10-K 1 d10k.htm LANTRONIX, INC. - FORM 10-K Lantronix, Inc. - Form 10-K
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 

 
FORM 10-K
 
(Mark One)
 
x
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
           For the fiscal year ended June 30, 2002
 
¨
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
           For the transition period from ________ to ________
 
Commission File Number 1-16027
 

 
LANTRONIX, INC.
(Exact name of registrant as specified in its charter)
 
Delaware
 
33-0362767
(State or other jurisdiction
of incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
15353 Barranca Parkway, Irvine, California 92618
(Address of principal executive offices)
 
(949) 453-3990
(Registrant’s telephone number, including area code)
 

 
Securities registered pursuant to Section 12(b) of the Act: None
 
Securities registered pursuant to Section 12(g) of the Act:
 
Title of each class

 
Name of each exchange
on which registered

Common Stock, $0.0001 par value
 
The Nasdaq National Market
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x    No ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    Yes ¨     No x
 
As of September 27, 2002, there were 54,433,953 shares of the Registrant’s common stock outstanding, and the aggregate market value of shares held by non-affiliates of the Registrant (based on the closing sale price of such shares on the NASDAQ National Market on September 27, 2002) was approximately $14.9 million. Shares of the Registrant’s common stock held by each executive officer, director and holder of five percent or more of the Registrant’s common stock as of September 27, 2002 have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
 


Table of Contents
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the definitive Proxy Statement for the Lantronix, Inc. Annual Meeting of Stockholders scheduled to be held on November 12, 2002 are incorporated by reference into Part II and Part III of this Form 10-K.
 
Certain exhibits filed in connection with the Lantronix, Inc. Registration Statement on Form S-1, originally filed May 19, 2000, and Registration Statement on Form S-1, originally filed June 13, 2001, are incorporated by reference into Part IV of this Form 10-K.
 
LANTRONIX, INC.
ANNUAL REPORT ON FORM 10-K
For the Fiscal Year Ended June 30, 2002
 
 
         
Page

    
PART I
    
ITEM 1.
     
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ITEM 2.
     
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ITEM 3.
     
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ITEM 4.
     
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PART II
    
ITEM 5.
     
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ITEM 6.
     
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ITEM 7.
     
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ITEM 7A.
     
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ITEM 8.
     
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ITEM 9.
     
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PART III
    
ITEM 10.
     
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ITEM 11.
     
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ITEM 12.
     
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ITEM 13.
     
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ITEM 14.
     
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PART IV
    
ITEM 15.
     
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FORWARD-LOOKING STATEMENTS
 
THIS DOCUMENT CONTAINS STATEMENTS THAT ARE NOT HISTORICAL FACTS BUT ARE FORWARD-LOOKING STATEMENTS RELATING TO SUCH MATTERS AS ANTICIPATED FINANCIAL PERFORMANCE, BUSINESS PROSPECTS, TECHNOLOGICAL DEVELOPMENTS, NEW PRODUCTS, ENGINEERING AND DEVELOPMENT ACTIVITIES AND SIMILAR MATTERS. SUCH STATEMENTS ARE GENERALLY IDENTIFIED BY THE USE OF FORWARD-LOOKING WORDS AND PHRASES, SUCH AS “INTENDED,” “EXPECTS,” “ANTICIPATES” AND “IS (OR ARE) EXPECTED (OR ANTICIPATED).” THESE FORWARD-LOOKING STATEMENTS INCLUDE BUT ARE NOT LIMITED TO STATEMENTS CONCERNING INDUSTRY TRENDS, ANTICIPATED DEMAND FOR OUR PRODUCTS, THE IMPACT OF PENDING LITIGATION, OUR STRATEGY, THE FUTURE BENEFITS OF OUR ACQUISITIONS, INCLUDING THE BENEFITS OF USING THE TECHNOLOGY DEVELOPED BY THE COMPANIES WE ACQUIRE IN OUR EXISTING PRODUCT LINE AND THE POSSIBLE SALES OF OUR PRODUCTS TO THE ACQUIRED COMPANIES’ EXISTING CUSTOMERS, THE POSSIBILITY OF FUTURE INVESTMENTS OR ACQUISITIONS, FUTURE CUSTOMER AND SALES DEVELOPMENTS, MANUFACTURING FORECASTS, INCLUDING THE POTENTIAL BENEFITS OF OUR CONTRACT MANUFACTURERS SOURCING AND SUPPLYING RAW MATERIALS, COMPONENTS AND INTEGRATED CIRCUITS, THE POSSIBILITY OF AN EXPANDING ROLE FOR ORIGINAL EQUIPMENT MANUFACTURERS IN OUR BUSINESS, THE FUTURE COST AND POTENTIAL BENEFITS OF OUR RESEARCH AND DEVELOPMENT EFFORTS, AND LIQUIDITY AND CASH RESOURCES FORECASTS. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE DISCUSSED IN SUCH FORWARD-LOOKING STATEMENTS, AND OUR STOCKHOLDERS SHOULD CAREFULLY REVIEW THE CAUTIONARY STATEMENTS SET FORTH IN THIS FORM 10-K, INCLUDING FACTORS THAT MAY AFFECT FUTURE RESULTS. WE MAY FROM TIME TO TIME MAKE ADDITIONAL WRITTEN AND ORAL FORWARD-LOOKING STATEMENTS, INCLUDING STATEMENTS CONTAINED IN OUR FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION AND IN OUR REPORTS TO STOCKHOLDERS. WE DO NOT UNDERTAKE TO UPDATE ANY FORWARD-LOOKING STATEMENTS THAT MAY BE MADE FROM TIME TO TIME BY US OR ON OUR BEHALF.

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PART I
 
ITEM 1.    BUSINESS
 
Overview
 
Lantronix, Inc. (“Lantronix” or “we” or “us”) designs, develops and markets products and software solutions that make it possible to access, manage, control and configure almost any electronic device over the Internet or other networks. We are a leader in providing innovative networking solutions. We were initially formed as “Lantronix,” a California corporation, in June 1989. We reincorporated as “Lantronix, Inc.,” a Delaware corporation in May 2000.
 
We have a history of providing devices that enable information technology (IT) equipment to network using standard protocols for connectivity, including fiber optic, Ethernet and wireless. Our first product was a terminal server that allowed “dumb” terminals to connect to a network. Building on the success of our terminal servers, we introduced a complete line of print servers in 1991 that enabled users to inexpensively share printers over a network. Over the years, we have continually refined our core technology and have developed additional innovative networking solutions that expand upon the business of providing our customers network connectivity. We provide three broad categories of products: “device servers,” that enable almost any electronic device to be connected to a network; “multiport device solutions,” that enable multiple devices—usually network computing devices such as servers, routers, switches, and similar equipment to be managed over a network; and software—software that is either embedded in the hardware devices that are mentioned above, or stand-alone application software.
 
Today, our solutions include fully integrated hardware and software products, as well as software tools to develop related customer applications. Because we deal with network connectivity, we have provided products to extremely broad market segments, including industrial, medical, commercial, financial, governmental, retail, building and home automation, and many more. Our technology is used with devices such as networking routers, medical instruments, manufacturing equipment, bar code scanners, building HVAC systems, elevators, process control equipment, vending machines, thermostats, security cameras, temperature sensors, card readers, point of sale terminals, time clocks, and virtually any device that has some form of standard data control capability. Our current product offerings include a wide range of hardware devices of varying size, packaging and, where appropriate, software solutions that allow our customers to network-enable virtually any electronic device.
 
We sell products through a global network of distributors, systems integrators, value-added resellers (VARs), manufacturers’ representatives and original equipment manufacturers (OEMs). In addition, we sell directly to selected accounts.
 
Our common stock is currently traded on The Nasdaq National Market under the symbol LTRX. We intend to apply to transfer the listing of our Common Stock to The Nasdaq SmallCap Market on or before October 17, 2002. Our worldwide headquarters are located in Irvine, California and we have offices throughout the U.S. and worldwide, including Switzerland, Germany, France and Hong Kong.
 
Our Strategy
 
Our business strategy is based on our proven capability to develop fully integrated networking solutions that increase the value of our customer’s products by making it easy to take advantage of features that can be made available when these products are network-enabled. This strategy is accomplished by providing our customers with hardware and software that connect devices and systems to a network, and intelligently manages and controls them. Through our 13 years of networking expertise, knowledge of industry trends, and our capability to develop solutions based on open industry standards, we have been able to anticipate our customers’ networking technology requirements and to offer solutions that enable them to achieve their connectivity objectives. By providing a complete solution of hardware and integrated software, we have been able to provide “turnkey” solutions, eliminating the need for our customers to build expensive design and manufacturing expertise in-house. This results in savings to the customer both in terms of financial investment, and in time.

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Our fully integrated hardware, software, and applications development tools have enabled us to become a technology and industry leader. While our solutions could address practically any application, we have focused on the following key areas:
 
 
 
Device Networking—We offer an array of embedded and external device networking solutions that enable manufacturers of electro-mechanical devices to add network connectivity, manageability, and control to their devices. Our customers’ devices originate from a wide variety of industries, including such devices as blood analyzers that relay critical patient information directly to a hospital’s information system, to simple devices such as audio/visual equipment to improve how these devices are managed and controlled.
 
 
 
Information Technology Management—We manufacture off-the-shelf products that enable IT professionals to remotely manage network infrastructure equipment and large groups of servers. Our multiport device and console management systems solutions provide a comprehensive solution to the command and control of today’s network infrastructure.
 
 
 
Residential/Building Automation—Our advanced home and building management solutions link security, lighting, air conditioning and other systems together by providing the necessary tools to more efficiently manage an entire home or building, or even a complex of buildings such as a college campus. Over the past several years, our capability has grown from simply providing hardware devices to link the air conditioners, lighting, and other systems to a network, to now include an entire software platform that is the basis for much more extensive command and control systems.
 
 
 
Industrial Automation—We sell specialized products for the industrial automation market to connect factory equipment to a network, as well as monitor and control systems.
 
Recent Acquisitions and Investments
 
We have completed a number of acquisitions and investments since our initial public offering in August 2000, the purpose of which is to expand our product offerings, increase our technology base and provide a foundation for future growth. In December 2000, we completed the acquisition of United States Software Corporation (“USSC”), a developer of a software operating system, protocol stacks and an application development environment for embedded technology.
 
In June 2001, we completed the acquisition of Lightwave Communications, Inc., (“Lightwave”), a developer of console management products, visualization (matrix switches), and keyboard, video and mouse (“KVM”) switches.
 
In October 2001, we completed the acquisition of Synergetic Micro Systems, Inc. (“Synergetic”), a provider of high performance embedded network communication solutions that complement our external device products.
 
In January 2002, we completed the acquisition of Premise Systems, Inc. (“Premise”), a developer of client-side software applications that complement our device networking products by providing superior management and control capabilities for devices that have been network and internet enabled. Premise software enables us to expand our offering into the residential and building management markets as a technology leader.
 
In September and October 2001, we acquired a minority interest in Xanboo Inc. (“Xanboo”) through a cash investment. Xanboo, a privately-held company, develops technology that allows users to control, command and view their home or business remotely over the Internet.
 
In August 2002, we completed the acquisition of Stallion Technologies PTY, LTD (“Stallion”), an Australian company that provides terminal servers and multiport products. Stallion products are complementary to our existing product line. In addition to the products acquired, we obtained intellectual property and patents that strengthen our technology base.
 

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Products
 
Device Networking Solutions
 
We provide manufacturers, integrators, and users with complete device networking solutions that include all the necessary technology required for products to be connected, managed and controlled over networks using standard protocols for connectivity, including fiber optic, Ethernet and wireless. As common, everyday devices such as lighting, security and audio/visual systems leverage the power of network connectivity, manufacturers and users are realizing the benefits of device networking. Our device networking solutions dramatically shorten a manufacturer’s development time to implement network connectivity, significantly speed time-to-market with competitive advantages of new features, and greatly reduce engineering and marketing risks. Our hardware solutions include integrated circuits (ICs), embedded boards (completed boards with electronic components and the necessary connectors and software that is mounted within a customer’s product), and external hardware modules (with single, multi- or wireless ports), as well as the related real-time operating system and application software that is required to make the devices effective. We also offer application- and industry-specific solutions such as industrial device servers, network time servers and print servers.
 
Our device servers allow a wide range of equipment to be quickly network-enabled without the need for intermediary gateways, workstations, or PCs. This distributed computing approach significantly improves the reliability and up-time of the network. Our device servers also eliminate the high cost of ownership associated with PCs and workstations needed when device server technology is not used. Our device servers contain high-performance processors capable of not only controlling the attached device, but are also capable of accumulating data and status. Such data can then be formatted by the device server and presented to users via the built in Web server, SNMP, e-mail, etc. Device servers are easy to manage using any standard Web browser, due to a built-in HTTP server and powerful Java technology.
 
We recently announced a line of device servers based on our new DSTni chip, which is a single chip solution providing the key elements of network connectivity in a highly integrated form. As of June 30, 2002, we have not recognized revenue from this product.
 
Multiport Device Solutions
 
Our multiport device solutions provide IT professionals with the tools they need to remotely manage computer network hardware and software systems. Our terminal servers provide simple and cost-effective network connectivity.
 
IT professionals use our multiport device solutions to monitor and run their systems to assure the performance and availability of critical business information systems, network infrastructure, and telecommunications equipment. The equipment they manage includes routers, switches, servers, phone switches and public branch exchanges (PBXs) that are often located in remote or inaccessible locations.
 
Our console servers provide systems administrators and network managers a way to connect with their remote equipment through a universal interface, called a console port, helping them work more efficiently, without having to leave their desk or office. With remote access, system downtime and its impact on business is minimized. Our console servers provide IT professionals with peace-of-mind, through extensive security features and provisions for dial-in access via modem (“out of band” connectivity) in case the network is not available.
 
We offer console management software that automates many of the tasks related to managing IT equipment. Installed on a central server, this software monitors remote systems, alerts appropriate personnel when trouble is detected and provides them with many of the tools they need to quickly and efficiently diagnose and correct problems through a conventional Web browser.
 
We also design and manufacture KVM switches and KVM extension systems. KVM products enable a single keyboard, monitor and mouse to be switched between multiple computers, providing immediate access

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and control from a single location. Our visualization products are a mixture of matrix hubs, KVM switches and KVM extension devices. These products provide a valuable solution for extending and sharing audio, video, keyboard and mouse signals among many users and over large distances without loss of resolution.
 
Print Servers and Other Legacy Products
 
We began our business by providing print servers that connect various printers to a network for shared printing tasks. Over the years, we have updated and continue to provide print servers that work with a myriad of operating systems and network configurations.
 
Embedded Software and Operating Systems Capability
 
As part of our hardware offering, as well as separately, we offer embedded software solutions that span a variety of applications. In addition to providing the enabling technology to make our device servers and multiport device solutions complete, we provide software components that are used in a variety of consumer and business products, including devices such as mobile phones, medical devices, process controllers, and network routers and switches. Our SuperTask!® Real Time Operating System (RTOS) allows manufacturers to meet their high performance requirements with minimum code size requirements. Implementing and debugging these systems is made easier with our advanced embedded system development environment. We derive license fees from such software when licensed to third parties, rather than being embedded software within our own products.
 
We believe that an important competitive advantage is the flexible, modular design of our software products. This design maximizes the capability of our products to respond to new market conditions and accommodate new technologies as they emerge.
 
Software Application Solutions
 
We produce software application solutions targeted at the residential and building automation markets. These markets are emerging and fragmented, with numerous providers and a wide range of products and services. Our current product offering, Premise SYS® software, is a PC-based system that controls items such as audio, video, home theater systems, lighting, motorized drapes, heating and air conditioning units, closed circuit cameras, security systems, and other home electronic equipment. Premise SYS can be used to manage and play digital media. Although an emerging market and although we have not realized significant revenues for this software through June 30, 2002, our solution has received significant recognition in its marketplace. Our technology that is currently incorporated into the home and building automation application can also be adapted to provide software solutions that can be used in other products, such as our multiport device solutions.
 
The following are approximate revenues for these categories:
 
           
Net Revenues for the Years Ended

Product Family

  
Primary Product Function

    
June 30, 2002

    
June 30, 2001

    
June 30, 2000

           
(in millions)
Device servers
  
Enable almost any electronic
    
$
31.4
    
$
31.8
    
$
24.2
    (including software)
  
device to become network-enabled.
                          
Multiport device solutions (including software)
  
Network-enabled, allowing the user to control the devices by way of the Internet using a wide range of network protocols. This category also includes console servers, visualization and KVM products.
    
$
23.9
    
$
14.0
    
$
10.9
Print servers and other legacy business
  
Allow multiple users to share network printers
    
$
2.3
    
$
3.2
    
$
9.9

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Financial Accounting Standards Board (“FASB”) Statement No. 131, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for disclosures about operating segments in annual consolidated financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. We operate in one segment, networking and Internet connectivity.
 
Customers
 
Distributors
 
Our principal customers are our distributors, who are the source of our highest percentage of net revenues. Distributors resell our products to a wide variety of customers including consumers, corporate customers, value added resellers, etc. We sell to a group of eight major distributors, who operate, in some cases, from multiple warehouses. Our major distributors in the U.S. include: Ingram Micro, Tech Data, KMJ Communications and Arrow Electronics, Inc. In Europe, we distribute directly from a public warehouse located in Belgium which services, in part, the following major distributors: transtec AG, Atlantik Systems GmbH, Astradis Elecktronik GmbH and Lightwave Communications GmbH (not affiliated with Lightwave or Lantronix).
 
OEM Manufacturers
 
We have established a broad range of OEM electro-mechanical manufacturing customers in various industries such as industrial automation, medical, security, building automation, consumer and audio/visual. Our OEM customers typically lack the expertise or resources to develop hardware and software required to introduce network solutions to their end users in a timely manner. To shorten the development cycle to add network connectivity to a product, OEMs can use our external devices to network-enable their installed base of products, while board-level solutions, chips and embedded software is typically used in new product designs. Our capabilities and hardware and software solutions enable OEMs to focus on their core competencies, resulting in reduced research and development costs, fewer integration problems, and faster time to market.
 
End User Businesses
 
We have established a broad range of end user customers in various businesses such as airports, retail, universities/education, manufacturing, healthcare/hospitals and financial/banking. End-user businesses require solutions that are simple to install, setup, and operate, and can provide immediate results. Generally, these customers have requirements to connect a diverse range of devices and equipment, without modifying existing software and systems.
 
Our external devices solutions enable end users to quickly, securely, and easily connect their devices and equipment to networks, extending the life of existing investments without having to change business processes. In support of these customers, we provide a number of programs including telephone-based sales and technical support as well as a wide array of Internet-based resources. We maintain a field sales force and network of value-added resellers and system integrators throughout the world to call on IT departments and decision-makers within the end user accounts. In many cases, the customer simply has to call in to obtain assistance in identifying which networking device would be most appropriate for its need. After buying the devices from us or one of our distributors, a customer often only has to plug a cable from the device to be managed to our external device, and then plug our device into their network.
 
Consumer Market
 
We have made a strategic entry into the consumer networking market. The networking of consumer products and services will impact the value of broadband and entertainment services delivered to the home as well as create demand for newly emerging classes of computer, networking, and consumer electronics products.

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We believe the consumer networking market will develop very differently from the enterprise local area network market. We believe the home network will evolve steadily to encompass entertainment, communications, security, convenience, and control applications. We expect the key applications driving consumer networking adoption to include distribution of digital music and video, IP-based telephony, security and the automation of home appliances. In support of these customer and home integrator needs, we have developed our Premise SYS software. We maintain field sales specialists, a network of home integrators, and are developing products for a retail channel to serve and support the consumer.
 
See those sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” in Part II of this Form 10-K and Note 15 to the Notes to Consolidated Financial Statements for information regarding the geographic distribution of our net revenues for the years ended June 30, 2002, 2001 and 2000 and information regarding each customer whose sales constitute 10% or more of our consolidated net revenues.
 
Sales and Marketing
 
We maintain both an inside and a field sales force. We are also represented by manufacturer’s representatives throughout the world who call on engineering design and product management teams. We develop marketing programs, products, tools and services specifically geared to meet the needs of our targeted customers. Our sales and marketing force consisted of 89 employees as of June 30, 2002, and 118 employees as of June 30, 2001.
 
We believe that this direct distribution and multi-channel approach provides several advantages. We can engage the customers and end users through their channel of choice, making our solution available from a variety of sources.
 
Our embedded and external device networking solutions are principally sold direct to manufacturers by our worldwide OEM sales force and through our group of manufacturer’s representatives. We have recently expanded our use of manufacturer’s representatives, leveraging their established relationships to bring our device networking solutions to a greater number of customers within the OEM market.
 
We market and sell our line of console management solutions, application software and select external device networking solutions through information technology resellers, and industry-specific system integrators and directly to end-user organizations. Resellers and integrators will often obtain our products through distributors such as Ingram Micro, Tech Data and Atlantik Systems GmbH. These distributors supply our products to a broad range of value-added resellers, system integrators, direct marketers, government resellers and e-commerce resellers. In turn, these distributor customers market, sell, install and, in most cases, support our solution to the end users. We are expanding our use of cost-effective, indirect channels for basic offerings and will focus our direct end-user sales force for our more advanced technologies and solution selling.
 
We are expanding our market coverage with use of retail distributors for our solutions that are targeted at the consumer market.
 
Manufacturing
 
Our manufacturing strategy is to produce reliable, high quality products at competitive prices and to achieve on-time delivery to our customers. To achieve this strategy, we generally contract with others for the manufacturing of our products. This practice enables us to concentrate our resources on the design, engineering and marketing of our products where we believe we have greater competitive advantages. Recently, we have manufactured some of our multiport console solutions and KVM products in our Milford, Connecticut manufacturing facility, but are in the process of moving those products to contract manufacturers.
 

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We have agreements with multiple contract manufacturers. Our contract manufacturers are located in and around Irvine, California; Sacramento, California; and Dong guan, China. Under these agreements, the manufacturers source and supply raw materials, components and integrated circuits in accordance with our pre-determined specifications and forecasts, and perform final assembly, functional testing and quality control. We believe that this arrangement decreases our working capital requirements and provides better raw material and component pricing, enhancing our gross and operating margins. Please see “Risk Factors” for a discussion of the risks associated with contract manufacturing.
 
Research and Development
 
Our research and development efforts are focused on the development of technology and products that will enhance our position in our markets. Products are developed in-house and through outside research and development resources. We employed 67 employees in our research and development organization as of June 30, 2002 and 51 employees as of June 30, 2001. Our research and development expenses were $9.2 million (excluding $1.0 million of acquired in-process research and development) for the year ended June 30, 2002, $4.5 million (excluding $2.6 million of acquired in-process research and development) for the year ended June 30, 2001 and $3.2 million for the year ended June 30, 2000.
 
Industry Partners
 
In keeping with our business strategy, we have engaged a portfolio of partners, consortiums, and standards committees in an effort to provide the most complete networking solutions to our customers. We are an active member of many leading professional and industry associations. Membership in these associations provides us with a voice in the development of future standards that are vital to our customers. Industry associations also provide much needed standardization in specific technology areas and ensure that customers benefit from interoperable products regardless of vendor. To enhance our software products, for example, we embrace open standards-based systems, and participate in the development of these standards.
 
Software Developer Relations
 
Recruiting and informing third-party software developers is an integral part of our ongoing strategy. We encourage, enable, and support programmers to develop vertical applications using our hardware, firmware, and software products. With their help and investment in creating additional applications and markets for our products, we secure a defensible market position and loyal customers in the process.
 
Competition
 
The markets in which we compete are dynamic and highly competitive. We expect competition to intensify in the future. Our current and potential competitors include the following:
 
 
 
companies with network-enabling technologies, such as Avocent, Echelon, JUMPtec, Moxa, Digi, Cyclades and Wind River;
 
 
 
companies in the automation industries, such as Schneider and Siemens;
 
 
 
companies with significant networking expertise and research and development resources, including Cisco Systems, IBM, Lucent Technologies; and
 
 
 
home monitoring companies such as ADT, Brinks, or Pittston.
 
The principal competitive factors that affect the market for our products are:
 
 
 
product quality, technological innovation, compatibility with standards and protocols, reliability, functionality, ease of use, and compatibility; and

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price of our products; and potential customers’ awareness and perception of our products as well as network-enabling technologies.
 
Much of our technology can be reproduced by our competitors without royalties or license fees and could compete with our offerings. In addition, there is a risk that our customers or new entrants to the market could develop and market their own solutions without paying a fee to us.
 
Intellectual Property Rights
 
We have developed proprietary methodologies, tools, processes and software in connection with delivering our services. We have not historically relied on patents to protect our proprietary rights, although we have recently begun to build a patent portfolio. We have historically relied on a combination of copyright, trademark, trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses to establish and protect our proprietary rights. As of June 30, 2002, we have had two patents issued in the United States and one patent issued in Germany.
 
Trade secret and copyright laws afford us only limited protection. We cannot be certain that the steps we have taken in this regard will be adequate to deter misappropriation of our proprietary information or that we will be able to detect unauthorized use and take appropriate steps to enforce our intellectual property rights. An adverse change in the laws protecting intellectual property could harm our business. In addition, we believe that our success will depend principally upon continuing innovation, technical expertise, knowledge of networking, storage and applications, and to a lesser extent, on our ability to protect our proprietary technology. Furthermore, there can be no assurance that our current or future competitors will not develop technologies that are substantially equivalent to ours.
 
In July 2001, Digi International, Inc. filed a lawsuit against us alleging that our multiport device servers, specifically our ETS line of products, when coupled with our comm port redirector software infringe a patent held by Digi. We believe we have meritorious defenses to Digi’s lawsuit and are vigorously defending our position in the appropriate venue. Please see “ITEM 3. Legal Proceedings,” for a discussion of this, and related litigation with Digi.
 
Limitations on Our Rights to Intellectual Property
 
Gordian, Inc. (“Gordian”) has developed certain intellectual property used in our micro serial server line of products. These products represented and continue to represent a significant portion of our net revenues. Under the terms of an agreement dated February 29, 1989, Gordian owned the rights to the intellectual property developed under the agreement and required us to pay royalties based upon gross margin of products sold under the agreement. For the years ended June 30, 2002, 2001 and 2000, we paid Gordian approximately $1.2 million, $2.2 million and $2.2 million for royalties, respectively. Our agreement with Gordian was to terminate at the end of the sales life of the product.
 
On May 30, 2002, we announced that we signed a new intellectual property agreement with Gordian. The agreement gives us joint ownership of the Gordian intellectual property that is embodied in the products Gordian has designed for us since 1989. The agreement provides that we will be able to use the intellectual property to support, maintain and enhance our products. The agreement extinguishes our obligations to pay royalties for each unit of a Gordian-designed product that we sell.
 
The agreement requires us to pay Gordian $6.0 million, which will be paid in three installments. We paid $3.0 million concurrent with the signing of the agreement and $2.0 million on July 1, 2002. We will make the third payment of $1.0 million on July 1, 2003. We also have agreed to purchase $1.5 million of engineering and support services from Gordian over the 18-month period commencing June 2002. We are amortizing the intellectual property rights over the remaining life cycles of our products designed by Gordian, or approximately three years. We recorded $212,000 of amortization expense in cost of revenues for the year ended June 30, 2002.

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United States and Foreign Government Regulation
 
Many of our products and the industries in which they are used are subject to federal, state or local regulation in the United States. In addition, our products are exported worldwide. Therefore, we are subject to the regulation of foreign governments. For example, wireless communication is highly regulated in both the United States and elsewhere. Our products currently employ encryption technology; the export of some encryption software is restricted. We do not know whether these or other existing or future laws or regulations will adversely affect us.
 
Employees
 
As of June 30, 2002, we had 230 full-time employees consisting of 67 employees in research and development, 89 in sales and marketing department, 34 in operations department and 40 general and administrative employees. We have not experienced any work stoppages and we believe that our relationship with our employees is good. None of our employees are currently represented by a labor union.
 
Executive Officers of the Registrant
 
Marc H. Nussbaum, forty-six, has served as our Interim President and Chief Executive Officer since June 2002. From April 2000 to March 2002, Mr. Nussbaum served as Senior Vice President and Chief Technical Officer for MTI Technology Corporation, a developer of enterprise storage solutions. From April 1981 to November 1998, Mr. Nussbaum served in various positions at Western Digital Corporation, a manufacturer of PC components, communication controllers, storage controllers and hard drives. Mr. Nussbaum lead business development, strategic planning and product development activities, serving as Western Digital’s Senior Vice President, Chief Technical Officer from 1995 to 1998 and Vice President, Storage Technology and Product Development from 1988 through 1995. Mr. Nussbaum holds BA in physics from the State University of New York, Oswego.
 
James W. Kerrigan, sixty-six, has served as our Interim Chief Financial Officer since May 2002. From March 2000 to October 2000, he was Chief Financial Officer of Motiva, a privately-owned company that developed, marketed and sold collaboration software systems. From January 1998 to February 1999, he was Chief Financial Officer of Who?Vision Systems, Inc., an incubator company that developed biometric fingerprint devices and software. From April 1995 to March 1997, Mr. Kerrigan was Chief Financial Officer of Artios, Inc., a privately-owned company that designs, manufactures, and sells prototyping hardware and software to the packaging industry. Previously, Mr. Kerrigan has served as chief financial officer for other larger, public companies. He has an engineering and MBA degree from Northwestern University.
 
Frederick G. Thiel, forty-one, was the former Chief Executive Officer from April 1998 through May 2002. He assumed the role of Chief Technology and Strategy Officer of the Company effective May 30, 2002, and resigned from the Company effective September 1, 2002. Mr. Thiel served as director of Lantronix from August 2000 through May 2002. From July 1996 to April 1998, Mr. Thiel served as a Corporate Vice President, Marketing and General Manager, Storage Division for CMD Technology, a developer of RAID storage controllers. From June 1994 to March 1996, Mr. Thiel was with Standard Microsystem Corporation, a manufacturer of networking technology, and served in various senior marketing positions.
 
Michael Oswald, forty-seven, has served as our General Counsel and Secretary since December 2001. From June 2001 through December 2001, he provided legal services for clients as an independent consultant. From September 1999 to June 2001, he was General Counsel and Chief Administrative Officer at NowDocs, Inc., a private start-up Internet-enabled document printing and delivery company located in Aliso Viejo, California. From December 1996 to November 1999, he was General Counsel to Acuity Corp., a start-up CRM software producer in Austin, Texas. Mr. Oswald holds a J.D. from Santa Clara University School of Law, and a B.A. from the University of California at Riverside.

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ITEM 2.    PROPERTIES
 
We lease a building in Irvine, California that comprises our corporate headquarters and includes administration, sales and marketing, research and development, and operations functions. We also lease offices in Milford, Connecticut; Downers Grove, Illinois; Ames, Iowa; Redmond, Washington and Hillsboro, Oregon that provide some sales, research and development and operations functions. The foregoing leases comprise an aggregate of approximately 127,000 square feet. Our principal facilities have lease terms expiring between 2003 and 2011.
 
On September 12, 2002, we announced that we would be restructuring operations that will result in a buyout or sublease of our Milford, Connecticut and other offices.
 
Lantronix International AG Switzerland, which is our wholly owned subsidiary, operates out of a leased office in Cham, Switzerland. We also lease a research and development facility and sales office in Germany.
 
We consider the above facilities suitable to meet our requirements.
 
ITEM 3.    LEGAL PROCEEDINGS
 
Intellectual Property
 
On July 3, 2001, Digi International, Inc., filed a complaint alleging that we directly and/or indirectly infringes upon Digi’s U.S. Patent No. 6,047,319 by making, using, selling and or offering for sale certain of our multiport device servers, including the ETS line of products, when coupled with a software called the comm port redirector software. Digi alleges that we have willfully and intentionally infringed Digi’s patent, and its complaint seeks injunctive relief as well as unspecified damages, treble damages, attorney’s fees, interest and costs. Moreover, in conjunction with our acquisition of Stallion, we are party to similar litigation in both the U.S. and Australia, in which Digi International claims that Stallion’s easyserverII and ePipe products when coupled with software products called truport and extend, respectively, infringe Digi’s U.S. Patent No. 6,047,319. Digi filed suit in the U.S. District Court for the District of Minnesota on November 21, 2000 and in the Supreme Court of Queensland, Australia on August 10, 2001, claiming that the easy server II and ePipe products when coupled with the truport and extend software, respectively, infringe Digi’s Australian Letters Patent No. 706,132.
 
The litigation process is inherently uncertain and we may not prevail. Patent litigation is particularly complex and can extend for a protracted time, which can substantially increase the cost of such litigation. The Digi litigation has diverted the efforts and attention of some of our key management and technical personnel. Should the outcome of the litigation be adverse to us, we would be required to pay monetary damages to Digi, and we could be enjoined from selling those of our products found to infringe Digi’s patent, unless and until we are able to negotiate a license from Digi. A license may not be available on acceptable terms or at all. If we are required to pay significant monetary damages, are enjoined from selling any of our products or are required to make substantial royalty payments pursuant to any such license agreement, our business would be harmed. This litigation, or other similar litigation brought by us or others, could result in the expenditure of significant financial resources and the diversion of management’s time and efforts.
 
In addition, from time to time we could encounter other disputes over rights and obligations concerning intellectual property. We cannot assume that we will prevail in intellectual property disputes regarding infringement, misappropriation or other disputes. Litigation in which we are accused of infringement or misappropriation might cause a delay in the introduction of new products, require us to develop non-infringing technology, require us to enter royalty or license agreements, which might not be available on acceptable terms, or at all, or require us to pay substantial damages, including treble damages if we are held to have willfully infringed. In addition, we have obligations to indemnify certain of our customers under some circumstances for infringement of third-party intellectual property rights. If any claims from third-parties were to require us to indemnify customers under our agreements, the costs could be substantial, and our business could be harmed. If a

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successful claim of infringement were made against us and we could not develop non-infringing technology or license the infringed or similar technology on a timely and cost-effective basis, our business could be significantly harmed.
 
SEC Investigation
 
The SEC is conducting a formal investigation of the events leading up to our restatement of our financial statements on June 25, 2002. From the inception of the investigation, we have fully cooperated with the SEC.
 
Class Action Lawsuits
 
On May 15, 2002, Stephen Bachman filed a class action complaint entitled Bachman v. Lantronix, Inc., et al., No. 02-3899, in the U.S. District Court for the Central District of California against us and certain of our current and former officers and directors alleging violations of the Securities Exchange Act of 1934 and seeking unspecified damages. Subsequently, six similar actions were filed in the same court. Each of the complaints purports to be a class action lawsuit brought on behalf of persons who purchased or otherwise acquired our common stock during the period of April 25, 2001 through May 30, 2002, inclusive. The complaints allege that the defendants caused us to improperly recognize revenue and make false and misleading statements about our business. Plaintiffs further allege that we materially overstated our reported financial results, thereby inflating our stock price during our securities offering in July 2001, as well as facilitating the use of our stock as consideration in acquisitions. The complaints have subsequently been consolidated into a single action and we are awaiting the appointment of a lead plaintiff. Once appointed, a consolidated amended complaint will be filed by the lead plaintiff. We have not yet answered, discovery has not commenced, and no trial date has been established.
 
Derivative Lawsuit
 
On July 26, 2002, Samuel Ivy filed a shareholder derivative complaint entitled Ivy v. Bernhard Bruscha, et al., No. 02CC00209, in the Superior Court of the State of California, County of Orange, against certain of our current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, abuse of control, gross mismanagement, unjust enrichment, and improper insider stock sales. The complaint seeks unspecified damages against the individual defendants on our behalf, equitable relief, and attorneys’ fees. Discovery has not commenced and no trial date has been established.
 
Securities Claims and Employment Claims Brought by the Co-Founders of USSC
 
On August 23, 2002, Donald and Diane Dunstan, the co-founders of USSC, filed a complaint entitled Dunstan v. Lantronix, Inc., et al., in the Circuit Court of the State of Oregon, County of Multnomah. The complaint alleges Oregon state law claims for securities violations, fraud, and negligence. The complaint seeks not less than $3.6 million in damages, interest, attorneys’ fees, costs, expenses, and an unspecified amount of punitive damages. Discovery has not commenced and no trial date has been established. In addition, Donald Dunstan has requested arbitration of certain contract claims, including a claim of entitlement to $9.8 million for lost earnout opportunities.
 
Employment Suit Brought by Former CFO and COO Steve Cotton
 
On September 6, 2002, Steve Cotton, our former CFO and COO, filed a complaint entitled Cotton v. Lantronix, Inc., et al., No. 02CC14308, in the Superior Court of the State of California, County of Orange. The complaint alleges claims for breach of contract, breach of the covenant of good faith and fair dealing, wrongful termination, misrepresentation, and defamation. The complaint seeks unspecified damages, declaratory relief, attorneys’ fees and costs. Discovery has not commenced and no trial date has been established.
 

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Other
 
From time to time, we are subject to other legal proceedings and claims in the ordinary course of business. We currently are not aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business, prospects, financial position, operating results or cash flows.
 
Although we believe that the claims or any litigation arising therefrom will have no material impact on our business, all of the above matters are in either the pleading stage or the discovery stage, and we cannot predict their outcomes with certainty.
 
ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
Not applicable.

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PART II
 
ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
Price Range of Common Stock
 
Our common stock has been traded on The Nasdaq National Market under the symbol “LTRX” since August 4, 2000. We intend to apply to transfer the listing of our Common Stock to The Nasdaq SmallCap Market. Moreover, there is a risk that we will not meet the listing requirements for either The Nasdaq National Market or The Nasdaq SmallCap Market. See “Risk Factors—Our Common Stock May be Delisted.” The number of holders of our common stock as of September 27, 2002 was approximately 3,100. The following table sets forth, for the period indicated, the high and low per share closing prices for our common stock:
 
Fiscal Year 2001

  
High

    
Low

First Quarter
  
$
10.75
    
$
6.75
Second Quarter
  
$
8.75
    
$
4.69
Third Quarter
  
$
9.25
    
$
4.50
Fourth Quarter
  
$
10.30
    
$
5.06
 
Fiscal Year 2002

  
High

    
Low

First Quarter
  
$
10.20
    
$
5.57
Second Quarter
  
$
6.45
    
$
4.85
Third Quarter
  
$
6.93
    
$
2.02
Fourth Quarter
  
$
2.85
    
$
0.68
 
We believe that a number of factors including, but not limited to quarterly fluctuations in results of operations may cause the market price of our common stock to fluctuate significantly. See “Management’s Discussion and Analysis—Risk Factors.”
 
Dividend Policy
 
We have never declared or paid cash dividends on our common stock. We do not anticipate paying any cash dividends on our common stock in the foreseeable future, and we intend to retain any future earnings for use in the expansion of our business and for general corporate purposes. Pursuant to a two-year line of credit we entered into in January 2002, we are restricted from paying any dividends.
 
Recent Sales of Unregistered Securities
 
We have issued and sold the following unregistered securities since July 1, 2001:
 
In October 2001, we issued an aggregate of 2,234,715 shares of our common stock to the former stockholders of Synergetic in connection with our purchase of the capital stock of Synergetic.
 
In January 2002, we issued an aggregate of 1,063,371 shares of our common stock to the former stockholders of Premise in connection with our purchase of the capital stock of Premise.
 
The sales of the above securities were deemed to be exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act or, with respect to issuances to employees and consultants, Rule 701 promulgated under Section 3(b) of the Securities Act as transactions by an issuer not involving a public offering or transactions pursuant to compensatory benefit plans and contracts relating to compensation as provided under such Rule 701. All recipients either received adequate information about Lantronix or had adequate access to, through their relationships with Lantronix, such information. There were no underwritten offerings employed in connection with any of the transactions set forth above.

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ITEM 6.    SELECTED CONSOLIDATED FINANCIAL DATA
 
The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included below, including the information included under “Accounting Change and Restatement of Financial Statements.” The consolidated statements of operations data for the years ended June 30, 2002, 2001 and 2000 and the balance sheet data as of June 30, 2002 and 2001, are derived from the audited consolidated financial statements included elsewhere in this report. The consolidated statements of operations data for the years ended June 30, 1999 and 1998, and the balance sheet data as of June 30, 2000, 1999 and 1998, are derived from the audited consolidated financial statements not included elsewhere in this report. The historical results are not necessarily indicative of results to be expected for future periods.
 
    
Year ended June 30,

 
    
2002

    
2001

    
2000

    
1999

    
1998

 
    
(in thousands, except per share data)
 
Consolidated Statement of Operations Data:
                                            
Net revenues
  
$
57,646
 
  
$
48,972
 
  
$
44,975
 
  
$
32,980
 
  
$
28,300
 
Cost of revenues
  
 
40,510
 
  
 
24,530
 
  
 
21,526
 
  
 
16,824
 
  
 
16,812
 
    


  


  


  


  


Gross profit
  
 
17,136
 
  
 
24,442
 
  
 
23,449
 
  
 
16,156
 
  
 
11,488
 
    


  


  


  


  


Operating expenses:
                                            
Selling, general and administrative
  
 
43,487
 
  
 
23,998
 
  
 
16,744
 
  
 
9,173
 
  
 
7,857
 
Research and development
  
 
9,225
 
  
 
4,478
 
  
 
3,186
 
  
 
2,615
 
  
 
1,770
 
Stock-based compensation
  
 
2,863
 
  
 
3,019
 
  
 
1,093
 
  
 
—  
 
  
 
—  
 
Amortization of goodwill and purchased intangible assets
  
 
1,263
 
  
 
1,490
 
  
 
813
 
  
 
595
 
  
 
—  
 
Impairment of goodwill and purchased intangible assets
  
 
50,828
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
Restructuring charges
  
 
3,473
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
In-process research and development
  
 
1,000
 
  
 
2,596
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
    


  


  


  


  


Total operating expenses
  
 
112,139
 
  
 
35,581
 
  
 
21,836
 
  
 
12,383
 
  
 
9,627
 
    


  


  


  


  


Income (loss) from operations
  
 
(95,003
)
  
 
(11,139
)
  
 
1,613
 
  
 
3,773
 
  
 
1,861
 
Minority interest
  
 
—  
 
  
 
—  
 
  
 
(49
)
  
 
(30
)
  
 
—  
 
Interest income (expense), net
  
 
1,546
 
  
 
2,182
 
  
 
187
 
  
 
151
 
  
 
(5
)
Other income (expense), net
  
 
(760
)
  
 
(167
)
  
 
(47
)
  
 
(10
)
  
 
1
 
    


  


  


  


  


Income (loss) before income taxes and cumulative effect of accounting changes
  
 
(94,217
)
  
 
(9,124
)
  
 
1,704
 
  
 
3,884
 
  
 
1,857
 
Provision (benefit) for income taxes
  
 
(6,665
)
  
 
(1,876
)
  
 
649
 
  
 
1,098
 
  
 
554
 
    


  


  


  


  


Income (loss) before cumulative effect of accounting changes
  
 
(87,552
)
  
 
(7,248
)
  
 
1,055
 
  
 
2,786
 
  
 
1,303
 
Cumulative effect of accounting changes:
                                            
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(597
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
Adoption of new accounting standard, SFAS No. 142
  
 
(5,905
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
    


  


  


  


  


Net income (loss)
  
$
(93,457
)
  
$
(7,845
)
  
$
1,055
 
  
$
2,786
 
  
$
1,303
 
    


  


  


  


  


Basic income (loss) per share before cumulative effect of accounting changes
  
$
(1.70
)
  
$
(0.19
)
  
$
0.04
 
  
$
0.10
 
  
$
0.05
 
Cumulative effect of accounting changes per share:
                                            
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(0.02
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
Adoption of new accounting standard, SFAS No. 142
  
 
(0.12
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
    


  


  


  


  


Basic net income (loss) per share
  
$
(1.82
)
  
$
(0.21
)
  
$
0.04
 
  
$
0.10
 
  
$
0.05
 
    


  


  


  


  


Diluted income (loss) per share before cumulative effect of accounting changes
  
$
(1.70
)
  
$
(0.19
)
  
$
0.03
 
  
$
0.10
 
  
$
0.05
 
Cumulative effect of accounting changes per share:
                                            
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(0.02
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
Adoption of new accounting standard, SFAS No. 142
  
 
(0.12
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
    


  


  


  


  


Diluted net income (loss) per share
  
$
(1.82
)
  
$
(0.21
)
  
$
0.03
 
  
$
0.10
 
  
$
0.05
 
    


  


  


  


  


Weighted average shares (basic)
  
 
51,403
 
  
 
36,946
 
  
 
29,274
 
  
 
26,977
 
  
 
25,207
 
    


  


  


  


  


Weighted average shares (diluted)
  
 
51,403
 
  
 
36,946
 
  
 
34,178
 
  
 
28,880
 
  
 
25,443
 
    


  


  


  


  


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As of June 30,

    
2002

    
2001

  
2000

  
1999

  
1998

Consolidated Balance Sheet Data:
                                    
Cash and cash equivalents
  
$
26,491
 
  
$
15,367
  
$
1,988
  
$
5,833
  
$
1,759
Short-term investments
  
 
6,963
 
  
 
1,973
  
 
—  
  
 
—  
  
 
—  
Working capital
  
 
45,423
 
  
 
36,963
  
 
11,042
  
 
8,109
  
 
6,327
Goodwill, net
  
 
13,811
 
  
 
42,273
  
 
—  
  
 
—  
  
 
—  
Purchased intangible assets, net
  
 
14,681
 
  
 
13,328
  
 
586
  
 
1,399
  
 
—  
Total assets
  
 
103,812
 
  
 
116,861
  
 
20,210
  
 
17,292
  
 
9,800
Retained earnings (accumulated deficit)
  
 
(92,875
)
  
 
582
  
 
8,427
  
 
7,372
  
 
4,586
Total stockholders’ equity
  
 
82,157
 
  
 
99,496
  
 
12,547
  
 
10,312
  
 
6,928
 
ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. In addition to historical information, the discussion in this report contains forward-looking statements that involve risks and uncertainties. Actual results could differ materially from those anticipated by these forward-looking statements due to factors including, but not limited to, those factors set forth under “Risk Factors” and elsewhere in this report.
 
We have previously restated our consolidated financial statements for our fiscal year ended June 30, 2001. To the extent the following discussion and analysis refers to data from our consolidated financial statements for such period, such references are to the data as restated.
 
Accounting Change and Restatement of Financial Statements
 
In May 2002, we undertook a special investigation of our accounting, which revealed that beginning in the third and fourth quarters of fiscal 2001 certain shipments made to distributors and recorded as revenues in fiscal 2001 and 2002 did not qualify for revenue recognition upon shipment due to terms present in agreements with the distributors that were not considered in our original accounting decisions. Our consolidated financial statements included our previously filed Form 10-K/A (Amendment No. 1) for the year ended June 30, 2001 have been restated to change as of July 1, 2000 the accounting policy for recognizing revenue from sales to distributors. Formerly, revenue from sales to distributors was recognized upon shipment, but in some cases during fiscal 2001 this resulted in improper revenue recognition because we granted product return privileges, extended payment terms or other rights to certain distributors in connection with specific shipments that either converted such transactions into what in substance were consignment arrangements or precluded us from using our historical experience in product sales to make a reasonable estimate of future product returns at the time of shipment.
 
Under the newly adopted accounting policy, revenue from sales to distributors is not recognized until the distributor sells our products to end user customers. This manner of correcting the errors in sales recognition made in the previously issued financial statements for fiscal 2001 is deemed to be preferable in the circumstances because (1) it eliminates from revenue any effect of shipping excessive levels of inventory to the distributors; (2) all revenue from distributor sales in fiscal 2001 and thereafter will be recognized on a common basis; and (3) there is assurance that any additional agreements with distributors that may have existed with respect to specific orders but are presently unknown will not have an impact on amounts reported as revenue after the restatement.
 
The restatement for the year ended June 30, 2001 resulted in a reduction in revenue of approximately $6.2 million and an increase in the loss before cumulative effect of accounting change of $2.9 million or $0.07 per share. The cumulative effect of the accounting change recorded as of July 1, 2000 was a charge of $597,000 (net of income taxes of $176,000) or $0.02 per share.

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Under the leadership of new management, we are actively working to strengthen our policies, procedures, personnel, controls and internal communications in response to the circumstances that led to the restatement.
 
Overview
 
Lantronix designs, develops and markets products and software solutions that make it possible to access, manage, control and configure almost any electronic device over the Internet or other networks. We are a leader in providing innovative networking solutions. We were initially formed as “Lantronix,” a California corporation, in June 1989. We reincorporated as “Lantronix, Inc.,” a Delaware corporation in May 2000.
 
We have a history of providing devices that enable information technology (IT) equipment to network using standard protocols for connectivity, including fiber optic, Ethernet and wireless. Our first product was a terminal server that allowed “dumb” terminals to connect to a network. Building on the success of our terminal servers, we introduced a complete line of print servers in 1991 that enabled users to inexpensively share printers over a network. Over the years, we have continually refined our core technology and have developed additional innovative networking solutions that expand upon the business of providing our customers network connectivity. We provide three broad categories of products: “device servers,” that enable almost any electronic device to be connected to a network; “multiport device solutions,” that enable multiple devices—usually network computing devices such as servers, routers, switches, and similar equipment to be managed over a network; and software—software that is either embedded in the hardware devices that are mentioned above, or stand-alone application software.
 
Today, our solutions include fully integrated hardware and software products, as well as software tools to develop related customer applications. Because we deal with network connectivity, we have provided products to extremely broad market segments, including industrial, medical, commercial, financial, governmental, retail, building and home automation, and many more. Our technology is used with devices such as networking routers, medical instruments, manufacturing equipment, bar code scanners, building HVAC systems, elevators, process control equipment, vending machines, thermostats, security cameras, temperature sensors, card readers, point of sale terminals, time clocks, and virtually any device that has some form of standard data control capability. Our current product offerings include a wide range of hardware devices of varying size, packaging and, where appropriate, software solutions that allow our customers to network-enable virtually any electronic device.
 
Our products are sold to OEMs, VARs, systems integrators and distributors, as well as directly to end-users. One customer accounted for approximately 12%, 14% and 13% of our net revenues for the years ended June 30, 2002, 2001 and 2000, respectively. Another customer accounted for approximately 11%, 10% and 12% of our net revenues for the years ended June 30, 2002, 2001 and 2000, respectively. Accounts receivable attributable to these two domestic customers accounted for approximately 21% and 31% of total accounts receivable at June 30, 2002 and 2001, respectively.
 
One international customer, transtec AG, which is a related party due to common ownership by our largest stockholder and former Chairman of our Board of Directors, Bernhard Bruscha, accounted for approximately 5%, 9% and 7% of our net revenues for the years ended June 30, 2002, 2001 and 2000, respectively. Included in the accompanying consolidated balance sheets are approximately $246,000 and $787,000 due to this related party at June 30, 2002 and 2001, respectively. We also have an agreement with transtec AG for the provision of technical support services at the rate of $7,500 per month. Included in selling, general and administrative expenses is $90,000 for each of the three years in the period ended June 30, 2002 for these support services.
 
In July 2001, we completed a public offering of 8,534,000 shares of our common stock, including an underwriter’s over-allotment option to purchase an additional 534,000 shares, at an offering price of $8.00 per share. We sold 6,000,000 shares and selling shareholders sold 2,000,000 shares of the primary offering. Additionally, we sold 400,500 shares and selling stockholders sold 133,500 shares of the over-allotment option. We received net proceeds of approximately $47.1 million in connection with this offering.

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We have completed a number of acquisitions and investments since our initial public offering in August 2000, the purpose of which is to expand our product offerings, increase our technology base and provide a foundation for future growth.
 
In December 2000, we completed the acquisition of USSC, a developer of a software operating system, protocol stacks and an application development environment for embedded technology. The total purchase price consisted of $2.5 million in cash and 653,846 shares of our common stock. In addition, we assumed existing employee stock and issued new options to acquire 133,333 shares of our common stock at a weighted average exercise price of $1.00 per share. USSC provides an open standards-based operating system and supports a variety of processors. USSC technology enables us to sell products directly to OEMs, systems integrators and other users who already have existing network connectivity devices but lack the key elements to provide system management solutions. We believe the acquisition of USSC helps expand our product offering and enables us to provide USSC and our customers’ customers with an integrated software and hardware embedded solution.
 
In June 2001, we completed the acquisition of Lightwave, a developer of multiport device solutions. The purchase price included 3,428,571 shares of our common stock and $12.0 million in cash. In addition, we assumed options issued to employees and issued options to acquire 870,513 shares of our common stock at a weighted average exercise price of $3.67 per share. We also paid off approximately $6.7 million of debt to a creditor of Lightwave. Recently, we paid $2.0 million to the former stockholders of Lightwave in connection with the termination of a registration rights agreement entered into pursuant to this acquisition. Lightwave develops and markets a variety of console management products including keyboard, video and mouse, or KVM, switches and multiport device solutions. The Lightwave KVM switch allows a single keyboard, monitor and mouse to be switched among multiple workstations providing immediate access to each workstation from a single location. Lightwave multiport device solutions allow remote access to a variety of equipment that often exists in a redundant scheme, including workstations, servers and networking equipment, as if the user were physically at the remote site where the equipment is aggregated. The benefits of the Lightwave products include reduced costs to access, manage and upgrade remote equipment through a secure and fail-safe networked system.
 
In October 2001, we completed the acquisition of Synergetic, a provider of high performance embedded network communication solutions that complement our external device products. In connection with the acquisition, we paid cash consideration of $2.7 million and issued an aggregate of 2,234,715 shares of our common stock in exchange for all outstanding shares of Synergetic common stock and reserved 615,705 additional shares of common stock for issuance upon exercise of outstanding employee stock options and other rights of Synergetic. Portions of the cash consideration and shares issued are held in escrow pursuant to the terms of the acquisition agreement.
 
In January 2002, we completed the acquisition of Premise, a developer of client-side software applications that complement our device networking products by providing superior management and control capabilities for devices that have been network and internet enabled. Prior to the acquisition, we held shares of Premise representing 19.9% ownership and, in addition, held convertible promissory notes of $1.2 million with interest accrued there-on at the rate of 9.0%. The convertible promissory notes were converted into equity securities of Premise at the closing of the transaction. We issued an aggregate of 1,063,371 shares of our common stock in exchange for all remaining outstanding shares of Premise common stock and reserved 875,000 additional shares of common stock for issuance upon exercise of outstanding employee stock options and other rights of Premise. Pursuant to the acquisition agreement, 106,337 shares are held in escrow to secure certain indemnification obligations, and 531,686 of such shares are held in escrow pending achievement of certain performance obligations. In connection with the acquisition, we recorded a one-time charge for purchased in-process research and development expenses of $1.0 million in our fourth fiscal quarter ended June 30, 2002.
 
In August 2002, we completed the acquisition of Stallion, a provider of terminal servers and multiport products. In connection with the acquisition, we paid $867,000 in cash consideration, of which $200,000 was paid upon the execution of the Letter of Intent dated May 9, 2002, issued an aggregate of 866,667 shares of our

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common stock, based upon the fair market value of our common stock at June 14, 2002, and issued a two-year note of $867,000 convertible into our common stock at a $5.00 conversion price. In accordance with the acquisition agreement, we established a cash escrow account in the amount of $867,000 at the acquisition date to be used in lieu of our common stock in the event such securities are not freely traded.
 
In September and October 2001, we made a strategic investment in Xanboo, a privately-held company, that develops technology that allows users to control, command and view their home or business remotely over the Internet. We paid an aggregate of $3.0 million for convertible promissory notes, which converted in January 2002, in accordance with their terms, into Xanboo preferred stock. In addition, we purchased $4.0 million of Xanboo preferred stock in January 2002. Our ownership interest in Xanboo was 15.8% at June 30, 2002. Our investment in Xanboo is accounted for using the equity method of accounting based on our ability through representation on Xanboo’s board of directors to exercise significant influence over its operations. Our losses in Xanboo aggregating $526,000 for the year ended June 20, 2002 have been recognized as other expense in the accompanying consolidated statement of operations.
 
Stock-based compensation relates to deferred compensation recorded in connection with the grant of stock options to employees where the option exercise price is less than the estimated fair value of the underlying shares of common stock as determined for financial reporting purposes as well as the fair market value of the vested portion of non-employee stock options utilizing the Black-Scholes option pricing model. Deferred compensation also includes the value of employee stock options assumed in connection with the acquisitions of USSC, Lightwave and Synergetic calculated in accordance with current accounting guidelines. Deferred compensation is presented as a reduction to stockholders’ equity and is amortized over the vesting period of the related stock options, which is generally four years. At June 30, 2002, a balance of $4.5 million remains and will be amortized as follows: $2.0 million in fiscal 2003, $1.6 million in fiscal 2004, $857,000 in fiscal 2005 and $17,000 in fiscal 2006. The amount of stock-based compensation in future periods will increase if we grant stock options where the exercise price is less than the quoted market price of the underlying shares. The amount of stock-based compensation actually recognized in future periods could decrease if options for which deferred compensation has been recorded are forfeited.
 
Critical Accounting Policies and Estimates
 
The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenues and expenses during the reporting period. We regularly evaluate our estimates and assumptions related to net revenues, allowances for doubtful accounts, sales returns and allowances, inventory reserves, goodwill and purchased intangible asset valuations, warranty reserves, restructuring costs, litigation and other contingencies. We base our estimates and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected.
 
We believe the following critical accounting policies require us to make significant judgments and estimates in the preparation of our consolidated financial statements:
 
Revenue Recognition
 
We do not recognize revenue until all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; our price to the buyer is fixed or determinable; and collectibility is reasonably assured. Commencing July 1, 2000, recognition of revenue and related gross profit from sales to distributors are deferred until the distributor resells the product to provide

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assurance that all revenue recognition criteria are met at or prior to the point at which revenue is recognized. Net revenue from certain smaller distributors for which point-of-sale information is not available, is recognized one month after the shipment date. This estimate approximates the timing of the sale of the product by the distributor to the end user. Revenues from product sales to OEMs, end-user customers, other resellers and from sales to distributors prior to July 1, 2000 generally are or have been recognized upon product shipment, but may be deferred to a later date if all revenue recognition criteria are not met at the date of shipment. When product sales revenue is recognized, we establish an estimated allowance for future product returns based on historical returns experience; when price reductions are approved, we establish an estimated liability for price protection payable on inventories owned by product resellers. Should actual product returns or pricing adjustments exceed our estimates, additional reductions to revenues would result. Revenue from the licensing of software is recognized at the time of shipment (or at the time of resale in the case of software products sold through distributors), provided we have vendor-specific objective evidence of the fair value of each element of the software offering and collectibility is probable. Revenue from post-contract customer support and any other future deliverables is deferred and recognized over the support period or as contract elements are delivered. Our products typically carry a ninety day to five year warranty. Although we engage in extensive product quality programs and processes, our warranty obligation is affected by product failure rates, use of materials or service delivery costs that differ from our estimates. As a result, additional warranty reserves could be required, which could reduce gross margins. Prior to July 1, 2000, the effective date of the change in accounting method for recognizing revenue for sales to distributors, we recorded an estimated allowance for future product returns for sales to distributors based on historical returns experience when the related revenue was recorded and provided for appropriate price protection reserves when pricing adjustments were approved. As indicated above, recognition of revenue and related gross profit on sales to distributors is now deferred until the distributor resells the product.
 
Allowance for Doubtful Accounts
 
We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Our allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts, the aging of accounts receivable, our history of bad debts and the general condition of the industry. If a major customer’s credit worthiness deteriorates, or our customers’ actual defaults exceed our historical experience, our estimates could change and impact our reported results.
 
Inventory Valuation
 
Our policy is to value inventories at the lower of cost or market on a part-by-part basis. This policy requires us to make estimates regarding the market value of our inventories, including an assessment of excess and obsolete inventories. We determine excess and obsolete inventories based on an estimate of the future sales demand for our products within a specified time horizon, generally twelve months. The estimates we use for demand are also used for near-term capacity planning and inventory purchasing and are consistent with our revenue forecasts.
 
If our sales forecast is less than the inventory we have on hand at the end of an accounting period, we may be required to take excess and obsolete inventory charges which will decrease gross margin and net operating results for that period.
 
Valuation of Deferred Income Taxes
 
We have recorded a valuation allowance to reduce our net deferred tax assets to zero, primarily due to our inability to estimate future taxable income. We consider estimated future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. If we determine that it is more likely than not that we will realize a deferred tax asset, which currently has a valuation allowance, we would be required to reverse the valuation allowance which would be reflected as an income tax benefit at that time.

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Goodwill and Purchased Intangible Assets
 
The purchase method of accounting for acquisitions requires extensive use of accounting estimates and judgments to allocate the purchase price to the fair value of the net tangible and intangible assets acquired, including IPR&D. Goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are subject to annual impairment tests. The amounts and useful lives assigned to intangible assets impact future amortization and the amount assigned to in-process research and development (IPR&D) is expensed immediately. If the assumptions and estimates used to allocate the purchase price are not correct, purchase price adjustments or future asset impairment charges could be required.
 
Impairment of Long-Lived Assets
 
We evaluate long-lived assets used in operations when indicators of impairment, such as reductions in demand or significant economic slowdowns, are present. Reviews are performed to determine whether the carrying values of assets are impaired based on comparison to the undiscounted expected future cash flows. If the comparison indicates that there is impairment, the expected future cash flows using a discount rate based upon our weighted average cost of capital is used to estimate the fair value of the assets. Impairment is based on the excess of the carrying amount over the fair value of those assets. Significant management judgment is required in the forecast of future operating results that is used in the preparation of expected discounted cash flows. It is reasonably possible that the estimates of anticipated future net revenue, the remaining estimated economic lives of the products and technologies, or both, could differ from those used to assess the recoverability of these assets. In that event, additional impairment charges or shortened useful lives of certain long-lived assets could be required.
 
Impact of Adoption of New Accounting Standards
 
In June 2001, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” (“SFAS No. 141”), effective for acquisitions consummated after June 30, 2001, and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and certain intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests. Other intangible assets will continue to be amortized over their useful lives.
 
We have elected to early adopt the rules set forth in SFAS No. 142 on accounting for goodwill and other intangibles effective as of July 1, 2001. For the year ended June 30, 2002, early adoption resulted in non-amortization of goodwill of $9.1 million or $0.18 per share based on the weighted average shares outstanding.
 
The following table presents the impact of SFAS No. 142 on net loss and net loss per share had SFAS No. 142 been in effect for the years ended June 30 (in thousands, except per share data):
 
    
2001

    
2000

Net income (loss) as reported
  
$
(7,845
)
  
$
1,055
Adjustments:
               
Amortization of goodwill
  
 
752
 
  
 
60
    


  

Net adjustments
  
 
752
 
  
 
60
    


  

Net income (loss) as adjusted
  
$
(7,093
)
  
$
1,115
    


  

Basic net income (loss) per share—as reported
  
$
(0.21
)
  
$
0.04
    


  

Basic net income (loss) per share—as adjusted
  
$
(0.19
)
  
$
0.03
    


  

Diluted net income (loss) per share—as reported
  
$
(0.21
)
  
$
0.03
    


  

Diluted net income (loss) per share—as adjusted
  
$
(0.19
)
  
$
0.03
    


  

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Impairment of goodwill and purchased intangible assets
 
Under the transitional provisions of SFAS No. 142, effective as of July 1, 2002, we completed our initial assessment and concluded that goodwill arising from the acquisition of USSC having a carrying amount of approximately $5.9 million as of July 1, 2001 may be impaired. We engaged an independent valuation service to perform a review of the value of our goodwill related to USSC. Based on the independent valuation, which utilized a discounted cash flow valuation technique, we recorded a $5.9 million charge for the impairment of our USSC goodwill. This amount is reflected as the cumulative effect of adopting the new accounting standard effective July 1, 2001.
 
We performed the first of the required annual impairment tests of goodwill under the guidelines of SFAS No. 142 effective as of June 1, 2002. As a result of industry conditions, lower market valuations and reduced estimates of information technology capital equipment spending in the future, we determined that there were indicators of impairment to the carrying value of goodwill related to the acquisitions of Lightwave and Synergetic which had carrying values of $39.7 million and $13.9 million, respectively, as of June 1, 2002. During the fourth quarter of fiscal 2002, we engaged an independent valuation service to perform a review of the value of our goodwill and based on the independent valuation we recorded a $46.4 million impairment charge of our goodwill of which $32.5 million related to Lightwave and $13.9 million related to Synergetic.
 
Additionally, during the fourth quarter of 2002, we performed a review of the value of our purchased intangible assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS No. 144”) which supercedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (“SFAS No. 121”) and the accounting and reporting provisions of Accounting Principles Board Opinion No. 30, “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” This statement retains certain requirements of SFAS No. 121 relating to the recognition and measurement of impairment of long-lived assets to be held and used. Additionally, this statement results in one accounting model, based on the framework established in SFAS No. 121, for long-lived assets to be disposed of by sales and also addresses certain implementation issues related to SFAS No. 121, including the removal of goodwill from its scope due to the issuance of SFAS No. 142. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. We have elected to early adopt the provisions of SFAS No. 144 effective as of July 1, 2001.
 
As a result of industry conditions, lower market valuations and reduced estimates of information technology capital equipment spending in the future, we determined that there were indicators of impairment to the carrying value of our purchased intangible assets related to our acquisitions. During the fourth quarter of fiscal 2002, we engaged an independent valuation company to perform a review of the value of our purchased intangible assets and based on the independent valuation we recorded a $10.2 million impairment charge of which $969,000, $764,000, $7.6 million and $849,000 related to USSC, Lightwave, Synergetic and Premise, respectively. Additionally, we recorded an impairment charge of $665,000 related to intellectual property not associated with an acquisition.

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Consolidated Results of Operations
 
The following table sets forth, for the periods indicated, the percentage of net revenues represented by each item in our consolidated statements of operations:
 
    
Year ended June 30,

 
    
2002

    
2001

    
2000

 
Net revenues
  
100.0
%
  
100.0
%
  
100.0
%
Cost of revenues
  
70.3
 
  
50.1
 
  
47.9
 
    

  

  

Gross profit
  
29.7
 
  
49.9
 
  
52.1
 
    

  

  

Operating expenses:
                    
Selling, general and administrative
  
75.4
 
  
49.0
 
  
37.2
 
Research and development
  
16.0
 
  
9.1
 
  
7.1
 
Stock-based compensation
  
5.0
 
  
6.2
 
  
2.4
 
Amortization of goodwill and purchased intangible assets
  
2.2
 
  
3.0
 
  
1.8
 
Impairment of goodwill and purchased intangible assets
  
88.2
 
  
 
  
 
Restructuring charges
  
6.0
 
  
 
  
 
In-process research and development
  
1.7
 
  
5.3
 
  
 
    

  

  

Total operating expenses
  
194.5
 
  
72.6
 
  
48.5
 
    

  

  

Income (loss) from operations
  
(164.8
)
  
(22.7
)
  
3.6
 
Minority interest
  
 
  
 
  
(0.1
)
Interest income (expense), net
  
2.7
 
  
4.4
 
  
0.4
 
Other income (expense), net
  
(1.3
)
  
(0.3
)
  
(0.2
)
    

  

  

Income (loss) before income taxes and cumulative effect of accounting changes
  
(163.4
)
  
(18.6
)
  
3.7
 
Provision (benefit) for income taxes
  
(11.6
)
  
(3.8
)
  
1.4
 
    

  

  

Income (loss) before cumulative effect of accounting changes
  
(151.9
)
  
(14.8
)
  
2.3
 
Cumulative effect of accounting changes:
                    
Change in revenue recognition policy, net of income tax benefit of $176
  
 
  
(1.2
)
  
 
Adoption of new accounting standard, SFAS No. 142
  
(10.2
)
  
 
  
 
    

  

  

Net income (loss)
  
(162.1
)%
  
(16.0
)%
  
2.3
%
    

  

  

 
Comparison of the Years Ended June 30, 2002 and 2001
 
Net Revenues
 
Net revenues increased $8.7 million, or 17.7%, to $57.6 million for the year ended June 30, 2002 from $49.0 million for the year ended June 30, 2001. The increase was primarily attributable to an increase in net revenues of our multiport device solutions products, partially offset by a decline in our device server and our print server and other products. Device server net revenues decreased $428,000, or 1.3%, to $31.4 million or 54.4% of net revenues for the year ended June 30, 2002 from $31.8 million or 64.9% of net revenues for the year ended June 30, 2001. This slight decrease is attributable to increased competitive pricing pressure and the current economic slowdown. Device server net revenues for the years ended June 30, 2002 and 2001 includes $1.4 million and $1.5 million of software revenue generated from USSC, respectively. Multiport device solutions net revenues increased $9.9 million, or 71.7%, to $23.9 million or 41.6% of net revenues for the year ended June 30, 2002 from $14.0 million or 28.6% of net revenues for the year ended June 30, 2001. The increase in multiport device solutions net revenue is primarily attributable to the acquisition of Lightwave which offset reductions in older multiport devices as IT purchases declined industry-wide. Fiscal year 2002 was the first full year of inclusion of Lightwave revenues, whereas fiscal 2001 included one month of Lightwave revenues.

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Net revenues generated from sales in the Americas increased $14.6 million, or 44.1%, to $47.7 million or 82.8% of net revenues for the year ended June 30, 2002 from $33.1 million or 67.6% of net revenues for the year ended June 30, 2001. Our net revenues derived from customers located in Europe decreased $5.7 million, or 40.8%, to $8.2 million or 14.3% of net revenues for the year ended June 30, 2002 from $13.9 million or 28.4% of net revenues for the year ended June 30, 2001. Our net revenues derived from customers located in other geographic areas decreased slightly to $1.7 million or 2.9% of net revenues for the year ended June 30, 2002 from $1.9 million or 3.9% of net revenues for the year ended June 30, 2001.
 
Gross Profit
 
Gross profit represents net revenues less cost of revenues. Cost of revenues consists primarily of the cost of raw material components, subcontracted labor assembly from contract manufacturers and associated overhead costs. As part of an agreement with Gordian, an outside research and development firm, a royalty charge was included in cost of revenues and was calculated based on the related products sold. Gordian royalties were $1.2 million and $2.2 million for the years ended June 30, 2002 and 2001, respectively. Additionally, cost of revenues for the years ended June 30, 2002 and 2001 consisted of $2.4 million and $220,000, respectively of non-cash amortization of purchased intangible assets. Cost of revenues for the year ended June 30, 2002 also includes a $6.4 million impairment charge of purchased intangible assets in accordance with SFAS No. 144. No similar charge was recorded for the year ended June 30, 2001.
 
Gross profit decreased by $7.3 million, or 29.9%, to $17.1 million or 29.7% of net revenues for the year ended June 30, 2002 from $24.4 million or 49.9% of net revenues for the year ended June 30, 2001. The decrease in gross profit in absolute dollars and as a percentage of net revenues is primarily attributable to the $6.4 million impairment charge and $2.4 million of non-cash amortization of purchased intangible assets and the increase in our inventory reserve of $3.3 million. We also used volume pricing agreements and competitive pricing strategies, which, to a lesser degree, contributed to the decrease in gross profit.
 
In May 2002, we signed a new agreement with Gordian to acquire a joint interest in the intellectual property that is evident in products designed by Gordian and to extinguish our obligation to pay royalties on future sales of our products. We agreed to pay $6.0 million for this intellectual property and will amortize this asset to cost of sales over the remaining life cycles of our products designed by Gordian, or approximately 3 years. Effective May 30, 2002, upon the signing of the agreement, royalty expenses will be replaced by an amortization of the prepaid royalties and entitlement to the intellectual property that was part of the agreement. Amortization expense related to the Gordian agreement totaled $212,000 for the year ended June 30, 2002.
 
Selling, General and Administrative
 
Selling, general and administrative expenses consist primarily of personnel-related expenses including salaries and commissions, facilities expenses, information technology expenses, trade show expenses, advertising, and professional fees. Selling, general and administrative expenses increased $19.5 million, or 81.2%, to $43.5 million or 75.4% of net revenues for the year ended June 30, 2002 from $24.0 million or 49.0% of net revenues for the year ended June 30, 2001. Selling, general and administrative expense increased primarily due to increased legal and other professional fees, increased allowance for doubtful accounts primarily related to Lightwave receivables, an allowance related to our officer loans, bonuses paid to our former executive officers, increased personnel-related costs and facilities costs from the acquisitions of USSC, Lightwave, Synergetic and Premise. We expect selling, general and administrative expenses in absolute dollars will decrease in the future as a result of our restructuring plans, and decrease as a percentage of net revenues.
 
Research and Development
 
Research and development expenses consist primarily of salaries and the related costs of employees, as well as expenditures to third-party vendors for research and development activities. Research and development

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expenses increased $4.7 million, or 106.0%, to $9.2 million or 16.0% of net revenues for the year ended June 30, 2002, from $4.5 million or 9.1% of net revenues for the year ended June 30, 2001. This increase resulted primarily from increased personnel-related costs due to the acquisitions of USSC, Lightwave, Synergetic and Premise, as well as hiring a senior engineering executive and expenses related to new product development.
 
Stock-based compensation
 
Stock-based compensation expense generally represents the amortization of deferred compensation. We recorded approximately $1.2 million of deferred compensation for the year ended June 30, 2002. Additionally, we recorded deferred compensation forfeitures of $3.1 million for the year ended June 30, 2002. Deferred compensation represents the difference between the fair value of the underlying common stock for accounting purposes and the exercise price of the stock options at the date of grant. Deferred compensation is presented as a reduction of stockholders’ equity and is amortized ratably over the respective vesting periods of the applicable options, which is generally four years. Included in cost of revenues is stock-based compensation of $117,000 and $87,000 for the years ended June 30, 2002 and 2001, respectively. Stock-based compensation expense decreased $156,000, or 5.2%, to $2.9 million or 5.0% of net revenues for the year ended June 30, 2002 from $3.0 million or 6.2% of net revenues for the year ended June 30, 2001. The decrease in stock-based compensation for the year ended June 30, 2002 is primarily attributable to the restructuring plan whereby options for which deferred compensation in the amount of $595,000 was charged to restructuring due to the fact that it was associated with the extension of the exercise period for stock options that were vested at the termination date. We expect to incur additional stock-based compensation expenses in future periods as a result of the continued amortization of deferred compensation.
 
Amortization of goodwill and purchased intangible assets
 
In connection with the two purchase transactions completed during fiscal 2001 and the two purchase transactions completed during fiscal 2002, we recorded approximately $13.6 million and $14.8 million, of identified purchased intangible assets, respectively. Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired in order to allocate the purchase price. We obtained independent appraisals of the fair value of tangible and intangible assets acquired in order to allocate the purchase price. Purchased intangible assets are amortized on a straight-line basis over the economic lives of the respective assets, generally two to five years. The amortization of goodwill and purchased intangible assets decreased $227,000 or 15.2%, to $1.3 million or 2.2% of net revenues for the year ended June 30, 2002 from $1.5 million or 3.0% of net revenues for the year ended June 30, 2001. In addition, approximately $2.4 million and $220,000 of amortization of purchased intangible assets has been classified as cost of revenues for the years ended June 30, 2002 and 2001, respectively. The increase in amortization of purchased intangible assets is due to the acquisitions of USSC and Lightwave completed in fiscal 2001 and Synergetic and Premise completed in fiscal 2002.
 
Restructuring charges
 
On February 6, 2002, we announced a restructuring plan to prioritize our initiatives around areas of our business that we believe represent high-growth opportunities, focus on profit contribution, reduce expenses, and improve operating efficiency. This restructuring plan includes a worldwide workforce reduction and consolidation of excess facilities and other charges. As of June 30, 2002, we recorded restructuring costs totaling $3.5 million, which are classified as operating expenses.
 
Through June 30, 2002, the February 6, 2002 restructuring plan had resulted in the reduction of approximately 50 regular employees worldwide. We recorded a worldwide workforce reduction charge of approximately $1.9 million related to severance and fringe benefits. Included in this amount is a stock-based compensation charge in the amount of $595,000 associated with the extension of the exercise period for stock

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options that were vested at the termination date. In addition, the number of temporary and contract workers employed by us was also reduced. Property and equipment that was disposed or removed from operations resulted in a charge of $1.6 million and consisted primarily of computer software and related equipment, production, engineering and office equipment and furniture and fixtures.
 
On September 12, 2002, we announced a restructuring plan to further prioritize our initiatives around the growth areas of our business, focus on profit contribution, reduce expenses, and improve operating efficiency. This restructuring plan includes a worldwide workforce reduction, consolidation of excess facilities and other charges. The restructuring plan will result in the reduction of approximately 50 regular employees worldwide. Property, equipment and other assets that will be disposed or removed from operations consists primarily of computer software, services and related equipment, production, office equipment and furniture and fixtures. The restructuring plan also will result in the closing of the Milford, Connecticut manufacturing operations, and Ames, Iowa and Singapore offices. This restructuring plan is expected to result in a charge of approximately $5.0 million which will be recorded during the first fiscal quarter ended September 30, 2002.
 
In-process research and development
 
IPR&D related to acquisitions aggregated $1.0 million and $2.6 million for the purchase transactions completed during fiscal 2002 and fiscal 2001, respectively. The amounts allocated to IPR&D were determined through established valuation techniques in the high-technology industry and were expensed upon acquisition as it was determined that the underlying projects had not reached technological feasibility and no alternative future uses existed.
 
The fair value of the IPR&D for each of the acquisitions was determined using the income approach. Under the income approach, the expected future cash flows from each project under development are estimated and discounted to their net present value at an appropriate risk-adjusted rate of return. Significant factors considered in the calculation of the rate of return are the weighted-average cost of capital and return on assets, as well as the risks inherent in the development process, including the likelihood of achieving technological success and market acceptance. Each project was analyzed to determine the unique technological innovations, the existence and reliance upon core technology, the existence of any alternative future use or current technological feasibility, and the complexity, cost and time to complete the remaining development. Future cash flows for each project were estimated based upon forecasted revenues and costs, taking into account product life cycles, and market penetration and growth rates.
 
The IPR&D charge includes only the fair market value of IPR&D performed to date. The fair value of completed technology is included in identifiable intangible assets, and the fair values of IPR&D to be completed and future research and development are included in goodwill. We believe the amounts recorded as IPR&D, as well as developed technology, represent fair values and approximate the amounts an independent party would pay for these projects.
 
As of the closing date of each purchase transaction, development projects were in process. Although the costs to bring the products from the acquired companies to technological feasibility are not expected to have a material impact on our future results of operations or financial condition, the development of these technologies remains a significant risk due to the remaining effort to achieve technical viability, rapidly changing customer markets, uncertain standards for new products and significant competitive threats from numerous companies. The nature of the efforts to develop the acquired technologies into commercially viable products consists principally of planning, designing and testing activities necessary to determine that the products can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in loss of market share or a lost opportunity to capitalize on emerging markets and could have a material and adverse impact on our business and operating results.

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Interest Income (Expense), Net
 
Interest income (expense), net consists primarily of interest earned on cash, cash equivalents and short-term and long-term investments. Interest income (expense), net was $1.5 million for the year ended June 30, 2002 and $2.2 million for the year ended June 30, 2001. The decrease is primarily due to lower average investment balances and interest rates for the year ended June 30, 2002.
 
Benefit for Income Taxes
 
We utilize the liability method of accounting for income taxes as set forth in FASB Statement No. 109, “Accounting for Income Taxes.” Our effective tax rate was 7% for the year ended June 30, 2002, and 21% for the year ended June 30, 2001. The federal statutory rate was 34% for both periods. Our effective tax rate associated with the income tax benefit for the year ended June 30, 2002, was lower than the federal statutory rate primarily due to nondeductible goodwill amortization and in-process research and development costs associated with current year acquisitions, change in the valuation allowance, as well as the amortization of stock-based compensation for which no current year tax benefit was provided. Our effective tax rate associated with the income tax benefit for the year ended June 30, 2001, was lower than the federal statutory rate primarily due to nondeductible goodwill amortization and in-process research and development costs associated with current year acquisitions, as well as the amortization of stock-based compensation for which no current year tax benefit was provided.
 
Comparison of the Years Ended June 30, 2001 and 2000
 
Net Revenues
 
Net revenues increased $4.0 million, or 8.9%, to $49.0 million for the year ended June 30, 2001 from $45.0 million for the year ended June 30, 2000. The increase was primarily attributable to an increase in net revenues of our device server and multiport device server products, partially offset by a decline in our print server and other products. Device server net revenues increased $7.6 million, or 31.2%, to $31.8 million or 64.9% of net revenues for the year ended June 30, 2001 from $24.2 million or 53.8% of net revenues for the year ended June 30, 2000. This increase is attributable to the rapid adoption rates of OEMs, as well as strong sales of our UDS-10 Device Server, which was introduced during the fourth quarter of fiscal 2000. Device server net revenues for the year ended June 30, 2001 includes $1.5 million of software revenue generated from USSC. Multiport device solutions net revenues increased $3.1 million, or 28.5%, to $14.0 million or 28.6% of net revenues for the year ended June 30, 2001 from $10.9 million or 24.3% of net revenues for the year ended June 30, 2000. The increase in multiport device solutions net revenue is primarily attributable to the acquisition of Lightwave effective June 8, 2001. Print Server and other revenues decreased $6.7 million, or 67.6%, to $3.2 million, or 6.5% of net revenues for the year ended June 30, 2001 from $9.9 million, or 21.9% of net revenues for the year ended June 30, 2000.
 
Net revenues generated from sales in the Americas increased $2.9 million, or 9.5%, to $33.1 million or 67.7% of net revenues for the year ended June 30, 2001 from $30.3 million or 67.3% of net revenues for the year ended June 30, 2000. Our net revenues derived from customers located in Europe increased $1.3 million, or 10.1%, to $13.9 million or 28.4% of net revenues for the year ended June 30, 2001 from $12.7 million or 28.2% of net revenues for the year ended June 30, 2000. Our net revenues derived from customers located in other geographic areas decreased slightly to $1.9 million or 3.9% of net revenues for the year ended June 30, 2001 from $2.0 million or 4.5% of net revenues for the year ended June 30, 2000.
 
Gross Profit
 
Gross profit represents net revenues less cost of revenues. Cost of revenues consists primarily of the cost of raw material components, subcontract labor assembly from outside manufacturers and associated overhead costs. As part of our agreement with Gordian, an outside research and development firm, a royalty charge was included

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in cost of revenues and was calculated based on the related products sold. Gross profit increased by $1.0 million, or 4.2%, to $24.4 million or 49.9% of net revenues for the year ended June 30, 2001 from $23.4 million or 52.1% of net revenues for the year ended June 30, 2000. Gordian royalties were $2.2 million for the years ended June 30, 2001 and 2000. The increase in gross profit was primarily attributable to increased sales volume of our device server product line and cost containment initiatives offset by a one-time inventory reserve charge related to the acquisition of Lightwave in the amount of $1.8 million and competitive pricing strategies.
 
Selling, General and Administrative
 
Selling, general and administrative expenses consist primarily of personnel-related expenses including salaries and commissions, facilities expenses, information technology, trade show expenses, advertising, and professional fees. Selling, general and administrative expenses increased $7.3 million, or 43.3%, to $24.0 million or 49.0% of net revenues for the year ended June 30, 2001 from $16.7 million or 37.2% of net revenues for the year ended June 30, 2000. This increase is due primarily to an increase in our sales force, including new offices in Europe and Asia and an increase in marketing and advertising expenses to increase brand awareness.
 
Research and Development
 
Research and development expenses consist primarily of salaries and the related costs of employees, as well as expenditures to third-party vendors for research and development activities. Research and development expenses increased $1.3 million, or 40.6%, to $4.5 million or 9.1% of net revenues for the year ended June 30, 2001, from $3.2 million or 7.1% of net revenues for the year ended June 30, 2000. This increase resulted primarily from increased headcount, expenses related to new product development and the acquisitions of USSC and Lightwave.
 
Stock-based compensation
 
Stock-based compensation generally represents the amortization of deferred compensation. We recorded approximately $4.2 million and $10.1 million of deferred compensation in fiscal 2001 and 2000, respectively. Stock-based compensation charged to operating expenses increased $1.9 million, or 176.2%, to $3.0 million or 6.2% of net revenues for the year ended June 30, 2001 from $1.1 million or 2.4% of net revenues for the year ended June 30, 2000. Additionally, cost of revenues includes stock-based compensation of $87,000 and $26,000 in the fiscal year 2001 and 2000, respectively. The increase in stock-based compensation for the year ended June 30, 2001 reflects stock options assumed in the two purchase transactions completed during the year that were accounted for in accordance with FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation—An Interpretation of APB Opinion No. 25.
 
Amortization of goodwill and purchased intangible assets
 
In connection with the two purchase transactions completed during fiscal 2001, we recorded approximately $56.6 million of goodwill and purchased intangible assets. We obtained independent appraisals of the fair value of tangible and intangible assets acquired in order to allocate the purchase price. Goodwill and purchased intangible assets are amortized on a straight-line basis over the economic lives of the respective assets, generally three to seven years. The amortization of goodwill and purchased intangible assets increased $677,000 or 83.3%, to $1.5 million or 3.0% of net revenues for the year ended June 30, 2001 from $813,000 or 1.8% of net revenues for the year ended June 30, 2000. In addition, approximately $220,000 of amortization of purchased intangible assets has been classified as cost of revenues for the year ended June 30, 2001. The increase in the amortization of goodwill and purchased intangible assets is primarily attributable to goodwill and purchased intangible asset amortization from our acquisitions of USSC and Lightwave which occurred in the second and fourth quarters of fiscal 2001, respectively.

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In-process research and development
 
IPR&D aggregated $2.6 million for the purchase transactions completed during fiscal 2001. No amounts of IPR&D were recorded during fiscal 2000. The amounts allocated to IPR&D were determined through established valuation techniques in the high-technology industry and were expensed upon acquisition as it was determined that the underlying projects had not reached technological feasibility and no alternative future uses existed.
 
Interest Income (Expense), Net
 
Interest income (expense), net consists primarily of interest earned on cash, cash equivalents and short-term and long-term investments. Interest income (expense), net was $2.2 million for the year ended June 30, 2001 and $187,000 for the year ended June 30, 2000. The increase is primarily due to higher average investment balances for the year ended June 30, 2001, as a result of the proceeds from our initial public offering completed August 9, 2000.
 
Provision (Benefit) for Income Taxes
 
We utilize the liability method of accounting for income taxes as set forth in FASB Statement No. 109, Accounting for Income Taxes. Our effective tax rate was 21% for the year ended June 30, 2001, and 38% for the year ended June 30, 2000. The federal statutory rate was 34% for both periods. Our effective tax rate associated with the income tax benefit for the year ended June 30, 2001, was lower than the federal statutory rate primarily due to nondeductible goodwill amortization and in-process research and development costs associated with current year acquisitions, as well as the amortization of stock-based compensation for which no current year tax benefit was provided. Our effective tax rate associated with the income tax expense for the year ended June 30, 2000, was higher than the statutory rate primarily due to the amortization of stock-based compensation for which no benefit was provided, and the effects of an unfavorable foreign tax rate variance.
 
Liquidity and Capital Resources
 
Since inception, we have financed our operations through the issuance of common stock and through net cash generated from operations. We consider all highly liquid investments purchased with original maturities of 90 days or less to be cash equivalents. Cash and cash equivalents consisting of money-market funds and commercial paper totaled $26.5 million at June 30, 2002. Short-term investments consist of investments maturing in 12 months or less and totaled $7.0 million at June 30, 2002. Long-term investment consists of an equity security of a privately held company, Xanboo and totaled $6.8 million at June 30, 2002.
 
Our operating activities used cash of $12.8 million for the year ended June 30, 2002. We incurred a net loss of $93.5 million, which includes the following non-cash adjustments: cumulative effect of accounting change of $5.9 million, impairment of goodwill and purchased intangible assets of $57.3 million, amortization of purchased intangible assets of $3.7 million, deferred income taxes of $5.6 million, provision for officer loans of $4.4 million, amortization of stock-based compensation of $3.0 million, restructuring charges of $3.5 million, depreciation of $2.5 million, Lightwave settlement of $1.9 million, equity losses from unconsolidated businesses of $1.0 million, $1.0 million of in-process research and development, and a $1.7 million provision for doubtful accounts. The changes in our operating assets consist of a decrease in accounts receivable of $2.5 million, decrease in inventory of $3.0 million and increase in Gordian liability of $3.0 million which was reduced by increases in prepaid expenses and other assets of $3.9 million, and a decrease in accounts payable of $3.8 million. The decrease in accounts receivable was due to decreased sales in the last month of the fourth quarter of fiscal 2002, increased collections from some of our U.S. distributors and European customers, and by the effects of the change in our accounting policy made as of July 1, 2000 under which sales to distributors are not recognized until the distributor sells our product to end user customers. The decrease in inventory was primarily due to lower levels of inventory at distributors resulting from the change in our accounting policy for sales to distributors as well as a significant increase to our inventory reserve. The increase in prepaid expenses and other assets is primarily due to an increase in our contract manufacturer receivables offset by a decrease in prepaid taxes. The increase in accounts payable is due to our ability to negotiate extended payment terms with our

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contract manufacturers. Our operating activities used cash of $5.0 million and $1.6 million for the years ended June 30, 2001 and 2000, respectively.
 
Our investing activities used $25.8 million of cash for the year ended June 30, 2002 compared with $29.3 million for the year ended June 30, 2001. We used $9.5 million to invest in held-to-maturity investments in debt securities and received $4.5 million in proceeds from the sales of securities. We used $7.3 million to purchase preferred stock in Xanboo. We used $4.7 million, net of cash acquired, to acquire Synergetic in October 2001 and Premise in January 2002. We used $6.0 million to acquire an interest in the Gordian intellectual property. We also used $2.8 million of cash to purchase property and equipment, primarily computer hardware and software pertaining to Oracle software enhancements, support of our international operations and a software package to support our sales force.
 
Cash provided by financing activities was $49.7 million for the year ended June 30, 2002, primarily related to the net proceeds from our secondary public offering completed in July 2001. Cash provided by financing activities was $47.7 million for the year ended June 30, 2001, primarily related to the net proceeds from our initial public offering in August 2000.
 
In January 2002, we entered into a two-year line of credit with a bank in an amount not to exceed $20.0 million. Borrowings under the line of credit bear interest at either (i) the prime rate or (ii) the LIBOR rate plus 2.0%. We are required to pay a $100,000 facility fee of which $50,000 was paid upon the closing and $50,000 is to be paid in January 2003. We are also required to pay a quarterly unused line fee of 0.125% of the unused line of credit balance. The line of credit contains customary affirmative and negative covenants. Effective June 30, 2002, we amended the existing line of credit reducing the revolving line to $12.0 million, removing the LIBOR rate option and adjusting the customary affirmative and negative covenants. To date, we have not borrowed against this line of credit. We are not in compliance with the revised financial covenants of the amended line of credit at June 30, 2002.
 
The following table summarizes our contractual payment obligations and commitments:
 
    
Fiscal Years

         
    
2003

  
2004

  
2005

  
2006

  
2007

  
Thereafter

  
Total

Operating leases
  
$
4,072
  
$
3,419
  
$
2,856
  
$
1,741
  
$
894
  
$
1,996
  
$
14,978
Other contractual obligations
  
 
127
  
 
62
  
 
10
  
 
1
  
 
—  
  
 
—  
  
 
200
    

  

  

  

  

  

  

Total
  
$
4,199
  
$
3,481
  
$
2,866
  
$
1,742
  
$
894
  
$
1,996
  
$
15,178
    

  

  

  

  

  

  

 
We believe that our existing cash, cash equivalents and short-term investments and any available borrowings under our line of credit facility will be adequate to meet our anticipated cash needs through at least the next twelve months. Our future capital requirements will depend on many factors, including the timing and amount of our net revenues, research and development and infrastructure investments, and expenses related to an on-going Securities and Exchange Commission investigation and pending litigation, which will affect our ability to generate additional cash. If cash generated from operations and financing activities is insufficient to satisfy our working capital requirements, we may need to borrow funds through bank loans, sales of securities or other means. There can be no assurance that we will be able to raise any such capital on terms acceptable to us, if at all. If we are unable to secure additional financing, we may not be able to develop or enhance our products, take advantage of future opportunities, respond to competition or continue to operate our business.
 
Risk Factors
 
You should carefully consider the risks described below before making an investment decision. The risks and uncertainties described below are not the only ones facing our company. Our business operations may be impaired by additional risks and uncertainties of which we are unaware or that we currently consider immaterial.

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Our business, results of operations or cash flows may be adversely affected if any of the following risks actually occur. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment.
 
VARIATIONS IN QUARTERLY OPERATING RESULTS, DUE TO FACTORS INCLUDING CHANGES IN DEMAND FOR OUR PRODUCTS AND CHANGES IN OUR MIX OF NET REVENUES, COULD CAUSE OUR STOCK PRICE TO DECLINE.
 
Our quarterly net revenues, expenses and operating results have varied in the past and might vary significantly from quarter to quarter in the future. We therefore believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance, and you should not rely on them to predict our future performance or the future performance of our stock price. Our short-term expense levels are relatively fixed and are based on our expectations of future net revenues. If we were to experience a reduction in net revenues in a quarter, we would likely be unable to adjust our short-term expenditures. If this were to occur, our operating results for that quarter would be harmed. If our operating results in future quarters fall below the expectations of market analysts and investors, the price of our common stock would likely fall. Other factors that might cause our operating results to fluctuate on a quarterly basis include:
 
 
 
changes in the mix of net revenues attributable to higher-margin and lower-margin products;
 
 
 
customers’ decisions to defer or accelerate orders;
 
 
 
variations in the size or timing of orders for our products;
 
 
 
short-term fluctuations in the cost or availability of our critical components, such as flash memory;
 
 
 
changes in demand for our products generally;
 
 
 
loss or gain of significant customers;
 
 
 
announcements or introductions of new products by our competitors;
 
 
 
defects and other product quality problems; and
 
 
 
changes in demand for devices that incorporate our connectivity products.
 
OUR COMMON STOCK MAY BE DELISTED, WHICH COULD SIGNIFICANTLY HARM OUR BUSINESS
 
Our common stock is currently listed on The Nasdaq National Market under the symbol “LTRX.” On July 19, 2002, we received notice from Nasdaq that our stock had traded below the $1.00 minimum per share price required for continued listing on The Nasdaq National Market for thirty consecutive trading days. Accordingly, to regain compliance with that requirement, our stock must trade above $1.00 on or before October 17, 2002, and remain above $1.00 for a minimum of ten consecutive trading days thereafter.
 
On or before October 17, 2002, we intend to request the listing of our common stock to be transferred to The Nasdaq SmallCap Market. To transition to The Nasdaq SmallCap Market, we must satisfy the continued inclusion requirements for The Nasdaq SmallCap Market, with the exception of the requirement that we maintain a minimum $1.00 bid price. If the transfer is approved, we will be granted an additional grace period in which to regain compliance with the $1.00 minimum bid price requirement for inclusion in The Nasdaq SmallCap Market. We may then be eligible for an additional 180 calendar day grace period in which to regain compliance with the $1.00 minimum bid price requirement for inclusion in The Nasdaq SmallCap Market, provided we meet the initial listing requirements for The Nasdaq SmallCap Market at that time. We may be eligible to transfer back to The Nasdaq National Market if we meet the $1.00 minimum bid price requirement for thirty consecutive trading days and meet all other maintenance requirements. The delisting of our common stock from The Nasdaq National Market may result in a reduction in some or all of the following, each of which could have a material adverse effect on our investors:

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the liquidity of our common stock;
 
 
 
the market price of our common stock;
 
 
 
the number of institutional investors that will consider investing in our common stock;
 
 
 
the number of investors in general that will consider investing in our common stock;
 
 
 
the number of market makers in our common stock;
 
 
 
the availability of information concerning the trading prices and volume of our common stock;
 
 
 
the number of broker-dealers willing to execute trades in shares of our common stock; and
 
 
 
our ability to obtain financing for the continuation of our operations.
 
IF OUR COMMON STOCK IS DELISTED, THE LIQUIDITY OF OUR STOCK WOULD BE LIMITED
 
If our common stock were to be delisted from The Nasdaq National Market, and not accepted for listing on, or delisted from, The Nasdaq SmallCap Market, it could become subject to the Securities and Exchange Commission’s “Penny Stock” rules. “Penny stocks” generally are equity securities with a price of less than $5.00 per share that are not registered on certain national securities exchanges or quoted on the Nasdaq system. Broker-dealers dealing in our common stock would then be subject to the disclosure rules for transactions involving penny stocks, which require the broker-dealer to determine if purchasing our common stock is suitable for a particular investor. The broker-dealer must also obtain the written consent of purchasers to purchase our common stock. The broker-dealer must also disclose the best bid and offer prices available for our stock and the price at which the broker-dealer last purchased or sold our common stock. These additional burdens imposed upon broker-dealers may discourage them from effecting transactions in our common stock, which could make it difficult for investors to sell their shares and, hence, limit the liquidity of our common stock.
 
IF WE MAKE UNPROFITABLE ACQUISITIONS OR ARE UNABLE TO SUCCESSFULLY INTEGRATE ANY FUTURE ACQUISITIONS, OUR BUSINESS COULD SUFFER.
 
We have in the past and intend to continue in the future to acquire businesses, client lists, products or technologies that we believe complement or expand our existing business. In December 2000, we acquired USSC, a company that provides software solutions for use in embedded technology applications. In June 2001, we acquired Lightwave, a company that provides console management solutions. In October 2001, we acquired Synergetic, a provider of embedded network communication solutions. In January 2002, we acquired Premise, a developer of client-side software applications. In August 2002, we acquired Stallion, an Australian based provider of solutions that enable Internet access, remote access and serial connectivity. Acquisitions of this type involve a number of risks, including:
 
 
 
difficulties in assimilating the operations and employees of acquired companies;
 
 
 
diversion of our management’s attention from ongoing business concerns;
 
 
 
our potential inability to maximize our financial and strategic position through the successful incorporation of acquired technology and rights into our products and services;
 
 
 
additional expense associated with amortization of acquired assets;
 
 
 
maintenance of uniform standards, controls, procedures and policies; and
 
 
 
impairment of existing relationships with employees, suppliers and customers as a result of the integration of new management employees.
 
Any acquisition or investment could result in the incurrence of debt and the loss of key employees. Moreover, we often assume specified liabilities of the companies we acquire. Some of these liabilities, such as

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environmental and tort liabilities, are difficult or impossible to quantify. If we do not receive adequate indemnification for these liabilities our business may be harmed. In addition, acquisitions are likely to result in a dilutive issuance of equity securities. For example, we issued common stock and assumed options to acquire our common stock in connection with our acquisitions of USSC, Lightwave, Synergetic and Premise. We cannot assure you that any acquisitions or acquired businesses, client lists, products or technologies associated therewith will generate sufficient net revenues to offset the associated costs of the acquisitions or will not result in other adverse effects. Moreover, from time to time we may enter into negotiations for the acquisition of businesses, client lists, products or technologies, but be unable or unwilling to consummate the acquisition under consideration. This could cause significant diversion of managerial attention and out of pocket expenses to us. We could also be exposed to litigation as a result of an unconsummated acquisition, including claims that we failed to negotiate in good faith, misappropriated confidential information or other claims.
 
In addition, from time to time we intend to invest in businesses that we believe present attractive investment opportunities, or provide other synergetic benefits. In September and October 2001, we paid an aggregate of $3.0 million to Xanboo for convertible promissory notes, which have converted, in accordance with their terms, into Xanboo preferred stock. In addition, the Company purchased an additional $4.0 million of preferred stock in Xanboo. As of June 30, 2002, we hold a 15.8% ownership interest in Xanboo. This investment is speculative in nature, and there is risk that we could lose part or all of our investment.
 
WE ARE CURRENTLY INVOLVED AND MIGHT BECOME INVOLVED IN ADDITIONAL LITIGATION OVER PROPRIETARY RIGHTS, WHICH COULD BE COSTLY AND TIME CONSUMING.
 
Substantial litigation regarding intellectual property rights exists in our industry. There is a risk that  third-parties, including current and potential competitors, current developers of our intellectual property, our manufacturing partners, or parties with which we have contemplated a business combination will claim that our products, or our customers’ products, infringe on their intellectual property rights or that we have misappropriated their intellectual property. In addition, software, business processes and other property rights in our industry might be increasingly subject to third-party infringement claims as the number of competitors grows and the functionality of products in different industry segments overlaps. Other parties might currently have, or might eventually be issued, patents that infringe on the proprietary rights we use. Any of these third parties might make a claim of infringement against us.
 
On July 3, 2001, Digi International, Inc., filed a complaint alleging that we directly and/or indirectly infringe upon Digi’s U.S. Patent No. 6,047,319 by making, using, selling and or offering for sale certain of our multiport device servers, including the ETS line of products, when coupled with a software called the comm port redirector software. Digi alleges that we have willfully and intentionally infringed Digi’s patent, and its complaint seeks injunctive relief as well as unspecified damages, treble damages, attorney’s fees, interest and costs. Moreover, in conjunction with our acquisition of Stallion, we became party to similar litigation in both the U.S. and Australia, in which Digi International claims that Stallion’s easyserverII and ePipe products when coupled with a software product called truport and extend, respectively, infringe Digi’s U.S. Patent No. 6,047,319. Digi filed suit in the U.S. District Court for the District of Minnesota on November 21, 2000, and in the Supreme Court of Queensland, Australia on August 10, 2001, claiming that the easy server II and ePipe products when coupled with the truport and extend software, respectively, infringe Digi’s Australian Letters Patent No. 706,132.
 
The litigation process is inherently uncertain and we may not prevail. Patent litigation is particularly complex and can extend for a protracted time, which can substantially increase the cost of such litigation. The Digi litigation has diverted the efforts and attention of some of our key management and technical personnel. Should the outcome of the litigation be adverse to us, we would be required to pay monetary damages to Digi, and we could be enjoined from selling those of our products found to infringe Digi’s patent unless and until we are able to negotiate a license from Digi. A license may not be available on acceptable terms or at all. If we are required to pay significant monetary damages, are enjoined from selling any of our products or are required to

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make substantial royalty payments pursuant to any such license agreement, our business would be harmed. This litigation, or other similar litigation brought by us or others, could result in the expenditure of significant financial resources and the diversion of management’s time and efforts.
 
In addition, from time to time we could encounter other disputes over rights and obligations concerning intellectual property. We cannot assume that we will prevail in intellectual property disputes regarding infringement, misappropriation or other disputes. Litigation in which we are accused of infringement or misappropriation might cause a delay in the introduction of new products, require us to develop non-infringing technology, require us to enter into royalty or license agreements, which might not be available on acceptable terms, or at all, or require us to pay substantial damages, including treble damages if we are held to have willfully infringed. In addition, we have obligations to indemnify certain of our customers under some circumstances for infringement of third-party intellectual property rights. If any claims from third-parties were to require us to indemnify customers under our agreements, the costs could be substantial, and our business could be harmed. If a successful claim of infringement were made against us and we could not develop non-infringing technology or license the infringed or similar technology on a timely and cost-effective basis, our business could be significantly harmed.
 
WE ARE CURRENTLY ENGAGED IN MULTIPLE SECURITIES CLASS ACTION LAWSUITS, A LAWSUIT BY THE FORMER OWNERS OF OUR USSC SUBSIDIARY AND A STATE DERIVATIVE SUIT, ANY OF WHICH, IF IT RESULTS IN AN UNFAVORABLE RESOLUTION, COULD ADVERSELY AFFECT OUR BUSINESS, RESULTS OF OPERATIONS OR FINANCIAL CONDITION.
On May 15, 2002, Stephen Bachman filed a class action complaint entitled Bachman v. Lantronix, Inc., et al., No. 02-3899, in the U.S. District Court for the Central District of California against us and certain of our current and former officers and directors alleging violations of the Securities Exchange Act of 1934 and seeking unspecified damages. Subsequently, six similar actions were filed in the same court. Each of the complaints purports to be a class action lawsuit brought on behalf of persons who purchased or otherwise acquired our common stock during the period of April 25, 2001 through May 30, 2002, inclusive. The complaints allege that the defendants caused us to improperly recognize revenue and make false and misleading statements about our business. Plaintiffs further allege that we materially overstated our reported financial results, thereby inflating our stock price during our securities offering in July 2001, as well as facilitating the use of our stock as consideration in acquisitions. The complaints have subsequently been consolidated into a single action and we are awaiting the appointment of a lead plaintiff. Once appointed, a consolidated amended complaint will be filed by the lead plaintiff. We have not yet answered, discovery has not commenced, and no trial date has been established.
 
On July 26, 2002, Samuel Ivy filed a shareholder derivative complaint entitled Ivy v. Bernhard Bruscha, et al., No. 02CC00209, in the Superior Court of the State of California, County of Orange, against certain of our current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, abuse of control, gross mismanagement, unjust enrichment, and improper insider stock sales. The complaint seeks unspecified damages against the individual defendants on our behalf, equitable relief, and attorneys’ fees. Discovery has not commenced and no trial date has been established.
 
On August 23, 2002, Donald and Diane Dunstan, the co-founders of USSC, filed a complaint entitled Dunstan v. Lantronix, Inc., et al., in the Circuit Court of the State of Oregon, County of Multnomah. The complaint alleges Oregon state law claims for securities violations, fraud, and negligence. The complaint seeks not less than $3.6 million in damages, interest, attorneys’ fees, costs, expenses, and an unspecified amount of punitive damages. Discovery has not commenced and no trial date has been established. In addition, Donald Dunstan has requested arbitration of certain contract claims including entitlement to $9.8 million for lost earnout opportunities.
All the above matters are in early stages and we cannot predict their outcomes with certainty. The litigation process is inherently uncertain and we may not prevail. Moreover, securities litigation can extend for protracted times, and involves substantial legal fees.

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THERE IS A RISK THAT THE SEC COULD LEVY FINES AGAINST US, OR DECLARE US TO BE OUT OF COMPLIANCE WITH THE RULES REGARDING OFFERING SECURITIES TO THE PUBLIC.
 
The U.S. Securities and Exchange Commission is investigating the events surrounding our recent restatement of our financial statements. The SEC could conclude that we violated the rules of the Securities Act of 1933 or the Securities and Exchange Act of 1934. In either event, the SEC might levy civil fines against us, or might conclude that we lack sufficient internal controls to warrant our being allowed to continue offering our shares to the public. This investigation involves substantial cost and could significantly divert the attention of management. In addition to sanctions imposed by the SEC, an adverse determination could significantly damage our reputation with customers and vendors, and harm our employees’ morale.
 
STOCK-BASED COMPENSATION WILL NEGATIVELY AFFECT OUR OPERATING RESULTS.
 
We have recorded deferred compensation in connection with the grant of stock options to employees where the option exercise price is less than the estimated fair value of the underlying shares of common stock as determined for financial reporting purposes. We recorded approximately $1.2 million of deferred compensation for the year ended June 30, 2002. Additionally, we recorded deferred compensation forfeitures of $3.1 million for the year ended June 30, 2002. At June 30, 2002, a balance of $4.5 million remains and will be amortized as follows: $2.0 million in fiscal 2003, $1.6 million in fiscal 2004, $857,000 in fiscal 2005 and $17,000 in fiscal 2006.
 
The amount of stock-based compensation in future periods will increase if we grant stock options where the exercise price is less than the quoted market price of the underlying shares. The amount of stock-based compensation amortization in future periods could decrease if options for which accrued, but unvested deferred compensation has been recorded are forfeited.
 
WE PRIMARILY DEPEND ON THREE THIRD-PARTY MANUFACTURERS TO MANUFACTURE ALL OF OUR PRODUCTS, WHICH REDUCES OUR CONTROL OVER THE MANUFACTURING PROCESS. IF THESE MANUFACTURERS ARE UNABLE OR UNWILLING TO MANUFACTURE OUR PRODUCTS AT THE QUALITY AND QUANTITY WE REQUEST, OUR BUSINESS COULD BE HARMED AND OUR STOCK PRICE COULD DECLINE.
 
We primarily outsource all of our manufacturing to three third-party manufacturers, APW, Inc., Irvine Electronics and Uniprecision. Our reliance on these third-party manufacturers exposes us to a number of significant risks, including:
 
 
 
reduced control over delivery schedules, quality assurance, manufacturing yields and production costs;
 
 
 
lack of guaranteed production capacity or product supply; and
 
 
 
reliance on third-party manufacturers to maintain competitive manufacturing technologies.
 
Our agreements with these manufacturers provide for services on a purchase-order basis. If our manufacturers were to become unable or unwilling to continue to manufacture our products in required volumes, at acceptable quality, quantity, yields and costs, or in a timely manner, our business would be seriously harmed. We may also experience unforeseen problems as we attempt to transition a significant portion of our manufacturing requirements to Uniprecision. We do not have a significant operating history with this entity and if this entity is unable to provide us with satisfactory service, or we are unable to successfully complete the transition, our operations could be interrupted. As a result, we would have to attempt to identify and qualify substitute manufacturers, which could be time consuming and difficult, and might result in unforeseen manufacturing and operations problems. In addition, a natural disaster could disrupt our manufacturers’ facilities

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and could inhibit our manufacturers’ ability to provide us with manufacturing capacity on a timely basis, or at all. If this were to occur, we likely would be unable to fill customers’ existing orders or accept new orders for our products. The resulting decline in net revenues would harm our business. In addition, we are responsible for forecasting the demand for our individual products by regional location. These forecasts are used by our contract manufacturers to procure raw materials and manufacture our finished goods. If we forecast demand too high, we may invest too much cash in inventory and we may be forced to take a write-down of our inventory balance, which would reduce our earnings. If our forecast is too low for one or more products, we may be required to pay expedite charges which would increase our cost of sales or we may be unable to fulfill customer orders thus reducing net revenues and therefore earnings.
 
WE HAVE ELECTED TO USE A CONTRACT MANUFACTURER IN CHINA. WHILE AFFORDING COST SAVINGS, OTHER RISKS COULD NEGATIVELY IMPACT US OR OFFSET THE ANTICIPATED SAVINGS.
 
We have recently elected to use a contract manufacturer based in China, which involves numerous risks, including:
 
 
 
Delivery times are extended due to the distances involved, requiring more lead-time in ordering and increasing the risk of excess inventories.
 
 
 
We could incur ocean freight delays because of labor problems, weather delays or expediting and customs problems.
 
 
 
China does not afford the same level of protection to intellectual property as domestic or many other foreign countries. If our products were reverse-engineered or our intellectual property were otherwise pirated—reproduced and duplicated without our knowledge or approval, our revenues would be reduced.
 
 
 
China and U.S foreign relations have, historically, been subject to change. Political considerations and actions could interrupt our expected supply of products from China.
 
On September 12, 2002, we announced our intent to source our Lightwave products from contract manufacturers, and close our operations in Milford, Connecticut. If we are unsuccessful in making this transition, our supply of these products and hence our revenues, could be reduced.
 
OUR MANAGEMENT TEAM IS IN TRANSITION, WHICH COULD HARM OUR BUSINESS
 
Our management team is undergoing a significant transition. We have recently replaced our Chairman of the Board, Chief Executive Officer and Chief Financial Officer/Chief Operating Officer. Currently, Marc Nussbaum is serving as our interim Chief Executive Officer, and James Kerrigan is serving as our interim Chief Financial Officer. We will need to hire a permanent Chief Executive Officer and Chief Financial Officer in the near future. Although the Company might hire Mssrs. Nussbaum and Kerrigan to serve in permanent capacities, it is also possible that new executives will be hired. The recent management changes have been disruptive to our business and additional changes would likely be disruptive as well. If we are unable to manage this process effectively, our relationship with our employees, customers and vendors could be significantly harmed.
 
THERE IS A RISK THAT OUR OEM CUSTOMERS WILL DEVELOP THEIR OWN INTERNAL EXPERTISE IN NETWORK-ENABLING PRODUCTS, WHICH COULD RESULT IN REDUCED SALES OF OUR PRODUCTS.
 
For most of our existence, we primarily sold our products to VARs, system integrators and OEMs. Although we intend to continue to use all of these sales channels, we have begun to focus more heavily on selling our products to OEMs. Selling products to OEMs involves unique risks, including the risk that OEMs will develop internal expertise in network-enabling products or will otherwise provide network functionality to their products

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without using our device server technology. If this were to occur, our stock price could decline in value and you could lose part or all of your investment.
 
WE HAVE EXCESS INVENTORIES AND THERE IS A RISK WE MAY BE UNABLE TO DISPOSE OF THEM.
 
Our products and therefore our inventories are subject to technological risk—at any time either new products may enter the market or prices of competitive products may be introduced with more attractive features or at lower prices than ours. There is a risk that we may be unable to sell our on-hand or on-order inventory in a timely manner to avoid their becoming obsolete.
 
OUR ENTRY INTO, AND INVESTMENT IN, THE HOME NETWORK MARKET HAS RISKS INHERENT IN RELYING ON ANY EMERGING MARKET FOR FUTURE GROWTH.
 
With our Premise SYS software, and our investment in Xanboo, we are relying on the future development of an emerging market for future growth. It is possible this home network market may develop slowly or that others could enter this market with superior product offerings that would impair our own success. We could lose some or all of our investment, or be unsuccessful in achieving significant revenues and therefore profitability, in these initiatives.
 
TERRORIST ATTACKS OR THREATS OF ATTACKS, AND BUSINESS INTERRUPTION CAUSED BY SUCH ATTACKS, NATURAL DISASTERS AND ELECTRICAL BLACKOUTS IN THE STATE OF CALIFORNIA COULD ADVERSELY AFFECT OUR BUSINESS.
 
Interruptions in business, a decline in demand in our products, or a general economic decline resulting from actual or threatened terrorist attacks or military action could harm our business. Adverse effects could include, but are not limited to, physical damage to our facilities, and disruptions caused by trade restrictions imposed by the United States or foreign governments. In addition, a general economic downturn in any of our target markets or general disruption of the financial markets caused by such attacks could substantially harm our business. Moreover, our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure and other events beyond our control. We do not have a detailed disaster recovery plan. Our facilities in the State of California may be subject to electrical blackouts as a consequence of a shortage of available electrical power. In the event these blackouts continue or increase in severity, they could disrupt the operations of our affected facilities.
 
WE INTEND TO CONTINUE TO DEVOTE SIGNIFICANT RESOURCES TO OUR RESEARCH AND DEVELOPMENT, WHICH, IF NOT SUCCESSFUL, COULD CAUSE A DECLINE IN OUR REVENUES AND COULD HARM OUR BUSINESS.
 
We intend to continue to devote significant resources to research and development in the coming years to enhance and develop additional products. For the year ended June 30, 2002, research and development expenses comprised 16.0% of our net revenues. If we are unable to develop new products as a result of this effort, or if the products we develop are not successful, our business could be harmed. Even if we do develop new products that are accepted by our target markets, we do not know whether the net revenue from these products will be sufficient to justify our investment in research and development.
 
IF A MAJOR CUSTOMER CANCELS, REDUCES, OR DELAYS PURCHASES, OUR NET REVENUES MIGHT DECLINE AND OUR BUSINESS COULD BE ADVERSELY AFFECTED.
 
Our top five customers accounted for 35% of our net revenues for the year ended June 30, 2002. One customer accounted for approximately 12%, 14% and 13% of our net revenues for the years ended June 30, 2002, 2001 and 2000, respectively. Another customer accounted for approximately 11%, 10% and 12% of our net revenues for the

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years ended June 30, 2002, 2001 and 2000, respectively. Accounts receivable attributable to these two domestic customers accounted for approximately 21% and 31% of total accounts receivable at June 30, 2002 and 2001, respectively. The number and timing of sales to our distributors have been difficult for us to predict. The loss or deferral of one or more significant sales in a quarter could harm our operating results. We have in the past, and might in the future, lose one or more major customers. If we fail to continue to sell to our major customers in the quantities we anticipate, or if any of these customers terminate our relationship, our reputation, the perception of our products and technology in the marketplace and the growth of our business could be harmed. The demand for our products from our OEM, VAR and systems integrator customers depends primarily on their ability to successfully sell their products that incorporate our device server technology. Our sales are usually completed on a purchase order basis and we have no long-term purchase commitments from our customers.
 
Our future success also depends on our ability to attract new customers, which often involves an extended process. The sale of our products often involves a significant technical evaluation, and we often face delays because of our customers’ internal procedures used to evaluate and deploy new technologies. For these and other reasons, the sales cycle associated with our products is typically lengthy, often lasting six to nine months and sometimes longer. Therefore, if we were to lose a major customer, we might not be able to replace the customer on a timely basis or at all. This would cause our net revenues to decrease and could cause the price of our stock to decline.
 
WE HAVE ESTABLISHED CONTRACTS AND OBLIGATIONS THAT WERE IMPLEMENTED WHEN WE ANTICIPATED HIGHER REVENUES AND ACTIVITIES.
 
We have several agreements that obligate us to facilities or services that are in excess of our current requirements. It may be necessary that we sublease or otherwise negotiate settlement of our obligations rather than perform on them as we originally expected. If we are unable to negotiate a favorable resolution to these contracts, we may be required to pay the entire cost of our obligations under the agreement, which could harm or business.
 
THE AVERAGE SELLING PRICES OF OUR PRODUCTS MIGHT DECREASE, WHICH COULD REDUCE OUR GROSS MARGINS.
 
In the past, we have experienced some reduction in the average selling prices and gross margins of products and we expect that this will continue for our products as they mature. In the future, we expect competition to increase, and we anticipate this could result in additional pressure on our pricing. In addition, our average selling prices for our products might decline as a result of other reasons, including promotional programs and customers who negotiate price reductions in exchange for longer-term purchase commitments. In addition, we might not be able to increase the price of our products in the event that the prices of components or our overhead costs increase. If this were to occur, our gross margins would decline. In addition, we may not be able to reduce the cost to manufacture our products to keep up with the decline in prices.
 
NEW PRODUCT INTRODUCTIONS AND PRICING STRATEGIES BY OUR COMPETITORS COULD ADVERSELY AFFECT OUR ABILITY TO SELL OUR PRODUCTS AND COULD REDUCE OUR MARKET SHARE OR RESULT IN PRESSURE TO REDUCE THE PRICE OF OUR PRODUCTS.
 
The market for our products is intensely competitive, subject to rapid change and is significantly affected by new product introductions and pricing strategies of our competitors. We face competition primarily from companies that network-enable devices, companies in the automation industry and companies with significant networking expertise and research and development resources. Our competitors might offer new products with features or functionality that are equal to or better than our products. In addition, since we work with open standards, our customers could develop products based on our technology that compete with our offerings. We might not have sufficient engineering staff or other required resources to modify our products to match our competitors. Similarly, competitive pressure could force us to reduce the price of our products. In each case, we could lose new and existing customers to our competition. If this were to occur, our net revenues could decline and our business could be harmed.

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INABILITY OR DELAYS IN DELIVERIES FROM OUR COMPONENT SUPPLIERS COULD DAMAGE OUR REPUTATION AND COULD CAUSE OUR NET REVENUES TO DECLINE AND HARM OUR RESULTS OF OPERATIONS.
 
Our contract manufacturers and we are responsible for procuring raw materials for our products. Our products incorporate components or technologies that are only available from single or limited sources of supply. In particular, some of our integrated circuits are available from a single source. From time to time in the past, integrated circuits we use in our products have been phased out of production. When this happens, we attempt to purchase sufficient inventory to meet our needs until a substitute component can be incorporated into our products. Nonetheless, we might be unable to purchase sufficient components to meet our demands, or we might incorrectly forecast our demands, and purchase too many or too few components. In addition, our products use components that have in the past been subject to market shortages and substantial price fluctuations. From time to time, we have been unable to meet our orders because we were unable to purchase necessary components for our products. We rely on a number of different component suppliers. Because we do not have long-term supply arrangements with any vendor to obtain necessary components or technology for our products, if we are unable to purchase components from these suppliers, product shipments could be prevented or delayed, which could result in a loss of sales. If we are unable to meet existing orders or to enter into new orders because of a shortage in components, we will likely lose net revenues and risk losing customers and harming our reputation in the marketplace.
 
OUR INTELLECTUAL PROPERTY PROTECTION MIGHT BE LIMITED.
 
We have not historically relied on patents to protect our proprietary rights, although we have recently begun to build a patent portfolio. We rely primarily on a combination of laws, such as copyright, trademark and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. Despite any precautions that we have taken:
 
 
 
laws and contractual restrictions might not be sufficient to prevent misappropriation of our technology or deter others from developing similar technologies;
 
 
 
other companies might claim common law trademark rights based upon use that precedes the registration of our marks;
 
 
 
policing unauthorized use of our products and trademarks is difficult, expensive and time-consuming, and we might be unable to determine the extent of this unauthorized use;
 
 
 
current federal laws that prohibit software copying provide only limited protection from software pirates; and
 
 
 
the companies we acquire may not have taken similar precautions to protect their proprietary rights.
 
Also, the laws of other countries in which we market and manufacture our products might offer little or no effective protection of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third parties to benefit from our technology without paying us for it, which could significantly harm our business.
 
UNDETECTED PRODUCT ERRORS OR DEFECTS COULD RESULT IN LOSS OF NET REVENUES, DELAYED MARKET ACCEPTANCE AND CLAIMS AGAINST US.
 
We currently offer warranties ranging from ninety days to five years on each of our products. Our products could contain undetected errors or defects. If there is a product failure, we might have to replace all affected products without being able to book revenue for replacement units, or we may have to refund the purchase price for the units. Because of our recent introduction of our line of device servers, we do not have a long history with which to assess the risks of unexpected product failures or defects for this product line. Regardless of the amount

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of testing we undertake, some errors might be discovered only after a product has been installed and used by customers. Any errors discovered after commercial release could result in loss of net revenues and claims against us. Significant product warranty claims against us could harm our business, reputation and financial results and cause the price of our stock to decline.
 
BECAUSE WE ARE DEPENDENT ON INTERNATIONAL SALES FOR A SUBSTANTIAL AMOUNT OF OUR NET REVENUES, WE FACE THE RISKS OF INTERNATIONAL BUSINESS AND ASSOCIATED CURRENCY FLUCTUATIONS, WHICH MIGHT ADVERSELY AFFECT OUR OPERATING RESULTS.
 
Net revenues from international sales represented 17%, 32% and 33% of net revenues for the years ended June 30, 2002, 2001 and 2000, respectively. Net revenues from Europe represented 14%, 28% and 28% of our net revenues for the years ended June 30, 2002, 2001 and 2000, respectively.
 
We expect that international revenues will continue to represent a significant portion of our net revenues in the foreseeable future. Doing business internationally involves greater expense and many additional risks. For example, because the products we sell abroad and the products and services we buy abroad are priced in foreign currencies, we are affected by fluctuating exchange rates. In the past, we have from time to time lost money because of these fluctuations. We might not successfully protect ourselves against currency rate fluctuations, and our financial performance could be harmed as a result. In addition, we face other risks of doing business internationally, including:
 
 
 
unexpected changes in regulatory requirements, taxes, trade laws and tariffs;
 
 
 
reduced protection for intellectual property rights in some countries;
 
 
 
differing labor regulations;
 
 
 
compliance with a wide variety of complex regulatory requirements;
 
 
 
changes in a country’s or region’s political or economic conditions;
 
 
 
greater difficulty in staffing and managing foreign operations; and
 
 
 
increased financial accounting and reporting burdens and complexities.
 
Our international operations require significant attention from our management and substantial financial resources. We do not know whether our investments in other countries will produce desired levels of net revenues or profitability.
 
OUR EXECUTIVE OFFICERS AND TECHNICAL PERSONNEL ARE CRITICAL TO OUR BUSINESS, AND WITHOUT THEM WE MIGHT NOT BE ABLE TO EXECUTE OUR BUSINESS STRATEGY.
 
Our financial performance depends substantially on the performance of our executive officers and key employees. We are dependent in particular on Marc Nussbaum, who serves as our Interim President and Chief Executive Officer, and James Kerrigan, who serves as our Interim Chief Financial Officer. We have no contract agreements with those executives who are serving on an interim basis. We are also dependent upon our technical personnel, due to the specialized technical nature of our business. If we lose the services of Mr. Nussbaum, Mr. Kerrigan or any of our key personnel and are not able to find replacements in a timely manner, our business could be disrupted, other key personnel might decide to leave, and we might incur increased operating expenses associated with finding and compensating replacements.

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WE MIGHT BE UNABLE TO HIRE AND RETAIN THE SKILLED PERSONNEL NECESSARY TO DEVELOP OUR OPERATIONS, SALES, TECHNICAL AND SUPPORT CAPABILITIES IN ORDER TO CONTINUE TO GROW, WHICH COULD HARM OUR BUSINESS.
 
Our business cannot continue to grow if we do not hire and retain qualified technical personnel. Competition for these individuals is intense, and we might not be able to attract, assimilate or retain highly qualified technical personnel in the future. In addition, we need to continue to hire and retain operations, sales and support personnel. Our failure to attract and retain highly trained personnel in these areas might limit the rate at which we can develop, which would harm our business.
 
Key employees at the companies we acquired may join the securities class action suit, with possible negative consequences for productivity and employee retention.
 
THE MARKET FOR OUR PRODUCTS IS NEW AND RAPIDLY EVOLVING. IF WE ARE NOT ABLE TO DEVELOP OR ENHANCE OUR PRODUCTS TO RESPOND TO CHANGING MARKET CONDITIONS, OUR NET REVENUES WILL SUFFER.
 
Our future success depends in large part on our ability to continue to enhance existing products, lower product cost and develop new products that maintain technological competitiveness. The demand for network-enabled products is relatively new and can change as a result of innovations or changes. For example, industry segments might adopt new or different standards, giving rise to new customer requirements. Any failure by us to develop and introduce new products or enhancements directed at new industry standards could harm our business, financial condition and results of operations. These customer requirements might or might not be compatible with our current or future product offerings. We might not be successful in modifying our products and services to address these requirements and standards. For example, our competitors might develop competing technologies based on Internet Protocols, Ethernet Protocols or other protocols that might have advantages over our products. If this were to happen, our net revenue might not grow at the rate we anticipate, or could decline.
 
ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
 
Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments for speculative or trading purposes. We place our investments in instruments that meet high credit quality standards, as specified in our investment policy. Information relating to quantitative and qualitative disclosure about market risk is set forth below and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”
 
Interest Rate Risk
 
Our exposure to interest rate risk is limited to the exposure related to our cash and cash equivalents and our credit facilities, which is tied to market interest rates. As of June 30, 2002, we had cash and cash equivalents of $26.5 million, which consisted of cash and short-term investments with original maturities of ninety days or less, both domestically and internationally. We believe our short-term investments will decline in value by an insignificant amount if interest rates increase, and therefore would not have a material effect on our financial condition or results of operations.
 
Foreign Currency Risk
 
We sell products internationally. As a result, our financial results could be harmed by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets.

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Investment Risk
 
As of June 30, 2002, we have a net investment of $6.8 million in Xanboo, a privately held company which can still be considered in the start-up or development stages. This investment is inherently risky as the market for the technologies or products they have under development are typically in the early stages and may never materialize. There is a risk that we could lose part or all of our investment.
 
We are exposed to market risk as it relates to changes in the market value of our investments. As of June 30, 2002, we have short-term investments of $7.0 million consisting of United States Treasury notes, obligations of U.S. Government agencies, state, municipal and county governments notes and bonds and corporate bonds. These securities are subject to interest rate risk and will decline in value if interest rates increase. Because the maturity dates of our investment portfolio are relatively short, an immediate 100 basis point increase in interest rates would have no material impact on our consolidated financial position, results of operations, or cash flows.
 
ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
The financial statements and supplementary data required by this item are incorporated by reference from Part IV, Item 15 of this Form 10-K and are presented beginning on page F-1.
 
ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
Not Applicable.

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PART III
 
ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
 
(a)
 
The information regarding Directors appearing under the caption “Election of Directors” in the Company’s Proxy Statement related to the Annual Meeting of Stockholders scheduled to be held on November 12, 2002, is incorporated herein by reference. The information with respect to executive officers appears in Part I of this Form 10-K entitled “ITEM 1—Business—Executive Officers of the Company.”
 
 
(b)
 
The information appearing under the caption “Compliance with Section 16 of the Securities Exchange Act of 1934” in the Company’s Proxy Statement related to the Annual Meeting of Stockholders scheduled to be held November 12, 2002, is incorporated herein by reference.
 
ITEM 11.    EXECUTIVE COMPENSATION
 
The information appearing under the caption “Executive Compensation and Related Information” in the Company’s Proxy Statement related to the Annual Meeting of Stockholders scheduled to be held on November 12, 2002, is incorporated herein by reference.
 
ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
The information appearing under the captions “Election of Directors” and “Security Ownership of Certain Beneficial Owners and Management” in the Company’s Proxy Statement related to the Annual Meeting of Stockholders to be held on November 12, 2002, is incorporated herein by reference.
You are also directed to “PART II—Equity Compensation Plans,” for additional information.
 
ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
The information appearing under the caption “Security Ownership of Certain Beneficial Owners and Management” and “Executive Compensation and Related Information” in the Company’s Proxy Statement related to the Annual Meeting of Stockholders scheduled to be held on November 12, 2002, is incorporated herein by reference.
 
Howard Slayen, a member of our Board of Directors, and Marc Nussbaum, our Interim Chief Executive Officer, also serve as our nominees to the Xanboo Board of Directors.
 
One international customer, transtec AG, which is a related party due to common ownership by our largest stockholder and former Chairman of our Board of Directors, Bernhard Bruscha, accounted for approximately 5%, 9% and 7% of our net revenues for the years ended June 30, 2002, 2001 and 2000, respectively. Included in the accompanying consolidated balance sheets are approximately $246,000 and $787,000 due to this related party at June 30, 2002 and 2001, respectively. We also have an agreement with transtec AG for the provision of technical support services at the rate of $7,500 per month. Included in selling, general and administrative expenses is $90,000 for each of the three years in the period ended June 30, 2002 for these support services.
 
ITEM 14.    CONTROLS AND PROCEDURES
 
Not applicable.

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PART IV
 
ITEM 15.    EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K
 
(a)     1.    Consolidated Financial Statements.
 
    
    Page    

Report of Independent Auditors
  
F-1
Consolidated Balance Sheets as of June 30, 2002 and 2001
  
F-2
Consolidated Statements of Operations for the years ended June 30, 2002, 2001 and 2000
  
F-3
Consolidated Statements of Stockholders’ Equity for the years ended June 30, 2002, 2001 and 2000
  
F-4
Consolidated Statements of Cash Flows for the years ended June 30, 2002, 2001 and 2000
  
F-5
Notes to Consolidated Financial Statements
  
F-6 – F-32
 
         2.    Financial Statement Schedule
 
The following financial statement schedule of the Company is filed as part of this Form 10-K. All other schedules have been omitted because they are not applicable, not required, or the information is included in the consolidated financial statements or notes thereto.
 
      
Page

(1) Report of Independent Auditors on Financial Statement Schedule
    
S-1
(2) Schedule II—Consolidated Valuation and Qualifying Accounts
    
S-2
 
         3.    Exhibits
 
The following exhibits immediately follow the financial statements and are filed as part of, or hereby incorporated by reference into this Form 10-K.
 
Exhibit
Number

  
Description of Document

  3.1*
  
Certificate of Incorporation of registrant.
  3.4
  
Bylaws of the registrant as amended on October 1, 2002.
  4.1**
  
Form of registrant’s common stock certificate.
10.1**
  
Form of Indemnification Agreement entered into by registrant with each of its directors and executive officers.
10.2**++
  
1993 Stock Option Plan and forms of agreements thereunder.
10.3**++
  
1994 Nonstatutory Stock Option Plan and forms of agreements thereunder.
10.4***++
  
2000 Stock Plan and forms of agreements thereunder.
10.5**++
  
2000 Employee Stock Purchase Plan.
10.6**
  
Form of Warranty.
10.7*
  
Employment Agreement between registrant and Frederick Thiel.
10.8*
  
Employment Agreement between registrant and Steven Cotton.
10.9*
  
Employment Agreement between registrant and Johannes Rietschel.
10.10**
  
Lease Agreement between registrant and The Irvine Company.
10.11**
  
Loan and Security Agreement between registrant and Silicon Valley Bank.
10.12+**
  
Research and Development Agreement between registrant and Gordian.
10.13+**
  
Distributor Contract between registrant and Tech Data Corporation.

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Exhibit
Number

  
Description of Document

10.14+**
  
Distributor Contract between registrant and Ingram Micro Inc.
21.1****
  
Subsidiaries of registrant.
23.1
  
Consent of Independent Auditors.
24.1
  
Power of Attorney (see page II-2).
99.1
  
Certification of Interim Chief Executive Officer and Interim Chief Financial Officer.

*
 
Incorporated by reference to the same numbered exhibit previously filed with Lantronix’s Registration Statement on Form S-1 (SEC file no. 333-37508) originally filed May 19, 2000.
**
 
Incorporated by reference to the same numbered exhibit previously filed with Lantronix’s Registration Statement on Form S-1, Amendment No. 1, (SEC file no. 333-37508) originally filed June 13, 2000.
***
 
Incorporated by reference to the same numbered exhibit previously filed with Lantronix’s Registration Statement on Form S-1, Amendment No. 1, (SEC file no. 333-63030) originally filed June 14, 2001.
****
 
Incorporated by reference to the same numbered exhibit previously filed with Lantronix’s Annual Report on Form 10-K, originally filed September 28, 2001.
+
 
Confidential treatment granted as to portions of this exhibit.
++
 
Designates management contract or compensatory plan arrangements required to be filed as an exhibit of this Annual Report on Form 10-K pursuant to Item 14(c).
 
FINANCIAL STATEMENT SCHEDULES
 
(1
)
  
Report of Independent Auditors on Financial Statement Schedule
  
S-1
(2
)
  
Schedule II—Valuation and Qualifying Accounts
  
S-2
 
(b)    Reports on Form 8-K.
 
    
 
The Company filed the following current reports on Form 8-K during the quarter ended June 30, 2002:
 
    
 
Form 8-K filed on May 7, 2002 reporting its decision to terminate the employment of its Chief Operating Officer and Chief Financial Officer and announcing James W. Kerrigan as Interim Chief Financial Officer.
 
    
 
Form 8-K filed on June 7, 2002 announcing 1) a voluntary internal review by its audit committee; 2) the appointment of Marc Nussbaum as Interim Chief Executive Officer and President succeeding Fred Thiel, who has assumed the role of Chief Technical and Strategy Officer; 3) notification that Thiel and Bernhard Bruscha have resigned from the Board of Directors, and election of H.K. Desai as Chairman of the Board; 4) that the Company received notification from Nasdaq on May 23, 2002, that it does not meet the filing requirements for continued listing on the Nasdaq National Market and is therefore subject to delisting; 5) notification that the Company signed an intellectual property and engineering support services agreement with Gordian Corporation.

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REPORT OF INDEPENDENT AUDITORS
 
The Board of Directors and Stockholders
Lantronix, Inc.
 
We have audited the accompanying consolidated balance sheets of Lantronix, Inc. as of June 30, 2002 and 2001, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended June 30, 2002. 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 auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lantronix, Inc. at June 30, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 2002, in conformity with accounting principles generally accepted in the United States.
 
As discussed in Note 2, the accompanying financial statements for the year ended June 30, 2001 have been restated to change as of July 1, 2000 the accounting policy for recognizing revenue from sales to distributors. Under the newly adopted policy, revenue from sales to distributors is not recognized until the distributor sells the Company’s products to end user customers. As discussed in Note 6, effective July 1, 2001, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.”
 
/s/    ERNST & YOUNG LLP
 
Orange County, California
October 2, 2002

F-1


Table of Contents
 
LANTRONIX, INC.
 
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
 
    
June 30,

 
    
2002

    
2001

 
ASSETS
                 
Current assets:
                 
Cash and cash equivalents
  
$
26,491
 
  
$
15,367
 
Short-term investments
  
 
6,963
 
  
 
1,973
 
Accounts receivable (net of allowance for doubtful accounts of $1,466 and $405 at June 30, 2002 and 2001, respectively)
  
 
6,172
 
  
 
9,134
 
Inventories
  
 
10,743
 
  
 
13,560
 
Deferred income taxes
  
 
5,205
 
  
 
3,621
 
Prepaid expenses and other current assets
  
 
5,299
 
  
 
4,778
 
    


  


Total current assets
  
 
60,873
 
  
 
48,433
 
Property and equipment, net
  
 
5,039
 
  
 
5,492
 
Goodwill, net
  
 
13,811
 
  
 
42,273
 
Purchased intangible assets, net
  
 
14,681
 
  
 
13,328
 
Long-term investments
  
 
6,761
 
  
 
2,424
 
Officer loans (net of allowance of $4,154 at June 30, 2002)
  
 
104
 
  
 
4,131
 
Other assets
  
 
2,543
 
  
 
780
 
    


  


Total assets
  
$
103,812
 
  
$
116,861
 
    


  


LIABILITIES AND STOCKHOLDERS’ EQUITY
                 
Current liabilities:
                 
Accounts payable
  
$
4,607
 
  
$
5,698
 
Due to related party
  
 
246
 
  
 
787
 
Accrued payroll and related expenses
  
 
1,530
 
  
 
1,243
 
Due to Gordian
  
 
2,000
 
  
 
—  
 
Accrued Lightwave settlement
  
 
2,004
 
  
 
—  
 
Accrued acquisition costs
  
 
—  
 
  
 
840
 
Other current liabilities
  
 
5,063
 
  
 
2,902
 
    


  


Total current liabilities
  
 
15,450
 
  
 
11,470
 
Deferred income taxes
  
 
5,205
 
  
 
5,895
 
Due to Gordian
  
 
1,000
 
  
 
—  
 
Commitments and contingencies
                 
Stockholders’ equity:
                 
Preferred stock, $0.0001 par value; 5,000,000 shares authorized; none issued and outstanding
  
 
—  
 
  
 
—  
 
Common stock, $0.0001 par value; 200,000,000 shares authorized; 54,252,528 and 43,301,803 shares issued and outstanding at June 30, 2002 and 2001, respectively
  
 
5
 
  
 
4
 
Additional paid-in capital
  
 
179,547
 
  
 
109,871
 
Notes receivable from officers (net of allowance of $249 at June 30, 2002)
  
 
(28
)
  
 
(790
)
Deferred compensation
  
 
(4,546
)
  
 
(10,020
)
Retained earnings (accumulated deficit)
  
 
(92,875
)
  
 
582
 
Accumulated other comprehensive gain (loss)
  
 
54
 
  
 
(151
)
    


  


Total stockholders’ equity
  
 
82,157
 
  
 
99,496
 
    


  


Total liabilities and stockholders’ equity
  
$
103,812
 
  
$
116,861
 
    


  


 
See accompanying notes.

F-2


Table of Contents
LANTRONIX, INC.
 
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
 
    
Years ended June 30,

 
    
2002

    
2001

    
2000

 
Net revenues (A)
  
$
57,646
 
  
$
48,972
 
  
$
44,975
 
Cost of revenues (B)
  
 
40,510
 
  
 
24,530
 
  
 
21,526
 
    


  


  


Gross profit
  
 
17,136
 
  
 
24,442
 
  
 
23,449
 
    


  


  


Operating expenses:
                          
Selling, general and administrative (C)
  
 
43,487
 
  
 
23,998
 
  
 
16,744
 
Research and development (C)
  
 
9,225
 
  
 
4,478
 
  
 
3,186
 
Stock-based compensation (B) (C)
  
 
2,863
 
  
 
3,019
 
  
 
1,093
 
Amortization of goodwill and purchased intangible assets
  
 
1,263
 
  
 
1,490
 
  
 
813
 
Impairment of goodwill and purchased intangible assets
  
 
50,828
 
  
 
—  
 
  
 
—  
 
Restructuring charges
  
 
3,473
 
  
 
—  
 
  
 
—  
 
In-process research and development
  
 
1,000
 
  
 
2,596
 
  
 
—  
 
    


  


  


Total operating expenses
  
 
112,139
 
  
 
35,581
 
  
 
21,836
 
    


  


  


Income (loss) from operations
  
 
(95,003
)
  
 
(11,139
)
  
 
1,613
 
Minority interest
  
 
—  
 
  
 
—  
 
  
 
(49
)
Interest income (expense), net
  
 
1,546
 
  
 
2,182
 
  
 
187
 
Other income (expense), net
  
 
(760
)
  
 
(167
)
  
 
(47
)
    


  


  


Income (loss) before income taxes and cumulative effect of accounting changes
  
 
(94,217
)
  
 
(9,124
)
  
 
1,704
 
Provision (benefit) for income taxes
  
 
(6,665
)
  
 
(1,876
)
  
 
649
 
    


  


  


Income (loss) before cumulative effect of accounting changes
  
 
(87,552
)
  
 
(7,248
)
  
 
1,055
 
Cumulative effect of accounting changes:
                          
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(597
)
  
 
—  
 
Adoption of new accounting standard, SFAS No. 142
  
 
(5,905
)
  
 
—  
 
  
 
—  
 
    


  


  


Net income (loss)
  
$
(93,457
)
  
$
(7,845
)
  
$
1,055
 
    


  


  


Basic income (loss) per share before cumulative effect of accounting changes
  
$
(1.70
)
  
$
(0.19
)
  
$
0.04
 
Cumulative effect of accounting changes per share:
                          
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(0.02
)
  
 
—  
 
Adoption of new accounting standard, SFAS No. 142
  
 
(0.12
)
  
 
—  
 
  
 
—  
 
    


  


  


Basic net income (loss) per share
  
$
(1.82
)
  
$
(0.21
)
  
$
0.04
 
    


  


  


Diluted income (loss) per share before cumulative effect of accounting changes
  
$
(1.70
)
  
$
(0.19
)
  
$
0.03
 
Cumulative effect of accounting changes per share:
                          
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(0.02
)
  
 
—  
 
Adoption of new accounting standard, SFAS No. 142
  
 
(0.12
)
  
 
—  
 
  
 
—  
 
    


  


  


Diluted net income (loss) per share
  
$
(1.82
)
  
$
(0.21
)
  
$
0.03
 
    


  


  


Weighted average shares (basic)
  
 
51,403
 
  
 
36,946
 
  
 
29,274
 
    


  


  


Weighted average shares (diluted)
  
 
51,403
 
  
 
36,946
 
  
 
34,178
 
    


  


  


(A) Includes revenues from related parties
  
$
2,644
 
  
$
4,257
 
  
$
3,226
 
    


  


  


(B) Cost of revenues includes the following:
                          
Amortization of purchased intangible assets
  
$
2,446
 
  
$
220
 
  
$
—  
 
Impairment of purchased intangible assets
  
 
6,448
 
  
 
—  
 
  
 
—  
 
Stock-based compensation
  
 
117
 
  
 
87
 
  
 
26
 
    


  


  


    
$
9,011
 
  
$
307
 
  
$
26
 
    


  


  


(C) Stock-based compensation is excluded from the following:
                          
Selling, general and administrative expenses
  
$
2,086
 
  
$
2,589
 
  
$
1,025
 
Research and development expenses
  
 
777
 
  
 
430
 
  
 
68
 
    


  


  


    
$
2,863
 
  
$
3,019
 
  
$
1,093
 
    


  


  


 
See accompanying notes.

F-3


Table of Contents
 
LANTRONIX, INC.
 
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands, except share data)
 
   
Common Stock

 
Additional
Paid-In
Capital

    
Notes
Receivable
From
Officers

    
Deferred
Compensation

    
Retained
Earnings
(Accumulated
Deficit)

    
Accumulated
Other
Comprehensive
Gain (Loss)

    
Total
Stockholders’
Equity

 
   
Shares

 
Amount

                
Balance at June 30, 1999
 
28,745,512
 
$
3
 
$
2,944
 
  
$
—  
 
  
$
—  
 
  
$
7,372
 
  
$
(7
)
  
$
10,312
 
Stock options exercised
 
1,057,720
 
 
—  
 
 
64
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
64
 
Deferred compensation, net
 
—  
 
 
—  
 
 
10,061
 
  
 
—  
 
  
 
(10,061
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
Stock-based compensation
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
1,119
 
  
 
—  
 
  
 
—  
 
  
 
1,119
 
Notes receivable issued to officers
 
—  
 
 
—  
 
 
152
 
  
 
(152
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
Components of comprehensive income:
                                                              
Translation adjustment
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
(3
)
  
 
(3
)
Net income
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
1,055
 
  
 
—  
 
  
 
1,055
 
                                                          


Comprehensive income
                                                        
 
1,052
 
   
 

 


  


  


  


  


  


Balance at June 30, 2000
 
29,803,232
 
 
3
 
 
13,221
 
  
 
(152
)
  
 
(8,942
)
  
 
8,427
 
  
 
(10
)
  
 
12,547
 
Issuance of common stock in initial public offering
 
6,000,000
 
 
1
 
 
53,706
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
53,707
 
Stock options exercised
 
1,450,656
 
 
—  
 
 
689
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
689
 
Deferred compensation, net
 
—  
 
 
—  
 
 
4,184
 
  
 
—  
 
  
 
(4,184
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
Stock-based compensation
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
3,106
 
  
 
—  
 
  
 
—  
 
  
 
3,106
 
Notes receivable issued to officers for stock purchase
 
1,965,498
 
 
—  
 
 
670
 
  
 
(670
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
Purchase transactions
 
4,082,417
 
 
—  
 
 
37,401
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
37,401
 
Repayment of notes receivable
 
—  
 
 
—  
 
 
—  
 
  
 
32
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
32
 
Components of comprehensive loss:
                                                              
Translation adjustment
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
(9
)
  
 
(9
)
Change in net unrealized loss on investment
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
(132
)
  
 
(132
)
Net loss
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
(7,845
)
  
 
—  
 
  
 
(7,845
)
                                                          


Comprehensive loss
                                                        
 
(7,986
)
   
 

 


  


  


  


  


  


Balance at June 30, 2001
 
43,301,803
 
 
4
 
 
109,871
 
  
 
(790
)
  
 
(10,020
)
  
 
582
 
  
 
(151
)
  
 
99,496
 
Issuance of common stock in secondary public offering
 
6,400,500
 
 
1
 
 
47,085
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
47,086
 
Stock options exercised
 
1,073,452
 
 
—  
 
 
1,619
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
1,619
 
Employee stock purchase plan
 
178,687
 
 
—  
 
 
437
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
437
 
Deferred compensation, net
 
—  
 
 
—  
 
 
(1,899
)
  
 
—  
 
  
 
1,899
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
Stock-based compensation
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
3,575
 
  
 
—  
 
  
 
—  
 
  
 
3,575
 
Repayment of notes receivable
 
—  
 
 
—  
 
 
—  
 
  
 
513
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
513
 
Provision for notes receivable from officers
 
—  
 
 
—  
 
 
—  
 
  
 
249
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
249
 
Purchase transactions
 
3,298,086
 
 
—  
 
 
22,941
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
22,941
 
Repurchase of common stock
 
—  
 
 
—  
 
 
(507
)
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
(507
)
Components of comprehensive loss:
                                                              
Translation adjustment
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
73
 
  
 
73
 
Change in net unrealized loss on investment
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
132
 
  
 
132
 
Net loss
 
—  
 
 
—  
 
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
(93,457
)
  
 
—  
 
  
 
(93,457
)
                                                          


Comprehensive loss
                                                        
 
(93,252
)
   
 

 


  


  


  


  


  


Balance at June 30, 2002
 
54,252,528
 
$
5
 
$
179,547
 
  
$
(28
)
  
$
(4,546
)
  
$
(92,875
)
  
$
54
 
  
$
82,157
 
   
 

 


  


  


  


  


  


 
See accompanying notes.

F-4


Table of Contents
 
LANTRONIX, INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
    
Years ended June 30,

 
    
2002

    
2001

    
2000

 
Cash flows from operating activities:
                          
Net income (loss)
  
$
(93,457
)
  
$
(7,845
)
  
$
1,055
 
Adjustments to reconcile net income (loss) to net cash used in operating activities:
                          
Cumulative effect of accounting changes:
                          
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
597
 
  
 
—  
 
Adoption of new accounting standard, SFAS No. 142
  
 
5,905
 
  
 
—  
 
  
 
—  
 
Depreciation
  
 
2,510
 
  
 
909
 
  
 
502
 
Amortization of goodwill and purchased intangible assets
  
 
3,709
 
  
 
1,710
 
  
 
813
 
Impairment of goodwill and purchased intangible assets
  
 
57,276
 
  
 
—  
 
  
 
—  
 
Stock-based compensation
  
 
2,980
 
  
 
3,106
 
  
 
1,119
 
Deferred income taxes
  
 
(5,594
)
  
 
(2,232
)
  
 
798
 
Provision for officer loans
  
 
4,403
 
  
 
—  
 
  
 
—  
 
Restructuring charges
  
 
3,473
 
  
 
—  
 
  
 
—  
 
Lightwave settlement
  
 
1,912
 
  
 
—  
 
  
 
—  
 
Equity losses from unconsolidated businesses
  
 
1,002
 
  
 
—  
 
  
 
—  
 
Provision for doubtful accounts
  
 
1,680
 
  
 
108
 
  
 
1
 
In-process research and development
  
 
1,000
 
  
 
2,596
 
  
 
—  
 
Revaluation of strategic investment
  
 
500
 
  
 
—  
 
  
 
—  
 
Loss on disposal of assets
  
 
—  
 
  
 
25
 
  
 
—  
 
Changes in operating assets and liabilities, net of effect from acquisitions:
                          
Accounts receivable
  
 
2,543
 
  
 
(1,440
)
  
 
(1,759
)
Inventories
  
 
2,984
 
  
 
(2,589
)
  
 
(2,079
)
Prepaid expenses and other current assets
  
 
(1,451
)
  
 
(1,902
)
  
 
(3,164
)
Other assets
  
 
(2,404
)
  
 
(742
)
  
 
19
 
Accounts payable
  
 
(3,829
)
  
 
2,216
 
  
 
650
 
Due to related party
  
 
(541
)
  
 
—  
 
  
 
—  
 
Due to Gordian
  
 
3,000
 
  
 
—  
 
  
 
—  
 
Other current liabilities
  
 
(431
)
  
 
530
 
  
 
463
 
    


  


  


Net cash used in operating activities
  
 
(12,830
)
  
 
(4,953
)
  
 
(1,582
)
    


  


  


Cash flows from investing activities:
                          
Purchases of property and equipment, net
  
 
(2,750
)
  
 
(4,632
)
  
 
(942
)
Purchases of held-to-maturity investments
  
 
(9,490
)
  
 
(30,470
)
  
 
—  
 
Purchase of intellectual property
  
 
(6,000
)
  
 
—  
 
  
 
—  
 
Purchases of minority investments
  
 
(7,288
)
  
 
(2,136
)
  
 
(500
)
Proceeds from sale of held-to-maturity investments
  
 
4,500
 
  
 
28,497
 
  
 
—  
 
Officer loans
  
 
—  
 
  
 
(4,131
)
  
 
—  
 
Acquisition of businesses, net of cash acquired
  
 
(4,746
)
  
 
(16,464
)
  
 
(116
)
    


  


  


Net cash used in investing activities
  
 
(25,774
)
  
 
(29,336
)
  
 
(1,558
)
    


  


  


Cash flows from financing activities:
                          
Net proceeds from underwritten offerings of common stock
  
 
47,085
 
  
 
53,706
 
  
 
—  
 
Net proceeds from other issuances of common stock
  
 
2,057
 
  
 
689
 
  
 
64
 
Proceeds from repayment of notes receivable from officers
  
 
513
 
  
 
32
 
  
 
—  
 
Payments on debt obligations
  
 
—  
 
  
 
(6,750
)
  
 
(766
)
    


  


  


Net cash provided by (used in) financing activities
  
 
49,655
 
  
 
47,677
 
  
 
(702
)
Effect of exchange rates on cash
  
 
73
 
  
 
(9
)
  
 
(3
)
    


  


  


Net increase (decrease) in cash
  
 
11,124
 
  
 
13,379
 
  
 
(3,845
)
Cash and cash equivalents at beginning of year
  
 
15,367
 
  
 
1,988
 
  
 
5,833
 
    


  


  


Cash and cash equivalents at end of year
  
$
26,491
 
  
$
15,367
 
  
$
1,988
 
    


  


  


Supplemental disclosure of cash flow information:
                          
Interest paid
  
$
49
 
  
$
8
 
  
$
5
 
Income taxes paid
  
$
210
 
  
$
276
 
  
$
1,828
 
 
See accompanying notes.

F-5


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
June 30, 2002

1.    Summary of Significant Accounting Policies
 
The Company
 
Lantronix, Inc. (the “Company”), incorporated in California in June 1989 and re-incorporated in the State of Delaware in May 2000, is engaged primarily in the design and distribution of networking and Internet connectivity products on a worldwide basis. The actual assembly and a significant portion of the engineering of the Company’s products is outsourced to third parties.
 
Basis of Presentation
 
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.
 
Use of Estimates
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. The industry in which the Company operates is characterized by rapid technological change and short product life cycles. As a result, estimates made in preparing the financial statements include the allowance for doubtful accounts, sales returns and allowances, inventory reserves, allowance for officer loans, strategic investments, goodwill and purchased intangible asset valuations, deferred income tax asset valuation allowances, warranty reserves, restructuring costs, litigation and other contingencies. To the extent there are material differences between estimates and the actual results, future results of operations will be affected.
 
Revenue Recognition
 
The Company does not recognize revenue until all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the Company’s price to the buyer is fixed or determinable; and collectibility is reasonably assured. Commencing July 1, 2000, recognition of revenue and related gross profit from sales to distributors are deferred until the distributor resells the product (Note 2) to provide assurance that all revenue recognition criteria are met at or prior to the point at which revenue is recognized. Net revenue from certain smaller distributors for which point-of-sale information is not available, is recognized one month after the shipment date. This estimate approximates the timing of the sale of the product by the distributor to the end user. Revenues from product sales to original equipment manufacturers, end-user customers, other resellers and from sales to distributors prior to July 1, 2000 generally are or have been recognized upon product shipment, but may be deferred to a later date if all revenue recognition criteria are not met at the date of shipment. When product sales revenue is recognized, the Company establishes an estimated allowance for future product returns based on historical returns experience; when price reductions are approved, it establishes an estimated liability for price protection payable on inventories owned by product resellers. Should actual product returns or pricing adjustments exceed our estimates, additional reductions to revenues would result. Revenue from the licensing of software is recognized at the time of shipment (or at the time of resale in the case of software products sold through distributors), provided the Company has vendor-specific objective evidence of the fair value of each element of the software offering and collectibility is probable. Revenue from post contract customer support and any other future deliverables is deferred and recognized over the support period or as contract elements are delivered.

F-6


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

 
Concentration of Credit Risk
 
The Company’s accounts receivable are derived from revenues earned from customers located throughout North America, Europe and Asia. The Company performs ongoing credit evaluations of its customers’ financial condition and maintains allowances for potential credit losses. Credit losses have historically been within management’s expectations. The Company generally does not require collateral or other security from its customers. The Company invests its excess cash in deposits with major banks, in U.S. Treasury and U.S. Agency obligations.
 
Fair Value of Financial Instruments
 
The Company’s financial instruments consist principally of cash and cash equivalents, short-term investments, accounts receivable, accounts payable and accrued liabilities. The Company believes all of the financial instruments’ recorded values approximate current values because of the short maturities of these investments.
 
Foreign Currency Translation
 
The financial statements of foreign subsidiaries whose functional currency is not the U.S. dollar have been translated to U.S. dollars in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 52, “Foreign Currency Translation.” Foreign currency assets and liabilities are remeasured into U.S. dollars at the end-of-period exchange rates. Revenues and expenses are translated at average exchange rates in effect during each period, except for those expenses related to balance sheet amounts, which are translated at historical exchange rates. Exchange gains and losses from foreign currency translations are reported as a component of accumulated other comprehensive gain (loss) within stockholders’ equity. Exchange gains and losses from foreign currency transactions are recognized in the consolidated statements of operations and historically have not been material.
 
Cash and Cash Equivalents
 
Cash and cash equivalents consist of cash and short-term investments with original maturities of ninety days or less.
 
Investments
 
The Company accounts for its investments in debt and equity securities with readily determinable fair values that are not accounted for under the equity method of accounting under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Management determines the appropriate classification of such securities at the time of purchase and reevaluates such classification as of each balance sheet date. Debt securities, which are classified as held-to-maturity, are stated at cost, adjusted for amortization of premiums and discounts to maturity.
 
The Company defines short-term investments as income yielding securities which can be readily converted to cash. Short-term investments consists of United States Treasury notes, obligations of U.S. Government agencies, state, municipal and county governments notes and bonds and corporate bonds. These investments are carried at cost which approximates fair value.
 
In September and October 2001, the Company paid an aggregate of $3.0 million to Xanboo Inc. (“Xanboo”) for convertible promissory notes, which converted in January 2002, in accordance with their terms, into Xanboo preferred stock. In addition, the Company purchased $4.0 million of Xanboo preferred stock in January 2002. The Company’s ownership interest in Xanboo was 15.8% at June 30, 2002. The Company is accounting for this long-term investment under the equity method based upon the Company’s ability through representation on Xanboo’s board of directors to exercise significant influence over its operations. The Company’s interest in the losses of Xanboo aggregating $526,000 during the year ended June 30, 2002 have been recognized as other expense in the accompanying consolidated statement of operations.

F-7


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

 
The Company periodically reviews its investments for which fair value is less than cost to determine if the decline in value is other than temporary. If the decline in value is judged to be other than temporary, the cost basis of the security is written down to fair value. The Company generally believes an other-than-temporary decline has occurred when the fair value of the investment is below the carrying value for two consecutive quarters, absent evidence to the contrary. During the year ended June 30, 2002, the Company recorded a $500,000 revaluation of a non-marketable equity investment resulting from an other-than-temporary decline in its value. This amount is included within the consolidated statements of operations as other expense.
 
Inventories
 
Inventories are stated at the lower of cost (on a first-in, first-out basis) or market. The Company provides reserves for excess and obsolete inventories determined primarily based upon estimates of future demand for the Company’s products. Shipping and handling costs are classified as a component of cost of revenues in the consolidated statements of operations.
 
Property and Equipment
 
Property and equipment are carried at cost. Depreciation is provided using the straight-line method over the assets’ estimated useful lives ranging from three to five years. Major renewals and betterments are capitalized, while replacements, maintenance and repairs which do not improve or extend the lives of the respective assets are expensed as incurred.
 
Long-Lived Assets
 
Long-lived assets and certain identifiable intangible assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicates that the carrying amount of such assets may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.
 
Capitalized Internal Use Software Costs
 
The Company capitalizes the costs of computer software developed or obtained for internal use in accordance with AICPA Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” Capitalized computer software costs consist of purchased software licenses and implementation costs. Costs capitalized at June 30, 2002 and 2001 of $2.5 million and $2.6 million, respectively, are included in computer and office equipment in the accompanying consolidated balance sheet. The capitalized software costs are being amortized on a straight-line basis over a period of three years. Amortization for the years ended June 30, 2002 and 2001 totaled $999,000 and $221,000, respectively. No amortization was charged for the year ended June 30, 2000. Capitalized internal use software with a net carrying amount of approximately $898,000 was written off in connection with the restructuring approved in February 2002 (Note 7).
 
Income Taxes
 
Income taxes are computed under the liability method. This method requires the recognition of deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities. The impact on deferred taxes of changes in tax rates and laws, if any, are

F-8


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

applied to the years during which temporary differences are expected to be settled and are reflected in the consolidated financial statements in the period of enactment.
 
Stock-Based Compensation
 
The Company accounts for stock-based awards to employees in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations, and has adopted the disclosure-only alternative of SFAS No. 123, “Accounting for Stock-Based Compensation.” Options granted to non-employees, as defined, have been accounted for at fair market value in accordance with SFAS No. 123.
 
The Company also complies with Financial Accounting Standards Board (“FASB”) Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation”—An Interpretation of APB Opinion No. 25 (“FIN 44”) which was issued in March 2000. FIN 44 clarifies the definition of an employee for purposes of applying APB 25, the criteria for determining whether a plan qualifies as a noncompensatory plan, the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and the accounting for an exchange of stock compensation awards in a business combination. FIN 44 was effective July 1, 2000 but certain conclusions therein cover specific events that occurred after either December 15, 1998 or January 12, 2000.
 
For stock option grants to non-employees who are consultants to the Company, the Company complies with the provisions of Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with, Selling Goods or Services” (“EITF 96-18”). EITF 96-18 requires variable plan accounting with respect to such non-employee stock options, whereby compensation associated with such options is measured on the date such options vest, and incorporates the then-current fair market value of the Company’s common stock into the option valuation model.

F-9


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

 
Earnings Per Share
 
Basic earnings (loss) per share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding during the year. Diluted earnings (loss) per share is calculated by adjusting outstanding shares assuming any dilutive effects of stock options.
    
Years ended June 30,

    
2002

    
2001

    
2000

    
(In thousands, except per share data)
Numerator:
                        
Income (loss) before cumulative effect of accounting changes
  
$
(87,552
)
  
$
(7,248
)
  
$
1,055
Cumulative effect of accounting changes:
                        
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(597
)
  
 
—  
Adoption of new accounting standard, SFAS No. 142
  
 
(5,905
)
  
 
—  
 
  
 
—  
    


  


  

Net income (loss)
  
$
(93,457
)
  
$
(7,845
)
  
$
1,055
    


  


  

Denominator:
                        
Weighted-average shares outstanding
  
 
51,909
 
  
 
37,227
 
  
 
29,274
Less: Non-vested common shares outstanding
  
 
(506
)
  
 
(281
)
  
 
—  
    


  


  

Denominator for basic earnings (loss) per share
  
 
51,403
 
  
 
36,946
 
  
 
29,274
    


  


  

Effect of dilutive securities
                        
Stock options
  
 
—  
 
  
 
—  
 
  
 
4,904
    


  


  

Denominator for diluted earnings (loss) per share
  
 
51,403
 
  
 
36,946
 
  
 
34,178
    


  


  

Basic income (loss) per share before cumulative effect of accounting changes
  
$
(1.70
)
  
$
(0.19
)
  
$
0.04
Cumulative effect of accounting changes per share:
                        
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(0.02
)
  
 
—  
Adoption of new accounting standard, SFAS No. 142
  
 
(0.12
)
  
 
—  
 
  
 
—  
    


  


  

Basic net income (loss) per share
  
$
(1.82
)
  
$
(0.21
)
  
$
0.04
    


  


  

Dilutive income (loss) per share before cumulative effect of accounting changes
  
$
(1.70
)
  
$
(0.19
)
  
$
0.03
Cumulative effect of accounting changes per share:
                        
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(0.02
)
  
 
—  
Adoption of new accounting standard, SFAS No. 142
  
 
(0.12
)
  
 
—  
 
  
 
—  
    


  


  

Diluted net income (loss) per share
  
$
(1.82
)
  
$
(0.21
)
  
$
0.03
    


  


  

F-10


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

 
Research and Development Costs
 
Costs incurred in the research and development of new products and enhancements to existing products are expensed as incurred. The Company believes its current process for developing products is essentially completed concurrently with the establishment of technological feasibility. Software development costs incurred after the establishment of technological feasibility have not been material and, therefore, have been expensed as incurred.
 
Warranty
 
Upon shipment to its customers, the Company provides for the estimated cost to repair or replace products to be returned under warranty. The Company’s warranty periods generally range from ninety days to five years from the date of shipment. The estimated warranty reserve accrual at June 30, 2002 and 2001 was $479,000 and $562,000, respectively.
 
Advertising Costs
 
The Company expenses advertising costs as incurred. Advertising expense was approximately $703,000, $1.1 million, and $1.1 million for the years ended June 30, 2002, 2001 and 2000, respectively.
 
Comprehensive Income
 
SFAS No. 130, “Reporting Comprehensive Income,” establishes standards for reporting and displaying comprehensive income (loss), and its components in the consolidated financial statements. Other accumulated comprehensive loss includes foreign currency translation adjustments and unrealized losses on investments.
 
Segment Information
 
SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” establishes standards for the way companies report information about operating segments in annual financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company has only one reportable segment.
 
Reclassifications
 
Certain amounts in the 2001 and 2000 consolidated financial statements have been reclassified to conform with current year presentation.
 
Recent Accounting Pronouncements
 
In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”) requiring that a liability for costs associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not expect the adoption of SFAS 146 to have a material impact on its consolidated financial position, results of operations, or cash flows.

F-11


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

 
2.    Accounting Change and Restatement of Financial Statements
 
In May 2002, the Company undertook a special investigation of its accounting, which revealed that beginning in the third and fourth quarters of fiscal 2001 certain shipments made to distributors and recorded as revenues in fiscal 2001 and 2002 did not qualify for revenue recognition upon shipment due to terms present in agreements with the distributors that were not considered in the Company’s original accounting decisions. The Company’s consolidated financial statements included in the Company’s previously filed Form 10-K/A (Amendment No. 1) for the year ended June 30, 2001 have been restated to change the accounting policy for recognizing revenue from sales to distributors as of July 1, 2000. Formerly, revenue from sales to distributors was recognized upon shipment, but in some cases during fiscal 2001 this resulted in improper revenue recognition because the Company granted product return privileges, extended payment terms or other rights to certain distributors in connection with specific shipments that either converted such transactions into what in substance were consignment arrangements or precluded the Company from using its historical experience in product sales to make a reasonable estimate of future product returns at the time of shipment.
 
Under the newly adopted accounting policy, revenue from sales to distributors is not recognized until the distributor sells the Company’s products to end user customers. This manner of correcting the errors in sales recognition made in the previously issued financial statements for fiscal 2001 is deemed to be preferable in the circumstances because (1) it eliminates from revenue any effect of shipping excessive levels of inventory to the distributors; (2) all revenue from distributor sales in fiscal 2001 and thereafter will be recognized on a common basis; and (3) there is assurance that any additional agreements with distributors that may have existed with respect to specific orders but are presently unknown will not have an impact on amounts reported as revenue after the restatement.
 
The restatement for the year ended June 30, 2001, resulted in a reduction in revenue of approximately $6.2 million and an increase in the loss before cumulative effect of accounting change of $2.9 million or $0.07 per share. The cumulative effect of the accounting change recorded as of July 1, 2000 was a charge of $597,000 (net of income taxes of $176,000) or $0.02 per share.
 
3.    Business Combinations
 
During fiscal year 2001, the Company completed the acquisitions of United States Software Corporation (“USSC”) and Lightwave Communications, Inc. (“Lightwave”). During fiscal year 2002, the Company completed the acquisitions of Synergetic Micro Systems, Inc. (“Synergetic”) and Premise Systems, Inc. (“Premise”). These acquisitions have been accounted for under the purchase method of accounting. The consolidated financial statements include the results of operations of these acquisitions after their dates of acquisition. The acquisition of USSC provides the Company with a software operating system, protocol stacks and an application development environment for embedded technology. The acquisition of Lightwave provides the Company with a higher end console management product. The acquisition of Synergetics provides the Company with high-performance embedded chips to complement its device networking products. The acquisition of Premise and its SYS(TM) software suite complements the Company’s Device Networking products by providing management and control capabilities for devices that have been network and internet-enabled.

F-12


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

 
A summary of transactions accounted for using the purchase method of accounting is outlined below:
 
Company Acquired

  
Date Acquired

  
Business

  
Shares Issued

  
Shares Reserved for Options Assumed

  
Total Shares Issued or Reserved

  
Cash Consideration

USSC
  
Dec. 2000
  
Software solutions provider
  
653,846
  
133,333
  
787,179
  
$
2.5 million
Lightwave
  
Jun. 2001
  
Developer of console management products
  
3,428,571
  
870,513
  
4,299,084
  
$
12.0 million
Synergetic
  
Oct. 2001
  
Embedded network communications solutions provider
  
2,234,715
  
615,705
  
2,850,420
  
$
2.7 million
Premise
  
Jan. 2002
  
Developer of client-side software applications
  
1,063,371
  
875,000
  
1,938,371
  
 
—  
 
The share issuances were exempt from registration pursuant to section 4(2) of the Securities Act of 1933, as amended. Portions of the cash consideration and shares issued will be held in escrow pursuant to the terms of the acquisition agreements.
 
The Premise agreement required the Company to issue 1,150,000 shares of common stock in exchange for all remaining shares of Premise. Prior to the acquisition, the Company held shares of Premise representing 19.9% ownership and, in addition, held convertible promissory notes of $1.2 million with interest accrued thereon at the rate of 9.0%. The convertible promissory notes were converted into equity securities of Premise at the closing of the transaction. The Company issued an aggregate of 1,063,371 shares of its common stock in exchange for all remaining outstanding shares of Premise common stock and reserved 875,000 additional shares of common stock for issuance upon exercise of outstanding employee stock options and other rights of Premise. Pursuant to the acquisition agreement, 106,337 shares are presently held in escrow to secure certain indemnification obligations, and 531,686 of such shares will be held in escrow pending achievement of certain performance obligations.
 
Allocation of Purchase Consideration
 
For each of the four purchase transactions, the Company obtained independent appraisals of the fair value of the tangible and intangible assets acquired in order to allocate the purchase price. Based upon those appraisals, the purchase price was allocated as follows (in thousands):
 
Company Acquired

    
Net Tangible Assets (Liabilities) Acquired

    
Goodwill

  
Purchased Intangibles

    
Deferred Compensation

  
Deferred Tax Liabilities

    
IPR&D

  
Total Consideration

USSC
    
$
(12
)
  
$
5,782
  
$
3,084
    
$
538
  
$
(1,117
)
  
$
496
  
$
  8,771
Lightwave
    
 
340
 
  
 
37,243
  
 
10,500
    
 
3,474
  
 
(4,183
)
  
 
2,100
  
 
49,474
Synergetic
    
 
(233
)
  
 
13,952
  
 
11,100
    
 
203
  
 
(5,213
)
  
 
—  
  
 
19,809
Premise
    
 
(79
)
  
 
6,593
  
 
3,700
    
 
—  
  
 
(1,480
)
  
 
1,000
  
 
9,734
 
The consideration for the purchase transactions was calculated as follows: a) common shares issued were valued based upon the Company’s stock price for a short period just before and after the companies reached agreement and the proposed transactions were announced and b) employee stock options were valued in

F-13


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

accordance with FIN 44. Net tangible assets acquired in connection with the purchase transactions include the acquisition costs incurred by the Company. Additionally, the net tangible assets of Lightwave and Synergetic reflect an outstanding note payable and credit facility aggregating $6.7 million and $626,000, respectively, which was paid in full by the Company in connection with the terms of the merger agreements.
 
In-Process Research and Development
 
In-process research and development (“IPR&D”) aggregated $496,000, $2.1 million and $1.0 million for the USSC, Lightwave and Premise purchase transactions, respectively. No IPR&D charge was identified as part of the Synergetic valuation. The amount allocated to IPR&D was determined through established valuation techniques in the high-technology industry and were expensed upon acquisition as it was determined that the projects had not reached technological feasibility and no alternative future uses existed.
 
The fair value of the IPR&D was determined using the income approach. Under the income approach, the expected future cash flows from each project under development are estimated and discounted to their net present value at an appropriate risk-adjusted rate of return. Significant factors considered in the calculation of the rate of return are the weighted-average cost of capital and return on assets, as well as the risks inherent in the development process, including the likelihood of achieving technological success and market acceptance. Each project was analyzed to determine the unique technological innovations, the existence and reliance upon core technology, the existence of any alternative future use or current technological feasibility, and the complexity, cost and time to complete the remaining development. Future cash flows for each project were estimated based upon forecasted revenues and costs, taking into account product life cycles, and market penetration and growth rates.
 
The IPR&D charge includes only the fair value of IPR&D performed to date. The fair value of existing technology is included in identifiable intangible assets, and the fair values of IPR&D to be completed and future research and development are included in goodwill. The Company believes the amounts recorded as IPR&D, as well as developed technology, represent fair values and approximate the amounts an independent party would pay for these projects.
 
As of the closing date of each purchase transaction, development projects were in process. Research and development costs to bring the products from the acquired companies to technological feasibility are not expected to have a material impact on the Company’s future consolidated financial position, results of operations, or cash flows.

F-14


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

 
Unaudited Pro Forma Data
 
The pro forma statements of operations data of the Company set forth below gives effect to the acquisitions of USSC, Lightwave, Synergetic and Premise as if they had occurred at the beginning of fiscal 2001. The following unaudited pro forma statement of operations data includes the amortization of purchased intangible assets and stock-based compensation. However, it excludes the charge for acquired IPR&D. This pro forma data is presented for informational purposes only and does not purport to be indicative of the results of future operations of the Company or the results that would have actually occurred had the acquisitions taken place at the beginning of fiscal 2001 (in thousands, except per share data):
 
    
Years ended June 30,

 
    
2002

    
2001

 
    
(In thousands, except per share data)
 
Net revenues
  
$
58,784
 
  
$
51,929
 
    


  


Loss before cumulative effect of accounting changes
  
$
(91,139
)
  
$
(12,123
)
Cumulative effect of accounting changes:
                 
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(597
)
Adoption of new accounting standard, SFAS No. 142
  
 
(5,905
)
  
 
—  
 
    


  


Net loss
  
$
(97,044
)
  
$
(12,720
)
    


  


Loss before cumulative effect of accounting change per share
  
$
(1.73
)
  
$
(0.30
)
Cumulative effect of accounting changes per share:
                 
Change in revenue recognition policy, net of income tax benefit of $176
  
 
—  
 
  
 
(0.02
)
Adoption of new accounting standard, SFAS No. 142
  
 
(0.11
)
  
 
—  
 
    


  


Basic and diluted net loss per share
  
$
(1.84
)
  
$
(0.32
)
    


  


 
4.    Components of Balance Sheet
 
Inventories
 
Inventories consist of the following:
 
    
June 30,

 
    
2002

    
2001

 
    
(In thousands)
 
Raw materials
  
$
6,389
 
  
$
6,752
 
Finished goods
  
 
9,079
 
  
 
6,526
 
Inventory at distributors
  
 
1,031
 
  
 
2,772
 
    


  


    
 
16,499
 
  
 
16,050
 
Reserve for excess and obsolete inventory
  
 
(5,756
)
  
 
(2,490
)
    


  


    
$
10,743
 
  
$
13,560
 
    


  


F-15


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

 
Property and Equipment
 
A summary of property and equipment, at cost, follows:
 
    
June 30,

 
    
2002

    
2001

 
    
(In thousands)
 
Computer and office equipment
  
$
8,381
 
  
$
6,869
 
Furniture and fixtures
  
 
1,776
 
  
 
1,534
 
Production and warehouse equipment
  
 
1,246
 
  
 
995
 
Transportation equipment
  
 
47
 
  
 
144
 
    


  


    
 
11,450
 
  
 
9,542
 
Accumulated depreciation
  
 
(6,411
)
  
 
(4,050
)
    


  


    
$
5,039
 
  
$
5,492
 
    


  


 
5.    Notes Receivable from Officers and Other Officer Loans
 
The Company had outstanding notes receivable of $28,000 (net of allowance of $249,000) and $790,000 from officers for the exercise of options at June 30, 2002 and June 30, 2001, respectively. These notes are full-recourse, are secured by the shares of stock issued upon exercise, are interest bearing at rates ranging from 5.06% to 7.50% per annum, and are due three years from the exercise date. The Company also had outstanding loans of $4.3 million and $4.1 million at June 30, 2002 and 2001, respectively, primarily related to taxes on exercised stock options. These notes are non-recourse, are secured by 2,573,394 shares of stock, and are interest bearing at rates ranging from 5.19% to 7.50% per annum. Principal and any unpaid interest are due upon any transfer or disposition of the common stock.
 
Due to the decrease in the trading price of the Company’s common stock, the aggregate value of the collateral related to the non-recourse loans is approximately $1.4 million (based on the quoted market price on September 20, 2002), which is below the amount owed on the notes. One of the noteholders is the former Chief Executive Officer who assumed the role of Chief Technology and Strategy Officer of the Company effective May 30, 2002 and resigned from the Company effective September 1, 2002. One of the noteholders is one of the Company’s outside directors and one of the noteholders is the former Chief Operating/Chief Financial Officer who was terminated by the Company on May 3, 2002. The Company reduced the carrying amount of the officer loans by $4.2 million by establishing a reserve for uncertainties relative to collection of the related receivables. Factors considered in determining the level of this reserve include the value of the collateral securing the notes, the ability of the Company to effectively enforce its collection rights and the ability of the former officers to honor their obligations to the Company. As of June 30, 2002, no impairment has been recorded as it relates to the note receivable from the outside director.

F-16


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

 
6.    Goodwill and Purchased Intangible Assets
 
Goodwill
 
The changes in the carrying amount of goodwill is as follows (in thousands):
 
    
Years Ended
June 30,

 
    
2002

    
2001

 
Balance as of July 1
  
$
43,025
 
  
$
—  
 
Reclassification of certain identified intangibles, net of related deferred tax liability of $2,229 in connection with adoption of SFAS No. 142 at July 1, 2001
  
 
3,329
 
  
 
—  
 
Goodwill acquired during the period
  
 
20,545
 
  
 
43,025
 
Impairment of goodwill in connection with adoption of SFAS No. 142 at July 1, 2001
  
 
(5,905
)
  
 
—  
 
Impairment of goodwill during the period
  
 
(46,431
)
  
 
—  
 
    


  


    
 
14,563
 
  
 
43,025
 
Less: accumulated amortization
  
 
(752
)
  
 
(752
)
    


  


Balance as of June 30
  
$
13,811
 
  
$
42,273
 
    


  


 
Purchased Intangible Assets
 
The composition of purchased intangible assets is as follows (in thousands):
 
         
June 30, 2002

  
June 30, 2001

    
Useful
Lives

  
Gross

    
Accumulated Amortization

    
Net

  
Gross

    
Accumulated Amortization

    
Net

Existing technology
  
3-5 years
  
$
12,720
    
$
(522
)
  
$
12,198
  
$
6,745
    
$
(188
)
  
$
6,557
Customer agreements
  
5
  
 
1,130
    
 
(143
)
  
 
987
  
 
—  
    
 
—  
 
  
 
—  
Customer lists
  
5
  
 
—  
    
 
—  
 
  
 
—  
  
 
3,500
    
 
(44
)
  
 
3,456
Patent/core technology
  
5
  
 
459
    
 
(212
)
  
 
247
  
 
299
    
 
(150
)
  
 
149
Tradename/trademark
  
5
  
 
532
    
 
(34
)
  
 
498
  
 
1,162
    
 
(65
)
  
 
1,097
Assembled workforce
  
5
  
 
—  
    
 
—  
 
  
 
—  
  
 
1,458
    
 
(68
)
  
 
1,390
Distribution network
  
5
  
 
—  
    
 
—  
 
  
 
—  
  
 
755
    
 
(76
)
  
 
679
Non-compete agreements
  
2-3
  
 
940
    
 
(189
)
  
 
751
  
 
—  
    
 
—  
 
  
 
—  
         

    


  

  

    


  

Total
       
$
15,781
    
$
(1,100
)
  
$
14,681
  
$
13,919
    
$
(591
)
  
$
13,328
         

    


  

  

    


  

 
The amortization expense for purchased intangible assets for the year ended June 30, 2002 was $3.7 million, of which $2.4 million was amortized to cost of revenues and $1.3 million was amortized to operating expenses. The estimated amortization expenses for the next five years are as follows:
 
    
Cost of
Revenues

  
Operating
Expenses

  
Total

Fiscal year ending June 30:
                    
2003
  
$
3,549
  
$
912
  
$
4,461
2004
  
 
3,549
  
 
694
  
 
4,243
2005
  
 
3,336
  
 
412
  
 
3,748
2006
  
 
1,459
  
 
380
  
 
1,839
2007
  
 
305
  
 
85
  
 
390
    

  

  

Total
  
$
12,198
  
$
2,483
  
$
14,681
    

  

  

F-17


Table of Contents

LANTRONIX, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
June 30, 2002

 
In acquisitions accounted for using the purchase method, goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. Prior to the adoption of SFAS No. 142, effective July 1, 2002, goodwill was amortized on a straight line basis over a seven year period. Purchased intangible assets are amortized on a straight line basis over periods ranging from two to five years.
 
In June 2001, the FASB issued SFAS No. 141, “Business Combinations,” effective for acquisitions consummated after June 30, 2001, and SFAS No. 142, “Goodwill and Other Intangible Assets” effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and certain intangible assets deemed to have indefinite lives are no longer amortized but are subject to annual impairment tests. Other intangible assets will continue to be amortized over their useful lives.
 
The Company elected to early adopt the rules set forth in SFAS No. 142 on accounting for goodwill and other intangibles effective as of July 1, 2001. For the year ended June 30, 2002, early adoption resulted in non- amortization of goodwill of $9.1 million or $0.18 per share, based on the weighted average shares outstanding for the year ended June 30, 2002.
 
The following table presents the impact of SFAS No. 142 on net loss and net loss per share had SFAS No. 142 been in effect for the years ended June 30:
 
    
2001

    
2000

Net income (loss) as reported
  
$
(7,845
)
  
$
1,055
Adjustments:
               
Amortization of goodwill
  
 
752
 
  
 
60
    


  

Net adjustments
  
 
752
 
  
 
60
    


  

Net income (loss) as adjusted
  
$
(7,093
)
  
$
1,115
    


  

Basic net income (loss) per share—as reported