Item 1. Business.
This report contains certain forward-looking statements that involve risks, uncertainties and assumptions that are difficult to predict. Words and expressions reflecting optimism, satisfaction or disappointment with current prospects, as well as words such as “believes,” “hopes,” “intends,” “estimates,” “expects,” “projects,” “plans,” “anticipates” and variations thereof, or the use of future tense, identify forward-looking statements, but their absence does not mean that a statement is not forward-looking. Such forward-looking statements are not guarantees of performance and our actual results could differ materially from those contained in such statements. In evaluating such statements we urge you to specifically consider various factors identified in this report, including the matters set forth under the heading “Risk Factors” in Part I, Item 1A
Item 1A. Risk Factors.
An investment in our company involves a high degree of risk. In addition to the other information included or incorporated by reference in this report, you should carefully consider each of the following risk factors in evaluating our business and prospects as well as an investment in our company. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or
that we currently consider immaterial may also impair our business operations. If any of the following risks actually occur, our business and financial results could be harmed. In that case the trading price of our common stock could decline.
Our cash and other sources of liquidity may not be adequate to fund our operations for the next twelve months. If we raise additional funding through sales of equity or equity-based securities, your shares will be diluted. If we need additional funding for operations and we are unable to raise it, we may be forced to liquidate assets and/or curtail or cease operations.
Management has projected that cash on hand, including cash received from our private placement of shares of Series A Convertible Preferred Stock in February 2010, and funding available under our non-OEM accounts receivable financing agreements will be sufficient to allow us to continue operations at current levels through the end of calendar 2010. Significant changes from our current forecast, including, but not limited to: (i) shortfalls from projected sales levels, (ii) unexpected increases in product costs, (iii) increases in operating costs and/or (iv) changes to the historical timing of collecting accounts receivable or to the borrowing terms on our non-OEM account receivable financing arrangements, could have a material adverse affect on our ability to access the level of funding necessary to continue operations at current levels. If any of these events occur management may be forced to make further reductions in spending, further extend payment terms with suppliers, liquidate assets where possible, and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects.
As a result of our recurring losses from operations and negative cash flows, the report from our independent registered public accounting firm regarding our consolidated financial statements for the fiscal year ended June 30, 2010 includes an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern.
We may seek debt, equity or equity-based financing (such as convertible debt) when market conditions permit. Such financing may not be available on favorable terms, or at all. If we need additional funding for operations and are unable to raise it through debt or equity financings, we may be forced to liquidate assets and/or curtail or cease operations. In addition, such financing may not be available on favorable terms, or at all. If we raise additional funds by selling additional shares of our capital stock, or securities convertible into shares of our capital stock, the ownership interest of our existing shareholders will be diluted. The amount of dilution could be increased by the issuance of warrants or securities with other dilutive characteristics, such as anti-dilution clauses or price resets.
We urge you to review the additional information about our liquidity and capital resources in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of this report. If we cease to continue as a going concern due to lack of available capital or otherwise, you may lose your entire investment in our company.
We have a history of net losses. We expect to continue to incur net losses for some time and we may not achieve or maintain profitability.
We have incurred significant operating losses in our last three fiscal years and we anticipate continued losses during fiscal 2011. As of June 30, 2010 we had an accumulated deficit of $82.1 million. To return to profitability we will need to maintain or increase revenue, increase gross profit margins and improve our operating model. We may also need to implement additional cost reduction efforts across our operations as discussed below.
Our financial condition and the “going concern” opinion from our independent registered public accounting firm may negatively impact our business.
As a result of our recurring losses from operations and negative cash flows, the report from our independent registered public accounting firm regarding our consolidated financial statements for the year ended June 30,
2010 includes an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern. Such report, and our financial condition and history of net losses, could cause current or potential customers to defer new orders with us or to select other suppliers, and may cause suppliers to require terms that are unfavorable to us.
We may need to implement additional cost reduction efforts across our operations.
During the second quarter of fiscal 2010 we reduced our worldwide workforce by 6.4%, or 15 employees, in connection with our realignment around core initiatives. During the fourth quarter of fiscal 2010, we further reduced our worldwide workforce by an additional 18.8%, or 42 employees, in connection with changes in our business model and a restructuring of our workforce. There can be no assurance that our cost reduction efforts will be successful and we may need to implement additional cost reduction initiatives, such as further reductions in the cost of our workforce and/or suspending or curtailing planned programs, either of which could materially harm our business, results of operations and future prospects.
We rely on indirect sales channels to market and sell our branded products. Therefore, the loss of, or deterioration in, our relationship with one or more of our distributors or resellers could negatively affect our operating results.
We sell all of our branded products through our network of distributors, VARs and DMRs, who in turn sell our products to end users. Our largest distributor in fiscal 2009 and 2008, Ingram Micro, accounted for 11.0% and 10.8% of sales in fiscal 2009 and 2008, respectively. In fiscal 2010, Ingram Micro accounted for less than 10.0% of our sales. The long-term success of any of our distributors or resellers is difficult to predict, and we have no purchase commitments or long-term orders from our any of them to assure us of any baseline sales through these channels. Most of our distributors and resellers also carry competing product lines that they may promote over our products. A distributor or reseller might not continue to purchase our products or market them effectively, and each determines the type and amount of our products that it will purchase from us and the pricing of the products that it sells to end user customers. Our operating results could be adversely affected by a number of factors, including, but not limited to:
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a change in competitive strategy that adversely affects a distributor’s or reseller’s willingness or ability to stock and distribute our products;
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the reduction, delay or cancellation of orders or the return of a significant amount of our products;
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the loss of one or more of our distributors or resellers; and
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any financial difficulties of our distributors or resellers that result in their inability to pay amounts owed to us.
If our suppliers fail to meet our manufacturing needs, it would delay our production and our product shipments to customers and negatively affect our operations.
Our products have a large number of components and subassemblies produced by outside suppliers. We depend greatly on these suppliers for items that are essential to the manufacture of our products, including tape drives, printed circuit boards and integrated circuits. We work closely with our regional, national and international suppliers, which are carefully selected based on their ability to provide quality parts and components that meet both our technical specifications and volume requirements. For certain items, we qualify only a single source, which magnifies the risk of shortages and decreases our ability to negotiate with that supplier on the basis of price. From time to time, we have been unable to obtain as many drives as we have needed due to drive shortages or quality issues from certain of our suppliers. If our suppliers fail to meet our manufacturing needs, it would delay our production and our product shipments to customers and negatively affect our operations.
We entered into a strategic manufacturing agreement with Foxconn as an outsourced manufacturer of select products. Our use of an outsourced manufacturing provider may not produce the intended benefits.
In October 2009, we entered into a strategic manufacturing agreement with Foxconn in order to strengthen our product supply chain and global manufacturing capabilities. Foxconn initially will collaborate with us on the manufacturing of one product line. The manufacturing agreement provides a framework for expansion of the collaboration to other product lines should the parties mutually decide to expand the relationship. Neither party is obligated to expand the relationship.
The transition to outsourced manufacturing is a complex task. If not properly executed, delays in transition may occur, product quality may decline and product costs may increase. If Foxconn is unable or unwilling to complete the transition in a timely and satisfactory manner, we may be required to continue to manufacture longer than originally intended or to locate an acceptable alternative manufacturer. Assuming a successful transition is completed, we still may have to change to another manufacturer because of problems with delivery schedules, manufacturing quality, product costs or other factors.
In addition to the above, reliance on outsourced manufacturing involves a number of risks, including reduced control over delivery schedules, manufacturing quality and product costs. Further, our requirements represent only a small portion of the total capacity of Foxconn, who could re-allocate capacity to other customers even during periods of high demand for our products. In addition, the continuing tight credit in financial markets may affect the ability of Foxconn and other suppliers to maintain their production capacity and result in a reduction in their supply to us. If we are unable to obtain our products from Foxconn and other suppliers on schedule, or at all, our ability to satisfy customer demand will be harmed and revenue from the sale of products may be lost or delayed.
Any problems associated with the matters discussed above could result in significant expense, delays in shipment, a significant loss of potential revenues and may adversely affect the market price of our common stock.
We have granted security interests over certain of our assets in connection with various debt arrangements.
We have granted security interests over certain of our assets in connection with various debt arrangements and we may grant additional security interests to secure future borrowings. If we are unable to satisfy our obligations under these arrangements, we could be forced to sell certain assets that secure these loans, which could have a material adverse effect on our ability to operate our business. We may grant additional security interests to secure future borrowings. In addition, we have granted security interests in connection with our non-OEM financing arrangements. In the event we were unable to maintain compliance with covenants set forth in these arrangements or if these arrangements are otherwise terminated for any reason, it could have a material adverse affect on our ability to access the level of funding necessary to continue operations at current levels. If any of these events occur, management may be forced to make further reductions in spending, further extend payment terms with suppliers, liquidate assets where possible, and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects.
Our success depends on our ability to anticipate rapid technological changes and develop new and enhanced products.
As an advanced technology company, we are subject to numerous risks and uncertainties characterized by rapid technological change and intense competition. Our future success will depend on our ability to anticipate changes in technology, and to develop, introduce, manufacture and achieve market acceptance of new and enhanced products on a timely and cost-effective basis.
Development schedules for technology products are inherently uncertain. We may not meet our product development schedules, and development costs could exceed budgeted amounts. Our business, results of
operations, financial position and liquidity may be materially and adversely affected if the products or product enhancements that we develop are delayed or not delivered due to developmental problems, quality issues or component shortage problems, or if our products or product enhancements do not achieve market acceptance or are unreliable. We or our competitors will continue to introduce products embodying new technologies, such as new sequential or random access mass storage devices. In addition, new industry standards may emerge. Such events could render our existing products obsolete or not marketable, which would have a material adverse effect on our business, results of operations, financial position and liquidity.
Our disk-based products involve many significant risks and may fail to achieve or maintain market acceptance.
The success of our Snap Server® family of disk-based products is uncertain and subject to significant risks that could have a material adverse effect on our business, results of operations, financial position and liquidity. We must commit significant resources to sustain these products and will continuously need to update and upgrade them to stay competitive. Any delay in the commercial release of new or enhanced disk-based products could result in a significant loss of potential revenue and may adversely impact the market price of our common stock. Furthermore, if our disk-based products do not achieve market acceptance or success, then the association of our brand name with these products may adversely affect our reputation and sales of other products, diluting the value of our brand name.
Our business has been highly dependent on sales to large OEM customers, and we are currently in a transition with our largest OEM customer.
HP has historically been our largest customer, accounting for 22.5%, 29.7% and 35.2% of sales in fiscal 2010, 2009 and 2008, respectively. Ingram Micro has historically been our largest distribution customer, accounting for 11.0% and 10.8% of sales in fiscal 2009 and 2008, respectively. In fiscal 2010, Ingram Micro accounted for less than 10.0% of sales. No other customer accounted for more than 10.0% of sales in any year during the three-year period ended June 30, 2010.
In August 2005, HP notified us that it had selected an alternate supplier for its next-generation mid-range tape automation products. HP began purchasing the first product of this new line from the alternate supplier during the first quarter of calendar year 2006, which decreased our sales to HP. However, in mid-2007, HP re-launched its tape automation products supplied by us with support for HP’s new LTO-4 tape drives, which slowed the rate of replacement of our supplied products by the alternate supplier’s product. Although we believe that our sales to HP will continue to decline, we recently extended our supply agreement with HP until July 2012 with automatic renewals for three consecutive one-year periods unless earlier terminated. We cannot predict the rate at which our sales to HP will decline. If they fall short of their forecast it may have a significant impact on revenue during fiscal 2011. Neither HP nor any other customer is obligated to purchase a specific amount of our products or provide binding forecasts of purchases for any period.
We face intense competition and price pressure, and many of our competitors have substantially greater resources than we do.
The worldwide storage market is intensely competitive. A number of manufacturers of tape and disk-based storage solutions compete for a limited number of customers. In addition, barriers to entry are relatively low in these markets. Some of our competitors have substantially greater financial and other resources, larger research and development staffs, and more experience and capabilities in manufacturing, marketing and distributing products. Ongoing pricing pressure could result in significant price erosion, reduced profit margins and loss of market share, any of which could have a material adverse effect on our business, results of operations, financial position and liquidity.
Our business is highly dependent on the continued market acceptance and usage of tape-based systems for data backup and recovery.
We have historically derived a majority of our revenue from products that use magnetic tape drives for backup and recovery of digital data. Our tape-based storage solutions now compete directly with other storage technologies, such as hard disk drives, and may face competition in the future from other emerging technologies. The prices of hard disk drives continue to decrease as their capacity and performance increase. We expect our tape-based products to face increased competition from these alternative technologies and come under increasing pricing pressure. If our strategy to compete in disk-based markets does not succeed, it could have a material adverse effect on our business, results of operations, financial position and liquidity.
If our revenue base continues to decline, we may choose to discontinue or exit some or a substantial portion of our current operations.
Our management team continually reviews and evaluates our product portfolio, operating structure and markets to assess the future viability of our existing products and market positions. We may determine that the infrastructure and expenses necessary to sustain an existing product offering are greater than the potential contribution margin that we would realize. As a result, we may determine that it is in our interest to exit or divest one or more existing product offerings, which could result in costs incurred for exit or disposal activities and/or impairments of long-lived assets. Moreover, if we do not identify other opportunities to replace discontinued products or operations, our revenues would decline, which could lead to further net losses and adversely impact the market price of our common stock.
Our ability to compete depends in part on our ability to protect our intellectual property rights.
We rely on a combination of patent, copyright, trademark, trade secret and other intellectual property laws to protect our intellectual property rights. However, these rights may not prevent competitors from developing products that are substantially equivalent or superior to our products. To the extent we have or obtain patents, such patents may not afford meaningful protection for our technology and products. Others may challenge our patents and, as a result, our patents could be narrowed, invalidated or declared unenforceable. In addition, our current or future patent applications may not result in the issuance of patents in the United States or foreign countries. The laws of certain foreign countries may not protect our intellectual property to the same extent as U.S. laws. Furthermore, competitors may independently develop similar products, duplicate our products or, if patents are issued to us, design around these patents.
In order to protect or enforce our patent rights, we may initiate interference proceedings, oppositions, or patent litigation against third parties, such as infringement suits. Such enforcement efforts could be expensive and divert management’s time and attention from other business concerns. The patent position of information technology firms in particular is highly uncertain, involves complex legal and factual questions, and continues to be the subject of much litigation. No consistent policy has emerged from the U.S. Patent and Trademark Office or the courts regarding the breadth of claims allowed or the degree of protection afforded under information technology patents.
In August 2010, we filed a patent infringement lawsuit in the United States District Court for the Southern District of California against BDT AG, BDT Products, Inc. and BDT-Solutions GmbH. The lawsuit claims infringement of two of our United States patents, Nos. 6,328,766 and 6,353,581. The complaint broadly claims infringement by BDT’s products, and it specifically identifies BDT’s FlexStor® II product line as infringing our patents. We have initiated service of the complaint on the defendants, and discovery is not yet underway in the litigation.
Our success depends in part on our ability to operate without infringing on or misappropriating the proprietary rights of others.
We may at any time be sued for infringing the patent rights or misappropriating the proprietary rights of others. Intellectual property litigation is costly and, even if we prevail, the cost of such litigation could adversely affect our business, liquidity, results of operations and financial position. In addition, litigation diverts management’s time, attention and resources away from other aspects of our business. If we do not prevail in any litigation, we could be required to stop the infringing activity and/or pay substantial damages. Under some circumstances in the United States, these damages could be triple the actual damages the patent holder incurs. If we supply infringing products to third parties, or if we license third parties to manufacture, use or market infringing products, we may be obligated to indemnify these third parties for any damages they may be required to pay to the patent holder and for any losses the third parties may sustain as a result of lost sales or damages paid to the patent holder.
If a third party holding rights under a patent successfully asserts an infringement claim with respect to any of our products, we may be prevented from manufacturing or marketing our infringing product in the country or countries covered by the patent we infringe, unless we can obtain a license from the patent holder. Such licenses may not be available to us on acceptable terms, or at all. Some licenses may be non-exclusive, which would give our competitors access to the same technology licensed to us. If we fail to obtain a required license or are unable to design around a patent, we may be unable to market some of our products, which could have a material adverse effect on our business, liquidity, results of operations and financial position.
We could incur charges for excess and obsolete inventory.
The value of our inventory may be adversely affected by factors that affect our ability to sell the products in our inventory. Such factors include changes in technology, introductions of new products by us or our competitors, the current or future economic downturns, or other actions by our competitors. If we do not effectively forecast and manage our inventory, we may need to write off inventory as excess or obsolete, which adversely affects cost of sales and gross profit. We have previously experienced, and may in the future experience, reductions in sales of older generation products as customers delay or defer purchases in anticipation of new products that we or our competitors may introduce. We have established reserves for slow moving or obsolete inventory. These reserves, however, may prove to be inadequate, which would result in additional charges for excess or obsolete inventory.
Our warranty reserves may not adequately cover our warranty obligations.
We have established reserves for the estimated liability associated with our product warranties. However, we could experience unforeseen circumstances where these or future reserves may not adequately cover our warranty obligations. For example, the failure or inadequate performance of product components that we purchase could increase our warranty obligations beyond these reserves.
The failure to attract, retain and motivate key personnel could have a significant adverse impact on our operations.
We have experienced significant changes in our senior management. In January 2010, our Board of Directors appointed Eric L. Kelly, who has served as our Chief Executive Officer since January 2009 and on our Board of Directors since November 13, 2007, as our President. In January 2009, Vernon A. LoForti, who had served as our Chief Executive Officer and President and on our Board of Directors since August 2007, transitioned to the role of President and resigned from our Board of Directors. In September 2009, we terminated the employment of Mr. LoForti. In February 2010, we terminated the employment of Ravi Pendekanti, our former Vice President of Business Development and Solutions. In September 2009, Christopher Gopal joined us as our Vice President of Worldwide Operations and in February 2010, Geoff Barrall joined us as our Chief Technology Officer and Vice President of Engineering. These changes may be a distraction to other senior
management, business operations, commercial partners and customers. Additionally, we have experienced a prolonged period of operating losses and declines in our stock price and cash position, which have affected and may continue to affect employee morale and retention. We reduced our workforce by 13.0% worldwide in August 2008, by 3.4% in December 2008, by 17.0% in January 2009, by 11.1% in March 2009, by 6.4% in October 2009 and by 18.8% in April 2010. In addition, we enacted a temporary 10.0% salary reduction for all employees in January 2009, which was partially reinstated in fiscal 2010. Additional turnover, particularly among senior management, may also create distractions as we search for replacement personnel, which could result in significant recruiting, relocation, training and other costs, and can cause operational inefficiencies as replacement personnel become familiar with our business and operations. In addition, manpower in certain areas may be constrained, which could lead to disruptions over time. We cannot guarantee that we will successfully attract or retain the management we need, or be able to maintain an optimal workforce size. Any inability to attract, retain or motivate such personnel or to address manpower constraints could materially adversely affect our results of operations, financial position or cash flows. We do not currently maintain any key-man insurance for any of our employees.
We face risks related to the continuing economic downturn.
The continuing economic downturn in the U.S. and global financial markets, and in the U.S. and global economies, has had, and may continue to have, a material and adverse impact on our business and our financial condition. Businesses may further reduce or postpone spending on IT infrastructure in response to tighter credit, negative financial news and declines in income or asset values. We believe that such reduction in, or postponement of, spending has had and may continue to have a material adverse effect on the demand for our products. We cannot predict the length or severity of the current economic downturn, or the timing or severity of future economic or industry downturns. The continuing uncertainty in the capital markets may also severely restrict our ability to access the capital markets, which would limit our ability to react to changing economic and business conditions. A prolonged recession or continued or further decline in the global economy would materially adversely affect our results of operations, financial position or cash flows.
Our financial results may fluctuate substantially for many reasons, and past results should not be relied on as indications of future performance.
The markets that we serve are volatile and subject to market shifts that we may be unable to anticipate. A slowdown in the demand for workstations, mid-range computer systems, networks and servers could have a significant adverse effect on the demand for our products in any given period. In the past, we have experienced delays in the receipt of purchase orders and, on occasion, anticipated purchase orders have been rescheduled or have not materialized due to changes in customer requirements. Our customers may cancel or delay purchase orders for a variety of reasons, including, but not limited to, the rescheduling of new product introductions, changes in our customers’ inventory practices or forecasted demand, general economic conditions affecting our customers’ markets, changes in our pricing or the pricing of our competitors, new product announcements by us or others, quality or reliability problems related to our products, or selection of competitive products as alternate sources of supply. In particular, our ability to forecast sales to distributors, VARs and DMRs is especially limited because these customers typically provide us with relatively short order lead times or are permitted to change orders on short notice. Because a large portion of our sales is generated by our European channel, our first fiscal quarter (July through September) results of operations are often impacted by seasonally slow European orders, reflecting the summer holiday period in Europe. None of our customers is obligated to purchase a specific amount of our products.
Our financial results have fluctuated and will continue to fluctuate quarterly and annually based on, among others, the following factors:
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changes in customer mix (e.g., OEM vs. branded);
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changes in product mix;
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fluctuations in average selling prices;
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currency exchange fluctuations;
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increases in costs and expenses associated with the introduction of new products; and
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increases in the cost of or limitations on the availability of materials.
We therefore believe that our revenue and operating results will continue to fluctuate, and that period-to-period comparisons are not necessarily meaningful and should not be relied on as indications of future performance. Our revenue and operating results may fail to meet the expectations of public market analysts or investors, which could have a material adverse effect on the price of our common stock. In addition, portions of our expenses are fixed and difficult to reduce if our revenues do not meet our expectations. These fixed expenses magnify the adverse effect of any revenue shortfall.
We plan to replace our Enterprise Resource Planning (ERP) System within the next several years. This will be expensive and may be disruptive to our business.
Our ERP system is 13 years old, and we plan to replace it within the next several years. Transitioning to a new ERP system will be expensive and time consuming, and our business and results of operations may be materially and adversely affected if problems occur during the transition. In addition, we have modified our current ERP system significantly during its term of use and it is possible that we will experience a significant system failure before we replace it. Any such failure may materially and adversely affect our business, liquidity, results of operations and financial position.
Our international operations are important to our business and involve unique risks.
Sales to customers outside of the United States represent a significant portion of our total sales and we expect them to continue to do so. Sales to customers outside the United States are subject to various risks, including, but not limited to:
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the imposition of governmental controls mandating compliance with various foreign and U.S. export laws;
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currency exchange fluctuations;
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weak economic conditions in foreign markets;
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political and economic instability;
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trade restrictions, tariffs and taxes;
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longer payment cycles typically associated with international sales; and
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difficulties in staffing and managing international operations.
Furthermore, we may be unable to comply with changes in foreign laws, rules and regulations applicable to us in the future, which could have a material adverse effect on our business, results of operation, financial position and liquidity.
We are subject to exchange rate risk in connection with our international operations.
We do not currently engage in foreign currency hedging activities and, therefore, we are exposed to some level of currency risk. While essentially all of our sales in international markets are denominated in U.S. dollars, our wholly-owned subsidiaries in the United Kingdom, France and Germany incur costs that are denominated in local currencies. As exchange rates vary, these results when translated into U.S. dollars may vary from expectations and adversely impact overall expected results. A weaker U.S. dollar would result in an increase to
revenue and expenses upon consolidation, and a stronger U.S. dollar would result in a decrease to revenue and expenses upon consolidation. Exchange rate transactions resulted in a net gain of $0.5 million during fiscal 2010.
We have made a number of acquisitions in the past, including our June 2008 acquisition of the Snap Server® product line, and we may make acquisitions in the future. The failure to successfully integrate acquisitions and successfully complete product development and launch of the related products could harm our business, financial condition and operating results.
We have in the past and may in the future make acquisitions of complementary businesses, products or technologies as we implement our business strategy. Mergers and acquisitions involve numerous risks, including liabilities that we may assume from the acquired company, difficulties in completion of in-process product development and assimilation of the operations and personnel of the acquired business, the diversion of management’s attention from other business concerns, risks of entering markets in which we have no direct prior experience, and the potential loss of key employees of the acquired business.
Future mergers and acquisitions by us also may result in dilutive issuances of our equity securities and the incurrence of debt, amortization expense and potential impairment charges related to intangible assets. Any of these factors could adversely affect our business, liquidity, results of operations and financial position.
The market price of our common stock is volatile.
The market price of our common stock has experienced significant fluctuations since it commenced trading in February 1997, and may continue to fluctuate significantly in the future. Many factors could cause the market price of our common stock to fluctuate, including, but not limited to:
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our ability to meet our working capital needs;
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announcements concerning us, our competitors, our customers or our industry;
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changes in earnings estimates by analysts;
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purchasing decisions of HP and other significant customers;
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quarterly variations in operating results;
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the introduction of new technologies or products by us or our competitors;
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changes in product pricing policies by us or our competitors;
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the terms of any financing arrangements we enter into; and
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changes in general economic conditions.
In addition, stock markets generally have experienced extreme price and volume volatility in recent years. This volatility has had a substantial effect on the market prices of securities of many smaller public companies for reasons frequently unrelated or disproportionate to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of our common stock.
We have transferred the listing of our common stock from The NASDAQ Global Market (Global Market) to The NASDAQ Capital Market (Capital Market). If our common stock is delisted from the Capital Market, our stock price could be adversely affected and the liquidity of our stock and our ability to obtain financing could be impaired.
On December 15, 2009, we received written notification from The NASDAQ Stock Market, LLC (NASDAQ) that because we had not regained compliance with the minimum market value of publicly held shares of $15 million requirement set forth in NASDAQ Listing Rule 5450(b)(1)(C) by the December 14, 2009 expiration of the 90-day compliance period for this requirement, our common stock would be delisted from the
Global Market unless we requested an appeal of this determination to a NASDAQ Hearings Panel (the Panel). We requested an appeal of the determination and met with the Panel on January 20, 2010. On March 3, 2010, we received written notification from the Panel that it would continue the listing of our common stock on the Global Market subject to our demonstrating compliance with all continued listing standards of the Global Market on or before June 14, 2010. Prior to June 14, 2010, our management determined to apply to NASDAQ to transfer the listing of our common stock from the Global Market to the Capital Market. On June 14, we were notified that NASDAQ approved our application to transfer the listing of our common stock to the Capital Market, effective at the opening of trading on June 16, 2010. We are currently in compliance with all of the listing standards for listing on the Capital Market but we cannot provide any assurance that we will continue to be in compliance in the future.
In addition, on December 8, 2009, we effected a one-for-three reverse stock split of our common stock to regain compliance with the minimum bid price of $1.00 per share requirement set forth in NASDAQ Listing Rule 5450(a)(1). Though the bid price of our common stock has remained above $1.00 per share since the reverse split, we cannot guarantee that it will remain at or above $1.00 per share. If the bid price drops below $1.00 per share, our common stock could become subject to delisting again and we may seek shareholder approval for an additional reverse split. A second reverse split could produce negative effects and we cannot provide any assurance that it would result in a long-term or permanent increase in the bid price of our common stock. For example, a second reverse split could make it more difficult for us to comply with other listing standards of NASDAQ, including requirements related to the minimum number of shares that must be in the public float, the minimum market value of publicly held shares and the minimum number of round lot holders. In addition, investors might consider the increased proportion of unissued authorized shares of common stock to issued shares of common stock to have an anti-takeover effect under certain circumstances by allowing for dilutive issuances which could prevent certain shareholders form changing the composition of our board of directors.
Any delisting of our common stock by NASDAQ could adversely affect the our ability to attract new investors, decrease the liquidity of our outstanding shares of common stock, reduce our flexibility to raise additional capital, reduce the price at which our common stock trades and increase the transaction costs inherent in trading such shares with overall negative effects for our shareholders. In addition, delisting of our common stock could deter broker-dealers from making a market in or otherwise seeking or generating interest in our common stock, and might deter certain institutions and persons from investing in our securities at all. For these reasons and others, delisting could adversely affect our business, financial condition and results of operations.
Item 1B.
Item 1B. Unresolved Staff Comments.
We have no unresolved comments from the SEC.
Item 2.
Item 2. Properties.
We own no real property and we currently lease all facilities used in our business. Our headquarters are located in San Diego, California, where we leased a 160,000 square foot facility in a light industrial complex as of June 30, 2010. On July 1, 2010, we modified our San Diego headquarters lease and reduced our facility by one building, or 67,285 square feet, which proportionally reduced our monthly base rent and share of facility expenses. The lease expires in February 2014 and can be renewed for one additional five-year period. This San Diego facility houses manufacturing, research and development, marketing and administrative functions.
We lease a 20,777 square feet facility in San Jose, California. The lease expires in May 2017. The San Jose facility houses research and development, sales and marketing, and administrative functions.
We lease a 17,000 square foot facility located in Wokingham, England, which houses sales, technical support and repair services. The lease expires in January 2018. We also maintain small sales offices located close to Paris, France; Munich, Germany; and in Singapore. During fiscal 2009, as part of our restructuring plan, we closed our sales offices in China and Korea, and our engineering office in Denver, Colorado.
Item 3.
Item 3. Legal Proceedings.
We are from time to time involved in various lawsuits, legal proceedings or claims that arise in the ordinary course of business. We do not believe any such legal proceedings or claims will have, individually or in the aggregate, a material adverse effect on our results of operations, financial position or cash flows. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business.
In December 2009, Crossroads Systems, Incorporated (Crossroads) filed a lawsuit against us and several other companies in the United States District Court for the Western District of Texas (the Complaint). The Complaint was served on us in December 2009, and alleged that our products infringe United States Patent Nos. 6,425,035 and 7,051,147. The Court had scheduled a hearing on issues of claim construction for June 3, 2010. Although we were prepared to vigorously defend against Crossroads’ lawsuit, in advance of the claim construction briefing, the parties reached a settlement of the lawsuit, and the Court entered an Order of Dismissal of the lawsuit on May 25, 2010.
Item 4.
Item 4. (Removed and Reserved).
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities.
Our common stock trades on The NASDAQ Capital Market under the symbol “OVRL.” As of September 7, 2010, there were approximately 33 shareholders of record. On December 8, 2009, we effected a one-for-three reverse stock split of our outstanding shares of common stock. The following table sets forth the range of high and low bid prices for our common stock for the past two fiscal years as reported by NASDAQ. All amounts in the table have been adjusted to give effect to the reverse stock split.
The above quotations reflect inter-dealer prices, without retail markup, markdown or commission and may not necessarily represent actual transactions. We have not paid any cash dividends on our common stock for our two most recent fiscal years and do not anticipate paying any cash dividends in the foreseeable future.
Item 6.
Item 6. Selected Financial Data.
The following selected financial data has been derived from our consolidated financial statements and related notes. This information should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with our consolidated financial statements and related notes appearing elsewhere in this report.
The consolidated statement of operations data for the years ended June 30, 2010, 2009 and 2008, and the consolidated balance sheet data at June 30, 2010 and 2009, are derived from our consolidated financial statements appearing elsewhere in this report. The consolidated statement of operations data for the years ended June 30, 2007 and 2006, and the consolidated balance sheet data at June 30, 2008, 2007 and 2006, are derived from our consolidated financial statements that are not included in this report. The historical results are not necessarily indicative of the results to be expected in any future period.
The following table summarizes selected financial data (in thousands, except per share amounts):
(1) See Note 1 to our consolidated financial statements for an explanation of shares used in computing net loss per share.
(2) Basic loss per share is computed by dividing net loss applicable to common shareholders by the weighted average number of common shares assumed to be outstanding during the periods of computation.
(3) Per share amounts have been adjusted to give effect to the December 8, 2009 one-for-three reverse stock split.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions that are difficult to predict. Words and expressions reflecting optimism, satisfaction or disappointment with current prospects, as well as words such as “believes,” “hopes,” “intends,” “estimates,” “expects,” “projects,” “plans,” “anticipates” and variations thereof, or the use of future tense, identify forward-looking statements, but their absence does not mean that a statement is not forward-looking. Such forward-looking statements are not guarantees of performance and our actual results could differ materially from those contained in such statements. In evaluating such statements we urge you to specifically consider various factors identified in this report, including the matters set forth under the heading “Risk Factors” in Part I, Item 1A of this report, any of which could cause actual results to differ materially from those indicated by such forward-looking statements. Forward-looking statements speak only as of the date of this report and we undertake no obligation to publicly update any forward-looking statements to reflect new information, events or circumstances after the date of this report. Per share amounts herein have been adjusted to give effect to the December 8, 2009 one-for-three reverse stock split.
We are a trusted global provider of unified data management and data protection solutions designed to enable SMEs, corporate departments and SMBs, to anticipate and respond to change. Whether an organization’s data is distributed around the corner or across continents, our solutions tie it all together for easy and cost-effective management of different tiers of information over time. We enable companies to expend fewer resources on IT allowing them to focus on being more responsive to the needs of their customers.
We develop and deliver a comprehensive solution set of award-winning products and services for moving and storing data throughout the organization and during the entire data lifecycle. Our Snap Server® product is a complete line of network attached storage and storage area network solutions designed to ensure primary and secondary data is accessible and protected regardless of its location. Our Snap Server® solutions are available with backup, replication and mirroring software in fixed capacity or highly scalable configurations. These solutions provide simplified disk-based data protection and maximum flexibility to protect mission critical data for both continuous local backup and remote disaster recovery. Our NEO SERIES® and REO SERIES® of virtual tape libraries, tape backup and archive systems are designed to meet the need for cost-effective, reliable data storage for long-term archiving and compliance requirements.
Our approach emphasizes long term investment protection for our customers and reduces the complexities and ongoing costs associated with storage management. Moreover, most of our products are designed with a scalable architecture which enables companies to purchase additional storage as needed, on a just-in-time basis, and make it available instantly without downtime.
End users of our products include SMEs, SMBs, distributed enterprise companies such as divisions and operating units of large multi-national corporations, governmental organizations, and educational institutions. Our products are used in a broad range of industries including financial services, video surveillance, healthcare, retail, manufacturing, telecommunications, broadcasting, research and development and many others. See “Business” in Part I, Item 1 of this report for more information about our business, products and operations.
Overview
This overview discusses matters on which our management primarily focuses in evaluating our financial position and operating performance.
Generation of revenue. We generate the majority of our revenue from sales of our data protection products. The balance of our revenue is provided by selling maintenance contracts and rendering related services, selling spare parts, and earning royalties on our licensed technology. The majority of our sales are generated through our branded channel which includes systems integrators and VARs, with the remainder from our private label arrangements with OEMs.
Business Transition. In August 2005, we announced that our largest OEM customer, HP, had selected an alternate supplier for its next-generation mid-range tape automation products. HP began purchasing the alternate supplier’s new product line during the first quarter of calendar year 2006, which decreased our sales to HP. However, in mid-2007 HP re-launched its tape automation products containing our product with support for HP’s new LTO-4 tape drives, causing a slowdown in the rate of replacement of our products by the alternate supplier’s product. Although we believe that our sales to HP will continue to decline, in the fourth quarter of fiscal 2009 we extended our supply agreement with HP until July 2012 with automatic renewals for three successive one-year periods unless earlier terminated by either party. Revenue from HP in fiscal 2010 decreased 44.2% compared with fiscal 2009, and decreased 30.2% in fiscal 2009 compared with fiscal 2008.
During fiscal 2010, we continued to experience decreased revenues. We believe customers have delayed purchases or chose not to purchase for a number of reasons, including, among others, (i) the uncertainty of the world economy and a general decrease in IT spending and (ii) a reluctance by some customers to purchase our products due to weakness in our financial condition.
Due in large part to the overall decline in HP revenue, we reported net revenue of $77.7 million for fiscal 2010, compared with $105.6 million for fiscal 2009. The decline in net revenue resulted in a net loss of $13.0 million, or $2.04 per share, for fiscal 2010 compared with a net loss of $18.0 million, or $4.23 per share, for fiscal 2009.
Positive trends. During fiscal 2010, we have achieved a number of financial and operational objectives designed to further our efforts to regain profitability:
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Operating expenses for fiscal 2010 decreased 22.3% compared to fiscal 2009.
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Research and development expense decreased approximately 37.6% to $5.8 million in fiscal 2010 from $9.3 million in fiscal 2009. The decrease is primarily associated with the streamlining of our product roadmap to focus on new products in tape, storage area network, and network attached storage disk-based solutions that better suit our product portfolio.
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Sales and marketing expense decreased approximately 31.6% to $18.0 million in fiscal 2010 from $26.3 million in fiscal 2009. The decrease is primarily attributable to changes in our marketing programs and realignment of our sales force.
Liquidity and capital resources. At June 30, 2010, we had a cash balance of $8.9 million, compared to $5.5 million at June 30, 2009. In fiscal 2010, we incurred a net loss of $13.0 million. During the third quarter of fiscal 2010, we sold an aggregate of 794,659 shares of Series A Convertible Preferred Stock and warrants to purchase up to 6,373,266 shares of common stock in a private placement for a total issuance price of $11.9 million (net proceeds of approximately $10.9 million). During the second quarter of fiscal 2010, we sold 2.1 million shares of our common stock in a public offering at $2.10 per share for gross proceeds of $4.3 million (net proceeds of approximately $3.7 million) and we received $2.0 million from the liquidation of our auction rate securities (ARS). Historically, our primary source of liquidity has been cash generated from operations. We currently have financing agreements in place with a borrowing base that is determined by the amount of qualifying non-OEM accounts receivable sales during a period. Our practice has been to borrow the full amount of non-OEM accounts receivable sales we transact. We have no unused source of liquidity at this time and cash management and preservation continues to be a top priority. We expect to incur negative operating cash flows during the remainder of calendar 2010 as we continue to reshape our business model and further improve operational efficiencies.
Management has projected that cash on hand, including cash received from our private placement of shares of Series A Convertible Preferred Stock in February 2010, and funding available under the our non-OEM accounts receivable financing agreements will be sufficient to allow us to continue operations at current levels through the end of calendar 2010. Significant changes from our current forecast, including, but not limited to:
(i) shortfalls from projected sales levels, (ii) unexpected increases in product costs, (iii) increases in operating costs and/or (iv) changes to the historical timing of collecting accounts receivable or to the borrowing terms on our non-OEM account receivable financing arrangements, could have a material adverse affect on our ability to access the level of funding necessary to continue operations at current levels. If any of these events occur, management may be forced to make further reductions in spending, further extend payment terms with suppliers, liquidate assets where possible, and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects.
As of June 30, 2010, we had working capital of $2.4 million, reflecting a $0.6 million increase in current assets compared to June 30, 2009, and a $4.5 million decrease in current liabilities during fiscal 2010. The increase in current assets is primarily attributable our private placement of shares of Series A Convertible Preferred Stock in February 2010, offset by cash used in operating activities and reduced sales, resulting in lower inventory balances. The decrease in current liabilities is primarily attributable to a $1.9 million reduction in debt primarily related to payments made on outstanding notes payable to Anacomp, Inc. (Anacomp) and Adaptec, Inc. (Adaptec), a $1.7 million reduction in the product warranty liability and a $0.9 million reduction in accrued liabilities. Current liabilities associated with our non-OEM accounts receivable financing arrangements, including accrued interest, were $4.5 million and $4.2 million as of June 30, 2010 and 2009, respectively. See “Liquidity and Capital Resources” below for a description of these arrangements.
Industry trends. We estimate that the cost of data management is four times the cost of storage devices. Furthermore, many SMEs and SMBs are seeking to implement tiered storage for primary and secondary data utilizing a combination of low cost SATA (Serial ATA) drives and high performance SAS (Serial Attached SCSI) drives. IDC estimates that the total networked attached storage (NAS) market will grow at approximately 7.6% through 2014, and the growth rate for NAS storage systems in price bands up to $15,000, where most of our Snap Server® solutions lie, is estimated at 10.8%. According to IDC, tape storage still constitutes approximately 8.1% of the total storage revenue in the global storage market. Sales of tape automation appliances represented 46.6% and 50.1% of our revenue during fiscal 2010 and 2009, respectively.
Recent Developments
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In July 2010, we launched two new products; the Snap Sever® N2000, our first 2U rack-mountable NAS product and the NEO® 8000e, which provides new functionality and increased performance to the NEO® 8000.
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On July 1, 2010, we modified our San Diego headquarters lease and reduced the facility by one building, or 67,285 square feet, which proportionally reduced our monthly base rent and share of facility expenses.
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On September 20, 2010, the Committee approved the Bonus Plan. For more information regarding the Bonus Plan, see “Business-Recent Developments” in Part I, Item 1 of this report.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial position and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of consolidated financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent liabilities. On an on-going basis, we evaluate our estimates, including, but not limited to, those related to revenue recognition, available-for-sale securities, share-based compensation, bad debts, inventories, intangible and other long-lived assets, warranty obligations, income taxes and restructuring charges. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Critical accounting policies are those policies that, in management’s view, are most important in the portrayal of our financial condition and results of operations. The footnotes to our consolidated financial statements also include disclosure of significant accounting policies. The methods, estimates and judgments that we use in applying our accounting policies have a significant impact on the results that we report in our financial statements. These critical accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain. Our critical accounting policies and estimates that require the most significant judgment are discussed further below.
Revenue Recognition
We recognize revenue from sales of products when persuasive evidence of an arrangement exists, the price is fixed or determinable, collectability is reasonably assured and delivery has occurred. Under this policy, revenue on direct product sales (excluding sales to distributors) is recognized upon shipment of products to our customers. These customers are not entitled to any specific right of return or price protection, except for any defective product that may be returned under our warranty policy. Generally, title and risk of loss transfer to the customer when the product leaves our dock. Product sales to distribution customers are subject to certain rights of return, stock rotation privileges and price protection. Because we are unable to estimate our exposure for returned product or price adjustments, revenue from shipments to these customers is not recognized until the related products are in turn sold to the ultimate customer by the distributor. For products in which software is more than an incidental component, we recognize revenue in accordance with current authoritative guidance for software revenue recognition.
When there are multiple elements in an arrangement, we allocate revenue to the separate elements based on relative fair value, provided we have fair value for all elements of the arrangement. If in an arrangement we have fair value for undelivered elements but not the delivered element, we defer the fair value of the undelivered element(s) and the residual revenue is allocated to the delivered element(s). Undelivered elements typically include services. Revenue from extended warranty and product service contracts is initially deferred and recognized ratably over the contract period.
We have various royalty arrangements with independent service providers that sell our product and also sell and provide service on our product. These independent service providers pay a royalty fee for service contracts in place on our product. The royalty fee is calculated by us for the units covered in the quarter, and agreed to by the service provider, based upon the monthly fee for each unit covered by the independent service provider.
We have various licensing agreements relating to our Variable Rate Randomizer (VR2® ) technology with third parties. The licensees pay us a royalty fee for sales of their products that incorporate our VR2® technology. The licensees provide us with periodic reports that include the quantity of units, subject to royalty, sold to their end users. We record the royalty when reported to us by the licensee, generally in the period during which the licensee ships the products containing VR2® technology.
Allowance for Doubtful Accounts
We estimate our allowance for doubtful accounts based on an assessment of the collectability of specific accounts and the overall condition of the accounts receivable portfolio. When evaluating the adequacy of the allowance for doubtful accounts, we analyze specific trade and other receivables, historical bad debts, customer credits, customer concentrations, customer credit-worthiness, current economic trends and changes in customers’ payment terms and/or patterns. If the financial condition of our customers were to deteriorate, impairing their ability to make additional payments, then we may need to make additional allowances. Likewise, if we determine that we could realize more of our receivables in the future than previously estimated, we would adjust the allowance to increase income in the period we made the determination. We review the allowance for doubtful accounts on a quarterly basis and record adjustments as considered necessary. Generally, our allowance for doubtful accounts is based on specific identification. If we fail to identify an account as doubtful, or if we identify an account as uncollectible that is later collected, our results could vary.
Share-Based Compensation
Share-based compensation expense can be significant to our results of operations, even though no cash is used for such expense. In determining period expense associated with unvested options, we estimate the fair value of each option at the date of grant. We use the Black-Scholes option pricing model to determine the fair value of the award. This model requires the input of highly subjective assumptions, including the expected volatility of our stock and the expected term the average employee will hold the option prior to the date of exercise. In addition, we estimate pre-vesting forfeitures for share-based awards that are not expected to vest. We primarily use historical data to determine the inputs and assumptions to be used in the Black-Scholes pricing model. Changes in these inputs and assumptions could occur and could materially affect the measure of estimated fair value and make it difficult to compare the results in future periods to our current results.
A 10.0% change in our share-based compensation for the year ended June 30, 2010 would have affected our net loss by $170,000.
Inventory Valuation
We record inventories at the lower of cost or market. We assess the value of our inventories periodically based upon numerous factors including, among others, expected product or material demand, current market conditions, technological obsolescence, current cost and net realizable value. If necessary, we adjust our inventory for obsolete or unmarketable inventory by an amount equal to the difference between the cost of the inventory and the estimated market value. If actual market conditions are less favorable than we project, we may need to record additional inventory adjustments and adverse purchase commitments.
Impairment of Long-Lived Assets
We test for recoverability of long-lived assets whenever events or changes in circumstances indicate the carrying value may not be recoverable. When the carrying value is not considered recoverable, an impairment loss is recognized for the amount by which the carrying value of a long-lived asset exceeds its fair value, with a corresponding reduction in the carrying value of the related assets. Such impairment charges may be material. Fair value is generally determined based on the estimated future discounted cash flows over the remaining useful life of the asset or asset group using a discount rate determined by management to be commensurate with the risk inherent in our current business model.
The assumptions supporting the cash flow analysis, including the discount rates, are determined using management’s best estimates as of the date of the impairment review. If these estimates or their related assumptions change in the future, or if our future results are significantly different than forecasted, we may be required to further evaluate our long-lived assets for recoverability and record impairment charges for these assets that could adversely affect our results of operations.
During the fourth quarter of fiscal 2008, we recorded a $7.4 million impairment related to our property and equipment. See “Fiscal 2009 Compared with Fiscal 2008-Impairment of Long-Lived Assets” under the heading “Results of Operations” below. The estimated fair value of these assets was determined using the income approach, which is based on a discounted cash flow analysis, as well as consideration of the estimated value that could be realized upon sale. The assumptions used by us included estimates of (i) projected cash flows for a period approximating the remaining estimated useful life of the asset group, (ii) a discount rate commensurate with the implied risk in an investment in us and the risk of the underlying cash flows, and (iii) enterprise value.
Warranty Obligations
We provide for estimated future costs of warranty obligations in accordance with current accounting rules. For return-to-factory and on-site warranties, we accrue for warranty costs at the time revenue is recognized based on contractual rights and on the historical rate of claims and costs to provide warranty services. If we experience
an increase in warranty claims above historical experience or our costs to provide warranty services increase, we may be required to increase our warranty accrual. Any such unforeseen increases may have an adverse impact on our gross margins in the periods in which they occur. Similarly, if we experience a decrease in warranty claims or our costs to provide services decline, we may be required to decrease our warranty accrual, which may have a favorable impact on our gross margins in the periods in which they occur.
Results of Operations
The following table sets forth certain financial data as a percentage of net revenue:
A summary of the sales mix by product follows:
Fiscal 2010 Compared with Fiscal 2009
Net Revenue. Net revenue decreased to $77.7 million during fiscal 2010 from $105.6 million during fiscal 2009, a decrease of $27.9 million, or 26.4%. The decline was primarily the result of anticipated lower OEM
revenue, specifically from HP, reflecting the previously announced transition by HP to an alternate supplier. In our branded channel, the decrease in net revenue was attributable to decreased volumes across all channels.
Product Revenue
Net product revenue decreased to $53.6 million during fiscal 2010 from $80.7 million during fiscal 2009, a decrease of $27.1 million, or 33.6%.
Net product revenue from OEM customers decreased to $14.9 million during fiscal 2010 from $28.7 million during fiscal 2009. The decrease of $13.8 million, or 48.1%, was primarily associated with declining sales to HP. Net revenue from HP represented 22.5% of total net revenue during fiscal 2010, compared with 29.7% during fiscal 2009.
Net product revenue from Overland branded products, excluding service revenue, decreased to $38.7 million during fiscal 2010 from $52.0 million during fiscal 2009. The decrease of $13.3 million, or 25.6%, was primarily associated with decreases of $6.0 million from ARCvault® products, $3.6 million from REO® products, $1.6 million from Ultamus® products and $1.0 million from Snap Sever® products. These decreases were partially offset by an increase of $0.4 million from NEO® products, which we began selling the NEO® S product in the second quarter of fiscal 2010. We believe that the overall decrease in sales of Overland branded products is primarily a result of (i) the uncertainty in the world economy, (ii) a general decrease in IT spending worldwide, and (iii) a reluctance to purchase our products due to uncertainty regarding our financial condition.
Service Revenue
Net service revenue was relatively constant at $23.6 million during fiscal 2010 compared to $24.1 million during fiscal 2009.
Royalty Fees
Net royalty fees decreased to $0.5 million during fiscal 2010 from $0.8 million during fiscal 2009. The decrease of $0.3 million, or 37.5%, is primarily associated with lower VR2® technology royalties. VR2® technology royalties during fiscal 2010 totaled $0.3 million compared with $0.7 million during fiscal 2009.
Gross Profit. Overall gross profit decreased to $21.4 million during fiscal 2010 from $29.2 million during fiscal 2009, a decrease of $7.8 million, or 26.7%. Gross margin remained relatively constant at 27.5% during fiscal 2010 compared to 27.6% during fiscal 2009.
Product Revenue
Gross profit on product revenue during fiscal 2010 was $8.3 million compared to $15.4 million during fiscal 2009. The decrease of $7.1 million, or 46.1%, was primarily due to the 33.6% decrease in net product revenue. Gross margin on product revenue at 15.5% for fiscal 2010 declined from 19.1% for fiscal 2009 primarily as a result of increased freight costs and warranty repair costs, as well as duplicative costs associated with our transition to an outsourced manufacturer. We expect these duplicative costs to continue until our transition to the outsourced manufacturer is complete.
Service Revenue
Gross profit on service revenue during fiscal 2010 was relatively constant at $12.6 million compared to $13.0 million in fiscal 2009. Gross margin on service revenue remained relatively constant at 53.4% during fiscal 2010 compared to 53.9% during fiscal 2009.
Share-Based Compensation. During fiscal 2010, we had share-based compensation expense of $1.7 million compared with $0.3 million in fiscal 2009. The increase of approximately $1.4 million is primarily due to a one time grant of stock options to acquire, in the aggregate, 1.8 million shares of our common stock in February 2010 to executive officers as a retention tool.
Share-based compensation was allocated as follows (in thousands):
Fiscal 2010 Cost Reductions and Restructuring of Workforce. During fiscal 2010, we implemented two reductions in force as part of our cost-cutting initiatives.
The following table summarizes the activity associated with the fiscal 2010 restructurings (severance costs in thousands):
(1) Severance costs, including our payments of COBRA premiums, are included in cost of goods sold, sales and marketing expense, research and development expense and general and administrative expense.
The following table summarizes the activity and balances of accrued restructuring charges during fiscal 2009 and 2010 (in thousands):
Sales and Marketing Expense. Sales and marketing expense in fiscal 2010 decreased to $18.0 million from $26.3 million during fiscal 2009. The decrease of $8.3 million, or 31.6%, was primarily a result of a decrease of $5.5 million in employee and related expenses including (i) a $0.8 million reduction in commissions as a result of reduced sales, (ii) a $0.6 million reduction in travel expenses due to cost control efforts and a reduction in the number of trade shows and partner conferences attended or hosted, (iii) the effects of a decrease in the average headcount by 32 employees, primarily due to the reductions in workforce in the first three quarters of fiscal 2009
and (iv) the effects of a company-wide temporary 10.0% salary reduction implemented in January 2009, which was partially reinstated in fiscal 2010. In addition, the following factors further contributed to the decrease in sales and marketing expenses: (i) a decrease of $1.6 million in public relations and advertising expense, including contractor fees, due to restructuring and reductions in marketing programs and bringing previously outsourced projects in house, (ii) a decrease of $0.5 million in distributor support and incentives, (iii) a decrease of $0.4 million in severance costs associated with the fiscal 2009 restructurings and (iv) a decrease of $0.4 million in demo and promotion costs. These decreases were slightly offset by a $0.3 million increase in share-based compensation expense primarily associated with company wide options granted in July 2009 and options granted to an executive officer in February 2010.
Research and Development Expense. Research and development expense in fiscal 2010 decreased to $5.8 million from $9.3 million during fiscal 2009. The decrease of $3.5 million, or 37.6%, is primarily a result of (i) a decrease of $2.6 million in employee and related expenses, including travel costs, associated with a decrease in average headcount by 13 employees and the effects of a company-wide temporary 10.0% salary reduction implemented in January 2009, which was partially reinstated in fiscal 2010, (ii) a decrease of $0.5 million for contractors expense, (iii) a decrease of $0.3 million in development expense due to the completion of scheduled research and development projects and (iv) a decrease of $0.2 million in severance costs associated with fiscal 2009 restructurings. These decreases were offset by a $0.2 million increase in share-based compensation expense primarily associated with company wide options granted in July 2009 and options granted to an executive officer in March 2010.
General and Administrative Expense. General and administrative expense in fiscal 2010 increased to $11.9 million from $10.4 million during fiscal 2009. The increase of $1.5 million, or 14.4%, is primarily a result of (i) an increase of $0.8 million in share-based compensation expense primarily associated with company wide options granted in July 2009 and options granted to executive officers in February 2010, (ii) an increase of $0.3 million in severance cost associated with the termination of an executive officer and (iii) an increase of $0.2 million in legal fees associated with the Crossroads settlement in May 2010.
Interest Expense. We incurred interest expense of $1.5 million and $0.6 million during fiscal 2010 and 2009, respectively. In fiscal 2009, we entered into two non-OEM accounts receivable financing agreements and converted $2.3 million in accounts payable to a note payable. Under the non-OEM accounts receivable financing agreements we recorded interest expense of $1.3 million, including $0.1 million in amortization of debt issuance costs, compared to $0.4 million in fiscal 2009. Interest expense associated with our notes payable to Anacomp and Adaptec totaled $0.2 million during fiscal 2010 compared to $0.1 million during fiscal 2009.
Other Income (expense), net. During fiscal 2010, we incurred other income (expense), net, of $1.0 million of income compared with $0.8 million of expense during fiscal 2009. The increase of $1.8 million, or 225.0%, was primarily the result of the liquidation of our ARS resulting in a recognized gain of $0.5 million during fiscal 2010, compared to a $1.6 million other than temporary impairment loss during fiscal 2009. This increase was partially offset by a decrease of approximately $0.4 million in realized currency exchange gains due to foreign currency fluctuations.
(Benefit from) provision for Income Taxes. During fiscal 2010, we recognized benefit from income taxes of $1.8 million compared to recording a provision for income taxes of $30,000 during fiscal 2009. The net benefit in fiscal 2010 primarily related to our net operating loss carry back recognized pursuant to amended Internal Revenue Code Section 172(b)(1)(H). In fiscal 2009, we recorded nominal income tax expense.
Fiscal 2009 Compared with Fiscal 2008
Net Revenue. Net revenue decreased to $105.6 million during fiscal 2009 from $127.7 million during fiscal 2008, a decrease of $22.1 million, or 17.3%. The decline was primarily the result of anticipated lower OEM revenue, specifically from HP, reflecting the previously announced transition by HP to an alternate supplier. In our branded channel, the decrease in net revenue was attributable to decreased volumes across all channels.
Product Revenue
Net product revenue decreased to $80.7 million during fiscal 2009 from $106.0 million during fiscal 2008, a decrease of $25.3 million, or 23.9%.
Net product revenue from OEM customers decreased to $28.7 million during fiscal 2009 from $46.4 million during fiscal 2008. The decrease of $17.7 million, or 38.1%, was primarily associated with declining sales to HP. Net revenue from HP represented 29.7% of total net revenue during fiscal 2009, compared with 35.2% during fiscal 2008.
Net product revenue from Overland branded products, excluding service revenue, decreased to $52.0 million during fiscal 2009 from $59.6 million during fiscal 2008. The decrease of $7.6 million, or 12.8%, was primarily associated with decreases of $9.5 million from NEO products, $3.8 million from ARCvault® products and $3.2 million from REO® products. These decreases were partially offset by $9.3 million of sales of Snap Server® products, which we began selling in the first quarter of fiscal 2009. We believe the overall decrease in sales of Overland branded products is primarily a result of (i) the uncertainty in the world economy, (ii) a general decrease in IT spending worldwide, and (iii) a reluctance to purchase our products due to uncertainty regarding our financial condition.
Service Revenue
Net service revenue increased to $24.1 million during fiscal 2009 from $20.6 million during fiscal 2008. The increase of $3.5 million, or 17.0%, is attributable to a $5.4 million increase in warranty revenue associated with an increase in the number of service contracts sold due to increased sales efforts, partially offset by a $1.9 million decrease in out-of-warranty services provided, primarily to HP.
Royalty Fees
Net royalty fees decreased to $0.8 million during fiscal 2009 from $1.1 million during fiscal 2008. The decrease of $0.3 million, or 27.3%, is primarily associated with lower VR2® technology royalties and HP software royalties. VR2® technology royalties during fiscal 2009 totaled $0.7 million compared with $0.8 million during fiscal 2008. HP software royalties were $26,000 and $0.2 million during fiscal 2009 and 2008, respectively.
Gross Profit. Overall gross profit increased to $29.2 million during fiscal 2009 from $28.1 million during fiscal 2008, an increase of $1.1 million, or 3.9%. Gross margin increased to 27.6% during fiscal 2009 from 22.0% during fiscal 2008.
Product Revenue
Gross profit on product revenue during fiscal 2009 was $15.4 million compared to $17.7 million during fiscal 2008. The decrease of $2.3 million, or 13.0%, was primarily due to the 23.9% decrease in product revenue. Gross margin on product revenue at 19.1% for fiscal 2009 increased from 16.7% for fiscal 2008 primarily due to Snap Server® product revenues, which began in fiscal 2009 and carry higher margins than most of our other products.
Service Revenue
Gross profit on service revenue during fiscal 2009 was $13.0 million compared to $9.2 million during fiscal 2008. The increase of $3.8 million, or 41.3%, was primarily associated with an increase in warranty contracts recognized in fiscal 2009 compared with fiscal 2008. Gross margin on service revenue at 53.9% for fiscal 2009 increased from 44.7% for fiscal 2008 primarily due to new service offerings and the addition of the Snap Server® product line, which have more favorable margins.
Share-Based Compensation. During fiscal 2009, we had share-based compensation expense of $0.3 million compared with $1.0 million in fiscal 2008. The decrease of approximately $0.7 million is primarily due to a one time grant of stock options to acquire, in the aggregate, 1.5 million shares of our common stock in August 2007 to executive officers and key employees as a retention tool. The share-based compensation expense associated with the August 2007 option grants was recognized primarily in fiscal 2008. These options vested monthly for one year and resulted in increased share-based compensation expense through the first quarter of fiscal 2009. Compensation expense associated with option and restricted stock awards with graded vesting is recognized on an accelerated basis.
Share-based compensation was allocated as follows (in thousands):
Fiscal 2009 Cost Reductions and Restructuring of Workforce. During fiscal 2009, we implemented several reductions in force as part of our cost-cutting initiatives. As part of the March 2009 restructuring, we terminated the employment of the sole employee in our Colorado facility. In April 2009, we vacated this facility, the lease for which expires February 2011. In the fourth quarter of fiscal 2009, we recorded a charge of $55,000 to research and development expense for the estimated fair value of the liability associated with vacating this facility.
The following table summarizes the activity associated with the fiscal 2009 restructurings (severance costs in thousands):
(1) Severance costs, including our payments of COBRA premiums, are included in sales and marketing expense, research and development expense and general and administrative expense.
(2) Severance costs, including our payments of COBRA premiums, are included in sales and marketing expense and research and development expense.
(3) Severance costs, including our payments of COBRA premiums, are included in cost of goods sold, sales and marketing expense, research and development expense and general and administrative expense.
(4) We implemented a temporary 10.0% salary reduction following the January 2009 restructuring, which was partially reinstated in fiscal 2010. No amounts are reflected in these tables for such salary reduction.
The following table summarizes the activity and balances of accrued restructuring charges during fiscal 2008 and 2009 (in thousands):
Sales and Marketing Expense. Sales and marketing expense in fiscal 2009 decreased to $26.3 million from $31.6 million during fiscal 2008. The decrease of $5.3 million, or 16.8%, is primarily due to a decrease of $3.0 million in employee and related expenses including (i) a $1.0 million reduction in commissions as a result of reduced sales, (ii) a $0.9 million reduction in travel expenses due to cost control efforts and a reduction in the number of trade shows and partner conferences attended or hosted, and (iii) the effects of a company-wide temporary 10.0% salary reduction implemented in January 2009. Other cost reductions included a $1.1 million reduction in public relations and advertising expense due to the reduction in trade shows and partner conferences attended or hosted, and a $0.5 million reduction in outside contractor expenses due to cost control efforts. These decreases were slightly offset by a $0.4 million increase in severance associated with the fiscal 2009 restructurings.
Research and Development Expense. Research and development expense in fiscal 2009 remained flat at $9.3 million compared to fiscal 2008. During fiscal 2009 there was a decrease of $1.6 million in material-intensive product development expenses due to the completion of scheduled research and development projects. This decrease was offset by (i) a $0.9 million increase in employee and related expenses related to our acquisition of the Snap Server® product line in June 2008, which increased average headcount by eight employees, and (ii) an increase of $0.5 million in outside contractor expenses for tape library development.
General and Administrative Expense. General and administrative expense in fiscal 2009 increased to $10.4 million from $10.1 million during fiscal 2008. The increase of $0.3 million, or 3.0%, is primarily due to (i) an increase of $0.7 million in legal fees, for financing and strategic alternatives, (ii) an increase of $0.6 million in amortization of intangibles associated with the acquisition of the Snap Server® product line in June 2008, and (iii) an increase of $0.3 million in outside contractor expenses, principally for financial and accounting services. These increases were offset by (i) a decrease of $0.9 million in depreciation expense due to lower carrying values of fixed assets, and (ii) a $0.5 million decrease in employee and related expenses related to our fiscal 2009 restructurings.
Impairment of Long-Lived Assets. In the fourth quarter of fiscal 2008, we recorded an impairment charge of $7.4 million related to property and equipment. As discussed in Note 2 to the consolidated financial statements, management performed impairment analyses of its long-lived assets as of June 30, 2009 and 2008 due to our continued operating and cash flow losses and our forecasts. The impairment analysis as of June 30, 2008, excluded the long-lived assets from the recently completed Snap Server acquisition (Note 3 to the consolidated financial statements). We concluded that the carrying amount of this asset group was not recoverable as of June 30, 2008, and consequently we recognized an impairment loss of $7.4 million. Management concluded that the carrying amount of the asset group (including the long-lived assets from the Snap Server acquisition which has been fully integrated into our operations) was recoverable as of June 30, 2009, and therefore did not record an impairment loss on our long-lived assets in fiscal 2009.
Interest Income. During fiscal 2009, we generated interest income of $0.2 million, compared with $0.8 million during the prior fiscal year. The decrease of $0.6 million, or 75.0%, is due to the decrease in cash and investment balances in fiscal 2009 compared with fiscal 2008. We liquidated our short-term investments in the first quarter of fiscal 2009.
Interest Expense. We incurred interest expense of $0.6 million and $5,000 during fiscal 2009 and 2008, respectively. In fiscal 2009, we entered into two non-OEM accounts receivable financing agreements and converted $2.3 million in accounts payable to a note (the Anacomp Note). Under the non-OEM accounts receivable financing agreements we recorded interest expense of $0.4 million, including $0.1 million in amortization of debt issuance costs. Interest expense associated with our notes payable to Anacomp and Adaptec totaled $0.1 million during fiscal 2009. During fiscal 2008, no interest expense was recorded related to the note payable to Adaptec.
Other Expense, net. During fiscal 2009, we incurred other expense, net, of $0.8 million compared with $2.0 million during fiscal 2008. The decrease of $1.2 million in other expense, net, is primarily associated with $0.9 million in realized currency exchange gains in fiscal 2009, compared with $61,000 of realized currency exchange losses in fiscal 2008. Losses on investments related to impairment charges were $1.6 million in fiscal 2009 and $1.9 million in fiscal 2008.
Provision for Income Taxes. We recorded nominal income tax expense during fiscal 2009 compared with $0.4 million during fiscal 2008. The decrease is primarily due to the expiration of statutes of limitations on certain tax positions and the favorable settlement of tax issues with the tax authorities.
Liquidity and Capital Resources
At June 30, 2010, we had a cash balance of $8.9 million, compared to $5.5 million at June 30, 2009. In fiscal 2010, we incurred a net loss of $13.0 million. During the third quarter of fiscal 2010, we sold an aggregate of 794,659 shares of Series A Convertible Preferred Stock and warrants to purchase up to 6,373,266 shares of common stock in a private placement for a total issuance price of $11.9 million (net proceeds of approximately $10.9 million). During the second quarter of fiscal 2010, we sold 2.1 million shares of our common stock in a public offering at $2.10 per share for gross proceeds of $4.3 million (net proceeds of approximately $3.7 million) and we received $2.0 million from the liquidation of our ARS. Historically, our primary source of liquidity has been cash generated from operations. We currently have financing agreements in place with a borrowing base that is determined by the amount of qualifying non-OEM accounts receivables sales during a period. Our practice has been to borrow the full amount of non-OEM accounts receivable sales we transact. We have no unused source of liquidity at this time and cash management and preservation continues to be a top priority. We expect to incur negative cash flows during the remainder of calendar 2010 as we continue to reshape our business model and further improve operational efficiencies.
As of June 30, 2010, we had working capital of $2.4 million, reflecting a $0.6 million increase in current assets compared to June 30, 2009, and a $4.5 million decrease in current liabilities during fiscal 2010. The increase in current assets is primarily attributable our private placement of shares of Series A Convertible Preferred Stock in February 2010, offset by cash used in operating activities and reduced sales, resulting in lower inventory balances. The decrease in current liabilities is primarily attributable to a $1.9 million reduction in debt related to payments made on our outstanding notes payable to Anacomp and Adaptec, a $1.7 million reduction in the product warranty liability and $0.9 million reduction in accrued liabilities. Current liabilities associated with our non-OEM accounts receivable financing arrangements, including accrued interest, were $4.5 million and $4.2 million as of June 30, 2010 and 2009, respectively.
We rely on our two financing arrangements to support our working capital needs. In November 2008, we entered into the Marquette Commercial Finance (MCF) Financing Agreement which provides up to $9.0 million (gross) of financing against domestic non-OEM accounts receivable. In March 2009, we entered into the Faunus Group International (FGI) Financing Agreement which provides up to $5.0 million (gross) of financing against foreign non-OEM accounts receivable.
Under the MCF Financing Agreement, we are not obligated to offer any accounts (invoices) in any month, and MCF has the right to decline to purchase any offered accounts (invoices). To date, individual invoices declined by MCF were considered immaterial to our accounts receivable balance, financial position and cash
flows. A significant increase in rebates claimed as a percentage of our gross collections could lead to our failure to satisfy the dilution covenant. In August and October 2009, due to rebates claimed, the permissible dilution covenant was exceeded. MCF waived this deviation from the covenant. In January 2010, MCF revised the dilution covenant to be based on a rolling 90 day calculation, excluding one time charges. As of June 30, 2010, we were in compliance with the dilution covenant in the MCF Financing Agreement as revised. Management continues to monitor our compliance with the dilution covenant, which is based on the aggregate amount of credit memoranda, discounts and other downward adjustments to the original invoiced price divided by gross collections. Based upon our current operating assumptions, we expect to remain in compliance with the permissible dilution covenant throughout fiscal 2011.
FGI may terminate the FGI Financing Agreement upon default by us, and may also terminate the agreement for convenience upon 30 days advance notice. We may terminate the agreement at any time by paying a $100,000 termination fee. The termination fee is not payable upon a termination by FGI or upon non-renewal. We were in compliance with the terms of the FGI Financing Agreement at June 30, 2010. Based upon our current operating assumptions, we expect to remain in compliance with the terms of the FGI Financing Agreement throughout fiscal 2011.
Management has projected that cash on hand, including cash received from our private placement of shares of Series A Convertible Preferred Stock in February 2010, and funding available under our non-OEM accounts receivable financing agreements will be sufficient to allow it to continue operations at current levels through the end of calendar 2010. Significant changes from our current forecast, including but not limited to: (i) shortfalls from projected sales levels, (ii) unexpected increases in product costs, (iii) increases in operating costs and/or (iv) changes to the historical timing of collecting accounts receivable or to the borrowing terms on our non-OEM account receivable financing arrangements, could have a material adverse affect on our ability to access the level of funding necessary to continue operations at current levels. If any of these events occur management may be forced to make further reductions in spending, may be forced to further extend payment terms with suppliers, liquidate assets where possible, and/or to suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects.
Debt consists of the following as of June 30, 2010 (in thousands):
As a result of our recurring losses from operations and negative cash flows, the report from our independent registered public accounting firm regarding our consolidated financial statements for the year ended June 30, 2010 includes an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern.
During fiscal 2010, we used cash in operating activities of $10.5 million, compared with $7.1 million in fiscal 2009 and $5.2 million in fiscal 2008. The use of cash during fiscal 2010 was primarily a result of our net loss of $13.0 million. In addition there was a $2.6 million reduction in inventory reflecting management’s overall focus on increasing inventory turns and continued cost cutting initiatives. The change from fiscal 2008 to 2009 of $1.9 million was primarily attributable to the $1.9 million decrease in accrued payroll and employee compensation as a result of our fiscal 2009 restructurings. All accrued and unpaid vacation was paid out upon termination. In addition, during fiscal 2009 we decreased the accrual rate and implemented a company-wide temporary 10.0% salary reduction, which further reduced the accrual.
Cash provided by investing activities was $1.7 million in fiscal 2010, compared with $0.3 million in fiscal 2009 and cash used in investing activities of $4.0 million in fiscal 2008. During fiscal 2010, we liquidated our ARS for $2.0 million. During fiscal 2008 through the first quarter of fiscal 2009, we liquidated our short-term investments to support operations. During fiscal 2008, we used cash of $2.5 million to acquire Snap Server and made net purchases of short-term investments of $0.9 million. During fiscal 2010, 2009 and 2008, capital expenditures totaled $0.3 million, $0.9 million and $0.6 million, respectively. During fiscal 2010, capital expenditures were primarily associated with computers, software and machinery and equipment to support new product introductions. During fiscal 2009, capital expenditures were primarily associated with the purchase of tooling for new products, computer equipment and software. During fiscal 2008, capital expenditures were primarily associated with tooling to support new product development.
During fiscal 2010, cash provided by financing activities was $12.2 million, compared with $3.9 million and $26,000 during fiscal 2009 and 2008, respectively. In February 2010, we sold an aggregate of 794,659 shares of Series A Convertible Preferred Stock and warrants to purchase up to 6,373,266 shares of common stock in a private placement for a total issuance price of $11.9 million (net proceeds of approximately $10.9 million). In November 2009, we completed the sale of 2.1 million shares of our common stock through a public offering of common stock at $2.10 per share resulting in gross proceeds of $4.3 million (net proceeds of approximately $3.7 million). We continued to make scheduled payments under the Anacomp and Adaptec notes, which totaled $1.6 million and $1.1 million during fiscal 2010, respectively. During the fourth quarter of fiscal 2010, the Adaptec note was paid in full and in the first quarter of fiscal 2011, the Anacomp note was paid in full. During fiscal 2010, $0.3 million of cash generated by financing activities related to net funding activity from accounts receivable pledged to MCF and FGI compared to $4.1 million of cash generated in fiscal 2009.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements or significant guarantees to third parties that are not fully recorded in our consolidated balance sheet or fully disclosed in the notes to our consolidated financial statements.
Contractual Obligations
The following schedule summarizes our contractual obligations to make future payments at June 30, 2010 (in thousands):
(1) Represents contractual lease obligations under non-cancellable operating leases on our San Diego, California; San Jose, California; Wokingham, England and Paris, France facilities. On July 1, 2010, we modified our San Diego headquarters lease and reduced the facility by one building, or 67,285 square feet, which proportionally reduced our monthly base rent and share of facility expenses. The table above reflects the amended lease payments.
(2) Represents non-OEM accounts receivable financing agreements with MCF and FGI, and notes payable to Anacomp, including accrued interest. Accrued interest as of June 30, 2010 totaled approximately $50,000.
(3) Represents purchase orders for inventory and non-inventory items entered into prior to June 30, 2010, with purchase dates extending beyond July 1, 2010. Some of these purchase obligations may be cancelled.
(4) Liabilities associated with uncertain tax provisions, currently estimated at $0.1 million (including interest), are not included in the table above as we cannot reasonably estimate when, if ever, an amount would be paid
to a government agency. Ultimate settlement of these liabilities is dependent on factors outside of our control, such as examinations by each agency and expiration of statues of limitation for assessment of additional taxes.
Inflation
Inflation has not had a significant impact on our operations during the periods presented. Historically, we have been able to pass on to our customers increases in raw material prices caused by inflation. If at any time we cannot pass on such increases, our margins could suffer. Our exposure to the effects of inflation could be magnified by the concentration of OEM business, where our margins tend to be lower.
Recently Issued Accounting Pronouncements
See Note 1 to our consolidated financial statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
Market risk represents the risk of loss that may impact our financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We are exposed to market risk from changes in foreign currency exchange rates as measured against the U.S. dollar. These exposures are directly related to our normal operating and funding activities. Historically, we have not used derivative instruments or engaged in hedging activities.
Foreign Currency Risk. We conduct business on a global basis and essentially all of our products sold in international markets are denominated in U.S. dollars. Historically, export sales have represented a significant portion of our sales and are expected to continue to represent a significant portion of sales. Our wholly-owned subsidiaries in the United Kingdom, France and Germany incur costs that are denominated in local currencies. As exchange rates vary, these results may vary from expectations when translated into U.S. dollars, which could adversely impact overall expected results. The effect of exchange rate fluctuations on our results of operations during fiscal 2010, 2009 and 2008 resulted in gains of $0.5 million and $0.9 million for fiscal 2010 and 2009, respectively and in a loss of $0.1 million for fiscal 2008.
Item 8.
Item 8. Financial Statements and Supplementary Data.
Our consolidated financial statements and supplementary data required by this item are set forth at the pages indicated in Item 15(a)(1) and 15(a)(2), respectively.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
Not applicable.
Item 9A.
Item 9A. Controls and Procedures.
Not applicable.
Item 9A(T). Controls and Procedures.
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report.
Internal Control Over Financial Reporting
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over our financial reporting. In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, management has conducted an assessment, including testing, using the criteria in Internal Control-Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Our system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Based on our evaluation under the framework in Internal Control-Integrated Framework, our Chief Executive Officer and Chief Financial Officer concluded that our internal control over financial reporting was effective as of June 30, 2010.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions and that the degree of compliance with the policies or procedures may deteriorate.
This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report on internal control over financial reporting was not subject to attestation by our independent registered public accounting firm pursuant to temporary rules of the SEC that permit us to provide only management’s report in this annual report.
This report on internal control over financial reporting shall not be deemed to be filed for purposes of Section 18 of the Exchange Act, or otherwise subject to the liabilities of that section, and is not incorporated by reference into any of our filings, whether made before or after the date hereof, regardless of any general incorporation language in such filing.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during the fiscal quarter ended June 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
Not applicable.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
We have adopted the Overland Storage, Inc., Code of Business Conduct and Ethics, a code which applies to our directors, officers and employees. A copy of the Code of Business Conduct and Ethics is publicly available on our website at www.overlandstorage.com. If we make any substantive amendments to the Code of Business Conduct and Ethics or grant any waiver from a provision of the code applying to our principal executive officer or our principal financial or accounting officer, we will disclose the nature of such amendment or waiver on our website or in a report on Form 8-K.
The other information required by this item will be contained in our proxy statement to be filed for our 2010 Annual Meeting of Shareholders and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation.
The information required by this item will be contained in our proxy statement to be filed for our 2010 Annual Meeting of Shareholders and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this item will be contained in our proxy statement to be filed for our 2010 Annual Meeting of Shareholders and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The information required by this item will be contained in our proxy statement to be filed for our 2010 Annual Meeting of Shareholders and is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services.
The information required by this item will be contained in our proxy statement to be filed for our 2010 Annual Meeting of Shareholders and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(a)(1) Financial Statements. The following consolidated financial statements of Overland Storage, Inc. and reports of independent registered public accounting firms are included in a separate section of this report at the page numbers so indicated:
Reports of Independent Registered Public Accounting Firms
Consolidated Balance Sheet as of June 30, 2010 and 2009
Consolidated Statement of Operations for the Years Ended June 30, 2010, 2009 and 2008
Consolidated Statement of Shareholders’ Equity (Deficit) and Comprehensive (Loss) Income for Years Ended June 30, 2010, 2009 and
Consolidated Statement of Cash Flows for the Years Ended June 30, 2010, 2009 and 2008
Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedules.
Schedules not listed above have been omitted because they are not applicable or are not required or the information required to be set forth therein is included in the consolidated financial statements or notes thereto.
(a)(3) Exhibits
+ Portions of this exhibit have been omitted pursuant to a request for confidential treatment and the non-public information has been filed separately with the SEC.
++ Certain schedules and similar attachments have been omitted pursuant to Item 601(b)(2) of Regulation S-K. A copy of the omitted schedules and similar attachments will be provided supplementally to the SEC upon request.
* Management contract or compensation plan or arrangement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
POWER OF ATTORNEY
Each person whose signature appears below constitutes and appoints Eric L. Kelly and Kurt L. Kalbfleisch, jointly and severally, as his attorney-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this annual report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Overland Storage, Inc.
San Diego, California
We have audited the accompanying consolidated balance sheet of Overland Storage, Inc. (the “Company”) as of June 27, 2010, and the related consolidated statements of operations, shareholders’ equity and comprehensive loss, and cash flows for the period then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Overland Storage, Inc. as of June 27, 2010, and the results of their operations and their cash flows for the period then ended, in conformity with accounting principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company’s recurring losses and negative operating cash flows raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans concerning these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ Moss Adams LLP
San Diego, California
September 24, 2010
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Overland Storage, Inc.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Overland Storage, Inc. and its subsidiaries at June 28, 2009, and the results of their operations and their cash flows for each of the two years in the period ended June 28, 2009 in conformity with accounting principles generally accepted in the United States of America. 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 of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has incurred losses and negative cash flows from operations that raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ PricewaterhouseCoopers LLP
San Diego, California
September 9, 2009, except for the last paragraph of Note 9, as to which the date is December 8, 2009
OVERLAND STORAGE, INC.
CONSOLIDATED BALANCE SHEET
(in thousands)
See accompanying notes to consolidated financial statements.
OVERLAND STORAGE, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands, except per share amounts)
See accompanying notes to consolidated financial statements.
OVERLAND STORAGE, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (DEFICIT) AND
COMPREHENSIVE LOSS
(in thousands)
See accompanying notes to consolidated financial statements.
OVERLAND STORAGE, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
See accompanying notes to consolidated financial statements.
OVERLAND STORAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
General
Overland Storage, Inc. (Overland or the Company) was incorporated on September 8, 1980, under the laws of the State of California. For more than 29 years, Overland has delivered data protection solutions designed for backup and recovery to ensure business continuity. Historically, the Company has focused on delivering a portfolio of tape automation solutions including loader and library systems designed for small and medium-sized business computing environments.
The Company operates and reports using a 52-53 week fiscal year with each quarter ending on the Sunday closest to the calendar quarter. For ease of presentation, the Company’s fiscal years are considered to end on June 30. For example, references to fiscal 2010, 2009 and 2008 refer to the fiscal years ended June 27, 2010, June 28, 2009, and June 29, 2008, respectively. Fiscal 2010, 2009 and 2008 each contained 52 weeks.
The Company has incurred losses for its last five fiscal years and negative cash flows from operating activities for its last four fiscal years. As of June 30, 2010, the Company had an accumulated deficit of $82.1 million. During fiscal 2010, the Company incurred a net loss of $13.0 million. Through calendar 2010, the Company expects to incur a net loss as it continues to change its business model and improve operational efficiencies. The Company has no unused sources of liquidity at this time.
The Company’s balance of cash increased by $3.4 million to $8.9 million compared with the balance at June 30, 2009. In February 2010, the Company sold an aggregate of 794,659 shares of Series A Convertible Preferred Stock and warrants to purchase up to 6,373,266 shares of common stock in a private placement for a total issuance price of $11.9 million (net proceeds of approximately $10.9 million). In November 2009, the Company sold 2.1 million shares of its common stock through a public offering of common stock at $2.10 per share resulting in gross proceeds of $4.3 million (net proceeds of $3.7 million). In addition, the Company liquidated all of its auction rate securities for $2.0 million in December 2009.
In March 2009, the Company entered into a foreign non-original equipment manufacturer (non-OEM) accounts receivable financing agreement with Faunus Group International (FGI). In November 2008, the Company entered into a domestic non-OEM accounts receivable financing agreement with Marquette Commercial Finance.
Management has projected that cash on hand, including cash received from the Company’s private placement of shares of Series A Convertible Preferred Stock in February 2010, and funding available under the Company’s non-OEM accounts receivable financing agreements will be sufficient to allow it to continue operations at current levels through the end of calendar 2010. Significant changes from the Company’s current forecast, including but not limited to: (i) shortfalls from projected sales levels, (ii) unexpected increases in product costs, (iii) increases in operating costs and/or (iv) changes to the historical timing of collecting accounts receivable or to the borrowing terms on the Company’s non-OEM account receivable financing arrangements, could have a material adverse affect on the Company’s ability to access the level of funding necessary to continue operations at current levels. If any of these events occur management may be forced to make further reductions in spending, may be forced to further extend payment terms with suppliers, liquidate assets where possible, and/or to suspend or curtail planned programs. Any of these actions could materially harm the Company’s business, results of operations and future prospects.
The Company’s recurring losses from operations and negative cash flows raise substantial doubt about its ability to continue as a going concern. The accompanying consolidated financial statements have been prepared
on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Overland may never return to profitability, or if it does, it may not be able to sustain profitability on a quarterly or annual basis.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Overland Storage (Europe) Ltd., Overland Storage SARL, Overland Storage GmbH, Okapi Acquisition Co., Inc. (dissolved effective July 5, 2007), Zetta Systems, Inc., and Overland Storage Export Limited (dissolved effective July 3, 2007). All significant intercompany accounts and transactions have been eliminated.
Management Estimates and Assumptions
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 reported amounts of revenue and expenses during the reporting period. Estimates have been prepared on the basis of the most current and best available information and actual results could differ from those estimates.
Revenue Recognition
Revenue from sales of products is recognized when persuasive evidence of an arrangement exists, the price is fixed or determinable, collectability is reasonably assured and delivery has occurred. Under this policy, revenue on direct product sales, excluding sales to distributors, is recognized upon shipment of products to customers. These customers are not entitled to any specific right of return or price protection, except for any defective product that may be returned under the Company’s warranty policy. Title and risk of loss transfer to the customer when the product leaves the Company’s dock. Product sales to distribution customers are subject to certain rights of return, stock rotation privileges and price protection. Because the Company is unable to estimate its exposure for returned product or price adjustments, revenue from shipments to these customers is not recognized until the related products are in turn sold to the ultimate customer by the distributor. For products for which software is more than an incidental component, the Company recognizes revenue in accordance with current authoritative guidance for software revenue recognition.
When there are multiple elements in an arrangement, the Company allocates revenue to the separate elements based on relative fair value, provided it has fair value for all elements of the arrangement. If the Company has fair value for undelivered elements but not the delivered element in an arrangement, the Company defers the fair value of the undelivered element(s) and the residual revenue is allocated to the delivered element(s). Undelivered elements typically include services. Revenue from extended warranty and product service contracts is initially deferred and recognized ratably over the contract period.
The Company has various royalty arrangements with independent service providers that sell its product and also sell and provide service on that product. These independent service providers pay a royalty fee for service contracts in place on the Company’s product. The royalty fee is calculated by Overland for the units covered in the quarter, and agreed to by the service provider, based upon the monthly fee for each unit covered by the independent service provider.
The Company has various licensing agreements relating to its Variable Rate Randomizer (VR2® ) technology with third parties. The licensees pay a royalty fee for sales of their products that incorporate the VR2® technology. The licensees provide the Company with periodic reports that include the number of units, subject to royalty, sold to their end users. The Company records the royalty when reported to it by the licensee, generally in the period during which the licensee ships the products containing VR2® technology.
Warranty and Extended Warranty
The Company records a provision for estimated future warranty costs for both return-to-factory and on-site warranties. If future actual costs to repair were to differ significantly from estimates, the impact of these unforeseen costs or cost reductions would be recorded in subsequent periods.
Separately priced extended on-site warranties are offered for sale to customers on all product lines. The Company contracts with third-party service providers to provide service relating to all on-site warranties. Extended warranty revenue and amounts paid in advance to outside service organizations are deferred and recognized as service revenue and cost of service, respectively, over the period of the service agreement.
Changes in the liability for product warranty and deferred revenue associated with extended warranties were as follows (in thousands):
Shipping and Handling
Amounts billed to customers for shipping and handling are included in product sales and costs incurred related to shipping and handling are included in cost of revenue.
Advertising Costs
Advertising costs are expensed as incurred. Advertising expenses were $0.5 million for fiscal years 2010, 2009 and 2008.
Research and Development Costs
Research and development costs are expensed as incurred. Software development costs are expensed until technological feasibility has been established, at which time any additional costs are capitalized. Because the Company believes its current process for developing software is essentially completed concurrently with the establishment of technological feasibility, which occurs upon the completion of a working model, no costs were capitalized during fiscal 2010, 2009 or 2008.
Segment Data
The Company reports segment data based on the management approach. The management approach designates the internal reporting that is used by management for making operating and investment decisions and evaluating performance as the source of the Company’s reportable segments. The Company uses one measurement of profitability and does not disaggregate its business for internal reporting. The Company has determined that it operates in one segment providing data storage solutions for mid-range businesses and distributed enterprises. The Company discloses information about products and services, geographic areas and major customers.
Information about Products and Services
The following table summarizes net revenue by product (in thousands):
Information about Geographic Areas
The Company markets its products domestically and internationally, with its principal international market being Europe. Revenue is attributed to the location to which the product was shipped. Long-lived assets are based on location of domicile.
The following table summarizes net revenue and long-lived assets by geographic area (in thousands):
(1) Fiscal 2009 and 2008 net revenue by geographic area have been reclassified to conform to fiscal 2010 presentation.
Cash and Cash Equivalents
Highly liquid investments with insignificant interest rate risk and original maturities of three months or less, when purchased, are classified as cash equivalents. Cash equivalents are composed of money market funds. The carrying amounts approximate fair value due to the short maturities of these instruments.
Accounts Receivable and Allowance for Doubtful Accounts
The Company records accounts receivable at invoice amount and does not charge interest thereon. The Company estimates its allowance for doubtful accounts based on an assessment of the collectability of specific accounts and the overall condition of the accounts receivable portfolio. When evaluating the adequacy of the
allowance for doubtful accounts, the Company analyzes specific trade and other receivables, historical bad debts, customer credits, customer concentrations, customer credit-worthiness, current economic trends and changes in customers’ payment terms and/or patterns. The Company reviews the allowance for doubtful accounts on a quarterly basis and records adjustments as considered necessary. Customer accounts are written-off against the allowance for doubtful accounts when an account is considered uncollectible.
Inventories
Inventories are stated at the lower of cost or market using the first-in-first-out method. The Company assesses the value of its inventories periodically based upon numerous factors including, among others, expected product or material demand, current market conditions, technological obsolescence, current cost and net realizable value. If necessary, the Company adjusts its inventory for obsolete or unmarketable inventory by an amount equal to the difference between the cost of the inventory and the estimated market value.
Property and Equipment
Property and equipment are recorded at cost. The Company also capitalizes qualifying internal use software costs incurred during the application development stage. Depreciation expense is computed using the straight-line method. Leasehold improvements are depreciated over the shorter of the remaining estimated useful life of the asset or the term of the lease. Estimated useful lives are as follows:
Expenditures for normal maintenance and repair are charged to expense as incurred, and improvements are capitalized. Upon the sale or retirement of property or equipment, the asset cost and related accumulated depreciation are removed from the respective accounts and any gain or loss is included in the results of operations.
Long-Lived Assets
The Company evaluates the recoverability of long-lived assets, including property and equipment and certain identifiable intangible assets, in accordance with current accounting rules. The Company tests for recoverability whenever events or changes in circumstances indicate the carrying value may not be recoverable. The Company’s consideration includes, but is not limited to, the following events or changes as potential indicators of non-recoverability:
•
Significant underperformance relative to historical or projected future operating results.
•
Significant changes in the manner of use of the assets or the strategy for the Company’s overall business.
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Significant decrease in the market value of the assets.
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Significant negative industry or economic trends.
When the carrying value is not considered recoverable, an impairment loss for the amount by which the carrying value of a long-lived asset exceeds its fair value is recognized, with an offsetting reduction in the carrying value of the related asset. If the Company’s future results are significantly different than forecasted, the Company may be required to further evaluate its long-lived assets for recoverability and such analysis could result in an impairment charge in a future period.
Deferred Rent
Rent expense is recorded on a straight-line basis over the term of the lease. The difference between rent expense and amounts paid under the lease agreements is recorded in other liabilities in the accompanying consolidated balance sheet.
Foreign Currency Translation
The financial statements of foreign subsidiaries, for which the functional currency is the local currency, are translated into U.S. dollars using the exchange rate at the balance sheet date for assets and liabilities and a weighted-average exchange rate during the year for revenue, expenses, gains and losses. Translation adjustments are recorded as accumulated other comprehensive income within shareholders’ equity (deficit). Gains or losses from foreign currency transactions are recognized currently in income. Such transactions resulted in gains of $0.5 million and $0.9 million for fiscal 2010 and 2009, respectively and in a loss of $0.1 million for fiscal 2008.
Income Taxes
The Company provides for income taxes utilizing the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes generally represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax bases of the Company’s assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when a judgment is made that it is considered more likely than not that a tax benefit will not be realized. A decision to record a valuation allowance results in an increase in income tax expense or a decrease in income tax benefit. If the valuation allowance is released in a future period, income tax expense will be reduced accordingly.
The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. The impact of an uncertain income tax position is recognized at the largest amount that is “more likely than not” to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result.
Accumulated Other Comprehensive (Loss) Income
Comprehensive (loss) income for the Company includes net loss and elements of other comprehensive (loss) income, including foreign currency translation adjustments and unrealized gains on available-for-sale securities, which are charged or credited to accumulated other comprehensive (loss) income within shareholders’ equity (deficit).
The components of accumulated other comprehensive (loss) income were as follows (in thousands):
Concentration of Credit Risks
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents and trade accounts receivable, which are generally not collateralized and accounts receivable pledged as collateral. The Company limits its exposure to credit loss by placing its cash equivalents with high quality financial institutions. The Company performs ongoing credit evaluations of its customers, generally requires no collateral and maintains allowances for potential credit losses and sales returns.
The following table summarizes certain financial data for the customers whom accounted for 10.0% or more of sales. No other customer accounted for 10.0% or more of sales in any of the three years presented.
Net Loss per Share
Basic net loss per share is computed by dividing net loss applicable to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net loss per share is computed based on the weighted-average number of shares of common stock outstanding during the period increased by the weighted-average number of dilutive common stock equivalents outstanding during the period, using the treasury stock method. Dilutive common stock equivalents are comprised of options granted under the Company’s stock option plans, employee stock purchase plan (ESPP) share purchase rights, common stock purchase warrants. For all periods presented, there is no difference in the number of shares used to calculate basic and diluted shares outstanding due to the Company’s net loss position.
Anti-dilutive common stock equivalents excluded from the computation of diluted net loss per share were as follows (in thousands):
As discussed in Note 9, the Company has recorded a beneficial conversion feature of $144,000 for the Series A Convertible Preferred Stock. This amount has been included as an increase to the net loss for common shareholders when computing loss per share for the fiscal year ended June 30, 2010.
Share-Based Compensation
The Company’s share-based compensation plans are described in Note 10. The Company accounts for stock option grants and similar equity instruments granted to non-employees under the fair value method.
The Company uses the Black-Scholes option pricing model to estimate the fair value of its options on the measurement date. The cost is recognized over the requisite service period (usually the vesting period) for the estimated number of instruments for which service is expected to be rendered.
Compensation expense associated with option awards with graded vesting is recognized pursuant to an accelerated method.
Fair Value of Financial Instruments
As of June 30, 2010, the Company’s financial instruments consist of accounts receivable (pledged and non-pledged), accounts payable and notes payable. As of June 30, 2009, the Company also had auction rate
securities (ARS) which were liquidated in fiscal 2010. See note 4 for a discussion of the fair value of ARS. The carrying value of accounts receivable and accounts payable approximates their fair value due to the short-term nature of the accounts. In addition, the carrying amounts of the Company’s notes payable to Adaptec, which was paid in full during fiscal 2010, and Anacomp approximate their fair values as the interest rates of the notes payable are substantially comparable to rates offered for similar debt instruments.
Fair Value Measurements
Effective July 1, 2009, the Company adopted the authoritative guidance for fair value measurements and the fair value option for non-financial assets and liabilities. At June 30, 2010, none of the Company’s non-financial assets and liabilities were recorded at fair value on a non-recurring basis. The Company did not record an adjustment to retained earnings as a result of the adoption of the guidance for fair value measurements, and the adoption did not have a material effect on the Company’s results of operations.
Recently Issued Accounting Pronouncements
In June 2009, the FASB issued ASU No. 2009-16, Transfers and Servicing (Topic 860): Accounting for Transfers of Financial Assets. ASU No. 2009-16 amends the guidance on accounting for transfers of financial assets, including securitization transactions, where entities have continued exposure to risks related to transferred financial assets. This ASU also expands the disclosure requirements for such transactions. This ASU will become effective for the Company in fiscal 2011. The Company is currently evaluating the impact of this ASU on its consolidated financial statements.
In October 2009, the FASB issued ASU No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements (a consensus of the FASB Emerging Issues Task Force), which amends ASC 605-25, Revenue Recognition: Multiple-Element Arrangements. ASU No. 2009-13 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting and how to allocate consideration to each unit of accounting in the arrangement. This ASU replaces all references to fair value as the measurement criteria with the term selling price and establishes a hierarchy for determining the selling price of a deliverable. This ASU also eliminates the use of the residual value method for determining the allocation of arrangement consideration and requires expanded disclosures. This ASU will become effective for the Company for revenue arrangements entered into or materially modified on or after June 28, 2010. Earlier application is permitted with required transition disclosures based on the period of adoption. The Company is currently evaluating the impact of this ASU on its consolidated financial statements. The adoption of the ASU is not expected to have a material effect on the Company’s results of operations, financial position or cash flows.
In October 2009, the FASB issued ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements (a consensus of the FASB Emerging Issues Task Force). ASU No. 2009-14 amends ASC 985-605, Software: Revenue Recognition, such that tangible products, containing both software and non-software components that function together to deliver the tangible product’s essential functionality, are no longer within the scope of ASC 985-605 on accounting for software sales. It also amends the determination of how arrangement consideration should be allocated to deliverables in a multiple-deliverable revenue arrangement. This ASU will become effective for the Company for revenue arrangements entered into or materially modified on or after June 28, 2010. The Company is currently evaluating the impact of this ASU on its consolidated financial statements. Both ASU No. 2009-13 and ASU No. 2009-14 must be adopted in the same period and must use the same transition disclosures.
In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends Subtopic 820-10, to require new disclosures regarding (i) transfers in and out of Levels 1 and 2 and (ii) activity in Level 3 fair value measurements. The new disclosures and clarifications of existing disclosures are effective for interim and annual
reporting periods beginning after December 15, 2009, expect for the disclosures about purchase, sales, issuance, and settlements in the roll forward of activity in Level 3 fair value measurements. This ASU will become effective for the Company for fair value measurements in fiscal 2011. The adoption of the ASU is not expected to have a material effect on the Company’s results of operations, financial position or cash flows.
In July 2010, the FASB issued ASU 2010-20, Disclosure about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. ASU 2010-20 amends ASU 310 to require additional disclosures regarding the credit quality of financing receivables and the related allowance for credit losses. The amended guidance requires entities to disaggregate by segment or class certain existing disclosures and provide certain new disclosures about its financial receivables and related allowance for credit losses. The amended guidance is effective for interim and annual financial periods beginning after December 15, 2010. The Company is currently evaluating the impact of this ASU on its consolidated financial statements. The adoption of the ASU is not expected to have a material effect on the Company’s results of operations, financial position or cash flows.
From time to time, new accounting pronouncements are issued by the FASB that are adopted by the Company as of the specified effective date. Unless otherwise discussed, management believes that the impact of recently issued standards, which are not yet effective, will not have a material impact on the Company’s consolidated financial statements upon adoption.
NOTE 2 - ASSET IMPAIRMENT AND COMPANY RESTRUCTURINGS
Fiscal 2008 Asset Impairment
The Company evaluated its long-lived assets, other than the long-lived assets from the Snap Server acquisition (Note 3), for impairment as of June 30, 2008 (Overland legacy assets) due to the Company’s continued operating and cash flow losses in 2008 and the Company’s forecasts for 2009 and beyond. The Company concluded that the carrying amount of the then asset group was not recoverable and an impairment loss should be recognized. An impairment charge totaling $7.4 million, related to property and equipment, was recorded in the fourth quarter of 2008. After the impairment, total property and equipment, including property and equipment acquired from Adaptec, was recorded at its estimated fair value of $1.2 million as of June 30, 2008. The estimated fair value of the Overland legacy assets was determined using the income approach, which is based on a discounted cash flow analysis, as well as consideration of the estimated value that could be realized upon sale. The assumptions used by the Company included estimates of (i) projected cash flows for a period approximating the remaining estimated useful life of the asset group, (ii) a discount rate commensurate with the implied risk in an investment in the Company and the risk of the underlying cash flows and (iii) an estimate of enterprise value.
Restructurings
Fiscal 2010 Realignment of Workforce
In fiscal October 2009, the Company reduced its worldwide workforce by 6.4%, or 15 employees, in accordance with the Company’s realignment around core initiatives. Severance costs, including COBRA premiums, related to the terminated employees of $422,000 were recorded in the first quarter of fiscal 2010. Severance charges are included in cost of goods sold, sales and marketing expense, research and development expense and general and administrative expense in the accompanying consolidated statement of operations.
In April 2010, the Company reduced its worldwide workforce by 18.8%, or 42 employees. Severance costs, including COBRA premiums, related to the terminated employees of $220,000 were recorded in the fourth quarter of fiscal 2010. Severance charges are included in cost of goods sold, sales and marketing expense, research and development expense and general and administrative expense in the accompanying consolidated statement of operations.
Fiscal 2009 Cost Reductions and Restructuring of Workforce
During fiscal 2009, the Company implemented several reductions in force as part of its cost-cutting initiatives. As part of the March 2009 restructuring, the Company terminated the employment of its sole employee in its Colorado facility. In April 2009, the Company vacated this facility, the lease for which expires February 2011. In the fourth quarter of fiscal 2009, the Company recorded a charge of $55,000 to research and development expense for the estimated fair value of the liability associated with vacating this facility.
The following table summarizes the activity associated with the fiscal 2009 restructurings (severance costs in thousands):
(1) Severance costs, including the Company’s payments of COBRA premiums, are included in sales and marketing expense, research and development expense and general and administrative expense.
(2) Severance costs, including the Company’s payments of COBRA premiums, are included in sales and marketing expense and research and development expense.
(3) Severance costs, including the Company’s payments of COBRA premiums, are included in cost of goods sold, sales and marketing expense, research and development expense and general and administrative expense.
(4) The Company implemented a company-wide 10.0% salary reduction following the January 2009 restructuring, which was partially reinstated in fiscal 2010. No amounts are reflected in these tables for such salary reduction.
The following table summarizes the activity and balances of accrued restructuring charges through fiscal 2010 (in thousands):
NOTE 3 - ACQUISITION
On June 27, 2008, the Company acquired the Snap Server® network attached storage (NAS) business (Snap Server®) from Adaptec, Inc., including the brand and all assets related to the Snap Server® network and desktop storage appliances. The net purchase price was $3.8 million, including $349,000 in direct acquisition costs and the adjustments discussed below, with $2.2 million paid in cash upon the closing of the transaction, and the remaining $1.4 million to be paid in cash in 12 months. In the fourth quarter of fiscal 2009, the Company and Adaptec restructured the note so that principal and interest are due in eleven unequal monthly installments
beginning May 31, 2009, and ending March 30, 2010. The note was paid in full as of June 30, 2010. The acquisition was made principally to broaden the Company’s capabilities by adding distributed NAS while also strengthening central and remote office data protection. The acquisition added 47 employees to the Company’s headcount.
The purchase agreement pursuant to which the Company acquired Snap Server® included a working capital adjustment to the purchase price based on the value of acquired inventory and fixed assets as of the closing of the acquisition. The final working capital adjustments totaled $147,000, of which $95,000 was applied as a reduction of the promissory note the Company issued to Adaptec and as a reduction in the acquired intangible assets. During the fourth quarter of fiscal 2009, as part of continued assessment and refinement of the purchase price allocation, the Company finalized the valuation of acquired inventory and recorded an adjustment to increase the acquired intangible assets and reduce inventory by $242,000.
The purchase consideration was allocated as follows (in thousands):
Assuming the acquisition of Snap Server® had occurred on July 1, 2007, the pro forma unaudited results of operations would have been as follows (in thousands):
The above pro forma unaudited results of operations do not include pro forma adjustments relating to costs of integration or post-integration cost reductions that may be incurred or realized by the Company in excess of actual amounts incurred or realized through June 30, 2008. The accompanying consolidated statement of operations for the years ended June 30, 2010 and June 30, 2009 includes the operations of Snap Server® from the date of acquisition.
NOTE 4 - FAIR VALUE MEASUREMENTS AND AUCTION RATE SECURITIES
Fair Value Measurements
Fair value is defined as exit price, or the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. The guidance also establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs market participants would use in valuing the asset or liability and are developed
based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the factors market participants would use in valuing the asset or liability. The guidance establishes three levels of inputs that may be used to measure fair value:
Level 1-Quoted prices in active markets for identical assets or liabilities. At this time the Company does not have any Level 1 instruments.
Level 2-Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. These inputs include quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. At this time the Company does not have any Level 2 instruments.
Level 3-Unobservable inputs that are supported by little or no market activity, including the Company’s own assumptions. As of June 30, 2009, the Company determined that its investments in ARS, describe in more detail below, were considered Level 3 instruments. As of June 30, 2010, the Company does not have any Level 3 instruments.
Auction Rate Securities
As of June 30, 2009, the Company held ARS which were considered level 3 investments. The estimated fair market value as of June 30, 2009, was $1.7 million, which reflected a $3.3 million adjustment to the principal value of $5.0 million. The $3.3 million adjustment included other-than-temporary impairment losses of $1.6 million and $1.9 million, pre-tax, recorded during fiscal 2009 and 2008, respectively. This impairment was recorded in other income (expense), net, in the accompanying consolidated statements of operations. As of June 30, 2009, the Company estimated the fair value of its ARS at $1.7 million and recorded an unrealized gain, as a separate component of shareholders’ equity (deficit), of $0.2 million, during the fourth quarter of fiscal 2009.
In the second quarter of fiscal 2010, the Company liquidated its ARS for $2.0 million in cash and recognized a gain of $0.5 million which is recorded in other income (expense) in the accompanying consolidated statements of operations. As of June 30, 2010, the Company no longer holds ARS and there are no accumulated unrealized losses in other comprehensive income related to ARS.
As of June 30, 2009, the fair value of the Company’s investment in ARS instruments of $1.7 was estimated utilizing pricing models incorporating transaction details such as (i) when a successful auction would occur or the securities would be redeemed, (ii) a discount rate commensurate with the implied risk associated with holding the securities including consideration of the ratings downgrades and the lack of liquidity, and (iii) future expected cash flow streams.
The Company endeavors to utilize the best available information in measuring fair value. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. As of June 30, 2010, the Company had no assets or liabilities that were accounted for at fair value on a recurring basis.
The following table summarizes assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended June 30, 2010 (in thousands):
NOTE 5 - COMPOSITION OF CERTAIN FINANCIAL STATEMENT CAPTIONS
The following table summarizes inventories (in thousands):
The following table summarizes other current assets (in thousands):
The following table summarizes property and equipment (in thousands):
Depreciation and amortization expense for property and equipment was $0.6 million, $0.6 million and $3.1 million, in fiscal 2010, 2009 and 2008, respectively.
The following table summarizes other assets (in thousands):
The following table summarizes accrued liabilities (in thousands):
The following table summarizes other long-term liabilities (in thousands):
As of the end of fiscal 2010 and 2009, the balances of accounts receivable and accounts receivable pledged as collateral consist entirely of accounts receivable trade balances, net of allowance for doubtful accounts, including amounts due from MCF and FGI related to customer remittances that had not been remitted to the Company as of the balance sheet date.
The following table summarizes the changes in allowance for doubtful accounts (in thousands):
NOTE 6 - INTANGIBLE ASSETS
Intangible assets consist of the following (in thousands):
Intangible assets, net, consist solely of the intangible assets acquired in the June 2008 acquisition of Snap Server. The identifiable intangible assets acquired in the Snap Server acquisition consist of existing and core technology (acquired technology), which has been assigned an estimated useful life of four years, and customer contracts and trade names, which have been assigned an estimated useful life of six years. During fiscal 2009, the Company recorded final working capital adjustments totaling $147,000 and finalized the valuation of the purchase price resulting in a $242,000 increase in the value of the acquired intangibles. These final adjustments were recorded proportionately as an increase to the acquired intangible assets. The intangible assets are being amortized on a straight-line basis over their estimated useful lives.
Amortization expense of intangible assets was $1.1 million, $1.0 million and $1.7 million during fiscal 2010, 2009 and 2008, respectively. Estimated amortization expense for intangible assets will be $1.1 million per year in fiscal 2011 and 2012, $0.7 million in fiscal 2013 and $0.6 million in fiscal 2014.
NOTE 7 - DEBT
The components of the Company’s outstanding debt are as follows (in thousands):
MCF Financing Agreement
In November 2008, the Company entered into a domestic non-OEM accounts receivable financing agreement (the MCF Financing Agreement) with Marquette Commercial Finance (MCF). Under the terms of the MCF Financing Agreement, the Company may offer to sell its accounts receivable to MCF each month during the term of the MCF Financing Agreement, up to a maximum amount outstanding at any time of $9.0 million in gross receivables submitted, or $6.3 million in net amounts funded based upon a 70.0% advance rate. The MCF Financing Agreement may be terminated by either party with 30 days written notice. The Company is not obligated to offer accounts in any month, and MCF has the right to decline to purchase any offered accounts (invoices). Net amounts funded by MCF as of June 30, 2010 and 2009, based upon a 70.0% advance rate, were $2.6 million.
The MCF Financing Agreement provides for the sale, on a revolving basis, of accounts receivable generated by specified debtors. The purchase price paid by MCF reflects a discount that is generally 2.5%, but can be increased in certain circumstances, including situations when the time elapsed between placement of the account with MCF and receipt of payment from the debtor exceeds certain thresholds. The Company continues to be responsible for the servicing and administration of the receivables purchased.
The Company accounts for the sale of receivables under the MCF Financing Agreement as a secured borrowing with a pledge of the subject receivables as collateral, in accordance with the authoritative guidance for accounting for transfers and servicing of financial assets and extinguishments of liabilities. The caption “Accounts receivable pledged as collateral” on the accompanying consolidated balance sheets in the amount of $6.2 million and $5.7 million as of June 30, 2010 and 2009, respectively, includes $3.7 million of gross receivables that have been designated as “sold” to MCF and that serve as collateral for short-term debt in the amount of $2.6 million, excluding accrued interest, as of June 30, 2010 and 2009.
The Company was in compliance with the terms of the MCF Financing Agreement at June 30, 2010. Management continues to monitor the Company’s compliance with the dilution covenant, which is based on the aggregate amount of credit memoranda, discounts and other downward adjustments to the original invoiced price divided by gross collections. A significant increase in rebates claimed as a percentage of the Company’s gross collections could lead to the Company’s failure to satisfy the dilution covenant. In August and October 2009, due to rebates claimed, the permissible dilution covenant was exceeded. MCF waived this deviation from the covenant. In January 2010, MCF revised the dilution covenant to be based on a rolling 90 day calculation, excluding one time charges. As of June 30, 2010, the Company was in compliance with the dilution covenant as revised. Based upon the Company’s current operating assumptions, the Company expects to remain in compliance with the permissible dilution covenant throughout fiscal 2011.
FGI Financing Agreement
In March 2009, the Company entered into a foreign non-OEM accounts receivable financing agreement (the FGI Financing Agreement) with Faunus Group International (FGI). Under the terms of the FGI Financing Agreement, the Company may offer to sell its foreign non-OEM accounts receivable to FGI each month during the term of the FGI Financing Agreement, up to a maximum amount outstanding at any time of $5.0 million in gross accounts receivable submitted, or $3.75 million in net amounts funded based upon a 75.0% advance rate. FGI becomes responsible for the servicing and administration of the accounts receivable purchased. The Company will pay FGI a monthly collateral management fee equal to 1.09% of the average monthly balance of accounts purchased by FGI. In addition, FGI will charge the Company interest on the daily net funds employed at a rate equal to the greater of (i) 7.5% or (ii) 3.0% above FGI’s prime rate. The Company is not obligated to offer accounts in any month and FGI has the right to decline to purchase any accounts. Net amounts funded by FGI as of June 30, 2010 and 2009, based upon a 75.0% advance rate, were $1.9 million and $1.5 million, respectively.
The FGI Financing Agreement is for a term of 24 months and automatically renews for additional two year terms unless either party gives notice of non-renewal. In addition, FGI may terminate the agreement upon a default by the Company and may also terminate the agreement for convenience upon 30 days advance notice. The Company may terminate the agreement at any time by paying a $100,000 termination fee. The termination fee is not payable upon a termination by FGI or upon non-renewal. FGI has a security interest in substantially all of the Company’s assets.
The Company accounts for the sale of accounts receivable under the FGI Financing Agreement as a secured borrowing with a pledge of the subject receivables as collateral, in accordance with the authoritative guidance for accounting for transfers and servicing of financial assets and extinguishments of liabilities. The caption “Accounts receivable pledged as collateral” on the accompanying consolidated balance sheet in the amount of $6.2 million and $5.7 million as of June 30, 2010 and 2009, respectively, includes $2.5 million and $2.0 million of gross accounts receivable that have been designated as “sold” to FGI and that serve as collateral for short-term debt in the amount of $1.9 million and $1.5 million as of June 30, 2010 and 2009, respectively.
The Company was in compliance with the terms of the FGI Financing Agreement at June 30, 2010. Based upon the Company’s current operating assumptions, the Company expects to remain in compliance with the terms of the FGI Financing Agreement throughout fiscal 2011.
Anacomp Note
In April 2009, the Company entered into a secured promissory note with Anacomp, Inc., one of the Company’s authorized service providers. The Anacomp note represents a conversion of accounts payable owed by the Company to Anacomp that accumulated primarily during the third quarter of fiscal 2009, during which time the Company was negotiating an extension and other terms under its agreement with Anacomp. The Anacomp note, as amended and restated to reflect the actual accounts payable due, is in the amount of $2.3 million and accrues simple interest at 12.0% per annum.
At June 30, 2010, $0.7 million of the amount due under the Anacomp note is recorded as a current liability, including $18,000 million of accrued interest. The Anacomp note is secured by collateral including all of the Company’s inventory, equipment, fixtures, accounts, contract rights, general intangibles and intellectual property, excluding (i) the intellectual property purchased from Adaptec in June 2008, and (ii) any accounts receivable transferred to FGI or MCF. Anacomp’s security interest is subordinated to FGI’s security interest. Subsequent to fiscal 2010 year end, the Anacomp note was paid in full.
Note Payable to Adaptec
In connection with the Snap Server acquisition in June 2008, the Company issued a $1.4 million promissory note in favor of Adaptec, Inc., which accrued interest at the rate of 4.0% per annum and is secured by intellectual property related to the Snap Server® business. Principal and interest under the note were originally due in one installment on June 27, 2009. In the fourth quarter of fiscal 2009, the Company and Adaptec restructured the note so that principal and interest are due in eleven unequal monthly installments beginning May 31, 2009, and ending March 31, 2010. As of June 30, 2010, the Adaptec promissory note was paid in full.
NOTE 8 - INCOME TAXES
The Company recognizes the impact of an uncertain income tax position on its income tax return at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained.
The following is a summary of the changes in the amount of unrecognized tax benefits (in thousands):
At June 30, 2010, $0.1 million of the unrecognized tax benefits, excluding interest, are presented as a component of long-term liabilities in the accompanying consolidated balance sheet and $0.3 million is presented as a reduction of the related deferred tax asset for which there is full valuation allowance. The entire amount of unrecognized tax benefits at June 30, 2010 will affect the effective tax rate if recognized. However, the portion that would be recognized as an increase to deferred tax assets may result in a corresponding increase in the valuation allowance at the time of recognition resulting in no net effect to the effective tax rate, depending upon the Company’s assessment of the likelihood of realization of the tax benefits at the time they are recognized.
The Company believes it is reasonably possible that, within the next twelve months, the amount of unrecognized tax benefits may remain unchanged. The Company recognizes interest and penalties related to unrecognized tax benefits in its provision for income taxes. The Company had no accrual for interest and penalties on its consolidated balance sheets at fiscal years ended June 30, 2010 and 2009 and recognized no interest and/or penalties in the consolidated statement of operations for the fiscal year ended June 30, 2010.
During fiscal 2010, the Company’s liability for unrecognized tax benefits decreased by $44,000 due to the expiration of the statute of limitation for certain years. The full amount was recognized as a tax benefit in the Company’s financial statements.
The Company is subject to federal and state taxation in the United States and also in certain foreign tax jurisdictions. Generally, the Company’s tax returns for fiscal 2006 and forward are subject to examination by the U. S. federal tax authorities and fiscal 2005 and forward are subject to examination by state tax authorities.
In December 2009, Section 172(b)(1)(H) of the Internal Revenue Code (Section 172(b)(1)(H)) was amended to allow all taxpayers to elect to carry back an applicable net operating loss (NOL) for a period of three, four or five years. This election traditionally provided that an NOL for any taxable year could be carried back to each of the two years preceding the taxable year of the NOL. For the Company, the first applicable tax year available to carry back NOLs under Section 172(b)(1)(H) is its fiscal year ended June 30, 2008. The Company elected to carry back its fiscal 2008 NOL of $20.2 million to the fifth, fourth and third preceding years as allowed under Section 172(b)(1)(H). As a result, the Company recognized a discrete tax benefit in the third quarter of fiscal 2010 of approximately $2.0 million.
Potential Section 382 Limitation
The Company’s ability to use its net operating loss (NOL) and research and development (R&D) credit carryforwards may be substantially limited due to ownership change limitations that may have occurred or that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended (the Code), as well as similar state provisions. These ownership changes may limit the amount of NOL and R&D credit carryforwards that can be utilized annually to offset future taxable income and tax, respectively. In general, an “ownership change” as defined by Section 382 of the Code results from a transaction or series of transactions over a three-year period resulting in an ownership change of more than 50.0% of the outstanding stock of a company by certain stockholders or public groups.
The Company has not completed a study to assess whether an ownership change has occurred or whether there have been multiple ownership changes since the Company became a “loss corporation” under the definition of Section 382. If the Company has experienced an ownership change, utilization of the NOL or R&D credit carryforwards would be subject to an annual limitation under Section 382 of the Code, which is determined by first multiplying the value of the Company’s stock at the time of the ownership change by the applicable long-term, tax-exempt rate, and then could be subject to additional adjustments, as required. Any limitation may result in expiration of a portion of the NOL or R&D credit carryforwards before utilization. Further, until a study is completed and any limitation known, no positions related to limitations are being considered as an uncertain tax position or disclosed as an unrecognized tax benefit. Any carryforwards that expire prior to utilization as a result of such limitations will be removed from deferred tax assets with a corresponding reduction of the valuation allowance. Due to the existence of the valuation allowance, it is not expected that any possible limitation will have an impact on the results of operations or financial position of the Company.
The components of loss before income taxes were as follows (in thousands):
The provision for income taxes includes the following (in thousands):
A reconciliation of income taxes computed by applying the federal statutory income tax rate of 34.0% to loss before income taxes to the total income tax provision reported in the accompanying consolidated statements of operations is as follows (in thousands):
Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities are shown below. A full valuation allowance has been recorded, as realization of such assets is uncertain. Deferred income taxes comprised (in thousands):
At June 30, 2010, the Company has federal and state net operating loss carryforwards of $95.4 million and $65.7 million, respectively. These amounts include share-based compensation deductions of $1.0 million that will be recorded to contributed capital when realized. The remaining federal net operating loss will begin expiring in 2023, unless previously utilized. State net operating loss carryforwards generally begin to expire in 2016, unless previously utilized.
At June 30, 2010, the Company had federal and California research and development tax credit carryforwards totaling $0.7 million and $2.0 million, respectively. The California research credit may be carried forward indefinitely. The federal research credit will begin expiring in 2025, unless previously utilized. In addition, the Company has foreign tax credit carryforwards totaling $0.3 million, which will begin expiring in 2015, unless previously utilized. The Company has federal alternative minimum tax credit carryforwards totaling $0.2 million that can be carried forward indefinitely.
NOTE 9 - EQUITY
Sale of Series A Convertible Preferred Stock and Issuance of Common Stock Warrants
In February 2010, the Company issued and sold an aggregate of 794,659 shares of Series A Convertible Preferred Stock (Series A Stock) and warrants to purchase up to 6,373,266 shares of common stock in a private placement for a total issuance price of $11.9 million (net proceeds of approximately $10.9 million). The Series A Stock was convertible into 4,521,616 shares of the Company’s common stock with no par value per share, and each warrant has an exercise price of $2.583 per share of common stock. In connection with this transaction, the Company issued a warrant to purchase up to 180,865 shares of common stock at an exercise price of $2.952 per share to the placement agent in February 2010. The warrants are immediately exercisable, have a five year term and provide for weighted-average anti-dilution protection in the event that the Company issues additional securities at a price less than the then-effective exercise price of the warrants.
The proceeds from the February 2010 transaction have been allocated to the Series A Stock and the warrants based on their relative fair values. The Company concluded that each share of Series A Stock had an estimated fair value of $9.54 at the time of issuance with a total fair value of approximately $7.6 million, and that each warrant issued had an estimated fair value of approximately $0.72 for each share exercisable under such warrant, or a total fair value of approximately $4.6 million. Based on the total proceeds of $11.9 million, the values recorded on the Company’s balance sheet were reduced to approximately $7.4 million for the Series A Stock and approximately $4.5 million for the warrants. The total estimated fair value of the warrant issued to the placement agent was estimated to be approximately $0.1 million, and was recorded as part of the financing costs associated with the transaction.
The Company has evaluated the warrants issued in the transaction and has concluded that equity classification is appropriate as all warrants are considered to be indexed to the Company’s equity and there are no settlement provisions that would result in classification as a debt instrument.
The Company also determined that the valuation of the components of the February 2010 transaction results in a beneficial conversion feature of $144,000 for the Series A Stock based on a comparison of the estimated fair value and allocated value. Based on the terms of the Series A Stock, the beneficial conversion feature has been recorded as an increase in value to the Series A Stock with an off-setting negative impact to accumulated deficit, and will increase the net loss attributable to common shareholders for the fiscal year ended June 30, 2010.
In April 2010, the shareholders approved the full conversion of the Series A Stock at a special shareholders’ meeting, and the 794,659 shares of Series A Stock thereafter automatically converted into 4,521,616 shares of common stock. As a result of this conversion, the Company’s consolidated balance sheet reflects a single class of stock ownership, and the net proceeds from the February 2010 transaction is reflected as common stock. As of June 30, 2010, there were 49,310 shares of common stock related to this conversion that were not issued, which subsequently have been issued in fiscal 2011.
Sale of Common Stock and Issuance of Common Stock Warrant
In November 2009, the Company sold 2,070,000 shares of its common stock through a public offering of common stock at $2.10 per share with gross proceeds of approximately $4.3 million (net proceeds of approximately $3.7 million). In addition, the Company issued a warrant for the purchase of 103,500 shares of the Company’s common stock at $2.625 per share to the underwriter of the offering. The warrant may be exercised at any time beginning on October 25, 2010 and ending on October 30, 2014. The warrant features a net exercise provision which enables the holder to choose to exercise the warrant without paying cash by surrendering shares subject to the warrant. This right is available only if a registration statement covering the shares subject to the warrant is not available at the time of exercise. The Company also agreed to grant a single demand registration right to the holder of the warrant under certain circumstances. The fair value of the warrant was estimated at $1.70 per share, or $176,000, utilizing a Black-Scholes model, and was recorded in equity as a financing cost.
The Company has evaluated the warrants issued in this transaction and has concluded that equity classification is appropriate as all warrants are considered to be indexed to the Company’s equity and there are no settlement provisions that would result in classification as a debt instrument.
Reverse stock split
In December 2008, the board of directors and shareholders approved a reverse stock split of the Company’s outstanding shares of common stock. On December 8, 2009, the Company filed a certificate of amendment to its amended and restated certificate of incorporation, as amended, with the Secretary of State of the State of California effecting a one-for-three reverse stock split of the outstanding shares of common stock. All share, per share and stock option data information in the consolidated financial statements and the notes thereto have been retroactively adjusted for all periods to give effect to the reverse stock split.
NOTE 10 - SHARE-BASED COMPENSATION
Equity Compensation Plans
The Company has six active stock option plans administered by the Compensation Committee of the Board of Directors. As of June 30, 2010, the Company had reserved an aggregate of 6.9 million shares of common stock for issuance under its six active plans: 1995 Stock Option Plan, 1997 Executive Stock Option Plan, 2000 Stock Option Plan, 2001 Supplemental Stock Option Plan (2001 Plan), 2003 Equity Incentive Plan (2003 Plan) and the 2009 Equity Incentive Plan (2009 Plan) (collectively, the Option Plans). The Option Plans provide for the granting of stock options. In addition, the 2003 Plan and the 2009 Plan provide for the granting of restricted stock, stock units and stock options. The Option Plans were approved by the Company’s shareholders with the exception of the 2001 Plan. Currently, the Company may grant new awards only from the 2009 Plan.
Certain options issued under selected plans allow for 100% vesting of outstanding options upon a change of control of the Company (if replacement options are not issued) or upon death or disability of the optionee. Options granted generally vest over a three-year period. Options generally expire after a period not to exceed six years, except in the event of termination, whereupon vested shares must be exercised generally within three months under the 2009 Plan and 2003 Plan and within 30 days under the other Option Plans, or upon death or disability, in which cases an extended six- or twelve-month exercise period is specified. As of June 30, 2010, approximately 3.3 million shares were reserved for issuance upon exercise of outstanding options and approximately 2.0 million shares were available for grant under the Option Plans.
The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model, which uses the weighted-average assumptions noted in the following table. Separate groups of employees that have similar historical exercise behavior are considered separately in determining certain valuation assumptions.
Prior to the fourth quarter of fiscal 2010, the expected volatility utilized in the valuation of equity awards was solely based on the historical volatility of the Company’s stock utilizing the daily closing prices. During the
third quarter of fiscal 2010, the Company completed a Series A Convertible Preferred Stock financing, which included Common Stock Warrants. The circumstances of this financing lead the Company to perform a valuation analysis and volatility study in order to properly ascribe the fair values of the proceeds of the financing to both the stock and the warrants. The Company then performed a similar volatility study for equity compensation and believes this approach is more sophisticated and a better indicator of expected volatility of its stock because it considers additional factors, such as the overall market conditions, the industry sector and the expected and realistic pricing of equity instruments in the marketplace and is generally reflective of both historical and implied volatility. Accordingly, the Company commenced using this new approach for estimating expected volatility for equity compensation beginning in the fourth quarter of fiscal 2010. The Company applies a forfeiture rate based upon historical pre-vesting option cancellations. The risk-free interest rate is determined based upon a U.S. constant rate Treasury Security with a contractual life approximating the expected term of the option. The expected term of options granted is estimated based on a number of factors, including but not limited to the vesting term of the award, historical employee exercise behavior (for both options that have run their course and outstanding options), the expected volatility of the Company’s stock and an employee’s average length of service. Weighted-average ranges below result from certain groups of employees exhibiting different behavior:
The stock option activity is summarized below (shares and aggregate intrinsic value in thousands):
During fiscal 2010, 2009 and 2008, the Company recorded share-based compensation associated with outstanding stock option grants of $1.7 million, $0.3 million and $1.0 million, respectively. As of June 30, 2010, there was $2.4 million of total unrecognized compensation expense related to non-vested stock options granted prior to June 30, 2010 under the Option Plans. This expense, associated with non-vested options granted prior to June 30, 2010, is expected to be recognized over a weighted-average period of 1.48 years.
The following table summarizes information about stock options for fiscal 2010, 2009 and 2008 (in thousands, except per share amounts):
2006 Employee Stock Purchase Plans
In February 2007, the Company adopted the 2006 Employee Stock Purchase Plan (2006 ESPP). A total of 166,666 shares of common stock have been reserved under the 2006 ESPP for issuance and purchase by employees of the Company to assist them in acquiring a stock ownership interest in the Company and to encourage them to remain employees of the Company. The 2006 ESPP is qualified under Section 423 of the Code and permits eligible employees to purchase common stock at a discount through payroll deductions during specified six-month offering periods. No employee may purchase more than $25,000 worth of stock in any calendar year or 500 shares in any one offering period.
During fiscal 2010, 2009 and 2008, the Company issued approximately 1,000, 5,000 and 5,000 shares, respectively, under the 2006 ESPP for combined proceeds of $1,000, $9,000 and $26,000, respectively. As of June 30, 2010, 156,000 shares were available under the 2006 ESPP.
NOTE 11 - 401(k) PLAN
The Company maintains an employee savings and retirement plan (the 401(k) Plan) covering all of the Company’s employees. The 401(k) Plan permits but does not require matching contributions by the Company on behalf of participants. Through October 2008, the Company matched employee contributions at 75%, up to 6% of an employee’s pretax income. The totals of these employer contributions were $0.2 million and $0.6 million in fiscal 2009 and 2008, respectively. As part of the Company’s cost reduction efforts, the Company has not made matching contributions since October 2008.
NOTE 12 - COMMITMENTS AND CONTINGENCIES
Leases
The Company leases its office, production and sales facilities under non-cancelable operating leases that expire in various years through fiscal year 2018. The leases provide for biennial or annual rent escalations intended to approximate increases in cost of living indices, and certain of the leases provide for rent abatement. The Company has a five-year option to renew its lease on its San Diego headquarters facility. Future minimum lease payments under these arrangements are as follows (in thousands):
On July 1, 2010, the Company modified its San Diego headquarters lease and reduced the facility by one building, or 67,285 square feet, which proportionally reduced the monthly base rent and share of facility expenses. The table above reflects the amended lease payments.
Rental expense is recognized on a straight-line basis over the respective lease terms and was $4.3 million, $4.6 million and $4.0 million in fiscal 2010, 2009 and 2008, respectively.
Litigation
From time to time, the Company may be involved in various lawsuits, legal proceedings or claims that arise in the ordinary course of business. Management does not believe any legal proceedings or claims pending at June 30, 2010, will have, individually or in the aggregate, a material adverse effect on its business, liquidity, financial position or results of operations. Litigation, however, is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm the Company’s business.
In December 2009, Crossroads Systems, Incorporated (Crossroads) filed a lawsuit against the Company and several other companies in the United States District Court for the Western District of Texas (the Complaint). The Complaint was served on the Company in December 2009, and alleged that its products infringe United States Patent Nos. 6,425,035 and 7,051,147. The Court had scheduled a hearing on issues of claim construction for June 3, 2010. Although the Company was prepared to vigorously defend against Crossroads’ lawsuit, in advance of the claim construction briefing, the parties reached a settlement of the lawsuit, and the Court entered an Order of Dismissal of the lawsuit on May 25, 2010.
NOTE 13 - SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following tables present selected quarterly financial information (in thousands, except per share data) for the periods indicated. This information has been derived from the Company’s unaudited quarterly consolidated condensed financial statements, which in the opinion of management include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of such information. These operating results are not necessarily indicative of results for any future period.
(1) Net loss per share is computed independently for each quarter and the full year based upon respective weighted average shares outstanding. Therefore, the sum of the quarterly earnings per share amounts may not equal the annual amounts reported.
(2) Basic loss per share is computed by dividing net loss applicable to common shareholders by the weighted average number of common shares assumed to be outstanding during the periods of computation.
NOTE 14 - SUBSEQUENT EVENTS
On September 20, 2010, the Compensation Committee of the Company’s Board of Directors (Committee) approved a new bonus plan, the Executive Bonus Plan (Bonus Plan), which provides bonus opportunities for the Company’s executive officers. Each participant in the Bonus Plan is assigned a target bonus percentage that is expressed as a percentage of the participant’s base salary for the applicable bonus period. Bonuses are determined based on the Company’s revenue, gross profit, operating income, operating expenses and/or earnings per share during the bonus period in relation to performance goals established by the Committee. The Committee may also provide for bonuses to be determined based on an individual participant’s performance during the bonus period and the criteria to be used to measure individual performance.