs, distributors and resellers could lead to reduced sales.

Use of distributors also entails the risk that distributors will build up inventories in anticipation of a growth in sales. If such growth does not occur as anticipated, these distributors may substantially decrease the amount of product ordered in subsequent quarters. Such fluctuations could contribute to significant variations in our future operating results. The loss or ineffectiveness of any of our major distributors or OEMs could adversely affect our operating results.

We allow our distributors to return a portion of our inventory to us for full credit against other purchases. In addition, in the event we reduce our prices, we credit our distributors for the difference between the purchase price of products remaining in their inventory and our reduced price for such products. Actual returns and price protection may adversely affect future operating results, particularly since we seek to continually introduce new and enhanced products and are likely to face increasing price competition.

Concentration of credit risks and of suppliers

Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of cash and accounts receivable. We invest our cash in cash demand deposits and in a money market fund. The Company places its investments with high-credit-quality financial institutions and limits the credit exposure to any one financial institution or instrument. However, we are exposed to credit risk in the event of default by these institutions to the extent of the amount recorded on our balance sheet. Accounts receivables are derived primarily from distributors and original equipment manufacturers. We perform ongoing credit evaluations of our customers' financial condition but generally require no collateral. Reserves are maintained for potential credit losses, and such losses have been within our expectations. However, to the extent that a large customer fails or is unable to pay, we are exposed to credit risk to the extent of the amounts due to us.

Several of our component parts are produced by a sole or limited number of suppliers. Shortages could occur in these essential materials due to an interruption of supply or increased demand in the industry. If we were unable to procure certain of such materials, we could be required to reduce our operations, which could have a material adverse effect upon our results. To the extent that we acquire extra inventory stocks to protect against possible shortages, we are exposed to additional risks associated with holding inventory including obsolescence, excess quantities or loss.

A significant portion of our revenues are derived from export sales

Export sales (sales to customers outside the United States) accounted for approximately 21% of our revenue in 2000 and approximately 32% of our revenue in the first half of 2001. Accordingly, our operating results are subject to the risks inherent in export sales, including

• longer payment cycles,
• unexpected changes in regulatory requirements, import and export restrictions and tariffs,
• difficulties in managing foreign operations,
• the burdens of complying with a variety of foreign laws,
• greater difficulty or delay in accounts receivable collection,
• potentially adverse tax consequences, and
• political and economic instability.

In addition, our export sales are currently denominated predominately in United States dollars and in Euros for a portion of our sales to our European distributors. Accordingly, an increase in the value of the United States dollar relative to foreign currencies could make our products more expensive and therefore potentially less competitive in foreign markets and declines in value in the Euro relative to the dollar may result in foreign currency losses relating to collection of Euro denominated receivables.

Our stock price is highly volatile

Our stock price is highly volatile. During the period from January 1, 2000 through August 1, 2001, our stock price fluctuated between a high of $51.38 and a low of $1.84. Stock price fluctuations are caused by many factors, some of which may be beyond our control including general economic conditions and the outlook of market analysts and investors of the industry that we are in.

Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure and other events beyond our control

We do not have a detailed disaster recovery plan. Our facilities in the State of California are currently subject to electrical blackouts as a consequence of a shortage of available electrical power. In the event these blackouts continue to increase in severity, they could disrupt our operations. In addition, we do not carry sufficient business interruption insurance to compensate us for losses that may occur and any losses or damages incurred by us could have a material adverse effect on our business.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk.

Our exposure to market risk for changes in interest rates relates primarily to invested cash. Our cash is invested in short-term money market investments backed by U.S. Treasury notes and other investments that mature within one year and whose principal is not subject to market rate fluctuations. Accordingly, interest rate declines would adversely affect our interest income but would not affect the carrying value of our cash investments. Based on a sensitivity analysis of our cash investments during the quarter ended June 30, 2001, a decline of 1% in interest rates would reduce our quarterly interest income by approximately $12,500.

Our bank credit line facilities of up to $4 million have variable interest rates based upon the lenders index rate plus 0.75% for the domestic line (up to $2.5 million) and the index rate plus 0.5% for the international line (up to $1.5 million). Accordingly, interest rate increases would increase our interest expense on outstanding credit line balances. We utilized our credit line facility only at the end of the quarter ended June 30, 2001 and did not subject ourselves to interest rate exposure. Based on a sensitivity analysis, an increase of 1% in the interest rate would increase our borrowing costs by $2,500 for each $1 million of borrowings against our bank credit facility or a maximum of $10,000 if we utilized our entire credit line.

Foreign Currency Risk. A substantial majority of our revenue, expense and purchasing activities are transacted in U.S. dollars. However, we allow certain of our European distributors to purchase our products in Euros, we pay the expenses of our European subsidiary in Euros or French Francs, we pay the expenses of our Japan office in Japanese Yen, and we expect to enter into selected future purchase commitments with foreign suppliers that will be paid for in the local currency of the supplier. To date these balances have been small and we have not been subject to significant losses from material foreign currency fluctuations. Based on a sensitivity analysis of our net assets at the beginning, during and at the end of the quarter ended June 30, 2001, an adverse change of 10% in exchange rates would result in an increase in our net loss for the quarter of approximately $14,000. We will continue to monitor and assess the risk associated with these exposures and may at some point in the future take actions to hedge or mitigate these risks.

Items 1 - 3. Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

At the Annual Meeting of Stockholders of the Company, held at the Company's Newark facilities on June 20, 2001, the stockholders reelected seven directors to serve until the next annual meeting of stockholders (proposal one), did not approve a proposal to amend the Company's Certificate of incorporation to divide the Board of Directors into three classes of Directors serving staggered three-year terms (proposal two), approved an amendment to the 1995 Stock Plan to increase the number of shares of Common Stock reserved for issuance as stock option grants thereunder by 900,000 shares to 5,035,000 shares (proposal three), approved an automatic annual increase of authorized shares under the 1995 Stock Option Plan equivalent to the lesser of 2 million shares, 4% of the outstanding shares of common stock on the first day of each fiscal year, or a lesser amount as determined by the Board of Directors (proposal four) and ratified the appointment of Ernst & Young LLP to continue as the independent public accountants of the Company for the fiscal year ending December 31, 2001 (proposal five). Total voting shares on the record date of April 23, 2001 consisted of 23,448,893 common shares issued and outstanding. A total of 19,405,006 shares or 82.8% of outstanding shares were present or voting by proxy.

Results of the stockholder vote were as follows:

Shareholder voting results (continued):

Item 5. Not applicable.

Item 6. Exhibits and Reports on Form 8-K.

(a.) Exhibits

None

(b.) Reports on Form 8-K

No reports on Form 8-K were filed with the Securities and Exchange Commission during the quarter ended June 30, 2001.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Registrant