ITEM 1. BUSINESS
BUSINESS
The discussion in this Annual Report on Form 10-K contains forward-looking statements which involve risks and uncertainties. Actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to such differences include, without limitation, those discussed in this section and the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" as well as those discussed elsewhere in this Annual Report on Form 10-K.
Artecon Inc. ("Artecon" or the "Company"), founded in 1984, designs, manufactures, markets and supports a broad range of data storage products used in Internet and enterprise storage networks and for the open-systems computing environment. The Company has established itself as a leader in the design, manufacture and sale of third-party mass storage solutions for a broad range of customers. The Company's enterprise storage product line includes scalable RAID systems which allow users to grow modularly from a single mass storage device to over 30 TB, of fault-tolerant mass storage, thereby meeting the capacity and performance needs of a wide range of customers while protecting and maintaining the customer's investment. Telecommunication companies often require certification of compliance with Bellcore's Network Equipment-Building System, or NEBS. The Company's telecommunications infrastructure and Internet storage EXTREME product line represent what the Company believes was the first fully NEBS-certified, multi-terabyte solution for high-end, application-specific needs of telecommunications and government customers using commercially available workstation technology. The Company also provides systems integration and a variety of other service and support programs for its customers.
In August 1997, Artecon, Inc., a California corporation, formerly a subsidiary of Artecon, or Artecon California, acquired substantially all of the assets and liabilities of Falcon Systems, Inc. or Falcon, a network-attached storage server integrator and storage peripherals reseller, in a transaction accounted for as a purchase of Falcon by Artecon California, or the Falcon acquisition. The Falcon acquisition has enabled Artecon to achieve several important strategic objectives, including the acquisition of the AerREAL(TM) real-time specialized file server software and other complementary products to better serve the Company's existing customers, the expansion of the Company's customer base in the UNIX market and a significant expansion of the Company's revenue base.
On March 31, 1998, Artecon, Inc. and Storage Dimensions, Inc., or SDI, completed a reverse merger whereby SDI acquired Artecon in a stock-for-stock transaction. Immediately after the merger, SDI changed its name to Artecon, Inc. In the merger, shareholders of the former Artecon, Inc. received approximately 62% of the common stock, and 100% of the preferred stock of the new Artecon. Since the former Artecon's shareholders received a substantial majority of the common stock of the new Artecon, the transaction was accounted for as a purchase of SDI by Artecon. As a result, the historical financial results included in this Annual Report on Form 10K are those of Artecon and include the results of operations of business of Falcon following the Falcon acquisition in August 1997 and the results of operations and business of SDI following the reverse merger on March 31, 1998. Subsequent to the SDI merger the new Artecon wrote off substantial research and development costs that were in process at SDI prior to the merger.
In June 1998, Artecon California was merged with and into the Company.
On April 30, 1999, the Company announced that it has entered into a definitive merger agreement whereby Artecon will merge with Box Hill Systems Corp., a New York corporation ("Box Hill") in a tax-free, stock-for-stock transaction intended to be accounted for as a pooling of interests. Under the terms of the Agreement and Plan of Merger dated April 29, 1999 ("the Merger Agreement"), each outstanding share of common stock of Artecon will be converted into 0.40 of a share of Box Hill Common Stock. Each issued and outstanding share of preferred stock of Artecon will be converted into Box Hill Common Stock based on the terms defined in the Merger Agreement. In addition to shareholder approvals, the Merger is subject to customary closing conditions as well as certain regulatory approvals. The parties anticipate that the Merger will close by the end of the third quarter of calendar 1999. If the Merger is successfully completed, the Company will cease to be a separate registrant with the Securities and Exchange Commission, and future operating results of the Company would be reported on a combined basis with Box Hill.
INDUSTRY BACKGROUND
The rapid proliferation of new data-intensive applications, such as video, the Internet, intranets, multimedia, data warehousing and data mining, and the migration of mission-critical applications away from mainframe computers have fueled the demand for open-systems data storage. Disk storage systems, tape backup systems and software-based management tools designed to operate on multiple platforms are becoming a strategic part of network computing. System purchase decisions are becoming increasingly focused on data storage and, increasingly, capital expenditures for storage systems are equal to or greater than those made on computer processing hardware. Storage architectures based on protocols such as UltraSCSI and Fibre Channel and topologies such as the SAN are driving a much greater focus on data center purchasing towards storage. Currently, the industry is split into solutions based on host-attached storage and solutions based on network-attached storage.
UNIX AND WINDOWS NT. Open-systems platforms today employ either UNIX variants, such as Solaris (Sun), HPUX (HP), AIX (IBM) and IRIX (SGI), or Windows NT from Microsoft. Together, these operating systems are installed on the vast majority of computers used in the enterprise. UNIX platforms currently have the largest installed user base in terms of numbers of units, with the Windows NT user base expanding.
Many companies use a combination of both types of systems, often employing Windows NT-based Intel machines for front office work (e.g., accounting, office support, administration) and UNIX-based RISC workstations and servers for back office functions such as engineering and manufacturing. More recently, Windows NT workstations have been developed by companies such as Compaq and Hewlett Packard, or "HP," among others, to challenge the dominance of UNIX workstations in the engineering, scientific and other technical arenas. This has resulted in a gradual but steady transition from the UNIX-installed base towards Windows NT, further stimulating the demand for open-systems storage solutions that support multiple operating systems on platforms from a variety of vendors.
HOST-ATTACHED STORAGE. The open-systems market's current host-attached storage options include disk arrays, RAID storage systems and tape backup systems. Each of these is generally attached to the host by a SCSI bus. SCSI, including UltraSCSI, Ultra2 and Ultra3, was designed to transfer data at higher rates with enhanced reliability and lower error rates, has been the dominant commercially available interface currently used in most disk array and RAID storage systems. Fibre Channel, an emerging high-speed serial interface that has recently become commercially available, is regarded by many industry participants as the storage industry's next-generation interface. Fibre Channel enables the transfer of data between computers and peripherals at substantially increased rates, over greatly increased cabling lengths and among a greater number of host/device connections. A number of industry leaders, including Microsoft Corporation, Seagate, Quantum, IBM, Sun, and Emulex, have indicated support for Fibre Channel technology and have announced that they are producing or plan to produce products that incorporate it.
SAN BASED ON FIBRE CHANNEL. The requirements of the data intensive network environment have contributed to the growing importance of SANs, based on Fibre Channel. SANs represent localized networks of storage pools that can collectively be accessed by many (and disparate) servers. Centralized management is a key benefit of SANs, which in their most basic form, could be physically distributed over the 10km distance limits of fibre channel. The Company's LynxArrayII and future hardware and software products form the nucleus of storage area network product suites.
The SAN architecture enhances the potential of open systems storage vendors as it tends to separate the storage purchasing decision. As a result, the SAN storage decision becomes one of "best-fit" or "best of breed" as opposed to simply foregoing the storage as an after thought to the server.
THE INTERNET AND THE WORLD WIDE WEB (WWW). The virtual explosion of the Internet and subsequently corporate-wide intranets has had a profound impact on the computer industry in general and on the demand for storage solutions in particular. The Internet and intranet environments involve intensive processing or computation of, and frequent user access to, large volumes of data and consequently require a mission critical level of high-availability mass storage. Moreover, the data intensity of these environments is expected to continue to increase substantially due to the development of new applications and services and the more prevalent use of stored digital graphics, voice and video, requiring dramatically more data capacity and performance than equivalent alphanumeric information.
TELECOMMUNICATIONS INDUSTRY. The enactment by Congress of the Telecommunications Deregulation Act in 1996, the opening up of additional radio frequency spectrum for wireless communications by the Federal Communications Commission and other significant recent developments have spurred dramatic changes in the worldwide telecommunications industry. The development and build-out of expanded markets and new modes of communication that have been enabled by these changes, including digital cellular systems, personal communications systems, or "PCS," satellite-based communications systems, Internet and cable systems, will require enormous capital expenditures for new infrastructure. The Company believes that a significant element of the required infrastructure will consist of high performance mass storage systems that must be specially adapted and certified for use in the telecommunications industry. Telecommunications companies are seeking commercial off-the-shelf, or "COTS,"-based solutions that can be adapted and deployed in their embedded architectures due to ever-increasing cost pressures and time-to-market constraints. These solutions are typically based on UNIX and/or Windows NT systems and employ highly redundant RAID storage systems.
THE ARTECON SOLUTION
The Company develops and markets a comprehensive range of scalable, fully integrated data storage products and services for the open-systems computing environment. Artecon's products are both host-attached and network-attached, are based on a common architecture allowing scalability from the first desktop mass storage unit purchased to multi-terabyte data center installations and are compatible with a variety of UNIX and Window NT operating systems. Artecon's family of products and services is intended to provide users with the following benefits:
- HIGH PERFORMANCE WITH MISSION-CRITICAL HIGH AVAILABILITY. Recognizing the increased demand for faster response times, greater capacities, higher availability of data and minimum system downtime, the Company has focused on developing high-
end,high-performance storage products using Ultra SCSI, LVD and Fibre Channel interfaces. Redundant system components such as dual power inlets and multiple fans are intended to eliminate any single point of failure to ensure maximum system uptime.
- SCALABILITY. The Company's products are designed using a flexible, modular architecture allowing the Company to size and configure storage systems to the application-specific requirements of individual customers. In addition, this architecture allows Artecon to resize and reconfigure these systems to adapt to the changing needs of customers, while allowing them to retain capital value in their underlying systems. This scalability preserves the customer's initial and subsequent storage investments by allowing users to grow modularly from a single mass storage device to over 30 terabytes of mass storage.
- MULTI-PLATFORM SUPPORT. As an independent provider of storage products, the Company is well positioned to provide storage systems specifically designed to be compatible with a variety of UNIX and Windows NT platforms. This multi-operating system capability allows end users to standardize on a single storage system that can readily be reconfigured and reused at minimal cost even if the user decides to change operating systems or other components of the network.
- HIGH-PERFORMANCE BACKUP. To satisfy market demand for reliable, high-quality backup products and systems, the Company offers a broad variety of backup products, including tape library systems, backup software, training and documentation. The Company has specialized expertise in the design and implementation of effective, well-integrated backup solutions designed to satisfy customers' individual needs, from departmental server systems to enterprise network systems.
- CARRIER CLASS RELIABILITY. The Company's products are believed to be the first open-systems storage RAID products that are fully certified to the telecommunications industry's demanding NEBS standards. NEBS certification assures customers that the Company's telecommunications products deliver true carrier-class reliability.
- ALL-ENCOMPASSING SOLUTIONS. The Company delivers all-encompassing solutions including design consulting, systems integration, installation, training, comprehensive service and technical support and software-based management tools. The Company employs a full staff of direct sales personnel and applications engineers to assist customers in making appropriate and effective storage system purchases and in addressing, analyzing and solving complex storage problems. This value-added approach is designed to foster customer loyalty and allow the Company to identify emerging customer requirements for future data storage products.
ARTECON'S STRATEGY
The Company's objective is to continue its growth and enhance its position as a leading independent provider of host-attached and network-attached storage solutions to the open-systems marketplace. To achieve this objective, Artecon plans to build upon its record of successfully introducing and commercializing new products and technologies that address the evolving data storage needs of its broad customer base. Key elements of this strategy are:
- PROVIDE COMPLETE SOLUTIONS AND PRODUCT MIGRATION PATH. The Company's products are designed to address a wide range of customer needs. By utilizing common core technology throughout its product line, the Company enables customers to migrate from product to product across multiple platforms to address the changing needs of growing companies. By providing comprehensive solutions, the Company is able to work more closely with customers, offer additional modules or products and provide additional services.
- EXPAND MARKET PENETRATION. While maintaining its status as a leading provider for the Sun market, the Company intends to continue to provide industry-leading mass storage and enhancement products for use in the Windows NT market and other UNIX markets. The Company has a number of products designed for use on Windows NT platforms. In addition, the Company recently introduced its Redundant Data Path, or "RDP," software for Windows NT platforms which provides the capability to support two independent data paths with failover capability.
- FOCUS ON SPECIALIZED STORAGE NEEDS OF DATA-INTENSIVE MARKETS. The Company intends to continue to target users of UNIX and Windows NT computing environments who require high-performance, high-availability and fault-tolerant storage solutions, such as end users in data-intensive industries, particularly the telecommunications and Internet/intranet, financial services and multimedia markets. The Company, as an independent provider of storage systems, believes that it is well positioned to address the multi-platform, multi-protocol computing requirements of these targeted high-end users.
- INTERNET AND TELECOMMUNICATIONS STRATEGY. The Company intends to continue to aggressively pursue Internet and telecommunications companies by realigning its internal resources and continuing to develop a series of new products that satisfy their rapidly expanding storage needs. In the implementation of its strategy the Company will focus its resources to enhance existing products and develop new products and services specifically targeted to the Internet and telecommunications segment of the storage market and increase sales and marketing efforts to key telecommunications, Internet, and other storage-intensive companies.
- REALIGN AND EXPAND DIRECT SALES FORCE WHILE LEVERAGING RESELLER CHANNELS. The Company believes that a properly managed direct sales force should result in the greatest penetration of the Company's markets. Direct customer contact provides the Company with valuable market feedback and the ability to provide high-quality technical support and enhance customer loyalty. In certain markets, however, the Company uses strong vertical market oriented resale partners and believes that leveraging these reseller channels will provide the Company with a significant competitive advantage.
PRODUCTS AND SERVICES
The Company's products and services are offered through two distinct sales groups: the Enterprise Storage Division and the TeleCom Division. In order to address the unique and highly specialized needs of the telecommunications and Internet/intranet marketplace, the Company formed its TeleCom Division in June 1996. The Company's Enterprise Storage Division is responsible for the other markets targeted by the Company, including finance (for example, commodities brokers and trading analysts), multimedia (such as entertainment providers, cable companies, news services and the companies building infrastructure to serve them), government, advanced-technology and industrial markets. Within these two divisions of the Company, the Company's data storage solutions fall into three general categories: enterprise storage, telecommunications storage and systems integration capability.
ENTERPRISE STORAGE DIVISION
The Company provides enterprise storage solutions to its customers through its Lynx product line. By allowing users to grow modularly from a single mass storage device to over 30 TB of rack-mounted, fault-tolerant RAID mass storage, The Company's Lynx hot-swap removable mass storage subsystems address the capacity and performance needs of customers while maintaining and protecting customer investment. The Lynx unit is the fundamental building block of all the Company storage solutions and has several unique and differentiating features, including interlocking stackability, cableless design, ruggedized hot-swap drive sleds, front-removable power supplies and auto termination. To date, over 70,000 Lynx storage units have been installed.
The Lynx line of storage solutions includes LynxArray and LynxStak RAID systems which offer host-attached RAID protection and performance enhancement for creating highly available, mission-critical storage systems. The Company believes that the performance, flexibility, true scalability, hot-swap removable components and compact form factor provide significant benefits to its customers.
The Company's LynxStak(TM) product is an interlocking modular desktop storage product that scales from 4 GB to 126 GB as required. The LynxStak system uses the same disk drives and controllers as the Company's LynxArray preserving the customer's initial and subsequent storage investment. The Company believes that the performance, flexibility, scalability, hot-swap removable components and compact form factor provide significant benefits to its customers. LynxStak won Windows NT Magazine's "Favorite Storage Product" in 1999.
The Company's LynxArray II is a tower or rackmount product for larger storage requirements. The LynxArray II uses the same architecture as capacity scales from 27 GB to more than 30 TB. LynxArray II uses an Intel-based RAID controller that operates at speeds up to 5000 input/outputs per second. LVD SCSI channels from host computer through controllers to disk drives allow 80 MB per second burst and 36 MB per second sustained transfer rates. Each LynxArray II can support up to 252 GB of hot-swappable disk capacity and two hot-swap failover RAID controllers. Inline support for tape drives makes backup possible within the RAID subsystem. Hot-swap removable failover controllers, redundant power supplies and fans are all available for more fail-safe, potentially nonstop operation.
To complement its disk products, the Company engineered a family of high-speed, high-reliability MEGAFLEX tape backup systems that are designed to address the challenges of backing up increasing amounts of data in ever-shortening time periods. These tape products are easily integrated and fully compatible with the Company's disk storage systems. In addition, tape backup products are offered as stand-alone products to back up data maintained on other manufacturers' disk storage systems. The Company believes that its disk and tape storage products are differentiated from competitive products based on functionality, performance, ease of use and lower life-cycle cost of ownership.
The Company's disk and tape storage products utilize proprietary software to incorporate leading edge hardware features and capabilities relative to the storage products offered by computer and server manufacturers, with design features specifically engineered to minimize system downtime and to support easy integration and administration.
RAIDScape is a Java-based enterprise storage management software package that combines configuration, maintenance, and monitoring tools into a single, easy-to-use application. RAIDScape enables remote administration of the Company disk arrays attached to Windows NT, Solaris and Netware servers located anywhere on a local or wide area network, greatly simplifying storage management and reducing costs. It is ideally suited for centralized information technology departments managing large, distributed networks.
Redundant Data Path, or "RDP," software provides the new level of resiliency and performance, as well as multiple server connectivity for the Company's LynxArray II dual active controller RAID storage systems on NT operating system. The
software's host-based driver supports dual active input/output paths from the server to the storage systems. This enhances resiliency by providing failover protection should a host bus adapter, cable, hub or controller on either data path fail. It also enhances performance by doubling the system's throughput potential.
The Company will continue to enhance its existing extensive proprietary software library. This library is designed to enable the Company to quickly integrate new hardware technologies to bring new products to market in a rapid and cost-effective manner.
WORKSTATION AND SERVER RACK SOLUTIONS. The Company's Sphinx(TM) workstation and server rack solutions enable users to rackmount COTS desktop workstations from Sun into powerful, application-specific servers. Sphinx products protect against shock and vibration events, maintain the thermal integrity of the workstation/server, enhance system physical security while providing a very compact expansion capability. The Company believes it offers a superior solution than the typical rack shelf used for rackmounting workstations and servers. Sphinx also allows hot swap removable devices to be added so that a variety of powerful and expandable configurations can be constructed, including high-end clustered compute servers, high availability failover servers, network servers and database servers.
The Company's Sphinx customers range from manufacturing floor and computer center applications, to government agencies with requirements for shipboard, aircraft and ground vehicle deployment of desktop workstations.
TELECOM DIVISION
The Company's TeleCom Division designs, manufactures, markets and supports fully integrated, industry-compliant storage products, services and solutions for the telecommunications and Internet/intranet markets by utilizing commercially available workstation, server and other application-specific products for enhanced price/performance characteristics and reduced time to market. Most of the products and services manufactured and marketed by the Company's Enterprise Storage Division can be utilized by telecommunications and Internet service providers. Requirements unique to the telecommunications industry include -48VDC power (native to the Central Office environment) and compliance with Bellcore's NEBS areas of standardization, which include electromagnetic compatibility, thermal robustness, fire resistance, earthquake and office vibration resistance, transportation and handling, acoustics and illumination and airborne contaminants. Telco embedded infrastructure projects are exceptionally demanding in terms of high availability and redundancy due to the uptime requirements of the world's telephone and communications support equipment. NEBS testing requires a certified unit to be able to withstand an earthquake, a lightning strike, a fire, severe airborne particulate contamination, extreme temperature ranges and other catastrophic events. The Company believes it was the first open-systems storage company whose RAID products are fully certified to Bellcore NEBS standards. In addition, the Company's commercial enterprise storage products are built to the same demanding standards, yielding very reliable systems for the commercial market.
TELCO STORAGE SOLUTIONS. Most of the Company's enterprise storage products, including LynxArray II, can be utilized by telecommunications and Internet service providers. The Company's LynxArray EXTREME products are already in use by telecommunications and Internet service providers.
WORKSTATION AND SERVER RACK SOLUTIONS. The Company's Sphinx EXTREME product line is fully NEBS-certified and has been instrumental in bringing Sun workstation products into the telecommunications and typical Internet service provider environment. The Company's TeleCom Division Sphinx customers include a wide range of telecommunications infrastructure and Internet/intranet service providers building new Internet, wireless and PCS services based on COTS workstations.
POWER PRODUCTS. The Company believes that its PowerSphinx(TM) EXTREME is the industry's first 1.75" DC/DC power converter which allows unmodified workstation, network and storage products to run in the 48VDC environment of the telecommunications Central Office. PowerSphinx EXTREME enables workstation and networking products typically used in 110-240VAC environments to run unmodified in the -48VDC context. The Company believes this feature may significantly accelerate its customers' time to market for new infrastructure while reducing costs due to the ability to employ standard (as opposed to custom) workstation, networking and other products.
PowerSphinx EXTREME is designed for use with 110-240VAC devices such as workstations, switches, routers and hubs so that they may operate in the -48VDC telecommunications environment, thereby expanding the limits of available product choices to engineers and integrators building telecommunications systems. The Company believes that the compact 1.75" EIA rack height is an improved and preferable alternative to typically large (often as much as 21" or 12u EIA) power inverters. PowerSphinx EXTREME has two hot-swappable, load-sharing power modules to assure uninterrupted operation, combined with dual - -48VDC inlet power connections to help virtually eliminate any single point of failure. Other features include 1600 watts of total power output, hot-plug removable power trays and fans, alarm system and dual LED displays. The PowerSphinx EXTREME is fully certified to Bellcore NEBS standards.
TELECOMMUNICATIONS SERVICES. Most of the regional Bell phone companies, long-distance service companies and Internet service providers often lack the resources, time, expertise and inclination to install and integrate storage solutions and therefore they look to a single source supplier who can provide a complete storage solution. As a consequence, the Company believes that its systems
integration services are well suited to the telecommunications market. The Company has established a product and integration contract with Motorola.
The Company has extensive experience as a systems integrator producing expandable systems to suit each client's unique situation. The Company utilizes commercially available workstation, server, networking and other application-specific products along with its own EXTREME product line. Utilizing commercially available equipment and an open-systems approach can accelerate customers' time to market and provide customers with superior price/performance.
PRODUCTS IN DEVELOPMENT
The Company has several products under development including a full Fibre Channel RAID storage system and RAID systems that will support Ultra3 SCSI.
In the area of software development for its server-attached disk storage products, the Company has recently completed development of its RDP software for Windows NT, that provides the capability to support two or more independent data paths with failover capability. This same software is being developed for Solaris and Linux. There is no guarantee that the Company will complete these projects.
The recently introduced CacheBack products will combine the Company's rugged carrier-class storage devices with performance enhancement storage and network capability. These products will utilize the highly regarded Inktomi traffic server, to provide the first in a series of scalable, carrier-class, high performance network cache solutions designed for Internet service providers and large enterprise intranets. This initial product is expected to become the foundation for an evolving product line of superior storage solutions.
In the rapidly expanding and evolving world of communications, developing the right technology is only part of the role of the equipment provider. Operators in today's markets are looking for total support from their suppliers, for service packages that are unique and tailored to meet their individual needs and requirements. The Company will carry the service concept far beyond the traditional vendor approach of simply providing equipment and systems support. Instead it will be based on the development of a long-term partnership between the operator and the Company, combining consulting on a strategic business level with implementation and operational support.
CUSTOMERS
The Company targets both the horizontal markets defined by the primary workstation vendors, such as Sun, SGI, HP and IBM, and the vertical markets of the data-intensive Internet, telecommunications, finance and multimedia industries. The Company's customers include OEMs, systems integrators, value added resellers, or "VARs," and end users and span market segments ranging from computer manufacturers to government agencies. The following customers of the Company accounted for approximately that percentage of the Company's total revenues set forth below during the periods indicated: Sales to one customer did not exceed 10% of total net revenue for the fiscal years ended March 31, 1998 and 1999; Tracor Enterprise Solution (25.4%) for the fiscal year ended March 31, 1997. No other customer accounted for more than 10% of the Company's total revenues during the fiscal years ended March 31, 1999, 1998 and 1997. Sun Financial Group accounted for approximately 10% of Storage Dimensions' total revenue for the fiscal year ended December 31, 1997.
SALES AND MARKETING
The Company utilizes both a direct sales force and selected reseller channels for certain products and markets in the U.S. and overseas to provide broad market coverage for its products. As of March 31, 1999, the Company's U.S. and foreign sales, marketing, service and support organization consisted of 112 personnel located in 16 offices around the world. In the U.S., 83 sales, marketing, service and support people are located in 11 geographical markets, including, San Jose, Los Angeles, and San Diego, California; Denver, Colorado; Atlanta, Georgia; Chicago, Illinois; Boston, Massachusetts; New York City, New York; Bridewater, New Jersey; Cleveland, Ohio; and Washington, D.C. The Company's international marketing group includes 30 sales, service and support personnel who work for a Japan-based subsidiary and a Europe-based subsidiary with offices in England, France and the Netherlands. The Company's sales to customers located in the United States represented approximately 86.3% and 90% for the fiscal years ended March 31, 1998 and 1999, respectively. The Company's sales to customers located outside the United States represented approximately 12% and 10% of the Company's net revenues for the fiscal years ended March 31, 1998 and 1999, respectively. For fiscal year ended March 31, 1997, the Company sales to customers located in the United States represented approximately 83.8% of the Company's net revenues and sales to customers located outside the United States represented approximately 16.2% of Artecon California's net revenues. Direct sales organizations of the Company's subsidiaries in Japan (Tokyo, Nagoya), the Netherlands (Encschede), France (Paris) and the United Kingdom (London) consisted of 10 sales professionals.
The Company also employs a leveraged sales model that utilizes resellers focused on the needs of specific end users. The Company has developed pricing structures and field sales commission plans that are designed to minimize sales channel conflicts. The
Company believes that this two-pronged sales strategy provides a meaningful competitive advantage over competitors who only provide products directly to end-user customers.
The Company will continue to focus much of its sales and marketing efforts on Internet service providers and telecommunications companies with rapidly increasing storage requirements. Their storage requirements are driven by their customers' demand for information that resides in heterogeneous UNIX and Windows NT operating environments.
CUSTOMER SERVICE AND SUPPORT
The Company believes that its ability to provide comprehensive and responsive support is an important element in penetrating new customer accounts and in securing repeat business from existing customers. The Company is committed to providing superior customer service and support aimed at simplifying installation, reducing field failures, minimizing system downtime and streamlining administration.
In certain geographical regions, the Company maintains a staff of on-call technical personnel who are available to visit the customer's site within a few hours of receiving a request for service. In other geographical regions, the Company indirectly provides the same level of support by using third-party service companies. In all cases, the Company's technical support engineers are available by phone on a seven-day-per-week, 24-hour-per-day basis. The Company plans to increasingly utilize the Internet and other on-line services in the support and distribution of its products.
The Company provides standard warranties with all products sold which are set forth in various documents and agreements, which are delivered to customers with each product. As a general policy, the Company ships replacement hardware components to customers in advance of receiving returns of defective components under a standard warranty, which generally runs three years. The Company occasionally issues credit in lieu of replacing a piece of equipment. A customer may also contract for an extended warranty or maintenance support from the Company on all products.
RESEARCH AND DEVELOPMENT
To date, the Company has made substantial investments in research and development, particularly in the areas of RAID, SANs, backup, FC-AL, GUI software development, and specialized file server software. The Company's engineering design team employs electrical engineering, mechanical engineering, systems engineers and computer science professionals and places great importance on the exchange of information with the Company's sales and marketing and customer support departments and with its resellers to develop new products and product enhancements that anticipate and address technological changes and evolving industry standards and customer needs.
The Company generally designs its products to have a modular architecture that can be readily modified to respond to technological developments and paradigm shifts in the open systems computing environment. This flexibility allows the Company to focus research and development resources on specific product innovations and advancements. The modular architecture of the products meets customer needs with solutions tailored to their applications and products that can be adapted to changes in technology and in their computing environments.
The Company's engineering design teams work cross-functionally with marketing managers, applications, technical and production engineers and customers to develop products and product enhancements. The Company employs a full staff of applications engineers to assist customers in making appropriate and effective storage system purchases and in addressing, analyzing and solving complex pre-deployment storage problems. The Company's technical support engineering team and production engineering team also contribute to the quality, manufacturability and usability of products from design to deployment. This value-added capability fosters customer loyalty and allows the Company to identify emerging customer requirements for future data storage products.
The Company's expenses for research and development for fiscal years 1997, 1998, and 1999 were $2.4 million, $3.2 million, and $7.3 million, respectively. As of March 31, 1999, the Company had 32 regular full-time and three contract employees engaged in research and development activities, of which four were specifically focused on research and development of products and services directed at the telecommunications and Internet/intranet markets. Additionally, Storage Dimensions' expenses for research and development for calendar year 1997 was $6.3 million.
The data storage system market is characterized by rapid technological change, changing customer needs, frequent new product introductions and evolving industry standards. The introduction of products embodying new technologies and increased storage capacities and the emergence of new industry standards could render the Company's existing products obsolete and unmarketable. The Company's future success will depend upon its ability to develop and introduce new products with increasing storage capabilities on a timely basis that keep pace with technological developments and emerging industry standards and address the increasingly sophisticated needs of its customers. There can be no assurance that the Company will be successful in developing and marketing any new products that respond to technological changes or evolving industry standards, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of new products, or that its new products will adequately meet the requirements of the marketplace and achieve market acceptance. In addition, storage system products like those
offered by the Company may contain undetected errors or failures when first introduced or as new versions are released. There can be no assurance that, despite testing by the Company and by current and potential customers, errors will not be found in new products after commencement of commercial shipments, resulting in a loss or delay in market acceptance, which could have a material adverse effect on the Company's business, operating results or financial condition.
MANUFACTURING
The Company operates 43,000 square feet of manufacturing space at its Carlsbad, California facilities. The Company's products are manufactured in a work cell production process. State-of-the-art equipment and software include manufacturing resource planning, just-in-time order processing and total-quality-management. The Company strives to develop close relationships with its suppliers, exchanging critical information and implementing joint corrective action programs to maximize the quality of its components, to reduce costs and inventory investments and to create flexibility for rapid capacity expansion when required. The Company believes that its current facilities and capital equipment will be adequate to meet its manufacturing needs in the foreseeable future.
In July 1998, the Company earned the ISO 9002 certification from the International Organization for Standardization. ISO 9002 certification covers the manufacture, distribution and support of the Company's high-performing storage systems. Attaining the certification entailed meticulous examination of the Company's manufacturing standards and processes. The Company must undergo periodic assessment by independent auditors in order to retain the ISO 9002 certification.
The Company subcontracts some of its manufacturing, such as plastic molding, metal bending, PCB fabrication and assembly, to qualified partners in the U.S. and Asia. The Company owns the design and tools/molds associated with the manufacture of these parts. The Company has designed and owns over 50 tools used to produce various components of its Lynx, LynxStak, and LynxArrayII products. In addition, the Company relies upon a limited number of suppliers of several key components utilized in the assembly of the Company's products, including Seagate, IBM, Quantum, Merisel, Infortrend, ATL, Flextronics, Exabyte and Mylex. The Company's reliance on its manufacturing subcontractors and suppliers involves several risks, including: an inadequate supply of required components; price increases; late deliveries; and poor component quality. Although to date the Company has been able to obtain its requirements of components, there can be no assurance that the Company will be able to obtain its full requirements of such components in the future or that prices of such components will not increase. In addition, there can be no assurance that problems with respect to yield and quality of such components and timeliness of deliveries will not occur. Disruption or termination of the supply of these components could delay shipments of the Company's products and could have a material adverse effect on the Company's business, operating results or financial condition. Such delays could also damage relationships with current and prospective customers. The Company has experienced delays in the shipments of its products in the past, principally due to an inability of vendors to deliver an adequate supply of components, resulting in delay or loss of product sales. Although these delays in the past have not had a material adverse effect upon the Company's business, operating results or financial condition, there can be no assurance that in the future any such delays would not have such a material adverse effect.
COMPETITION
The storage market is extremely competitive and is characterized by rapidly changing technology. The Company has a number of competitors in various markets, including Hewlett Packard, Sun Microsystems, IBM, Hitachi, Data General Corporation, Compaq Corporation, Network Appliance, nStor Technologies, LSI Logic, Ciprico, Andataco, StorageTek, Dell Computer Corp, SGI, DEC, Storage Works, MTI Technology and EMC Corporation, many of which have substantially greater name recognition, engineering, manufacturing and marketing capabilities, and greater financial and personnel resources than the Company. In particular, a number of the Company's customers are also competitors, including Sun and SGI. The Company expects to experience increased competition from established and emerging computer storage hardware and management software companies, particularly HP, Sun, IBM, Dell, Compaq and EMC Corporation.
In addition, increased competitive pressure could lead to intensified price-based competition, which could have a material adverse effect on the Company's results of operations. There also has been, and may continue to be, a willingness on the part of certain large competitors to reduce prices in order to preserve or gain market share. The Company believes that pricing pressures are likely to continue as competitors develop more competitive product offerings.
The principal factors of competition in the Company's markets include rapid introduction of new technology, product quality and reliability, price and performance characteristics, service and support and responsiveness to customers. The Company believes that, in general, it competes favorably with respect to these factors. The Company intends to maintain its competitive position by continuing to build a defensible niche in the Internet and telecommunications markets, while at the same time serving other industries and customers. Its strengths in product reliability and quality, price/performance characteristics and new technology are being supplemented by enhanced service and support. With Inktomi as a strategic partner in developing traffic-server software, the Company believes it can provide a superior network storage solution. However, there can be no assurance that the Company will be able to compete successfully or that competition will not have a material adverse effect on the Company's business, results of operations or financial condition.
INTELLECTUAL PROPERTY
The Company's success depends significantly upon its proprietary technology. The Company relies on a combination of patent, copyright, trademark and trade secret laws, employee and third-party nondisclosure agreements and technical measures to protect its proprietary rights in its products.
As of March 31, 1999, the Company had been awarded a total of seven U.S. patents covering certain elements of its products. There can be no assurance that any additional patents will be issued, that the Company will develop proprietary products or technologies that are patentable, that any patent issued in the future will provide the Company with any competitive advantages or will not be challenged by third parties, or that the patents of others will not have a material adverse effect on the Company's ability to do business. The Company seeks to protect its software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. The Company has registered numerous trademarks and will continue to evaluate the registration of additional trademarks as appropriate. The Company generally enters into confidentiality agreements with its employees and consultants and with key vendors and suppliers. All released documentation of products, including drawings, requirements specifications, source code, BOMs, costs and other materials, are kept in a secure, centralized document control area.
The Company expects that companies in the storage system market will increasingly be subject to infringement claims as the number of products and competitors in the Company's target markets grows. Although the Company believes that its products and trade designations do not infringe on the proprietary rights of third parties, there can be no assurance that third parties will not assert infringement claims against the Company in the future. If such a claim is made, the Company will evaluate the claim as it relates to its products and, if appropriate, may seek a license to use the protected technology. There can be no assurance that the Company would be able to obtain a license to use such technology or that such a license could be obtained on terms that would not have a material adverse effect on the Company. If the Company or its suppliers are unable to license protected technology, the Company could be prohibited from incorporating or marketing products incorporating that technology. The Company could also incur substantial costs to redesign its products or to defend any legal action taken against it. Should the Company's products be found to infringe protected technology, the Company could be required to pay damages to the infringed party or be enjoined from manufacturing and selling such products.
Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or to obtain and use information that the Company regards as proprietary. In addition, the laws of some foreign countries do not protect proprietary rights to as great an extent as do the laws of the United States. There can be no assurance that the Company's means of protecting its proprietary rights will be adequate or that the Company's competitors will not independently develop similar technology, duplicate the Company's products or design around patents issued to the Company or other intellectual property rights of the Company
EMPLOYEES
As of March 31, 1999, the Company had approximately 234 full-time employees worldwide, including 112 in marketing, sales and service support, 67 in manufacturing and quality assurance, 29 in engineering and research and development and 26 in general administration and finance.
None of the Company's employees is represented by a labor union. The Company has experienced no work stoppages and considers its relations with its employees to be good.
The Company's future performance depends in significant part upon the continued service of its key technical and senior management personnel. The Company provides incentives such as salary and benefits to attract and retain qualified employees. The loss of the services of one or more of the Company's officers or other key employees could have a material adverse effect on the Company's business, operating results or financial condition. The Company's future success also depends on its continuing ability to attract and retain highly qualified technical and management personnel. Competition for such personnel is intense, and there can be no assurance that the Company can retain its key technical and management employees or that it can attract, assimilate or retain other highly qualified technical and management personnel in the future.
CERTAIN RISK FACTORS RELATED TO THE COMPANY'S BUSINESS
In addition to those risks identified elsewhere in this Annual Report on Form 10-K, the Company's business and results of operations are subject to other risks, including the following risk factors:
HISTORY OF OPERATING LOSSES; POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS. For the fiscal years ended March 31, 1999 and 1998 the Company incurred a loss. The Company's operating results for the fiscal years ended March 31, 1999 and 1998 included expenses incurred as a result of the acquisition of Falcon and the acquisition of Storage Dimensions. There can be no assurance that the Company will be profitable on a quarterly or annual basis.
The Company's quarterly operating results have in the past varied and may in the future vary significantly depending on a number of factors, including: the level of competition; the size, timing, cancellation or rescheduling of significant orders; product configuration and mix; market acceptance of new products and product enhancements; new product announcements or introductions by competitors; deferrals of customer orders in anticipation of new products or product enhancements; changes in pricing by the Company or its competitors; the impact of price protection measures and return privileges granted by the Company to its distributors and VARs; the ability of the Company to develop, introduce and market new products and product enhancements on a timely basis; hardware component costs and availability, particularly with respect to hardware components obtained from sole sources; hardware supply constraints; the company's success in expanding its sales and marketing programs; technological changes in the network storage system market, in particular the PC-LAN and UNIX storage system markets; the mix of sales among the Company's sales channels; levels of expenditures on research and development; changes in the Company's strategy; personnel changes; and general economic trends and other factors.
Sales for any future quarter are not predictable with any significant degree of certainty. The Company generally operates with limited order backlog because its products typically are shipped shortly after orders are received. As a result, sales in any quarter are generally dependent on orders booked and shipped in that quarter. Sales are also difficult to forecast because the PC-LAN and UNIX storage system markets are rapidly evolving and the Company's sales cycles vary substantially from customer to customer. The Company's customers generally have the right to cancel orders at any time and a limited right to return products for a refund. The cancellation of orders already placed and the return of products could have a material adverse effect on operating results in any quarter. Due to the typical timing of customer orders, the Company often ships products representing a significant portion of its net sales for a quarter during the last month of that quarter. Any significant deferral of these sales could have a material adverse effect on the results of operations in any particular quarter. To the extent that the Company completes significant sales earlier than expected, operating results for subsequent quarters may be adversely affected. The Company's expense levels will be based, in part, on its expectations as to future sales. As a result, if sales levels are below expectations, net income may be disproportionately affected. There can be no assurance that the Company will experience sales growth with respect to its enterprise and OEM products in future periods.
Since the closing of the Storage Dimensions Merger, the Company's combined business consists of that of Artecon California, the former Storage Dimensions, Inc. and Falcon. Due to the foregoing, period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as an indicator of future performance. It is possible that in future quarters the Company's operating results may be below the expectations of public market analysts and investors. In such event, the price of the Company's Common Stock would likely be materially and adversely affected.
RELIANCE ON KEY CUSTOMERS AND INDIRECT DISTRIBUTION CHANNELS. The Company sells its products through a direct sales force and through value-added resellers ("VARs"). Approximately 26%, 27%, and 35% of revenues for the years ended March 31, 1999, March 31, 1998, and March 29, 1997 were to four, four, and two customers, respectively. The following customers of Artecon California accounted for approximately that percentage of Artecon's total revenues set forth below during the periods indicated: Sales to one customer did not exceed 10% of total revenue for the fiscal year ended March 31, 1999 and 1998; and sales to Tracor Enterprise Solution accounted for 25.4% of total revenue for the fiscal year ended March 31, 1997. No other customer accounted for more than 10% of Artecon's total revenues during the fiscal years ended March 31, 1999, 1998 tand March 29, 1997. Additionally, Storage Dimensions' top ten customers accounted for approximately 42% of total net sales in 1997, with Sun Financial Group accounting for 10% of total net sales. The Company expects that a high percentage of the Company's sales for the foreseeable future will continue to come from a relatively small number of customers. There can be no assurance that orders from existing customers will continue at their historical levels, or that the Company will be able to obtain orders from new customers. The Company generally has not entered into long-term volume purchase contracts with its customers, and customers generally have certain rights to extend or to delay the shipment of their orders. The Company's distributors and VARs may also carry competing product lines and could reduce or discontinue sales of the Company's products, which could have a material adverse effect on the Company's operating results. Although the Company believes that it provides adequate allowances for product returns, there can be no assurance that actual returns will not exceed recorded allowances which could have a material adverse effect on the Company's operating results. In addition, there can be no assurance that existing end- user customers will not purchase their storage equipment from the manufacturer that provides their network computing systems and, as a result, reduce or eliminate purchases from the Company. The loss of one or more of the Company's current customers, particularly a principal customer, or cancellation or rescheduling of orders already placed, could materially and adversely affect the Company's business, operating results or financial condition.
DEPENDENCE ON NEW PRODUCTS; RAPID TECHNOLOGICAL CHANGE. The storage system market is characterized by rapid technological change, changing customer needs, frequent new product introductions and evolving industry standards. The introduction of products embodying new technologies and increased storage capacities by the Company's competitors and the emergence of new industry standards could render the Company's products obsolete and unmarketable. The Company's future success will depend upon its ability to develop and to introduce new products with increasing storage capabilities (including new software releases and enhancements) on a timely basis that keep pace with technological developments and emerging industry standards and address the increasingly sophisticated needs of its customers. There can be no assurance that the Company will be successful in developing and marketing any other products that respond to technological changes or evolving industry standards, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of new products, or that its new products will adequately meet the requirements of the marketplace and achieve market acceptance. If the Company is unable, for technological or other reasons, to develop and introduce new products, in particular those for use with Windows NT and UNIX systems, in a timely
manner in response to changing market conditions or customer requirements, the Company's business, operating results and financial condition will be materially and adversely affected.
Storage system products like those offered by the Company may contain undetected software errors or failures when first introduced or as new versions are released. There can be no assurance that, despite testing, errors will not be found in new products after commencement of commercial shipments, resulting in a loss of or delay in market acceptance, which could have a material adverse effect on the Company's business, operating results or financial condition. The Company's standard warranty provides that if the system does not function to published specifications the Company will repair or replace the defective component without charge. Although to date the Company's suppliers of hardware components have generally covered the warranty costs associated with such components, there can be no assurance that such manufacturers will continue to be willing or able to cover such costs, and their failure to do so would result in such costs being borne by the Company. There can be no assurance that the Company's warranty costs will not be significant in the future. Significant warranty costs, particularly those that exceed reserves, could have a material adverse effect on the Company's business, operating results or financial condition.
The Company's agreements with customers typically contain provisions intended to limit exposure to potential product liability claims. It is possible that the limitation of liability provisions contained in the Company's agreements may not be effective. Although the Company has not received any product liability claims to date, the sale and support of products by the Company and the incorporation of products from other companies may entail the risk of such claims. A successful product liability claim against the Company could have a material adverse effect on the Company's business, operating results or financial condition.
DEPENDENCE ON KEY PERSONNEL. The Company's future performance will depend in significant part upon the continued service of its senior management and key sales and technical personnel. The Company expects to provide incentives such as salary, benefits and option grants (which are typically subject to vesting over four years) to attract and retain qualified employees. In recent periods, the Company has experienced difficulties retaining existing and attracting and training new, skilled personnel. Any inability to attract, train and retain skilled sales personnel in future periods or the loss of the services of one or more of the Company's officers or other key employees could have a material adverse effect on the Company's business, operating results or financial condition. The Company's future success will also depend on its ability to attract and retain highly qualified technical and management personnel. Competition for such personnel is intense, and there can be no assurance that the Company can retain its key technical and management employees or that it can attract, assimilate or retain other highly qualified technical and management personnel in the future.
COMPETITION. The storage system market is intensely competitive. The Company has a number of competitors in various markets, including Hewlett Packard, Sun Microsystems, IBM, Hitachi, Data General Corporation, Compaq Corporation, Network Appliance, nStor Technologies, LSI Logic, Ciprico, Andataco, StorageTek, Dell Computer Corp, SGI, DEC, Storage Works, MTI Technology and EMC Corporation, many of which have substantially greater name recognition, engineering, manufacturing and marketing capabilities, and greater financial and personnel resources than the Company. In particular, a number of the Company's customers are also competitors, including Sun and SGI. The Company expects to experience increased competition from established and emerging computer storage hardware and management software companies, particularly HP, Sun, IBM, Dell, Compaq, and EMC Corporation. Many of the Company's current and potential competitors have significantly greater financial, technical, marketing, purchasing and other resources than the Company, and as a result, may be able to respond more quickly to new or emerging technologies and changes in customer requirements, to devote greater resources to the development, promotion and sale of products than can the Company, or to deliver competitive products at a lower end-user price. The Company also expects that competition will increase as a result of industry consolidations. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of the Company's prospective customers. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. Increased competition is likely to result in price reductions, reduced operating margins and loss of market share, any of which could have a material adverse effect on the Company's business, operating results or financial condition.
The Company believes that the principal competitive factors affecting its markets include: fault-tolerant reliability, performance, ease of use, scalability, configurability, price and customer service and support. There can be no assurance that the Company will be able to successfully incorporate these factors into its products and to compete against current or future competitors or that competitive pressures faced by the Company will not materially and adversely affect its business, operating results or financial condition.
DEPENDENCE ON LIMITED NUMBER OF SUPPLIERS OF HIGH QUALITY COMPONENTS. The Company relies upon a limited number of suppliers of several key components utilized in the assembly of the Company's products, including Seagate Technology, Inc. ("Seagate"), Quantum Corporation ("Quantum"), IBM, Infortrend, Intel, Mylex, Sony and American Megatrends, Inc. The Company's reliance on its suppliers involves several risks, including: an inadequate supply of required components; price increases; late deliveries; and poor component quality. These risks are particularly significant with respect to suppliers of disk drives because, in order to meet product performance requirements, the Company must obtain disk drives with extremely high quality and capacity. In addition, there is currently a significant market demand for disk drives, tape drives and RAID controllers, and from time to time the Company may experience component shortages, selective supply allocations and increased prices of such components. Although to date the Company has not experienced shortages of such components, there can be no assurance that the Company will be able to obtain its full requirements of such components in the future or that prices of such components will not increase. In addition, there can
be no assurance that problems with respect to yield and quality of such components and timeliness of deliveries will not occur. Disruption or termination of the supply of these components could delay shipments of the Company's products and could have a material adverse effect on the Company's business, operating results or financial condition. Such delays could also damage relationships with current and prospective customers.
In the past, due to the Company's quality requirements, the Company has experienced delays in the shipments of its new products principally due to an inability to qualify component parts from disk drive manufacturers and other suppliers, resulting in delay or loss of product sales. The Company has currently qualified disk drives manufactured by Seagate and IBM, tape drives from Quantum, and RAID controllers from Mylex Corporation Infortrend and American Megatrends. Although these delays in the past have not had a material adverse effect upon the Company's business, operating results or financial condition, there can be no assurance that in the future any such delays will not have such a material adverse effect on the Company.
INTERNATIONAL OPERATIONS; CURRENCY FLUCTUATIONS. Artecon California's international sales represented approximately 10.0%, 11.7% and 14.0% of the Company's total revenues for the fiscal years ended March 31, 1999, March 31, 1998, and March 29, 1997, respectively. The Company currently has sales offices in Japan, France, England and the Netherlands. The Company believes that the continued growth and profitability of the Company will require expansion of international operations, particularly in Europe and Japan. Accordingly, the Company intends to expand its international operations and enter additional international markets, which will require significant management attention and financial resources. In addition, the Company's international operations are subject to a variety of risks associated with conducting business internationally, including fluctuations in currency exchange rates, longer payment cycles, difficulties in staffing and managing international operations, problems in collecting accounts receivable, seasonal reductions in business activity during the summer months in Europe and certain other parts of the world, increases in tariffs, duties, price controls or other restrictions on foreign currencies, and trade barriers imposed by foreign countries, any of which could have a material adverse effect on the Company's business, operating results and financial condition. In addition, the Company has only limited experience in developing localized versions of its products and marketing and distributing its products internationally. There can be no assurance that the Company will be able to successfully localize, market, sell and deliver its products internationally. The inability of the Company to expand its international operations successfully and in a timely manner could have a material adverse effect on the Company's business, operating results and financial condition.
A significant portion of the Company's international business is presently conducted in currencies other than the U.S. dollar. Foreign currency transaction gains and losses arising from normal business operations are credited to or charged against earnings in the period incurred. As a result, fluctuations in the value of the currencies in which the Company conducts its business relative to the U.S. dollar will continue to cause the currency transaction gains and losses which Artecon has experienced in the past and continues to experience. Due to the substantial volatility of currency exchange rates, among other factors, the Company cannot predict the effect of exchange rate fluctuations upon future operating results. There can be no assurance that the Company will not experience currency losses in the future. The Company has not previously undertaken hedging transactions to cover its currency exposure but may hedge a portion of its currency exposure in the future as management deems appropriate.
DEPENDENCE ON PROPRIETARY TECHNOLOGY. The Company currently relies on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect its proprietary rights and seeks to protect its software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. The Company has registered numerous trademarks and will continue to evaluate the registration of additional trademarks as appropriate. The Company generally enters into confidentiality agreements with its employees and with key vendors and suppliers. As of March 31, 1999, the Company had been issued a total of seven U.S. patents covering certain elements of its products. There can be no assurance that issued patents will provide a meaningful competitive barrier or that any pending patents at either company will ever be issued, that the Company will develop proprietary products or technologies that are patentable, that any patent issued in the future will provide the Company with any competitive advantages or will not be challenged by third parties, or that the patents of others will not have a material adverse effect on the Company's ability to do business. The Company believes that the rapidly changing technology in the computer storage industry makes future success dependent more on the technical competence and creative skills of its personnel than on any patents it may be able to obtain.
There has also been substantial litigation in the computer industry regarding intellectual property rights, and litigation may be necessary to protect the Company's proprietary technology. The Company has from time to time received claims that it is infringing third parties' intellectual property rights, and there can be no assurance that third parties will not in the future claim infringement by the Company with respect to current or future products, trademarks or other proprietary rights. The Company expects that companies in the storage system market will increasingly be subject to infringement claims as the number of products and competitors in the Company's target markets grows. Any such claims or litigation may be time-consuming and costly, cause product shipment delays, require the Company to redesign its products or require the Company to enter into royalty or licensing agreements, any of which could have a material adverse effect on the Company's business, operating results or financial condition. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or to obtain and use information that the Company regards as proprietary. For example, in February 1998, Artecon filed a suit against certain former employees alleging, among other things, trade secret misappropriation. In addition, the laws of some foreign countries do not protect proprietary rights to as great an extent as do the laws of the United States. There can be no assurance that the Company's means of protecting its proprietary rights will be adequate or that the Company's competitors will not independently develop similar technology,
duplicate the Company's products or design around patents issued to the Company or other intellectual property rights of the Company.
YEAR 2000 COMPLIANCE. Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. Beginning in the year 2000, these date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, in less than two years, computer systems and/or software used by many companies may need to be upgraded to comply with such "Year 2000" requirements. Significant uncertainty exists in the software industry concerning the potential effects associated with such compliance. The cost of making the Company's products Year 2000 compliant is not expected to be material. For a more complete description of the Year 2000 issue and its impact on the Company business, see "Year 2000 Compliance" under Item 7 "Management Discussion and Analysis of Financial Condition and Results of Operations."
The Company believes that the purchasing patterns of customers and potential customers may be affected by the Year 2000 issues in a variety of ways. Many companies are expending significant resources to correct or patch their current software systems for Year 2000 compliance. These expenditures may result in reduced funds available to purchase products such as those offered by the Company. Other companies are delaying purchases of computer equipment, particularly equipment that contains new technology, until after the Year 2000. Also, Year 2000 issues could cause a significant number of companies, including current customers, to reevaluate their current information system needs, and as a result consider switching to other systems or suppliers. Any of the foregoing could result in a material adverse effect on the Company's business, operating results and financial condition.
INFLUENCE OF EXISTING STOCKHOLDERS. As of June 3, 1999, the Company's executive officers, directors and their affiliates beneficially owned approximately 72% of the Company's outstanding shares of Common Stock, giving effect to the conversion of the outstanding Series A Preferred Stock of the Company which was issued in connection with the Storage Dimensions Merger into the maximum number of shares of Common Stock. As a result, these stockholders, if acting together, would be able to influence matters requiring approval by the stockholders of the Company, including the election of a majority of the directors. The voting power of these stockholders under certain circumstances could have the effect of delaying or preventing a change in control of the Company. The Company has entered into agreements with its executive officers and directors indemnifying them against losses they may incur in legal proceedings arising from their service to the Company.
POSSIBLE VOLATILITY OF STOCK PRICE. The market price of the Company's Common Stock has been, and is expected to continue to be, volatile. This volatility may result from a number of factors, including fluctuations in the Company's quarterly revenues and net income, announcements of products by the Company or its competitors, and conditions in the network storage system market. Also, the stock market has experienced and continues to experience extreme price and volume fluctuations which have affected the market prices of securities, particularly those of technology companies, and which often have been unrelated to the operating performance of the companies. These broad market fluctuations, as well as general economic and political conditions, may adversely affect the market price of the Company's Common Stock in future periods.
EFFECT OF CERTAIN CHARTER PROVISIONS AND DELAWARE ANTI-TAKEOVER LAW. Certain provisions of the Company's Certificate of Incorporation, as amended, and Bylaws, as amended, the Delaware General Corporation Law (the "DGCL") and the Company's indemnification agreements with certain officers and directors of the Company may be deemed to have an anti-takeover effect. Such provisions may delay, defer or prevent a tender offer or takeover attempt that a stockholder might consider to be in that stockholder's best interests, including attempts that might result in a premium over the market price for the shares held by such stockholder.
The Board of Directors may issue additional shares of Common Stock or establish one or more classes or series of Preferred Stock, having the number of shares (up to 10,000,000), designations, relative voting rights, dividend rates, liquidation and other rights, preferences and limitations as determined by the Board without stockholder approval. The Company's Certificate of Incorporation, as amended, and Bylaws, as amended, contain a number of provisions that could impede a takeover or change in control of the Company, including but not limited to the elimination of stockholders' ability to take action by written consent and a fair price requirement. In addition, the Company's Certificate of Incorporation provides for a classified Board of Directors and eliminates the ability of stockholders to remove a director from office without cause except, until the third annual meeting of the stockholders following the Merger, by the affirmative vote of at least 80% of the outstanding voting stock of the Company and by the affirmative vote of at least 66 2/3% of the outstanding voting stock of the Company thereafter.
In addition, the Company is subject to the anti-takeover provisions of Section 203 of the DGCL. In general, the statute prohibits a publicly-held Delaware corporation from engaging in a "business combination" with an "interested stockholder" for a period of three years after the date of the transaction in which the person became an interested stockholder.
Each of the foregoing provisions gives the Board, acting without stockholder approval, the ability to prevent, or render more difficult or costly, the completion of a takeover transaction that stockholders might view as being in their best interests.
ITEM 2.
ITEM 2. PROPERTIES
The Company's principal administrative, sales, marketing, manufacturing and research and development facility is located in approximately 70,000 square feet of space in Carlsbad, California, including approximately 43,000 square feet of manufacturing space. This facility is leased through December 1999 with a two-year option to extend. Artecon leases other sales offices throughout the U.S., as well as operations sites in Japan, France, England and the Netherlands. Artecon believes that its existing facilities have the capacity to double its current production and therefore are adequate to meet expected requirements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to any material pending legal proceedings, other than ordinary routine litigation incidental to the business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Effective April 1, 1998 the Company's Common Stock was listed on the Nasdaq National Market under the ticker symbol "ARTE." Prior to such time, the Company's Common Stock had traded on the Nasdaq National Market under the symbol "STDM" since the Company's initial public offering in March 1997.
The approximate number of holders of record of the Company's Common Stock as of June 3, 1999 was 2,400.
The last sales price for the Company's Common Stock, as reported by Nasdaq on June 3, 1999 was $1.88.
The following table sets forth, for the fiscal quarters indicated, the range of high and low sale prices per share of Artecon common stock as reported on the Nasdaq National Market, since March 31, 1998. On March 31, 1998, Artecon concluded a merger with Storage Dimensions, Inc. The stock prices reflected below for periods prior to that time were those of Storage Dimensions, Inc. and were reported on Nasdaq under the symbol "STDM."
The Company has never paid any cash dividends on its Common Stock in the past, and currently intends to retain future earnings, if any, to fund the development and growth of its business. The Company does not anticipate paying any cash dividends in the foreseeable future.
During the period covered by this Annual Report on Form 10-K, the Company did not issue or sell any equity securities that were not registered under the Securities Act of 1933, as amended.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected historical financial information of Artecon, Inc. as of March 31, 1998 and March 31, 1999 and for the years ended March 29, 1997, March 31, 1998 and March 31, 1999 are derived from the audited consolidated financial statements of Artecon and related notes thereto included elsewhere in this Annual Report on Form 10K. The selected historical financial information as of March 25, 1995, March 30, 1996 and March 29, 1997 and for each of the years ended March 25, 1995 and March 30, 1996 has been derived from the audited consolidated financial statements of Artecon which are not included in this Annual Report on Form 10-K. Artecon's selected historical consolidated financial information includes financial information of Falcon Systems, Inc. following their acquisition of Falcon in August 1997 and of Storage Dimensions, Inc. following the acquisition of Storage Dimensions in March 1998. The following financial information should be read in conjunction with Artecon's financial statements and related notes thereto and with "Management's Discussion and Analysis of Financial Condition and Results of Operations," included elsewhere in this Annual Report on Form 10K.
SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION (IN THOUSANDS, EXCEPT PER SHARE DATA)
- ----------
(1) See Note 11 of Notes to Consolidated Financial Statements of Artecon, Inc. for the three years in the period ended March 31, 1999 for an explanation of shares used in computing basic and diluted net income (loss) per share.
(2) The financial information set forth above includes financial information for Falcon since August 21, 1997, the effective date of the Falcon Acquisition.
(3) The financial information set forth above includes financial information for Storage Dimensions since March 31, 1998, the effective date of the Storage Dimensions merger.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the consolidated financial statements and the related notes thereto included herein. The discussion in this Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties. The Company's actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to such differences include, without limitation, those discussed in this section and the section entitled "Business," as well as those discussed elsewhere in this Annual Report on Form 10-K.
OVERVIEW
The Company designs, manufactures, markets and supports a broad range of scalable, fully integrated data storage products for the open-systems computing environment. Artecon has established itself as a leader in the design, manufacture and sale of third-party mass storage and enhancement products in the Sun, UNIX and PC-LAN markets, offering both host-attached and network-attached storage solutions for a broad range of customers. Artecon offers a wide range of products and services in four principal areas: enterprise storage, telecommunications and Internet infrastructure and tape backup solutions.
On March 31, 1998, the Company (then known as Storage Dimensions, Inc.) entered into a merger transaction with Artecon California, in a stock-for-stock transaction that was accounted for as a purchase (the "Storage Dimensions merger"). The Storage Dimensions merger created a leading third-party storage company serving the combined PC-LAN and UNIX open systems network computing market. For financial reporting purposes, the Storage Dimensions merger was accounted for as an acquisition of Storage Dimensions by Artecon California, and, as such, the historical financial results of Artecon for all years ended prior to and including March 31, 1998 included in this prospectus/joint proxy statement are those of Artecon California. The historical financial results of Artecon subsequent to March 31, 1998 that are included in this Annual Report on Form 10-K include the results of the combined company.
In August 1997, Artecon California acquired substantially all of the assets and liabilities of Falcon. The Falcon acquisition has enabled the Company to achieve several important strategic objectives, including the acquisition of Falcon's AerREAL(TM) real-time specialized file server software and other complementary products to better serve Artecon's existing customers, the expansion of Artecon's customer base in the UNIX market and an expansion of Artecon's revenue base. The acquisition was accounted for as a purchase.
In June 1998, Artecon California was merged with and into the Company.
Except where otherwise noted, the financial and other matters in this Item 7 relate solely to Artecon California (including the results of operations for the Falcon business following the closing of the Falcon acquisition in August 1997). See Note 1 to Consolidated Financial Statements for certain additional pro forma combined financial information relating to Artecon California, Storage Dimensions, Inc. and Falcon.
The Company markets and distributes its products and services through its direct sales force employed in 11 domestic sales and support offices and 5 overseas sales offices located in Japan, France, England and the Netherlands. In addition, Artecon utilizes domestic and foreign reseller distribution channels to market and distribute its products and services. Artecon believes that such a diverse channel strategy results in the greatest penetration of the market and enables it to effectively and efficiently penetrate major accounts while at the same time leveraging its distribution network into vertical markets. Artecon believes that the direct customer contact resulting from the use of its own internal sales force provides it with invaluable market feedback and the ability to tailor its products and high-quality technical support services to enhance customer satisfaction and loyalty. Artecon generates revenue from the sales of products and services. Revenue from product sales is recognized upon shipment. Revenue generated from service contracts is recognized ratably over the term of the contract. Operating expenses consist primarily of rent, payroll, commissions, other selling and administrative expenses and research and development costs and are recognized in the period incurred.
The following table sets forth certain items from Artecon's consolidated statement of operations as a percentage of net sales for the periods indicated:
RESULTS OF OPERATIONS
YEAR ENDED MARCH 31, 1999 COMPARED TO YEAR ENDED MARCH 31, 1998
NET REVENUES. Net revenues reflect the invoiced amounts for products shipped less reserves for estimated returns. Net revenues for the year ended March 31, 1999 ("FY 1999") were $95.9 million compared to $66.3 million for the year ended March 31, 1998 ("FY 1998"), an increase of approximately 44.5%. The increase in net revenues is primarily attributable to sales generated from the Enterprise Storage Division. Net revenues for this division, which includes sales to the finance, multimedia, government, advanced-technology, and industrial markets, were $63.0 million for FY 1999 compared to $33.7 million for FY 1998, an increase of approximately 86.6%. This increase in net revenues from the Enterprise Storage Division is primarily attributable to revenue from the Storage Dimensions products.
GROSS MARGIN. Gross margin for FY 1999 was $33.5 million, or 35.0% of net revenues, compared to a gross margin of $15.4 million, or 23.2% of net revenues, for FY 1998. The increase in gross margin as a percentage of net revenues from FY 1998 to FY 1999 was primarily attributable to sales of higher margin products.
SELLING AND SERVICE EXPENSES. Selling and service expenses are comprised primarily of salaries, commissions, and marketing costs. Selling and service expenses increased to $26.1 million, or 27.2% of net revenues for FY 1999, from $11.4 million, or 17.2% of net revenues, for FY 1998. The increase in selling and service expenses as a percentage of net revenues is attributable to two factors: lower than expected revenues, and increased sales management overhead related to the Storage Dimensions merger.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative ("G & A") expenses are comprised primarily of overhead costs associated with Artecon's finance and administrative staff. G & A expenses for FY 1999 were $5.3 million or 5.6% of net revenues compared to $3.6 million, or 5.4% of net revenues for FY 1998. The increase in G & A expenses is primarily attributable to the following:
- additional amortization expense of $1.7 million for goodwill and other intangible assets associated with the Falcon acquisition and Storage Dimensions merger as a result of a full year of amortization in the current year
- additional depreciation expense of $1.5 million associated with property and equipment acquired in the Storage Dimensions merger on March 31, 1998
- a decrease in compensation expense of $700,000 for stock participation rights granted, and common stock issued, below fair market value to certain employees in FY 1998.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses are comprised primarily of prototype expenses, salaries for employees directly engaged in research and other costs associated with product development. Research and development expenses increased to $7.3 million, or 7.6% of net revenues, for FY 1999 compared to $3.2 million, or 4.8% of net revenues for FY 1998. The increase in research and development expenses is attributable to management's decision to initially maintain the combined Storage Dimensions and Artecon engineering staff and a separate engineering facility located in Milpitas, California which was acquired in connection with the Storage Dimensions merger. The engineering staff was reduced and the engineering facility located in Milpitas, California was closed in connection with the December 1998 restructuring discussed below. The increase in research and development expenses as a percentage of revenues compared to the prior year is attributable to the items discussed above and lower than expected revenues.
RESTRUCTURING EXPENSES AND IMPAIRMENT OF INTANGIBLE ASSETS. In December 1998, the Board of Directors approved a plan to consolidate one of Artecon's engineering facilities from Milpitas, California, to Carlsbad, California, to consolidate certain domestic
sales and service locations, and to eliminate certain product lines and development activities. Artecon recorded pre-tax restructuring charges of $1.8 million to cover the costs associated with these actions. The major components of the fiscal year 1999 charges and the remaining accrual balance as of March 31, 1999 were as follows:
Employee termination costs consist primarily of severance payments for 43 employees, all of which were terminated as of March 31, 1999. The majority of the employees terminated were employed at the engineering facility in Milpitas, California and at the various domestic sales and service locations. Remaining costs associated with bi-weekly payroll payments are expected to be paid in the first quarter of fiscal year 2000. Inventory write-downs and the tooling write-off primarily relate to the discontinuance of certain low-volume and low-profit product lines. Of the total restructuring charge associated with the inventory write-downs, $403,000 has been included as a separate component of cost of sales in the accompanying financial statements. Facility closures and related expenses consist of lease termination costs and the write-off of certain property and equipment disposed of associated with the closures. The majority of the remaining accrued costs are expected to be paid in fiscal year 2000.
In connection with the acquisitions of Falcon and SDI, the company allocated $420,000 and $1,600,000, respectively, to an assembled workforce intangible asset. The company recorded an impairment of these intangible assets of $300,000 during the year ended March 31, 1999 which has been included as a component of the restructuring charge, as the impairment was a direct result of employee terminations associated with restructuring activities. Furthermore, as a result of significant attrition and terminations of employees which had been utilized as the basis for the assembled workforce valuation, the company recognized additional amortization of $867,000 based on a change in estimate of the remaining useful life of the assembled workforce.
In connection with the merger with SDI, Artecon recorded a reserve for acquisition related costs of $6.6 million, of which $5.8 million was outstanding at March 31, 1998. All of the acquisition related costs were included in the purchase price allocation performed at March 31, 1998. The following is a summary related to the accrued merger costs at March 31, 1998, amounts utilized during fiscal year 1999 and remaining reserve balance at March 31, 1999:
The majority of the accrued merger costs at March 31, 1999 relate to remaining severance and benefit payments pursuant to the related agreements, lease and contract termination costs, and miscellaneous professional service fee obligations. Artecon anticipates that the remaining merger costs will be paid in fiscal year 2000 and believes that there are no unresolved issues or additional liabilities that may result in an adjustment to the purchase price allocation for the Storage Dimensions merger.
ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT COSTS. During fiscal 1998, Artecon California determined that certain hardware and software products in development that were acquired in the Falcon acquisition had not established technological feasibility. Accordingly, in fiscal 1998, Artecon California recognized a $3.7 million charge to earnings for write-off of these in-process research and development costs. In fiscal 1998 Artecon recognized an additional charge against earnings of $14.5 million for in-process research and development costs relating to the Storage Dimensions merger.
TOTAL OTHER EXPENSE. Total other expense is comprised of interest, taxes and other expenses, if any, relating to such periods presented. Total other expense for FY 1999 was $0.6 million compared to total other expense of $1.1 million for FY 1998. The decrease in total other expense was primarily attributable to legal settlement income received in FY 1999.
YEAR ENDED MARCH 31, 1998 COMPARED TO YEAR ENDED MARCH 29, 1997
NET REVENUES. Artecon's net revenues for FY 1998 were $66.3 million compared to $55.3 million for the year ended March 29, 1997 ("FY 1997"), an increase of approximately 19.9%. Such increase in net revenues was primarily attributable to the Falcon acquisition. Net revenues attributable to sales of Falcon products by Artecon from August 21, 1997, the date of the Falcon Acquisition, to March 31, 1998, were approximately $12.6 million. Net revenues for FY 1998 attributable to sales of Artecon products (excluding Falcon products) were $53.7 million, compared to $55.3 million for FY 1997. The decline in Artecon-only sales was primarily attributable to a decline in orders from a significant customer from $14.1 million in FY 1997 to $0.3 million in FY 1998. Future sales to this customer are not expected to be significant.
GROSS MARGIN. Gross margin for FY 1998 was $15.4 million, or 23.2% of net revenues, compared to a gross margin of $12.9 million, or 23.4% of net revenues, for FY 1997. The decrease in gross margin as a percentage of net revenues from FY 1997 to FY 1998 was due primarily to sales of higher margin products which favorably effected gross margin by approximately 6%, offset by a $5.0 million write off of inventory in FY 1998. The gross margin derived from sales of Falcon products during FY 1998 was approximately $3.3 million, or 26.2% of Falcon net revenues.
SELLING AND SERVICE EXPENSES. Selling and service expenses increased to $11.4 million, or 17.2% of net revenues for FY 1998, from $7.6 million, or 13.8% of net revenues, for FY 1997. The increase in selling and service expenses for FY 1998 was attributable primarily to the increase in Artecon's sales and marketing force resulting from the Falcon acquisition.
GENERAL AND ADMINISTRATIVE EXPENSES. G & A expenses for FY 1998 were $3.6 million or 5.4% of net revenues compared to $1.7 million, or 3.0% of net revenues for FY 1997. The increase in G & A expenses is primarily attributable to professional services and amortization expenses associated with the Falcon acquisition. In addition, $628,000 of compensation expense was recorded for issuance of common stock to certain employees in FY 1998.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses increased to $3.2 million, or 4.8% of net revenues, for FY 1998 compared to $2.4 million, or 4.3% of net revenues for FY 1997. The increase in research and development expenses is attributable to Artecon's continued development of new products.
ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT COSTS. During FY 1998, Artecon California determined that certain hardware and software products acquired from Falcon had not established technological feasibility and had no future alternative use. Accordingly, in fiscal 1998, Artecon California recognized a $3.7 million charge to earnings for write-off of these in-process research and development costs. In FY 1998 Artecon California recognized an additional charge against earnings of $14.5 million for in-process research and development costs relating to the Storage Dimensions merger.
TOTAL OTHER EXPENSE. Total other expense is comprised of interest, taxes and other expenses, if any, relating to such periods presented. Total other expense for FY 1998 was $1.1 million compared to total other expense of $0.2 million for FY 1997. The increase in total other expense was attributable primarily to interest payments made on the promissory note issued in connection with the Falcon acquisition and increased borrowings under Artecon's credit line.
LIQUIDITY AND CAPITAL RESOURCES. Since inception, Artecon has financed its operations primarily through a combination of cash generated from operations, bank borrowings, and through sales of its capital stock. At March 31, 1999, Artecon had $2.1 million in cash and cash equivalents compared to $8.0 million at March 31, 1998, a decrease of $5.9 million. This decrease was primarily attributable to net cash used in operating activities of $6.7 million which included the current year loss of $5.4 million. Financing activities and proceeds from Artecon's Stock Option Plans and Stock Purchase Plan provided $1.1 million and $313,000, respectively.
In May 1998, Artecon entered into a revolving credit facility with LaSalle National Bank (the "line of credit") which permits borrowings of up to $15,000,000. Under the terms of the line of credit, borrowings are collateralized by substantially all of Artecon's assets and mature in May 2001 unless otherwise renewed. Borrowings under the line of credit bear interest at the bank's prime rate. Monthly payments consist of interest only, with the principal due at maturity. As of March 31, 1999, the total outstanding balance under the line of credit was approximately $10.6 million. The line of credit agreement requires that Artecon comply with certain covenants, including minimum net income and tangible net worth. Artecon is currently not in compliance with the minimum net income covenant and has obtained a waiver regarding its non-compliance with this covenant.
Artecon's Japanese subsidiary has two lines of credit with a Japanese bank for borrowings of up to an aggregate of 35 million Yen (approximately US $295,000 at March 31, 1999) at interest rates ranging from 1.8% to 2.5%. Interest is due monthly, with principal due and payable on various dates through August 2005. Borrowings are secured by the inventories of the Japanese subsidiary. As of March 31, 1999, the total amount outstanding under the three credit lines was 33 million Yen (approximately US $275,000 at March 31, 1999).
The Falcon acquisition purchase price of $3,500,000 included $1,000,000 in cash and a promissory note in the original principal amount of $1,250,000 (the "Artecon Note"). Subsequent to the issuance of the Artecon Note, Artecon California and Falcon amended
the Artecon Note to decrease the principal amount due thereunder to $750,000. Concurrently with the Falcon acquisition, Falcon transferred certain technology assets (the "Falcon Technology") to Founding Partners, a California general partnership ("Founding Partners"), in exchange for a promissory note in the principal amount of $1,750,000 (the "Founding Partners Note"). Dana Kammersgard, James Lambert and W.R. Sauey, each of whom is an executive officer and/or director of Artecon, are the general partners of Founding Partners. Founding Partners is considered to be a "special purpose entity" and, accordingly, has been consolidated with Artecon for financial reporting purposes. The purchase price was allocated among the acquired assets to $10,232,000 for other assets acquired, $638,000 to goodwill and other intangible assets, $14,138,000 for liabilities assumed and to in-process research and development expenses of $3,700,000. Under the terms of the Artecon Note, as adjusted, and the Founding Partners Note (collectively, the "Notes"), Artecon and Founding Partners, respectively, are required to make monthly payments to Falcon of $15,935 and $37,182, respectively, through August 2002. Each of the Notes bears interest at the rate of 10% per annum. As of March 31, 1999, the approximate total amount of principal and interest outstanding under the Artecon Note was $556,000, and the total approximate amount of principal and interest outstanding under the Founding Partners Note was $1,298,000.
In connection with the Falcon acquisition and the transfer of the Falcon Technology, Artecon California and Founding Partners entered into a Technology License Agreement, dated August 21, 1997, pursuant to which Founding Partners granted to Artecon an exclusive, perpetual license of the Falcon Technology in exchange for monthly payments of $39,000 payable through August 2002.
As of March 31, 1999, Artecon's future commitments under its operating leases totaled approximately $3.1 million.
Capital spending for FY 1999, FY 1998 and FY 1997 was $638,000, $668,000, and $260,000 respectively.
Artecon's sales and operating results have in the past fluctuated from quarter to quarter and may vary in the future depending on a number of factors, including:
- the size and timing of significant purchase orders;
- the timing of hardware shipments by third-party vendors necessary to recognize revenues;
- Artecon's ability to continue to design, develop and market new products and services;
- Market acceptance of new products;
- Artecon's success in increasing its domestic and foreign sales force;
- the size and number of new accounts;
- technological changes in the storage systems market;
- the growth of the telecommunications and Internet/intranet industry;
- reduction in demand for Artecon's products as a result of new product introductions by competitors;
- levels of expenditure on research and development;
- the amount of additional capital needed by Artecon and the timing of such need;
- product quality problems;
- fluctuations in foreign currency exchange rates; and
- general economic trends and other factors.
Sales and operating results for past periods are not necessarily indicative of future periods and a period-to-period comparison of its sales or results of operations are not necessarily meaningful and should not be relied upon as an indicator of future performance.
Artecon's management believes that its expected cash resources from operations and amounts available under the line of credit are sufficient to meet its current capital commitments and the operating requirements of its existing business for at least the next twelve months. However, there can be no assurance that Artecon will not need to obtain additional capital before such time. The actual amount and timing of working capital and capital expenditures that Artecon may incur in future periods may vary significantly and will depend upon numerous factors, including the amount and timing of the receipt of revenues from continued operations, the increase in manufacturing capabilities, the timing and extent of the introduction of new products and services, and growth in personnel and operations.
YEAR 2000 COMPLIANCE.
Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. Beginning in the year 2000 ("Y2K"), these date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, in less than one year, computer systems and/or software used by many companies may need to be upgraded to comply with such Y2K requirements.
STATE OF READINESS
Artecon has defined Y2K compliance in accordance with the British Standards Institute (BSI). According to the BSI DISC PD2000, Y2K conformity shall mean that neither performance nor functionality is affected by dates prior to, during and after Y2K. Y2K compliance is based on the following factors: 1) during the normal operation, the value for the current date will not cause any interruption in operation; 2) date-based functionality must behave consistently for dates prior to, during and after Y2K; 3) in all interfaces and data storage, the century in any date must be specified either explicitly or by unambiguous algorithms or inferencing rules; and 4) Y2K must be recognized as a leap year.
In 1996, Artecon started a comprehensive Y2K program for its data storage products. This program includes verification testing of existing products, implementation of date code programming policies, and the integration of compliance tests for all enhancements and future products. Artecon established certain criteria to obtain Y2K compliance, expanding year fields to four digits, windowing, date encoding techniques, and absence of date code dependency. Artecon's technology generally lends itself to being Y2K compliant based on the absence of date dependencies in the hardware, software, and firmware code. Artecon certifies to its customers that the hardware, software, and firmware developed, manufactured and distributed by Artecon is Y2K compliant. In addition, Artecon's products also recognize Y2K as a leap year. Management believes that all of Artecon's data storage products are Y2K compliant.
In 1997, Artecon implemented a Y2K assessment program for its internal processing systems. The program currently includes an inventory and assessment of information systems, testing and implementation. Artecon has identified the major systems that will require modification to make them Y2K compliant and anticipates completion of the process by the end of March 1999. To date, approximately 80% of these internal processing systems are Y2K compliant, and Artecon anticipates having the remaining internal processing systems Y2K compliant by the second quarter of calendar 1999 with any additional testing of such systems to be completed by the third quarter of calendar 1999.
Artecon may include software from third party vendors as a part of its data storage products. Artecon has received compliance statements from such software vendors and has conducted internal testing to verify their Y2K compliance statements. Artecon has initiated communications with its significant supplier to determine the extent to which Artecon may be impacted by those third party suppliers who fail to remedy their own Year 2000 issues. To date Artecon has contacted 55% of its significant suppliers and has received assurance of Year 2000 compliance from a number of those contacted. Most suppliers under existing contracts with Artecon are under no contractual obligation to provide such information to Artecon. Artecon is taking steps with respect to new supplier agreements to assure that the suppliers' products and internal systems are Year 2000 compliant.
COSTS TO ADDRESS ARTECON'S Y2K ISSUES.
While it is difficult to quantify the total cost to Artecon of Y2K compliance activities, Artecon's best estimate of resources that are allocated to this program is approximately $500,000. However, there can be no assurance that Y2K issues will not have a material adverse impact on Artecon's business, results of operations or financial condition.
RISKS OF ARTECON'S Y2K ISSUES
Artecon believes that the Y2K issue may affect the purchasing patterns of customers and potential customers in a variety of ways. Many companies are expending significant resources to correct or patch their current software systems for Y2K compliance. These expenditures may result in reduced funds available to purchase products such as those offered by Artecon. Conversely, Y2K issues may cause other companies to accelerate purchases, thereby causing an increase in short-term demand and consequent decrease in long-term demand for products. Additionally, Y2K issues could cause a significant number of companies, including current customers, to reevaluate their current information system needs, and as result consider switching to other systems or suppliers. Any of the foregoing could result in a material adverse effect on Artecon's business, operating results and financial condition.
ARTECON'S CONTINGENCY PLAN
Artecon currently does not have a contingency plan in place if any of the systems, processes or third party suppliers mentioned is not Y2K compliant. Currently, Artecon is in the process of preparing a contingency plan for Y2K compliance issues, and anticipates having such a contingency plan in place by the end of the third quarter of calendar 1999.
THE EURO CONVERSION
On January 1, 1999, eleven of the fifteen member countries of the European Union established fixed conversion rates between their existing sovereign currencies and the euro. These countries have agreed to adopt the euro as their common legal currency on that date. The euro will then trade on currency exchanges and be available for non-cash transactions. These countries will issue sovereign debt exclusively in euro and will re-denominate outstanding sovereign debt. Effective on this date, these countries will no longer control their own monetary policies by directing independent interest rates for the legacy currencies. Instead, the authority to direct monetary policy, including money supply and official interest rates for the euro, will be exercised by the new European Central Bank.
Following introduction of the euro, the legacy currencies are scheduled to remain legal tender in these countries as a denominations of the euro between January 1, 1999 and January 1, 2002 (the "transition period"). During the transition period, public and private parties may pay for goods and services using either the euro or the country's legacy currency on a "no compulsion, no prohibition" basis. However, conversion rates no longer will be computed directly from one legacy currency to another. Instead a "triangulation" process will be applied whereby an amount denominated in one legacy currency first will be converted into an amount denominated in euro, and the resultant euro-denominated amount is converted into the second legacy currency.
Two countries that will convert to the euro, the Netherlands and France, generated revenue of approximately $894,000 and $763,000, respectively, or 1.7% of Artecon's total revenue for FY 1999. Based on this percentage of revenue generated from these two countries, Artecon does not anticipate that this conversion of the euro will have a significant impact on its financial statements. Artecon is continuing to evaluate the impact this conversion will have on its financial condition and results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item is incorporated by reference from pages through of this Annual Report on Form 10-K.
ITEM 9.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers and directors of Artecon and their ages as of June 3, 1999, were as follows:
James L. Lambert, a founder of Artecon California, has served as President, Chief Executive Officer and director of Artecon since March 1998 and, prior to such time, had served as President, Chief Executive Officer and a director of Artecon California since its inception in 1984. Prior to co-founding Artecon, from 1979 to 1984, Mr. Lambert served in various positions at CALMA, a division of General Electric Company, a publicly traded company, most recently, from 1981 to 1984, as Vice President of Research and Development. Mr. Lambert currently serves as a director of Snow Valley, Inc., a privately-held resort enterprise affiliated with the Nordic Group. Mr. Lambert serves as a director with the Nordic Group. He holds a B.S. and an M.S. in Civil and Environmental Engineering from the University of Wisconsin, Madison.
Dana W. Kammersgard, a founder of Artecon California, has served as Artecon's Secretary and Senior Vice President, Engineering since March 1998. Mr. Kammersgard served as a director of Artecon California from its inception in 1984 and as its Vice President, Sales and Marketing from March 1997 until March 1998. Between 1984 and March 1997, Mr. Kammersgard served in various positions at Artecon California in engineering and customer support. Prior to co-founding Artecon California, Mr.
Kammersgard was the Director of Software Development at CALMA, a division of General Electric Company, a publicly traded utility company. Mr. Kammersgard holds a B.A. in Chemistry from the University of California, San Diego.
Norman R. Farquhar has served as a director of Artecon since April 1998. Mr. Farquhar has served as Executive Vice President and Chief Financial Officer of Epicor Software Corporation (formerly known as Platinum Software Corporation), a developer of client/server enterprise resource planning software since December 1998. Mr. Farquhar served as Executive Vice President and Chief Financial Officer of DataWorks Corporation, a supplier of information systems to manufacturing companies ("DataWorks"), from February 1996 to December 1998 and as a director of DataWorks from August 1995 to December 1998. From April 1993 to December 1995, Mr. Farquhar served as Senior Vice President, Chief Financial Officer and Secretary of Wonderware Corporation, a manufacturer of software for the industrial automation industry. From December 1991 to April 1993, he was Vice President of Finance and Chief Financial Officer of MTI Technology Corporation, a developer of system-managed storage solutions. From November 1987 to December 1991, he was Senior Vice President and Chief Financial Officer of Amperif Corporation, a manufacturer of cache-based data storage subsystems. Mr. Farquhar is also a member of the Board of Directors of Alteer Corporation, a medical software company. Mr. Farquhar holds a B.S. from California State, Fullerton, and an MBA from California State, Long Beach.
William J. Filip has served as director of the Company since April 1998. From 1966 to 1996 he held a variety of positions with IBM, including Assistant General Manager of the Personal Systems Group, IBM Director of Plans and Strategies and Vice President of Marketing. Most recently, he served as General Manager of IBM's RS/6000 Division where he was responsible for development, manufacturing and worldwide marketing for IBM's RS/6000 family of workstations, servers and supercomputers. Mr. Filip also served as a member of IBM's Worldwide Management Committee, a member of the board of directors of IBM Credit Corporation, and a member of the Conference Board Council of Strategy Planning Executives. Mr. Filip graduated from the University of Illinois with a Bachelors degree in Physics, and attended the Executive Program at the University of Virginia, Darden School.
Brian D. Fitzgerald has served as a director of the Company since 1992 and was its Chairman of the Board from 1992 until March 1998. In 1982, Mr. Fitzgerald formed Capital Partners and Capital Partners I, L.P. and has since served as President of Capital Partners and a General Partner to Capital Partners I, L.P. Capital Partners acts as a diversified investment holding and operating company. Mr. Fitzgerald co-formed Capital Partners II, L.P. in 1990. Capital Partners I, Capital Partners II and related entities hold majority ownership positions and various officer and director positions in seven other businesses in diversified industries. From 1977 to 1982, Mr. Fitzgerald was a General Partner of Industrial Capital Group, a diversified investment holding and operating company, and from 1974 to 1977 served as strategic planning manager and corporate staff consultant at General Electric Company, a publicly traded company. Mr. Fitzgerald was formerly a director of Bryant Universal Roofing, Inc., a private corporation that filed for bankruptcy in 1996 under Chapter 11 of the U.S. Bankruptcy Code. Mr. Fitzgerald is also the Chairman of the Board of Security Capital Corporation, a public company, a position he has held since 1990, and is an officer and director of a number of privately-held companies. Mr. Fitzgerald holds a B.A. degree from Princeton University and an M.B.A. from the Harvard Graduate School of Business.
Chong Sup Park has served as a director of the Company 1996. Since 1996, Dr. Park has also served as the President of Hyundai Electronics America, an electronics company and the Chairman of Maxtor Corporation, a disk drive manufacturer. Dr. Park was the President of Maxtor Corporation from 1995 to 1996, the President of Axil Computer Inc., a workstation manufacturing company, from 1993 to 1995, the Executive Vice President at Ernst & Young Consulting, Inc., a public accounting firm, from 1992 to 1993, and the Senior Vice President of Hyundai Electronics Company Limited from 1990 to 1992. Dr. Park holds a B.A. in Management from Yonsei University, an M.A. in Management from Seoul National University, an M.B.A. from the University of Chicago and a Doctorate in Management from Nova SouthEastern University.
Jason C. Sauey has served as a director of the Company since March 1998 and, prior to such time, had served as a director of Artecon California since 1988. Since 1992, Jason Sauey has served as President of Flambeau Products Corporation and since 1994 has served as President of Flambeau Airmold Corporation, both privately-held plastics manufacturing companies affiliated with the Nordic Group. Jason Sauey holds a B.B.A. from the University of Wisconsin, Madison and an M.B.A. from the University of Chicago.
W.R. Sauey, a founder of Artecon California, has served as Chairman of the Board of Artecon since March 1998 and prior to such time, had served as Chairman of the Board of Artecon California since its inception in 1984. From 1984 to 1997, Mr. Sauey also served as Treasurer of Artecon California. Mr. Sauey founded and serves as Chairman of the Board for a number of manufacturing companies in the Nordic Group of Companies, a group of privately-held independent companies for which Mr. Sauey is the principal shareholder (the "Nordic Group"). Mr. Sauey is an advisory board member of Liberty Mutual Insurance Company, a publicly traded insurance company, and also serves as a Trustee to the State of Wisconsin Investment Board. Mr. Sauey holds an M.B.A. from the University of Chicago
Messrs. Farquhar and Filip are serving as Class I directors, whose term will expire at the first Annual Meeting following the Storage Dimensions Merger. Mr. Jason Sauey and Dr. Park are serving as Class II directors, whose term will expire at the second Annual Meeting following the Storage Dimensions Merger. Messrs. W.R. Sauey, Lambert and Fitzgerald are serving as Class III directors, whose term will expire at the third Annual Meeting following the Storage Dimensions Merger. Officers serve at the discretion of the Board of Directors. There are no family relationships between any of the directors or executive officers of the
Company, except that W.R. Sauey, Chairman of the Board of Directors, is (i) the father-in-law of James Lambert, the President, Chief Executive Officer and a director and (ii) the father of Jason Sauey, a director.
COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934
Section 16(a) of the Securities Exchange Act of 1934 requires the Company's directors and executive officers, and persons who own more than ten percent of a registered class of the Company's equity securities, to file with the Commission initial reports of ownership and reports of changes in ownership of Common Stock and other equity securities of the Company. Officers, directors and greater than ten percent stockholders are required by Commission regulation to furnish the Company with copies of all Section 16(a) forms they file.
To the Company's knowledge, based solely on a review of the copies of such reports furnished to the Company and written representations that no other reports were required, during the fiscal year ended March 31, 1999, all Section 16(a) filing requirements applicable to its officers, directors and greater than ten percent beneficial owners were complied with.
BOARD COMMITTEES
The Company has an Audit Committee and a Compensation Committee. The Audit Committee consists of Messrs. Farquhar (Chairman), Fitzgerald and W.R. Sauey. The Audit Committee recommends to the Board of Directors the engagement of Artecon's independent accountants, reviews with such accountants the plan, scope and results of their examination of the consolidated financial statements and determines the independence of such accountants. The Compensation Committee consists of Dr. Park (Chairman), and Messrs. Filip and Jason Sauey. The Compensation Committee reviews and makes recommendations to the Board of Directors regarding all forms of compensation to be provided to the executive officers, directors and consultants to Artecon and also administers Artecon's equity-based employee benefits plans.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following table shows, for the fiscal years ended March 31, 1999, March 31, 1998 and March 29, 1997, compensation awarded or paid to, or earned by, (i) the individuals who served as the Company's Chief Executive Officer during the fiscal year ended March 31, 1999, and (ii) the Company's only other executive officer earned at least $100,000 during the fiscal year ended March 31, 1999 (collectively, the "Named Executive Officers):
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(1) Includes term life insurance premium paid on behalf of Mr. Lambert.
(2) Includes tax gross-ups paid to Mr. Lambert of $44,808 in 1999 and $14,938 in 1998.
(3) Includes tax gross-ups paid to Mr. Kammersgard of $44,808 in 1999 and $14,938 in 1998.
(4) Represents the dollar value of shares of Artecon California common stock purchased pursuant to an option exercise, calculated by multiplying the difference between the fair market value of such stock on the date of grant ($1.20 per share) and the exercise price ($0.035 per share) by the number of shares of Artecon California common stock purchased (250,000 shares).
(5) Represents the dollar value of shares of Artecon California common stock purchased pursuant to an option exercise, calculated by multiplying the difference between the fair market value of such stock on the date of grant ($1.20 per share) and the exercise price ($0.035 per share) by the number of shares of Artecon California common stock purchased (125,000 shares).
OPTION GRANTS IN LAST FISCAL YEAR
Artecon grants options to its executive officers under its 1996 Stock Option Plan (the "1996 Plan"). The following table sets forth for each of Messrs. Lambert and Kammersgard information concerning stock options granted during the year ended March 31, 1999.
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(1) Options granted have a ten year term, and vest at the rate of 1/4 (one-fourth) of the shares subject to the Option shall vest on the first one (1) year anniversary of the vesting commencement date, and an additional 1/4th (one-fourth) of the shares shall vest on each one (1) year anniversary thereafter.
(2) Based on options to purchase 2,225,000 shares of Artecon common stock granted to employees, including Messrs. Lambert and Kammersgard, under the 1996 Plan during the fiscal year ended March 31, 1999.
(3) Calculated on the assumption that the market value of the underlying stock increases at the stated values, compounded annually. The total appreciation of the options over their ten-year terms at 5% and 10% is 63% and 159%, respectively
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND YEAR-END OPTION VALUES
During the fiscal year ended March 31, 1999, none of the Company's named executive officers exercised any stock options, nor were any stock options exercisable as of March 31, 1999.
EMPLOYEE BENEFIT PLANS
1996 STOCK OPTION PLAN
The 1996 Plan provides for granting to employees, including officers, directors, and consultants, of non-statutory stock options. A total of 3,000,000 shares of Artecon common stock are currently reserved for issuance pursuant to the 1996 Plan. As of March 31, 1999, options to purchase 1,410,497 shares of Artecon common stock were outstanding under the 1996 Plan and 1,589,503 shares of Artecon common stock remained available for issuance under the 1996 Plan. In April 1998, Artecon granted options to purchase 1,471,500 shares at exercise prices ranging from $3.38 to $3.75. Additionally, 217,500 options with exercise prices ranging from $5.13 to $7.00 were cancelled and re-granted at $3.375 per share.
1996 EMPLOYEE STOCK PURCHASE PLAN
The 1996 Employee Stock Purchase Plan (the "Purchase Plan") provides for the opportunity to purchase Artecon common stock through accumulated payroll deductions. A total of 400,000 shares of Artecon common stock are currently reserved for issuance under the Purchase Plan. As of March 31, 1999, 298,401 shares of Artecon common stock had been purchased under the Purchase Plan and 101,599 shares remained available for purchase under the Purchase Plan.
401(k) PLAN
Artecon has a savings plan under Section 401(k) of the Internal Revenue Code (the "401(k) Plan"). The 401(k) Plan allows eligible employees to contribute up to 15 percent of their compensation on a pre-tax basis up to the statutorily prescribed annual limit ($10,000 in 1998). Artecon matches 50 percent of the employee's contribution up to a specified limit. Such matching contributions vest incrementally over 5 years.
DIRECTOR COMPENSATION
For services as directors, effective April 1998, each non-employee member of the Artecon board of directors receives an annual fee of $10,000, plus $2,000 for each board meeting attended in person, $1,000 for each board meeting attended via telephone conference, $1,000 for each committee meeting attended in person and $500 for each committee meeting attended via telephone conference, provided that the committee meeting is not on the same date as the board meeting and reimbursement for reasonable expenses. The 1996 Plan provides that options may be granted to non-employee directors. See "-- Employee Benefit Plans -- 1996
Stock Option Plan." In April 1998, each non-employee director received an initial grant of options to purchase 50,000 shares of Common Stock at an exercise price of $3.75 per share. Concurrently with such grant, Mr. Fitzgerald and Dr. Park, two current Artecon directors, surrendered for cancellation certain non-employee director stock options granted to them prior to the Storage Dimensions merger.
OPTION REPRICING INFORMATION
In April 1998, following the Storage Dimensions merger, Artecon implemented an employee option exchange program (the "1998 Repricing") applicable to Artecon employees (other than executive officers). Under the program, outstanding options held by qualifying employees with an exercise price greater than $3.38 per share, the closing price of the Artecon common stock on the date of the exchange (the "1998 Exchange Price"), were exchanged for new options to purchase the same number of shares at an exercise price equal to the 1998 Exchange Price. Subject to certain exceptions, the new options are not exercisable until one year after the date of issuance, at which time they will continue to vest to the same extent as the old options surrendered therefor. During the past ten years, no options held by executive officers of Artecon have been repriced.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information with respect to beneficial ownership of the Company's Common Stock and Preferred Stock as of June 3, 1999, by:
- each shareholder who is known by the Company to own beneficially more than 5% or more of the outstanding shares of Common Stock;
- each named executive officer of the Company;
- each director of the Company; and
- all directors and executive officers of the Company as a group.
Unless otherwise indicated, to the knowledge of Artecon, all persons listed below have sole voting and investment power with respect to their shares of Artecon common stock and preferred stock, except to the extent authority is shared by spouses under applicable law.
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* Represents beneficial ownership of less than 1%.
(1) This table is based upon information supplied by executive officers, directors, principal stockholders and the company's transfer agent. Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission, and includes generally sole voting and investment power with respect to securities. Except as indicated by footnote, and subject to community property laws where applicable, the Company believes that the persons named in the table above have sole voting and investment power with respect to all shares of common stock and preferred stock shown as beneficially owned by them.
(2) Percentage of beneficial ownership is based on 21,772,227 shares of common stock outstanding as of June 3, 1999. Preferred stock is based on 2,494,159 shares of Series A Preferred Stock outstanding as of June 3, 1999.
(3) Represents 1,676,440 shares held by CP Acquisition, L.P. No. 4A, 926,790 shares held by CP Acquisition, L.P. No. 4B, 3,612 shares held by Capital Partners, Inc., and 293,781 shares held by FGS, Inc. The following affiliated entities are included in "Capital Partners Group"; (a) CP Acquisition, L.P. No. 4A, a Delaware limited partnership; (b) CP Acquisition, L.P. No. 4B, a Delaware limited partnership; (c) Capital Partners, Inc., a Connecticut corporation, of which Brian D. Fitzgerald is the sole stockholder, an officer and a director, and (d) FGS, Inc., a Delaware corporation, of which Mr. Fitzgerald is the controlling stockholder, an officer and a director. Mr. Fitzgerald may be deemed to beneficially own the shares held by the entities comprising the Capital Partners Group.
(4) Includes (i) 891,151 shares of common stock held by Flambeau Corp., (ii) 235,507 shares of common stock held by Flambeau Products Corp., (iii) 38,333 shares of common stock held by Seats, Inc. and (iv) 1,038,103 shares of common stock held by the W.R. & Floy A. Sauey Grandparents Trust established for the benefit of certain grandchildren of W.R. Sauey. Mr. Sauey is Chairman of the Board and the principal shareholder in each of Flambeau Corp., Flambeau Products Corp. and Seats, Inc. (collectively, the "Sauey Affiliates"). Mr. Sauey disclaims beneficial ownership of all the above-listed shares, except to the extent of his pecuniary or pro rata interest in such shares. Also, includes options to purchase 12,500 shares of common stock exercisable at or within 60 days of June 3, 1999.
(5) Includes (i) 1,038,604 shares of preferred stock held by Flambeau Corp., (ii) 1,038,604 shares of preferred stock held by Flambeau Products Corp. and (iii) 169,074 shares of preferred stock held by Seats, Inc. Mr. Sauey disclaims beneficial ownership of all the above-listed shares, except to the extent of his pecuniary or pro rata interest in such shares.
(6) Includes (i) 3,492,681 shares held jointly with Pamela Lambert, the spouse of Mr. Lambert, (ii) 3,600 shares of common stock held by Pamela Lambert, and 166 shares of common stock held by Mr. Lambert's daughter and (iii) options to purchase 10,000 shares of common stock exercisable at or within 60 days of June 3, 1999.
(7) Includes (i) 546 shares of common stock held by Lisa Kammersgard, the spouse of Mr. Kammersgard and (ii) options to purchase 6,250 shares of common stock exercisable at or within 60 days of June 3, 1999.
(8) Includes options to purchase 12,500 shares of common stock exercisable at or within 60 days of June 3, 1999.
(9) Includes 1,600,000 shares held by Maxtor Corporation. Dr. Park is President and Chief Executive Officer of Hyundai Electronics America, the parent of Maxtor Corporation, and Chairman of the Board of Maxtor Corporation. Also, includes options to purchase 12,500 shares of common stock exercisable at or within 60 days of June 3, 1999.
(10) Includes options to purchase 12,500 shares of common stock exercisable at or within 60 days of June 3, 1999.
(11) Includes options to purchase 12,500 shares of common stock exercisable at or within 60 days of June 3, 1999.
(12) Includes options to purchase 12,500 shares of common stock exercisable at or within 60 days of June 3, 1999.
(13) Includes 2,203,094 shares of common stock held by the Sauey Affiliates
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The Falcon acquisition purchase price of $3,500,000 included $1,000,000 in cash and a promissory note in the original principal amount of $1,250,000 (the "Artecon Note"). Subsequent to the issuance of the Artecon Note, Artecon California and Falcon amended the Artecon Note to decrease the principal amount due thereunder to $750,000. Concurrently with the Falcon Acquisition, Falcon transferred the Falcon Technology to Founding Partners, a California general partnership ("Founding Partners"), in exchange for a promissory note in the principal amount of $1,750,000 (the "Founding Partners Note"). Dana Kammersgard, James Lambert and W.R. Sauey, each of whom is an executive officer and/or director of Artecon, are the general partners of Founding Partners. Founding Partners is considered to be a "special purpose entity" and, accordingly, has been consolidated with Artecon for financial reporting purposes. The purchase price was allocated among the acquired assets to $10,232,000 for other assets acquired, $638,000 to goodwill and other intangible assets, $14,138,000 for liabilities assumed and to in-process research and development expenses of $3,700,000, which had no future alternative use, based on management assumptions. Under the terms of the Artecon Note, as adjusted, and the Founding Partners Note (collectively, the "Notes"), Artecon and Founding Partners are required to make monthly payments to Falcon of $15,935 and $37,182, respectively, through August 2002. Each of the Notes bears interest at the rate of 10% per annum. As of March 31, 1999, the approximate amount of principal outstanding under the Artecon Note was $552,000, and the approximate amount of principal outstanding under the Founding Partners Note was $1,287,000.
In connection with the Falcon acquisition and the transfer of the Falcon Technology, Artecon California and Founding Partners entered into a Technology License Agreement, dated August 21, 1997, pursuant to which Founding Partners granted to Artecon California an exclusive, perpetual license of the Falcon Technology in exchange for monthly payments of $39,000 payable through August 2002.
On December 27, 1997, Founding Partners and Artecon California amended the Technology License Agreement to provide for, among other things, the transfer of the Falcon Technology from Founding Partners to Artecon California upon the satisfaction in full of Founding Partners' obligations under the Founding Partners Note.
Pursuant to certain commitments between Artecon and the Nordic Group, in which W.R. Sauey holds a controlling interest, Artecon was obligated to pay fees to the Nordic Group for certain software maintenance services provided by and overhead costs incurred by the Nordic Group. Such fees totaled approximately $9,000 to $11,000 per month and represented Artecon's portion of overhead costs paid by the Nordic Group on its behalf. Such payments terminated effective upon the closing of the Merger. In addition, Artecon leases certain real property from W.R. Sauey at a monthly rental fee of approximately $1,125 under a month-to-month lease between the parties.
Since January 1997, Artecon California made a series of short-term loans to Flambeau Corp., a company in which W.R. Sauey is the principal shareholder, in the aggregate principal amount of $6,145,000. Such loans were made pursuant to the terms of a promissory note dated January 16, 1997 which bore interest at a rate of 7.25% per annum and which was due and payable on demand. The aggregate principal amount (including $14,506 in total interest payments) was paid in full by Flambeau Corp. in August 1997.
During the fiscal years ended March 29, 1997, March 31, 1998, and March 31, 1999, Artecon made payments to certain entities affiliated with W.R. Sauey (the "Nordic Group Companies") of approximately $85,000, $130,000 and $80,000, respectively, for the purchase of certain products and services from the Nordic Group Companies. In addition, during the fiscal years ended March 29, 1997, March 31, 1998 and March 31, 1999, the company received payments for the sale of certain products and services from certain of the Nordic Group Companies of approximately $74,000, $125,000 and $48,000, respectively. As of March 31, 1999, Artecon had accounts receivable from certain Nordic Group Companies of approximately $13,000 and accounts payable of zero.
In February 1999, the Company issued a promissory note to Flambeau Corporation, a company affiliated with Mr. W.R. Sauey, for the principal amount of $500,000 at an interest rate of prime minus one-half of one percent. Such note was paid in full by Artecon on March 30, 1999.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents Filed With Report
(1) Financial Statements
The consolidated balance sheets for the years ended March 31, 1999 and 1998, and the consolidated statements of operations, statements of shareholders' equity and cash flows for each of the years ended March 31, 1999, March 31, 1998 and March 29, 1997, together with the notes thereto.
(2) Financial Data Schedules
See Exhibit 27.1 below
(3) Exhibits
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(1) Schedules omitted pursuant to Regulation S-K, Item 601(b)(2) of the Commission. Registrant undertakes to furnish such schedules to the Commission supplementally upon request.
(2) Filed as an exhibit to Registrant's Registration Statement on Form S-1 (No. 333-20045), as amended, and incorporated herein by reference.
(3) Filed as an exhibit to the Current Report on Form 8-K of Box Hill dated April 29, 1999, and incorporated herein by reference.
(4) Filed as an exhibit to Registrant's Registration Statement on Form S-4 (No. 333-47593) and incorporated herein by reference.
(5) Filed as an exhibit to Registrant's Registration Statement on Form S-8 (No. 333-56281) and incorporated herein by reference.
(6) Indicates management or compensatory plan or arrangement required to be identified pursuant to Item 14(c).
(7) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1998 and incorporated herein by reference.
(b) Reports on Form 8-K
None
(c) See response to Item 14(a)(3) above.
(d) See response to Item 14(a)(2) above.
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.
ARTECON, INC.
By: /s/ JAMES L. LAMBERT ------------------------------------ James L. Lambert President
Date: June 29, 1999
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints James L. Lambert and each of them, as his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place, and stead, in any and all capacities, to sign any and all amendments to this Report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming that all said attorneys-in-fact and agents, or any of them or their or his substitute or substituted, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Registration Statement has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
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(1) Schedules omitted pursuant to Regulation S-K, Item 601(b)(2) of the Commission. Registrant undertakes to furnish such schedules to the Commission supplementally upon request.
(2) Filed as an exhibit to Registrant's Registration Statement on Form S-1 (No. 333-20045), as amended, and incorporated herein by reference.
(3) Filed as an exhibit to the Current Report on Form 8-K of Box Hill dated April 29, 1999, and incorporated herein by reference.
(4) Filed as an exhibit to Registrant's Registration Statement on Form S-4 (No. 333-47593) and incorporated herein by reference.
(5) Filed as an exhibit to Registrant's Registration Statement on Form S-8 (No. 333-56281) and incorporated herein by reference.
(6) Indicates management or compensatory plan or arrangement required to be identified pursuant to Item 14(c).
(7) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1998 and incorporated herein by reference.
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INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders Artecon, Inc.
We have audited the accompanying consolidated balance sheets of Artecon, Inc. and its subsidiaries (the Company) as of March 31, 1999 and 1998, and the related consolidated statements of operations, comprehensive operations, shareholders' equity and cash flows for each of the three years in the period ended March 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Artecon, Inc. and its subsidiaries at March 31, 1999 and 1998 and the results of their operations and their cash flows for each of the three years in the period ended March 31, 1999, in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Costa Mesa, California May 6, 1999
ARTECON, INC.
CONSOLIDATED BALANCE SHEETS AS OF MARCH 31, 1999 AND 1998
See accompanying notes to consolidated financial statements.
ARTECON, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE OPERATIONS FOR THE YEARS ENDED MARCH 31, 1999, MARCH 31, 1998 AND MARCH 29, 1997
See accompanying notes to consolidated financial statements.
ARTECON, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED MARCH 31, 1999, MARCH 31, 1998 AND MARCH 29, 1997
See accompanying notes to consolidated financial statements.
ARTECON, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED MARCH 31, 1999, MARCH 31, 1998 AND MARCH 29, 1997
See accompanying notes to consolidated financial statements.
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED MARCH 31, 1999, MARCH 31, 1998, AND MARCH 29, 1997
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1. DESCRIPTION OF BUSINESS ACTIVITIES
DESCRIPTION OF BUSINESS -- Artecon, Inc. and its wholly- and majority-owned subsidiaries, (collectively, the Company or Artecon), are manufacturers and suppliers of value-added computer products and services in the open systems workstation and server markets. The Company's principal markets include the United States, Europe, Canada, and Japan. The Company sells its products through a direct sales force, reseller distribution channels, worldwide government agencies and Fortune 1000 companies.
On August 21, 1997, the Company acquired certain net assets of Falcon Systems, Inc. (Falcon), a manufacturer and distributor of computer peripheral equipment. The purchase price of $3,500 included $1,000 in cash and $2,500 of promissory notes (Note 9). The acquisition was recorded as a purchase and the results of operations for the period from August 21, 1997 to March 31, 1998 are included in the accompanying consolidated financial statements. The purchase price was allocated $10,232 to assets acquired (consisting primarily of inventories, accounts receivable, property and equipment and other current assets), $638 to goodwill and other intangible assets, $14,138 to liabilities assumed, and $3,700 to in-process research and development expenses, which had no future alternative use, based on management assumptions. In connection with the acquisition, a partnership was created to purchase certain assets from Falcon. The partners are majority shareholders of the Company. The partnership is considered to be a Special Purpose Entity and, accordingly, the accompanying consolidated financial statements include the accounts of the partnership and all intercompany transactions have been eliminated.
On March 31, 1998, Artecon, Inc. and Storage Dimensions, Inc. (SDI) completed a reverse merger whereby SDI acquired Artecon, Inc. Immediately after the merger, SDI changed its name to Artecon, Inc. In the merger, shareholders of the former Artecon, Inc. received approximately 62% of the total issued and outstanding common stock, and 100% of the total issued and outstanding Preferred Stock of the new Artecon, Inc. Since the former Artecon shareholders received a substantial majority of the shares of common stock of the newly named Artecon, the transaction was treated as a purchase of SDI by Artecon for accounting purposes. As a result, the historical financial statements of Artecon, Inc. for the periods prior to the merger are those of Artecon, Inc., rather than those of SDI. The fair market value of stock was contractually determined based on the average bid and ask price of Storage Dimensions common stock of 3.96875 on December 18, 1997. The purchase price was allocated $25,064 to assets acquired (consisting primarily of cash and cash equivalents, accounts receivable, inventories, property and equipment, deferred tax assets, and other assets), $7,438 to goodwill and other intangible assets, $14,057 to liabilities assumed and $14,500 to in-process research and development expenses, which had no future alternative use, based on management assumptions.
During the year ended March 31, 1999, the Company recorded adjustments associated with certain tax-related matters that existed at the time of the merger with SDI. The amount of the purchase price allocated to goodwill was decreased by approximately $581 as a result of these adjustments.
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Unaudited pro forma results of operations of the Company for the years ended March 31, 1998 and March 29, 1997 are included below. Such pro forma presentation has been prepared assuming that the acquisitions had occurred as of April 1, 1996 for the Company.
The pro forma results include the historical accounts of the Company, Falcon and SDI and pro forma adjustments, as may be required, including the in-process research and development expense, the amortization of goodwill and other intangible assets, and the interest expense related to the promissory notes issued to Falcon's previous shareholder. The in-process research and development expense has been included as if recorded on April 1, 1996 and has been excluded from the year ended March 31, 1998. The pro forma results of operations are not necessarily indicative of actual results that may have occurred had the operations of Falcon and SDI been combined in prior years.
Effective December 31, 1997, the Company changed its fiscal year as ending on March 31 and its fiscal quarters as ending on June 30, September 30 and December 31, respectively. Prior to this change, the Company's fiscal year was previously on a 52- to 53-week basis that ended on the Saturday nearest to March 31. The fiscal year ended March 29, 1997 contained 52 weeks.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION -- The accompanying consolidated financial statements include the accounts of Artecon, Inc. and its subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.
CREDIT RISK -- The Company performs ongoing credit evaluations of its customers and requires no collateral. The Company maintains reserves for potential credit losses.
INVENTORIES -- Inventories are comprised of purchased parts and assemblies, which include direct labor and overhead, and are valued at the lower of cost (first-in, first-out) or market.
PROPERTY AND EQUIPMENT -- Property and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets (ranging from three to five years). Depreciation expense was $2,371, $859, and $664 for the years ended March 31, 1999, March 31, 1998 and March 29, 1997 respectively.
FOREIGN CURRENCY -- The accounts of foreign subsidiaries consolidated herein have been translated from their respective functional currencies at appropriate exchange rates in accordance with Financial Accounting Standards Board (FASB) Statement of Financial
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Accounting Standards (SFAS) No. 52. Cumulative translation adjustments are included as a separate component of shareholders' equity. Gains and losses on short-term intercompany foreign currency transactions are recognized as incurred.
LONG-LIVED ASSETS -- The Company accounts for the impairment and disposition of long-lived assets in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. In accordance with SFAS No. 121, long-lived assets to be held are reviewed whenever events or changes in circumstances indicate that their carrying value may not be recoverable. The Company periodically reviews the carrying value of long-lived assets to determine whether or not an impairment to such value has occurred. Based on its most recent analysis, the Company believes that no impairment exists at March 31, 1999. During the years ended March 31, 1999 and 1998, the Company recognized an impairment of certain long-lived assets in connection with the merger and restructuring activities (Note 4).
SOFTWARE LICENSE COSTS -- Software license costs are amortized as the related products which include the software are shipped. Included in other current assets in the accompanying consolidated financial statements at March 31, 1999 is $1,000 in unamortized software license costs that are expected to be utilized in fiscal year 2000.
GOODWILL AND OTHER INTANGIBLE ASSETS -- Goodwill related to acquisitions is being amortized on a straight-line basis over a period of seven years. Accumulated amortization was $679 and $12 at March 31, 1999 and March 31, 1998, respectively. Other intangible assets related to acquisitions are being amortized on a straight-line basis over two to four years. Goodwill and other intangible assets are periodically reviewed for events or changes whenever circumstances which indicate that their carrying value may not be recoverable. The Company periodically reviews the carrying value of goodwill and other intangible assets to determine whether or not an impairment to such values has occurred. During the year ended March 31, 1999, the Company recorded an impairment associated with certain other intangible assets of $300 and additional amortization of $867 associated with a change in estimate of the remaining useful lives of such assets (Note 4).
REVENUE RECOGNITION -- The Company recognizes revenue from product sales upon shipment, including products sold under a stock rotation program that entitles the buyer to the right to return products under certain conditions. The Company provides allowance for estimated returns. Revenue from service contracts is recognized ratably over the term of the contract.
USE OF ESTIMATES -- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
INCOME TAXES -- The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this statement, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
bases of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse.
CONCENTRATIONS -- The Company currently utilizes a limited number of suppliers for certain devices used in its products but has no long-term supply contracts with them. Due to the cyclical nature of the industry and competitive conditions, there can be no assurance that the Company will not experience difficulties in meeting its supply requirement in the future.
Approximately 26%, 27% and 35% of revenues for the years ended March 31, 1999, March 31, 1998 and March 29, 1997, were to four, four and two customers, respectively. For the years ended March 31, 1999 and 1998, no customer accounted for 10% or more of total revenues. For the year ended March 29, 1997, one customer accounted for 25% of total net revenues. The loss of, or a reduction in sales to, any such customers would have a material adverse effect on the Company's business, operating results and financial condition.
Revenues derived from various U.S. government agencies were approximately $1,440, $1,861 and $1,400 for the years ended March 31, 1999, March 31, 1998 and March 29, 1997, respectively. Export sales to international customers amounted to approximately $8,064, $7,737 and $7,675 for the years ended March 31, 1999, March 31, 1998 and March 29, 1997, respectively.
ACCOUNTING FOR STOCK-BASED COMPENSATION -- The Company accounts for stock-based compensation in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees.
EARNINGS (LOSS) PER SHARE -- Basic earnings (loss) per share is computed using the weighted average number of common shares outstanding during the reporting period. Diluted earnings (loss) per share is computed using the weighted average number of common shares outstanding and the potential dilutive effect of the convertible Preferred A shares and options to purchase common stock (see Note 10).
RECENT ACCOUNTING PRONOUNCEMENTS -- In June 1997, the FASB issued SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. This statement establishes standards for the way companies report information about operating segments in annual financial statements. It also establishes standards for related disclosure about products and services, geographic areas and major customers (see Note 16).
In February 1998, the FASB issued SFAS No. 132, Disclosures about Pensions and Other Post-Retirement Benefits. This statement revises and standardizes employers' disclosure requirements about pension and other post-retirement benefit plans, requires additional information on changes in the benefit obligations and fair values of plan assets that will facilitate financial analysis and eliminates certain disclosures that are no longer useful. The Company does not maintain an employee pension plan or any other post-retirement benefit plans.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. The Company does not invest in derivative
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
investments and engaged in limited hedging activity in the prior year (Note 15). The Company does not presently engage, nor does it intend to engage in future hedging activities.
RECLASSIFICATIONS -- Certain prior year balances have been reclassified to conform with the current year presentation.
3. OTHER COMPREHENSIVE OPERATIONS
Accumulated other comprehensive operations for each of the three years in the period ended March 31, 1999 is comprised of the following:
4. ACCRUED MERGER AND RESTRUCTURING LIABILITIES AND IMPAIRMENT OF INTANGIBLE ASSETS
In December 1998, the Board of Directors approved a plan to consolidate one of the Company's engineering facilities from Milpitas, California, to Carlsbad, California, to consolidate certain domestic sales and service locations, and to eliminate certain product lines and development activities. The Company recorded pre-tax restructuring charges of $1,807 to cover the costs associated with these actions. The major components of the fiscal year 1999 charges and the remaining accrual balance as of March 31, 1999 were as follows:
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Employee termination costs consist primarily of severance payments for 43 employees, all of which were terminated as of March 31, 1999. The majority of the employees terminated were employed at the engineering facility in Milpitas, California and at the various domestic sales and service locations. Remaining costs associated with bi-weekly payroll payments are expected to be paid in the first quarter of fiscal year 2000. Inventory write-downs and the tooling write-off primarily relate to the discontinuance of certain low-volume and low-profit product lines. Of the total restructuring charge associated with the inventory write-downs, $403 has been included as a separate component of cost of sales in the accompanying financial statements. Facility closures and related expenses consist of lease termination costs and the write-off of certain property and equipment which was disposed of associated with the closures. The majority of the remaining costs are expected to be paid in fiscal year 2000.
In connection with the acquisitions of Falcon and SDI, the Company allocated $420 and $1,600, respectively, to an assembled workforce intangible asset. The Company recorded an impairment of these intangible assets of $300 during the year ended March 31, 1999, which has been included as a component of the restructuring charge, as the impairment was a direct result of employee terminations associated with restructuring activities. Furthermore, as a result of significant attrition and terminations of employees, which had been utilized as the basis for the assembled workforce valuation, the Company recognized additional amortization of $867 based on a change in estimate of the remaining useful life of the assembled workforce.
In connection with the merger with SDI, the Company recorded a reserve for acquisition related costs of $6,581, of which $5,765 was outstanding at March 31, 1998. All of the acquisition related costs were included in the purchase price allocation performed at March 31, 1998. The following is a summary related to the accrued merger costs at March 31, 1998, amounts utilized during fiscal year 1999 and remaining reserve balance at March 31, 1999:
The majority of the accrued merger costs at March 31, 1999 relate to remaining severance and benefit payments pursuant to the related agreements, lease and contract termination costs, and miscellaneous professional service fee obligations. The Company anticipates that the remaining merger costs will be paid in fiscal year 2000 and believes that there are no unresolved issues or additional liabilities that may result in an adjustment to the purchase price allocation for the SDI merger.
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. INVENTORIES
Inventories consist of the following:
6. ACCOUNTS AND TRANSACTIONS WITH RELATED PARTIES
Revenues from sales to affiliated companies for the years ended March 31, 1999, March 31, 1998, and March 29, 1997 were approximately $48, $125, and $74, respectively. Accounts receivable from affiliated companies were approximately $13 and $3 at March 31, 1999 and March 31, 1998, respectively, and are included in accounts receivable in the accompanying consolidated balance sheets.
The Company purchases certain goods from affiliates and was subject to a management fee of approximately $4 per month from an affiliate which was terminated upon completion of the merger with SDI. Purchases from affiliated companies for the years ended March 31, 1999, March 31, 1998, and March 29, 1997 were approximately $80, $130, and $85, respectively.
7. SHORT-TERM BORROWINGS
As a result of the merger with SDI (Note 1), the Company assumed a Loan and Security Agreement with a financial institution. Borrowings outstanding under the line at March 31, 1998 included $35 representing borrowings under the loan provisions. Amounts outstanding under this agreement were repaid during the year ended March 31, 1999 and this agreement was not renewed upon expiration in May 1998.
8. BORROWINGS UNDER LINE OF CREDIT
The Company has a $15,000 revolving credit facility with a United States bank (the Agreement). The Agreement provides for financing collateralized by all assets of the Company, as defined by the Agreement, and matures May 14, 2001, unless otherwise renewed. The line of credit bears interest, at the bank's prime rate. Monthly payments consist of interest only, with the principal due at maturity. The Agreement requires that the Company comply with certain covenants including quarterly and annual profitability covenants. The Company was not in compliance with the net income covenants at March 31, 1999 and obtained a waiver from the bank which included a modification of the future net income requirements.
The Japanese subsidiary has two lines of credit with a Japanese bank for borrowings up to an aggregate 35 million Yen (US$295 at March 31, 1999) at rates ranging from 1.8% to 2.5%. At March 31, 1999, 33 million Yen (approximately US$275) were
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
outstanding. Interest is due monthly with the principal due on various dates through August 2005. Borrowings are collateralized by inventories of the Japanese subsidiary.
At March 31, 1999, the Company's borrowings under lines of credit were as follows:
During the year ended March 31, 1999, the Company received a short-term loan totaling $500 from an affiliate. The loan bore interest at 7.25% and interest expense related to the loan was immaterial. During the year ended March 31, 1998, the Company made a short-term loan totaling $754 to an affiliate. The loan bore interest at 7.25% per annum and interest income related to the loan was immaterial.. No amounts related to the loans were outstanding at March 31, 1999 and March 31, 1998.
9. LONG-TERM DEBT
Long-term debt consists of the following:
Long-term debt at March 31, 1999 matures as follows:
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Interest expense related to long-term debt was $207, $160 and $13 for the years ended March 31, 1999, March 31, 1998, and March 29, 1997, respectively.
10. SHAREHOLDERS' EQUITY
Immediately prior to the merger with SDI, there were two classes of preferred shares: the "Preferred" shares and the "Preferred B" shares. There were 10,000 shares of each preferred class authorized. All Preferred shares were nonvoting, did not provide for dividends, and had a liquidation preference over common shares. The shares were convertible into common shares, at the option of the holder, at the earlier of three years after issuance or upon the occurrence of certain other events, at the conversion rate of one common share for each 0.8 Preferred share. The liquidation preference for the Preferred was $.01 per share and for the Preferred B was $2.00 per share.
In December 1994, the Company entered into a repurchase agreement with certain shareholders who were holders of the Company's outstanding Preferred shares. The agreement required the Company to redeem 100 shares of the outstanding Preferred shares and grants the Company the option to repurchase the remaining shares at any time during the five-year period ending December 22, 1999 at prices ranging from $2.00 to $2.50 per share. During the year ended March 29, 1997, the Company repurchased 100 Preferred shares under the agreement at $2.30 per share.
As consideration for the option to repurchase the Preferred shares, in the period ended March 29, 1997, the Company issued 276 common shares to the holders of Preferred shares at the ratio of approximately one share of common stock for each ten shares of Preferred stock that were valued at $0.50 per common share. The value ascribed to the common stock outstanding at the date of issuance has been shown as a reduction in the carrying value of the Preferred stock.
In June and October 1997, the Company issued a total of 95 shares of common stock to certain employees in exchange for stock participation rights previously granted. The common stock was issued at prices of $1.20 and $2.00 per share. No stock participation rights or other options to purchase common stock were outstanding at March 31, 1998. Management has recorded $73 in compensation expense for the period ended March 31, 1998 as a result of these issuances.
In July 1997, the Company issued 475 shares of common stock to certain officers of the Company at a price of $0.035 per share. Management has recorded $553 in compensation expense for the period ended March 31, 1998 as a result of these issuances.
As a result of, and immediately following the merger with SDI, each share of common stock of the former Artecon, Inc. was converted into 2.19 shares of common stock of the new Artecon, Inc., and each share of convertible Preferred stock and convertible Preferred B stock of the former Artecon, Inc. was converted into one share of Series A convertible Preferred stock of the new Artecon, Inc.
The convertible Preferred A shares have voting rights, provide for dividends when and if declared by the Board of Directors and have liquidation preference over common shares. The convertible Preferred A shares are convertible into common shares, at the option of the holder, any time after January 1, 1999 at the conversion rate, as defined in the amended Articles of Incorporation.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The convertible Preferred A shares are automatically converted into common shares upon a unanimous resolution by the Board of Directors or upon the close of business on the first day following the date on which the average of the closing per share sales price of the common stock as reported on the NASDAQ National Market for 20 consecutive trading days equals or exceeds $9.00 per share, at the conversion rate defined in the amended Articles of Incorporation.
11. EARNINGS PER SHARE
Basic net (loss) income per share is computed using the weighted average number of common shares outstanding during the periods presented.
Diluted net (loss) income per share is computed using the weighted average number of common and common stock equivalent shares outstanding during the periods presented assuming the conversion of all shares of the Company's Convertible preferred stock into common stock. Common stock equivalent shares have not been included where inclusion would be antidilutive.
The following is a reconciliation between the components of the basic and diluted net income per share calculations (in thousands, except per share amounts):
12. EMPLOYEE STOCK AND SAVINGS PLANS
SAVINGS PLAN -- The Company has a savings plan, which qualifies under Section 401(k) of the Internal Revenue Code. Under the plan, participating U.S. employees may defer up to 15% of their pretax salary, but not more than statutory limits. The Company matches 50% of eligible employees' contributions up to a specified limit ($500). The Company's matching contributions to the savings plan were $67, $38 and $23 for the years ended March 31, 1999, March 31, 1998, and March 29, 1997, respectively.
STOCK PLANS -- In connection with the merger with SDI, the Company adopted, and the Board of Directors approved, the following employee stock plans:
1996 EMPLOYEE STOCK PURCHASE PLAN
Under the Company's 1996 Employee Stock Purchase Plan (the Purchase Plan), a total of 200 shares of SDI's common stock was originally reserved for issuance under the Purchase Plan. The Purchase Plan was amended in January 1998 and a total of 400 shares of Artecon common stock has been reserved for issuance under the amended purchase plan. As of March 31, 1999, 298 shares of common stock had been purchased under the Purchase Plan and 102 shares of common stock remained available for purchase under the Purchase Plan.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1993 STOCK OPTION PLAN
The 1993 Stock Option Plan (the 1993 Plan) provides for the granting of non-statutory stock options for the purchase of up to an aggregate of 556 shares of the Company's common stock by officers, employees, consultants and directors of the Company. The Board of Directors is responsible for administration of the 1993 Stock Option Plan. The Board of Directors determines the term of each option, option exercise price, number of shares for which each option is granted and the rate at which each option is exercisable. Options granted under the 1993 Stock Option Plan generally vest over a four-year period.
1996 STOCK OPTION PLAN
The 1996 Stock Option Plan (the 1996 Plan) provides for the granting to employees and consultants of non-statutory stock options. A total of 3,000 shares of common stock are currently reserved for issuance pursuant to the 1996 Plan. As of March 31, 1999, 3,214 options have been granted under the 1996 Plan. As of March 31, 1999, options to purchase 1,410 shares of common stock were outstanding under the 1996 plan and 1,590 shares of common stock remain for issuance under the 1996 plan.
In April 1998, the Company approved the cancellation of 218 previously outstanding SDI options with exercise prices ranging from $5.13 to $7.00 per share, and regranted the stock options at an exercise price of $3.38 per share, the fair market value on the date of the regrant. The options were considered granted on April 3, 1998 and are exercisable prospectively in accordance with the agreements evidencing those grants.
Non-statutory stock options may be granted at an exercise price per share of not less than 100% of the fair value per common share on the date of the grant (not less than 110% of the fair value in the case of holders of more than 10% of the Company's voting stock). Options granted under the 1993 and 1996 Stock Option Plans generally expire ten years from the date of the grant. Transactions under the 1993 and 1996 Stock Option Plans are summarized as follows (in thousands except per share amounts):
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table summarizes information about stock options outstanding and exercisable at March 31, 1999:
FAIR VALUE DISCLOSURES
Had compensation cost for options granted in fiscal years 1999, 1998 and 1997 under the Company's option plan been determined based on the fair value at the grant dates, as prescribed in SFAS No. 123, the Company's net (loss) income and pro forma net (loss) income per share would have been as follows (in thousands except per share amounts):
The fair value of each option grant is estimated on the date of grant using the minimum value method with the following assumptions used for grants during the applicable periods: dividend yield of 0.0% for all periods, risk-free interest rates of 4.54% to 5.63% for options granted during the year ended March 31, 1999, risk-free interest rates of 5.49% to 6.57% for options granted during the year ended March 31, 1998, and risk-free interest rates of 5.97% to 6.48% for options granted during the year ended March 29, 1997. An 80% volatility factor was used for the years ended March 31, 1998 and March 27, 1997, and a 137% volatility factor was used for the year ended March 31, 1999. A weighted average expected option term of five years was used for all periods.
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Because the determination of the fair value of all options granted after the Company became a public entity includes an expected volatility factor and because additional option grants are expected to be made each year, the above pro forma disclosures are not representative of pro forma effects of reported net income for future years.
13. INCOME TAXES
Significant components of the (benefit) provision for income taxes are as follows:
A reconciliation of the Company's effective tax rate compared to the statutory federal tax rate is as follows:
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Significant components of the Company's deferred tax assets and liabilities are as follows:
A valuation allowance of $1,995 was established at the date of the Company's merger with SDI in order to reflect limitations on the company's usage of SDI's net operating loss carryforwards associated with, among other factors, SDI continuing to be a separate subsidiary of Artecon. The valuation allowance has been reduced to zero in the fourth quarter of fiscal year 1999 as a result of the Company dissolving the subsidiary structure of SDI and making the determination that it is now more likely than not that these losses will be utilized. The reduction in the valuation allowance of $1,995 has reduced goodwill related to the SDI acquisition.
As of March 31, 1999, the Company has federal and state net operating losses of $15,612 and $7,512, which begin to expire in the tax years ending 2009 and 2010, respectively. In addition, the Company has federal and state tax credit carryforwards of $875 and $691, respectively.
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. COMMITMENTS
The Company leases office and equipment under non-cancelable operating leases. Lease terms range from three to five years. The Company's United States headquarters is leased under an operating lease that has been extended to December 1999.
Future minimum lease commitments for all operating leases are as follows:
Total rent expense for the years ended March 31, 1999, March 31, 1998, and March 29, 1997 was approximately $1,951, $1,027, and $698, respectively.
15. HEDGING ACTIVITIES
The company engaged in limited hedging activity in the prior year and the Company does not presently engage, nor does it intend to engage in future hedging activities.
In the prior year, the Company's Japanese subsidiary entered into derivative financial instruments, primarily foreign currency forward exchange contracts, to manage foreign exchange risk on foreign currency transactions and did not use the contracts for trading purposes. These financial instruments were used to protect the Company from the risk that the eventual net cash inflows from the foreign currency transactions would be adversely affected by changes in exchange rates. Gains and losses related to hedges of firmly committed transactions were deferred and recognized when the hedged transaction occurred.
The following table summarizes the notional amount, which approximates fair market value, of the Company's outstanding foreign exchange contracts at March 31, 1998 (none outstanding at March 31, 1999):
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The counterparties to these instruments were major financial institutions. The Company was exposed to credit losses in the event of nonperformance by counterparties to its forward exchange contracts but had no off-balance sheet credit risk of accounting loss. The Company anticipated, however, that the counterparties would be able to fully satisfy their obligations under the contracts. The Company did not obtain collateral or other security to support the forward exchange contracts subject to credit risk but monitored the credit standing of the counterparties.
16. GEOGRAPHICAL AND SEGMENT INFORMATION
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company's chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company's chief operating decision-maker is its Chief Executive Officer. The operating segments of the Company are managed separately because each segment represents a strategic business unit that offers different products or services.
The Company's reportable operating segments include the Enterprise Storage Division (ESD), the Telecommunications (Telco) Division and the International Division. The ESD Division provides enterprise storage solutions to the following markets: finance, multimedia, government, advanced-technology and industrial. The Telco Division designs, manufactures, markets, and supports fully integrated, industry-compliant storage products, services and solutions for the telecommunications and Internet/intranet markets by utilizing commercially available workstation, server and other application-specific products for enhanced price/performance characteristics and reduced time to market. The International Division provides storage solutions in various international markets.
The accounting policies of the Company's operating segments are the same as those described in Note 2, Summary of Significant Accounting Policies. The Company evaluates performance based on stand-alone segment gross margin. Because the Company does not evaluate performance based on segment operating income or return on assets at the operating segment level, Company operating expenses and total assets are not tracked internally by segment. Therefore, such information is not presented.
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Operating segment data for the years ended March 31, 1999, March 31, 1998, and March 29, 1997 are as follows:
Information concerning principal geographic areas in which the Company operates was as follows:
ARTECON, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
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(a) Includes pre-tax charges of $2,387 in the third quarter of 1999 and $287 in the fourth quarter of 1999 for restructuring and impairment of certain intangible assets.
(b) Includes pre-tax in-process research and development costs relating to the acquisition of Falcon of $3,700 in the second quarter of fiscal year 1998 and $14,500 in the fourth quarter of fiscal year 1998 relating to the acquisition of SDI.
(c) Includes the recognition of an income tax benefit of $2,841 and $2,234 during the fourth quarter of fiscal year 1999 and 1998, respectively.
18. SUBSEQUENT EVENT
On April 29, 1999, the Company and Box Hill Systems Corporation (Box Hill) signed an agreement and plan of merger (the Merger Agreement), whereby the two companies would be merged in a tax-free, stock-for-stock transaction intended to be accounted for as a pooling of interests. Under the terms of the Merger Agreement, each share of the Company's common stock will be converted into 0.40 of a share of Box Hill's common stock. Additionally, the Company's convertible Preferred A shares will be converted into Box Hill common stock based on the terms defined in the Merger Agreement.
INDEPENDENT AUDITORS' REPORT ON SCHEDULE
To the Stockholders and the Board of Directors Artecon, Inc. Carlsbad, California
We have audited the financial statements of Artecon, Inc. and its subsidiaries (the Company) as of March 31, 1999 and 1998 and for each of the three years in the period ended March 31, 1999, and have issued our report thereon dated May 6, 1999; such report is included elsewhere in this Form 10-K. Our audits also included the financial statement schedule of the Company listed in Item 14. The consolidated financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ DELOITTE & TOUCHE LLP May 6, 1999 Costa Mesa, California
S-1 SCHEDULE II
ARTECON, INC. VALUATION AND QUALIFYING ACCOUNTS
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(1) Reserves of companies acquired
(2) Uncollectible receivables charged off and credit issued for product returns
(3) Consists primarily of the write-off of excess/obsolete inventories
S-2