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|UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
FORM 10-K
þ             ANNUAL REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2006
o             TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934
Commission File Number: 0-220-20
CASTELLE(Exact name of Registrant as specified in its charter)

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|------------------------------- |  | ---------------------------------
|California                      |  | 77-0164056                       
|(State or other jurisdiction of |  | (IRS Employer Identification No.)
|incorporation or organization)  |  |                                  
|                                |  |                                  

|855 Jarvis Drive, Suite 100, Morgan Hill, California 95037(Address of principal executive offices, including zip code)
      (408) 852-8000(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: Common Stock, No Par Value
      Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes __ No ü
      Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes __ No ü
      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 ü  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 From 10-K or any amendment to this Form 10-K . ___
      Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):.
      Large Accelerated Filer__                                  Accelerated Filer__                                Non-Accelerated Filer ü
      Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes __ No ü
      The approximate aggregate market value of the Registrants common stock held by non-affiliates of the Registrant, based upon the last sale price of the common stock reported on the Nasdaq SmallCap Market on June 30, 2006 was $11,368,474.
      The number of shares of Registrants common stock outstanding at February 28, 2007 was 4,045,021.
      DOCUMENTS INCORPORATED BY REFERENCE
    The information required by Part III of this Form 10-K are incorporated by reference from certain portions of the Registrants proxy statement relating to its 2007 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission or will be provided in an amendment to this Form 10-K to be filed with the SEC no later than April 30, 2007.
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|CastelleTable of Contents2
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|                          

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|-------------------- | ------------------------------------------------------------------------------------------------------------ | ---- | 
|                     |                                                                                                              |      | 
|PART I               |                                                                                                              | 2    | 
|                     |                                                                                                              |      | 
|ITEM 1.              | BUSINESS                                                                                                     | 2    | 
|ITEM 1A.             | RISK FACTORS                                                                                                 | 10   | 
|ITEM 1B.             | UNRESOLVED STAFF COMMENTS                                                                                    | 18   | 
|ITEM 2.              | PROPERTIES                                                                                                   | 18   | 
|ITEM 3.              | LEGAL PROCEEDINGS                                                                                            | 18   | 
|ITEM 4.              | SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS                                                        | 18   | 
|                     |                                                                                                              |      | 
|PART II              |                                                                                                              | 19   | 
|                     |                                                                                                              |      | 
|ITEM 5.              | MARKET FOR REGISTRANT'S COMMON STOCK, RELATED SHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES | 19   | 
|ITEM 6.              | SELECTED FINANCIAL DATA                                                                                      | 22   | 
|ITEM 7.              | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                        | 24   | 
|ITEM 7A.             | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                   | 36   | 
|ITEM 8.              | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                  | 36   | 
|ITEM 9.              | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                         | 36   | 
|ITEM 9A.             | CONTROLS AND PROCEDURES                                                                                      | 36   | 
|ITEM 9B.             | OTHER INFORMATION                                                                                            | 37   | 
|                     |                                                                                                              |      | 
|PART III             |                                                                                                              | 38   | 
|                     |                                                                                                              |      | 
|ITEM 10.             | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                                           | 38   | 
|ITEM 11.             | EXECUTIVE COMPENSATION                                                                                       | 38   | 
|ITEM 12.             | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                                               | 38   | 
|ITEM 13.             | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                               | 38   | 
|ITEM 14.             | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                       | 38   | 
|                     |                                                                                                              |      | 
|PART IV              |                                                                                                              | 39   | 
|                     |                                                                                                              |      | 
|ITEM 15.             | EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K                                              | 39   | 
|                     |                                                                                                              |      | 
|SIGNATURES           |                                                                                                              | 42   | 
|                     |                                                                                                              |     
|FINANCIAL STATEMENTS | F-3                                                                                                          |     

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|SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements, within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that are
based on our current expectations about our company and our industry. All of our forward-looking
statements involve risks and uncertainties. Our actual results could differ significantly from our
expectations and from the results expressed in, or implied by, these forward-looking statements.
Factors that might cause such a difference include, but are not limited to, those discussed in Item
1A of Part I of this Annual Report on Form 10-K. We urge you to consider these cautionary statements
carefully in evaluating our forward-looking statements. Except as required by law, we undertake no
obligation to publicly update any forward-looking statements to reflect subsequent events and circumstances.
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|PART I
ITEM 1.          BUSINESS
The following summary should be read in conjunction with, and is qualified in its entirety by, the
more detailed information and Consolidated Financial Statements and Notes thereto appearing elsewhere
in this Annual Report on Form 10-K.
OVERVIEW
Castelle was incorporated in California in 1987, and its principal offices are located at 855 Jarvis
Drive, Suite 100, Morgan Hill, California 95037. Unless the context otherwise requires, references
in this Form 10-K to we, us, or the Company refer to Castelle.
Our telephone number is (408) 852-8000. Castelle®, LANpress® and JetPress® are registered trademarks of the Company. FaxPressTM, FaxPress PremierTM, FaxPress EnterpriseTM, FaxPress PlusTM and InfoPressTM are trademarks of the Company. This Annual Report on Form 10-K includes trademarks and trade names
of other companies. Our common stock is listed on the Nasdaq SmallCap Market under the symbol CSTL.
We maintain a Website with the addresswww.castelle.com. We are not including the information contained
on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K.
We make available free of charge through our website our Annual Reports on Form 10-K and Quarterly
Reports on Form 10-Q as soon as reasonably practicable after we electronically file such material
with the Securities and Exchange Commission. In addition, we intend to disclose on our website any
amendments to, or waivers of, our code of business conduct and ethics, that are required to be publicly
disclosed pursuant to the rules of the Securities and Exchange Commission and the Nasdaq Stock Market.
We develop, manufacture, market and support office automation systems that allow organizations
to implement faxing over local area networks (known as LANs) and the Internet. Our FaxPress
fax servers provide a simple way to integrate fax with email, desktop and back-end applications.
Our products are designed to be easy to use and maintain, and provide an economical way for companies
to share resources over their networks.
Our products have historically centered on fax and print servers and related technologies. Beginning in
1997, our revenues declined as competition increased with respect to print server products, while
at the same time the Internet and other networking technologies advanced. As a result, we experienced
annual operating losses during 1997 through 1999. During the past ten years, management has redirected
our efforts to focus on server appliances and on development efforts to integrate existing and future
products with the Internet and emerging networking technologies. During 2004, we discontinued our
LANpress print server and InfoPress product lines, but will continue to provide support to our customers
during the warranty periods. Through the introduction of enhanced fax automation products that generate
higher gross profits, restructuring actions and cost reductions, we were able to report operating
profits in the fourth quarter of 1999 and in each of the four quarters of 2000. We incurred a loss
in 2001 resulting from a decrease in demand for our products due in part to the general downturn
of the economy. Our sales and profitability rebounded in 2002, and since then we have had five consecutive
years of net profits.
Industry Background
In the mid-1980s, organizations began to interconnect personal computers into LANs in order to allow
workgroups to share files, peripherals such as printers, and other specialized applications. As LANs
have proliferated throughout organizations and client/server architectures have gained acceptance,
they have become increasingly complex and the applications operating on computer networks have become
more critical to the success of the business enterprise. The further proliferation of the Internet
and Intranets and popularity of electronic communications expanded the role of LANs as a means to
provide common access to the Internet, email and other office automation applications. Installation,
maintenance and administration of LAN equipment required a staff of highly skilled professionals.
The costs associated with LANs and related equipment, server-class hardware, specialized software,
network integration, and support services are significant and typically affordable only by larger
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|organizations.  Many businesses were not able to afford office automation applications beyond
basic email, such as integrating fax technology into the network. This has created the opportunity
for specialized networking equipment that would perform a single application very well, known in
the industry as a server appliance. It is similar to using a toaster instead of
an oven, as it does a specific job better and it costs less. A server appliance is an integrated
hardware and software product designed to reduce the complexity and cost for a specific server-based
application. Internet routers, email servers, remote access servers, communication servers, fax servers
and print servers are examples of server appliances used by businesses today.
      We
        are a pioneer in server appliances, establishing all-in-one
        network fax solutions for business and enterprise, with our easy to use
        fax server product family.
Fax Office Automation Products:Fax machines have become a basic method of doing business worldwide. Fax is ubiquitous in business;
many homes even have fax machines. While computers have automated many business applications, faxing
remains as a basic method of business communication. We believe fax is here to stay, just as the
computer has not replaced paper. Fax servers integrate legacy fax business methods into the network
to improve office productivity. Fax servers also provide the opportunity for new business applications
to be developed to take advantage of the inherent strength and prevalence of fax machines. Virtually
every business in the world has a fax machine that can be used to receive information. Sending purchase
orders, invoices, order confirmations, etc. directly to a fax machine, as compared to using the mail,
is a growing segment of the fax server market.
The increasing popularity of email and the Internet has provided a boost to electronic communications
as many users and organizations become more comfortable and accustomed to their use. To further simplify
and improve inter- and intra-organizational communications, corporate Management Information Services
departments are looking for ways to integrate different types of messaging into a unified messaging
environment. Fax remains one of the key business communication tools and is one of the essential
components of the corporate messaging environment. In corporate communication infrastructures, fax
is being integrated into email. To facilitate this capability companies install email-integrated
fax server systems.
Fax servers allow users to send and receive faxes as easily as emails, using the same email application
for both types of messages. A fax server can sort incoming faxes directly and deliver them electronically
and confidentially to the electronic mailboxes of the intended recipients. A fax server can also
be used as an independent network shared system in environments that require high volume incoming
and outgoing faxes. Users are able to send and receive faxes directly from their computers or workstations,
eliminating the need to print a document, take it to a stand-alone fax machine and wait for its transmission.
Fax servers can help reduce fax transmission costs by sending non-urgent faxes at off-peak
telephone rates and by utilizing fax over the Internet technology.
Many fax servers are implemented using complex software that requires the installation of a Windows
or UNIX network operating system, a server-class computer, and specialized expensive fax modems.
Our fax servers, FaxPress, FaxPress Premier and FaxPress Enterprise, are self-contained units with
all the necessary hardware and software to integrate fax into network, desktop, email and back-end
applications. As server appliances, they are designed to be easy to use and maintain and we believe
that they are more economical than other solutions.
Server appliances, such as communications/messaging servers, have emerged and gained market acceptance
due to their ability to significantly reduce complexity and cost associated with the installation
and maintenance of networking systems. These appliances also make the complex functionality of Internet
and Intranet communications available and affordable to smaller businesses. As professionals in enterprises
and small organizations alike continue to recognize the benefits of server appliances, such as remote
access, scanning, faxing, electronic mail and related functions, we believe that the demand for such
network systems will increase.
Our Strategy
Our
objective is to be a leading supplier of network server appliances worldwide for all-in-one
network fax solutions for business and enterprise, offering organizations several network fax options:
desktop faxing, production faxing, fax and email integration, workflow application integration, and
tools for developing custom fax applications. Our fax servers, FaxPress, FaxPress Premier, FaxPress
Enterprise, include the FaxPress or FaxPress Plus software suite that enables administrators and
users to perform functions such as managing fax queues, creating
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|reports, and viewing fax archives. Our products are installed in many Fortune 1000 companies and small
and medium sized businesses worldwide.
Focus on Server Appliances:We focus exclusively on providing innovative, reliable, easy-to-use network products. Since our inception,
we have focused on developing networking products that tightly integrate proprietary hardware systems
with standard computing platforms. As a result, we believe we have developed a high level of expertise
in networking, software development, hardware design and telephony technology. We plan to capitalize
on these attributes by continuing to focus on providing network enhancement products that enable
users to communicate more effectively.
Focus on Application Solutions and Communications:We focus on developing application solutions for inter and intra-company communications. We believe
that our focus on application servers rather than on infrastructure systems enables us to offer products
that bring higher value services to customers and provide a higher margin to us.
Expand Product Line:We are leveraging our expertise in server appliances to offer new easy-to-use, cost-effective solutions.
We continue to expand our fax server products and apply our proven technology to other areas.
Focus on E-commerce and Other High Volume Distribution Channels:We have established a two-tier domestic and international distribution network of leading national
and regional network product distributors and resellers including Ingram Micro and Tech Data. Our
products are well suited for sale by e-commerce vendors and we have been successful working with
leading resellers such as CDW and Insight. We are focused on maintaining and strengthening our current
distribution network in North America, Europe and the Pacific Rim.
Leverage Strategic Relationships:We augment our product offerings by establishing relationships with companies able to provide products
in areas outside of our core technical competencies or in instances where internal development of
such products is not cost-effective. We also establish relationships with numerous leaders in hardware
and software technology to keep abreast of, and respond quickly to, technological changes that may
affect the network enhancement market.
Products
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

| | We develop and
  market a range of fax servers that enhance network productivity, performance and functionality.
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|Fax Server Products:We have incorporated plug-and-play and ease of use with our FaxPress family
of network fax servers. We position FaxPress, FaxPress Premier and FaxPress Enterprise as the easiest
way to add faxing to a companys network and integrate fax with email. Our FaxPress family of
products allow network users to send, receive, route, print, store, edit and retrieve fax transmissions
from their own personal computers on a network. Our fax servers can be integrated into an email system
creating a unified fax/email environment. The FaxPress family of products enables users to transmit
documents directly to a fax device as easily as if they were printing to a local or network printer
or sending an email message. The product also provides network administration features such as, monitoring,
logging or configuring FaxPress, FaxPress Premier and FaxPress Enterprise users. Our fax server products
are designed to comply with current regulatory standards in the United States, Europe and the Pacific
Rim. During the past few years, fax products and related services represented almost 100% of our total net sales.
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| | Key features of FaxPress, FaxPress Premier and FaxPress Enterprise products (configured with its current
  software versions) include:
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| |                                                                                                                                       

| |  | Easy installation and maintenance:FaxPress, FaxPress Premier and FaxPress Enterprise are network fax servers that include all the necessary
  hardware and software. The hardware system is a box with an integrated 10/100 Base-T Ethernet interface
  and one to seventy-two fax channels. Our fax server products include all required server and client
  software.
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| |  | Support for popular network operating environments:Our fax server products operate in any local area network based on Microsoft Windows 2000 and 2003;
  Windows XP, Vista, and Terminal Server; Novell NetWare; or Linux servers.                                                                                                                                                                                                                                                                                               
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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Ability to create a unified fax/email messaging environment:Our fax server products have the ability to integrate fax into a corporate email system, allowing users
  to send and receive faxes in the same manner as emails. Our products support Microsoft Exchange/Outlook,
  Lotus Notes, Novell GroupWise, Netscape and other SMTP compatible email systems. Our unique Outlook
  Direct interface offloads fax processing from the Microsoft Exchange Server while maintaining tight
  integration with the Outlook client.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Integration with many popular accounting and Customer Relationship Management applications:Our fax server products are available with the Reform-for-FaxPress software package from FabSoft that
  allows users to send faxes from many popular accounting, financial and payroll systems including
  Oracle, SAP, PeopleSoft, Great Plains, ACCPAC and Macola. Reform can support any application that
  supports form printing. Our products also integrate with GoldMine contact management software.                         
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Ability to send faxes from many applications:Faxing from within any Windows applications such as Microsoft Office and Lotus Smart Suite.                                                                                                                                                                                                                                                                                                                                                                                         
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Electronic delivery of faxes to desktops:Our fax server products support several methods to deliver incoming faxes direct to the email or fax
  inbox of the intended recipient. Such methods include Direct Inward Dialing, Dual Tone Multifrequency,
  T.30 sub-addressing, and line routing.                                                                                                                                                                                                                                  
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Internet faxing capabilities reduce transmission costs:Our fax server products enable users to connect several units via the Internet or the Intranet to form
  a private Fax-over-IP network that can significantly reduce the cost of fax transmissions.                                                                                                                                                                                                                                                                       
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| |  | Integration into custom applications:We provide a software development kit that allows programmers to integrate fax functions into their
  current applications or to create new customized applications that use the FaxPress, FaxPress Premier,
  or FaxPress Enterprise servers.                                                                                                                                                                                                                                              
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| |  | Software options:We offer a range of value-added software options that increase the functionality of our FaxPress, FaxPress
  Premier and FaxPress Enterprise systems and enable these servers to address specialized applications
  as mentioned above. Software upgrades and options are available to the installed base units at prices
  starting at $495.                                                                                                                                                                   

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|We offer a family of FaxPress, FaxPress Premier and FaxPress Enterprise fax server systems ranging
from entry-level products targeted for small businesses with fewer than 50 users to high-end fax
solutions capable of supporting enterprise-wide installations. The suggested list prices for our
server products range from $1,995 to $81,495. Server pricing is based on hardware model, with no
per-user costs. The FaxPress 2500 and 5000 families come with the FaxPress 9.x network fax software
that adds integration with popular email packages, and many advanced fax management and integration
features. The FaxPress Premier and Enterprise families come with the FaxPress Plus 4.x network fax
software.
In July 2006, we announced the release of our new FaxPress Enterprise Redundant Fax Server, the
newest addition to our FaxPress Enterprise family of digital fax servers, providing an all-in-one
redundant fax solution for T1, E1 or ISDN environments. Duplicated and backup hardware components
provide increased reliability for business-critical faxing. In the event of a hardware failure, the
backup components are designed to automatically take over allowing the fax server to continue to
operate. The server-class hardware closely monitors the system and simultaneously sends notification
to the administrator reporting the failed component. FaxPress Enterprise Redundant features include:
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| |       Dual hot swappable hard disk drives
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| |       RAID technology for disk mirroring                               
| | ------------------------------------------------------------------------
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| |       Dual hot swappable power supplies                                
| |                                                                         
| |       Dual hot swappable cooling fans                                  
| |                                                                         
| |       Dual Gigabit Ethernet connectivity with client cross over support
| |                                                                         
| |       Industrial grade hardware                                        
| |                                                                         

| |  | Support for Digital T1, E1 and ISDN Environments in single or dual configurations for auto failover
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|In August 2006, we announced that we will enter into the fax-over-IP (FoIP) market with a new generation
of network fax servers that support internet protocol (IP) faxing, which will be the fastest growing
segment of the fax server market from 2004 to 2009, according to a report by independent research
firm, Davidson Consulting. We expect to release our new generation of IP fax servers in 2007. As
companies implement full IP telephony solutions or voice over IP (VoIP), the demand for IP fax solutions
is also expected to increase. By utilizing the IP faxing T.38 protocol, users are able to send faxes
in real time, receiving status and confirmation as the fax is sent over the VoIP network. The advantages
of IP faxing include significant savings on long distance charges, accelerated document processing
and centralized management for the network administrator.
The following table summarizes our FaxPress, FaxPress Premier and FaxPress Enterprise system products
:
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|                            |                          |                          |                         | Network Environment                              |                                            
|--------------------------- | ------------------------ | ------------------------ | ----------------------- | ------------------------------------------------ | -------------------------------------------
|                            |                          |                          |                         |                                                  |                                            
|Product Model               | Number of
      Channels | Email 
      Integration | Network 
      Topology | NetWare 
      3.x, 4.x, 5.x,
      6.x (IPX,IP) | Windows 
      NT/2000/XP/2003
      /Vista
|                            |                         
|                           
|FaxPress 2500               | 1, 2                     | ü                        | Ethernet                | ü                                                | ü                                          
|FaxPress 5000               | 2, 4 or 8                | ü                        | Ethernet                | ü                                                | ü                                          
|FaxPress Premier Analog     | 4, 8, 12, 16             | ü                        | Ethernet                | n/a                                              | ü                                          
|FaxPress Enterprise Digital | 8, 24, 48, 72            | ü                        | Ethernet                | n/a                                              | ü                                          
|T1                          |                          |                          |                         |                                                  |                                            
|FaxPress Enterprise ISDN    | 4, 8, 12                 | ü                        | Ethernet                | n/a                                              | ü                                          
|FaxPress Enterprise Digital | 10, 30, 60, 90           | ü                        | Ethernet                | n/a                                              | ü                                          
|E1                          |                          |                          |                         |                                                  |                                            

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|Research and Product Development
We have invested substantially in research and product development since inception. We believe our
future performance will depend in large part on our ability to enhance our current products, to expand
our product offerings, to maintain technological competitiveness, and to meet an expanding range
of customer requirements. We spent $1.8 million, $1.7 million and $1.7 million in research and product
development activities in 2006, 2005 and 2004, respectively.
We continue to invest in enhancing our server appliance product lines by developing new versions of
client and server software and server hardware. The product feature set is driven by the increasing
complexity of user needs. The changing corporate communications/messaging environment and increasing
demand for easy-to-use networking systems define these needs. The development efforts are focused
on enhancing functionality of existing

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|products and developing other systems to expand our product offerings. Our development efforts are
focusing on high value applications, while relying on our partners to provide basic functionality
for some of our product lines.
In January 2007, we released version 9.0 of our FaxPress software, following the release of FaxPress
Plus software version 4.0 in 2005. Our current version of the FaxPress Plus software is 4.1.1. The
new releases of FaxPress 9.0 and FaxPress Plus 4.1.1 Network Fax Software offer a new level of email
integration, expanded operating environments and fax automation. It integrates with popular multi-functional
peripherals from such suppliers as Xerox, HP, Canon eCopy, Ricoh GlobalScan, EFI and Sharp OSA. It
includes improved integration with Microsoft Exchange, enhanced Windows XP/2003/Vista and Citrix
MetaFrame XP support, improved Microsoft Office support, production faxing and fax automation made
easy. In 2006, we released our new FaxPress Enterprise Redundant Fax Server, which provides
full hardware redundancy for fax applications.
The current FaxPress, FaxPress Premier and FaxPress Enterprise fax server product lines are continuously
being enhanced to offer greater integration into corporate networking environments. In addition,
we expect to release a new generation of network fax servers that support IP faxing by early 2007.
Sales, Marketing and Distribution
Our products are installed in many Fortune 1000 firms and small and medium sized businesses worldwide.
We sell our products through multiple channels, determined by the product, market and customer need.
We have an established two-tier domestic and international distribution network of leading national
and regional network product distributors and resellers. Software enhancements and options that complement
the FaxPress products are primarily marketed directly by us to registered end users. The direct sales
group works closely with distributors and value-added resellers (VARs) in qualifying
sales opportunities for the fax server products. Demand for our products is created through a variety
of marketing programs. These programs are targeted toward end-users to stimulate demand for the products
and toward distributors, resellers, VARs and e-commerce vendors to promote the product in the sales
channel. These programs include targeted and active participation in industry networking and communication
trade shows, as well as advertising in associated publications. We increase awareness of our products
by Internet marketing via targeted e-advertising, publishing and sponsoring email newsletters, enhancing
our Web presence, print advertising, conducting direct mail campaigns, offering seminars, trade shows
and conferences, and other forms of public relations efforts. Our Web site has been updated and designed
to assist customers in obtaining information about our products and contacting our sales personnel.
Our
products are well suited for sale by e-commerce vendors, and we have experienced success working
with leading resellers such as CDW and Insight.
In 2006, Ingram Micro and Tech Data, our domestic distributors, individually accounted for more than
10% of our sales and collectively represented approximately 47% of our net sales. In 2005 and 2004,
the same distributors together accounted for approximately 43% and 44%, respectively, of our net
sales. Total sales to customers located in the Pacific Rim, Europe and rest of Americas comprised
approximately 14%, 20%, and 18% of our net sales in 2006, 2005 and 2004, respectively.
Customer Service and Support
We provide customers with support services, which are available to assist customers with installation,
use and operation issues in an effort to ensure smooth and reliable operation of our products. Our
network engineers, located at corporate headquarters, provide technical support via telephone, fax
and email during normal business days from 6:00 a.m. to 5:00 p.m. (Pacific Time). Support is provided
under warranty terms as well as through extended warranty agreements sold directly to the customer
by us. We also provide other customer support through our Web site. We have an automated call management
distribution system that provides improved levels of support to help resolve customer issues.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|7
|-



|Manufacturing
Our current in-house manufacturing operations consist primarily of material planning, final testing,
quality control and service repair. Most of our products are manufactured by third-party manufacturers
that provide customized, integrated manufacturing services, including procurement, manufacturing,
printed circuit board assembly and final testing. These arrangements enable us to shift certain costs
to such providers, thereby allowing us to focus resources on our product development efforts. The
failure of such manufacturers to meet their contractual commitments to us could cause delays in product
shipments, thereby potentially adversely affecting our business, operating results and financial condition.
      We
        do not currently have any material long-term supply contracts with any
        of our manufacturing subcontractors or component suppliers. We purchase
        finished products and components on a purchase order basis. We own all
        engineering, sourcing documentation, functional test equipment and tooling
        used in manufacturing our products and believe that we could shift product
        assembly to alternate suppliers if necessary. Certain key components of
        our products, including a modem chip set from Conexant, microprocessors
        from Motorola and integrated circuits and modem boards from Dialogic Corporation,
        and Kendin, are currently available from single sources. Other components
        of our products are currently available from only a limited number of
        sources. In addition, certain manufacturers have announced the end-of-life
        of certain standard off-the-shelf components which are being used by us
        in the making of our FaxPress Products. However, we purchased several
        years worth of supplies of these end-of-life components in an effort to
        guarantee an uninterrupted supply of FaxPress Products to our customers
        while we continue to develop new replacement products.
Competition
The network enhancement products and computer software markets are highly competitive, and we believe
that such competition will intensify in the future. The competition is characterized by rapid change
and improvements in technology along with constant pressure to reduce the prices of products. We
currently compete principally in the market for network fax servers.
The principal competitive factors affecting the market for our products include product functionality,
performance, quality, reliability, ease of use, quality of customer training and support, name recognition,
price, and compatibility and conformance with industry standards and changing operating system environments.
Several of our existing and potential competitors, have substantially greater financial, engineering,
manufacturing and marketing resources than us. We also experience competition from a number of other
software, hardware and service companies. In addition to our current competitors, we may face substantial
competition from new entrants into the network enhancement market, including established and emerging
computer, computer peripheral, communications and software companies. In the fax server market we
compete with companies such as Captaris, Inc., Omtool, Ltd. and Esker Software. In addition, certain
competing methods of communications such as the Internet or electronic mail could adversely affect
the market for fax products.
Proprietary Rights
Our success depends to a certain extent upon our technological expertise and proprietary software technology.
We rely upon a combination of contractual rights and copyright, trademark and trade secret laws to
establish and protect our technologies. Additionally, we generally enter into confidentiality agreements
with those employees, distributors, customers and suppliers who have access to sensitive information
and limit access to and distribution of our software documentation and other proprietary information.
Because of the rapid pace of technological change in the LAN product industry, we believe that patent
protection for our products is less significant to our success than the knowledge, ability and experience
of our employees, the frequent introduction and market acceptance of new products and product enhancements,
and the timeliness and quality of our support services. We may not be able to obtain the necessary
intellectual property rights and other parties may contest our intellectual property rights.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|8
|-



|Government Regulation
Certain aspects of the networking industry in which we compete are regulated both in the United States
and in foreign countries. Imposition of public carrier tariffs, taxation of telecommunications services
and the necessity of incurring substantial costs and expenditure of managerial resources to obtain
regulatory approvals, particularly in foreign countries, could have a material, adverse effect on
our business, operating results and financial condition. Additionally, our products must comply with
a variety of equipment, interface and installation standards promulgated by communications regulatory
authorities in different countries.
Employees
As of March 11, 2007, we employed a total of 40 full-time equivalent personnel, 8 in operations,
10 in sales and marketing, 7 in engineering, 8 in customer service and 7 in finance and administration.
We have not experienced a work stoppage, no employees are represented by a labor organization and
we consider our employee relations to be good.
Executive Officers
The names and ages of our executive officers as of February 28, 2007 are set forth below:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

| | Name              | Age | Position                                                                         
| | ----------------- | --- | ---------------------------------------------------------------------------------
| | Scott C. McDonald | 53  | President, Chief Executive Officer                                               
| | Eric Chen         | 54  | Senior Vice President, Engineering and Business Development                      
| | Paul Cheng        | 58  | Vice President, Finance and Administration, Chief Financial Officer and Secretary
| | Richard Fernandez | 47  | Vice President, Operations                                                       
| | Edward J. Heinze  | 61  | Vice President, Worldwide Sales                                                  
| | Michael Petrovich | 45  | Vice President, North America Sales                                              

|                 
|-----------------
|Scott C. McDonald
|                 

| | Mr. McDonald has served as our President and
  Chief Executive Officer since April 2002 and has served as a director since April 1999. From May
  2001 to the first quarter of 2002, Mr. McDonald served on the board of directors for Octant Technologies
  and Digital Power Corporation and provided consulting services. Mr. McDonald served as the Chief
  Financial and Administrative Officer at Conxion Corporation, a network and Internet services company,
  from December 1999 to April 2001. From 1997 to 1999, Mr. McDonald served on the board of directors
  for CIDCO, Inc, Octant Technologies Inc. and Digital Power Corporation; in addition to providing
  consulting services to CIDCO, Inc. Mr. McDonald currently serves on the board of directors of privately
  held Octant Technologies, Inc. Mr. McDonald holds a BS in Accounting from the University of Akron
  and an MBA from Golden Gate University.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|         
|---------
|Eric Chen
|         

| | Mr. Chen has served as our Senior Vice President,
  Engineering and Business Development since May 2002. From May 2000 to May 2002, Mr. Chen served as
  our Vice President, Engineering. Upon joining us in 1989, Mr. Chen initially worked on software development
  projects including developing the first FaxPress e-mail gateways, porting FaxPress to non-Novell
  platforms, and the first menu-driven installation and configuration programs for both FaxPress and
  LANpress. Successive to that, Mr. Chen served as the Director of Print Server Product Marketing and
  Business Unit and has managed the engineering development and manufacturing business relationships
  with our partners. Before joining our company, Mr. Chen was with 3COM, a network solutions provider.
  Mr. Chen has a BS in Engineering from Taiwan and an MS in Computer Science from the University of
  Massachusetts.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|
|

|9
|-



|Paul Cheng
|----------
|          

| | Mr. Cheng has served as our Vice President, Finance
  and Administration since April 2000. In March 2001, Mr. Cheng was also appointed as Chief Financial
  Officer and Secretary. Mr. Cheng brings more than 20 years of financial experience from a career
  that was launched in Hong Kong where he was the Plant Controller of Fairchild Semiconductor Hong
  Kong Ltd. Before joining our company, he served as the Vice President of Finance and Administration
  at Eclipse International, Inc., a systems development company, from April 1997 to March 2000. In
  addition, he has held various executive positions including Vice President of Finance at Quintus
  Corporation, a developer of customer relations management software from 1993 to 1995 and Corporate
  Controller at Power Integration, Inc., a semiconductor manufacturer from 1995 to 1997. Mr. Cheng
  is a member of the Chartered Certified Accountants and holds a BS in Accounting from Hong Kong.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                 
|-----------------
|Richard Fernandez
|                 

| | Mr. Fernandez has served as our Vice President
  of Operations since December 2002. From June 2002 to December 2002, Mr. Fernandez served as our Director
  of Operations. Mr. Fernandez has more than 22 years of manufacturing and materials planning experience
  prior to joining the Company. Prior to joining our company, Mr. Fernandez managed the acquisition
  of servers and storage devices for Conxion Corporation from June 2000 to May 2002. Prior to joining
  Conxion, Mr. Fernandez was Director of Operations with CIDCO, Inc. since March 1994. In addition,
  Mr. Fernandez has held various management positions with Computer Products Inc., MAD Intelligent
  Systems and Sperry Univac.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                
|----------------
|Edward J. Heinze
|                

| | Mr. Heinze has served as our Senior Vice President,
  Sales since July 2006. From January 2000 to July 2006, Mr. Heinze served as our Vice President, Sales,
  U.S. From 1994 to January 2000, Mr. Heinze served in several capacities including Product Manager
  of the Fax Product Line, and Regional Sales Manager. Before joining our company, Mr. Heinze served
  in several capacities at Visual/White Pine Software, a software developer, including Vice President
  of Sales. Prior to his tenure at White Pine, he was Chief Operations Officer for XMARK, a computer
  systems manufacturer, and Vice President of Sales and Marketing at EIT, Millicom, Olympia, and Ontel.
  He holds a BS degree from Waynesburg College.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                 
|-----------------
|Michael Petrovich
|                 

| | Mr. Petrovich has served as our Vice President,
  North American Sales since July 2006. From October 2000 to July 2006, Mr. Petrovich served as our
  Vice President, Sales, International and has been with us since 1992. Prior to joining us, Mr. Petrovich
  was the marketing communications manager for Novells National Reseller Organization, a software
  company. In this role Mr. Petrovich focused on business strategies and development of Novells
  direct reseller sales channel. Before joining Novell, Mr. Petrovich held sales and marketing positions
  at Excelan, a LAN manufacturer, and International Microcircuits Incorporated, a semiconductor company.
  Mr. Petrovich holds a BA in Behavioral Sciences from San Jose State University.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ITEM 1A.       RISK FACTORS
Shareholders or investors considering the purchase of shares of our common stock should carefully consider
the following risk factors, in addition to other information in this Annual Report on Form 10-K.
Additional risks and uncertainties not presently known to us or that we currently deem immaterial
also may impair our business operations.
Our revenue and operating results have fluctuated in the past and are likely to fluctuate significantly
in the future, particularly on a quarterly basis.
Our operating results may vary significantly from quarter to quarter due to many factors, some of which
are outside our control. For example, the following conditions could all affect our results:

|10
|--



|
|
|

| |       changes in our product sales and customer mix;                       
| | ----------------------------------------------------------------------------
| |                                                                             
| |       constraints in our manufacturing and assembling operations;          
| |                                                                             
| |       shortages or increases in the prices of raw materials
and components;
| |                                                                             
| |       changes in pricing policy by us or our competitors;                  
| |                                                                             
| |       a slowdown in the growth of the networking market;                   
| |                                                                             
| |       seasonality;                                                         
| |                                                                             
| |       timing of expenditures; and                                          
| |                                                                             
| |       economic conditions in the United States, Europe and Asia.           

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Our sales often reflect orders shipped in the same quarter in which they are received. In addition,
significant portions of our expenses are relatively fixed in nature, and planned expenditures are
based primarily on sales forecasts. Therefore, if we inaccurately forecast demand for our products,
the impact on net income may be magnified by our inability to adjust spending quickly enough to compensate
for the net sales shortfall.
Other factors contributing to fluctuations in our quarterly operating results include:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

| |  | changes in the demand for our products;                                                                             
| | - | --------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                     
| |  | customer order deferrals in anticipation of new versions of our products;                                           
| |   |                                                                                                                     
| |  | the introduction and acceptance of new products and product enhancements by us or our competitors;                  
| |   |                                                                                                                     
| |  | the effects of filling the distribution channels following introductions of new products and product
  enhancements;
| |   |                                                                                                                     
| |  | potential delays in the availability of announced or anticipated products;                                          
| |   |                                                                                                                     
| |  | the mix of product and service revenue,                                                                             
| |   |                                                                                                                     
| |  | the commencement or conclusion of significant development contracts;                                                
| |   |                                                                                                                     
| |  | the timing of significant marketing and sales promotions ; and                                                      
| |   |                                                                                                                     
| |  | changes in income tax provisions or benefits                                                                        

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Based on the foregoing, we believe that quarterly operating results are likely to vary significantly
in the future and that period-to-period comparisons of our results of operations are not necessarily
meaningful and should not be viewed as indications of future performance.
We have a history of losses and may not be able to sustain profitability.
Though we have been profitable in recent years, we have experienced significant operating losses in
the past and, as of December 31, 2006, had an accumulated deficit of $19.1 million. Our development
and marketing of current and new products will continue to require substantial expenditures. We incurred
$591,000 of losses as recently as 2001 due to a slowdown in demand for our products due in part to
industry-wide adverse economic conditions. We were able to recover and since then we have five consecutive
years of net profits. There can be no assurance that growth in net sales will be achieved or profitability
sustained in future years.
All of our revenue comes from the sale of fax server products and related services, and a decline in
demand for those products and related services would harm our business, operating results and financial
condition.
We derived all of our revenue from the sale of fax server products and related services in 2006. We
expect that our current products and related services will continue to account for most of our sales
in the near future. A decline in demand for our fax server products as a result of competition, technological
change, shortages of components or other factors, or a delay in the development and market acceptance
of new features and products, would have a material adverse effect on our business, operating results
and financial condition.
We sell our products through a limited number of distributors, and any deterioration in our relationship
with those distributors would harm our business, operating results and financial condition.
We sell our products primarily through a two-tier domestic and international distribution network.
Our distributors sell our products to VARs, e-commerce vendors and other resellers. The distribution
of personal computers and networking products has been characterized by rapid change, including consolidations
due to the

|11
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|financial difficulties of distributors and the emergence of alternative distribution channels. An increasing
number of companies are competing for access to these channels. Our distributors typically represent
other products that are complementary to, or compete with, our products. Our distributors are not
contractually committed to future purchases of our products and could discontinue carrying our products
at any time for any reason. In addition, because we are dependent on a small number of distributors
for a significant portion of the sales of our products, the loss of any of our major distributors
or their inability to satisfy their payment obligations to us could have a significant adverse effect
on our business, operating results and financial condition. We have a stock rotation policy with
certain of our distributors that allows them to return marketable inventory against offsetting orders.
If we reduce our prices, we credit certain distributors for the difference between the purchase price
of products remaining in their inventory and our reduced price for these products. In addition, inventory
levels of our products held by distributors could become excessive due to industry conditions or
the actions of competitors, resulting in product returns and inventory write-downs.
The market for our products is affected by rapidly changing technology and if we fail to predict and
respond to customers changing needs, our business, operating results and financial condition
may suffer.
The market for our products is affected by rapidly changing networking technology, evolving industry
standards and the emergence of the Internet and other new communication technologies. We believe
that our future success will depend upon our ability to enhance our existing products and to identify,
develop, manufacture and introduce new products which
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

| |       conform to or support emerging network telecommunications
standards;    
| | -------------------------------------------------------------------------------
| |                                                                                
| |       are compatible with a growing array of computer and
peripheral devices; 
| |                                                                                
| |       support popular computer and network operating systems
and applications;
| |                                                                                
| |       meet a wide range of evolving user needs; and                           
| |                                                                                
| |       achieve market acceptance.                                              

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|There can be no assurance that we will be successful in these efforts.
We have incurred, and expect to continue to incur, substantial expenses associated with the introduction
and promotion of new products. There can be no assurance that the expenses incurred will not exceed
research and development cost estimates or that new products will achieve market acceptance and generate
sales sufficient to offset development costs. In order to develop new products successfully, we are
dependent upon timely access to information about new technological developments and standards. There
can be no assurance that we will have such access or will be able to develop new products successfully
and respond effectively to technological change or new product announcements by others.
Complex products such as those offered by us may contain undetected or unresolved hardware defects
or software errors when they are first introduced or as new versions are released. Changes in our
or our suppliers manufacturing processes or the inadvertent use of defective components could
adversely affect our ability to achieve acceptable manufacturing yields and product reliability.
We have in the past discovered hardware defects and software errors in certain of our new products
and enhancements after their introduction. Replacement of discontinued components used in our products
could lead to further defects and errors. There can be no assurance that despite testing by us and
by third-party test sites, errors and defects will not be found in future releases of our products,
which would result in adverse product reviews and negatively affect market acceptance of these products.
The introduction of new or enhanced products requires us to manage the transition from the older products
to the new or enhanced products or versions, both internally and for customers. We must manage new
product introductions so as to minimize disruption in customer ordering patterns, avoid excessive
levels of older product inventories and ensure that adequate supplies of new products can be delivered
to meet customer demands. We have from time to time experienced delays in the shipment of new products.
There can be no assurance that we will successfully manage future product transitions.

|12
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|Our success depends upon the continued contributions of our key management, marketing, product development
and operational personnel.
Our success will depend, to a large extent, upon our ability to retain and continue to attract highly
skilled personnel in management, marketing, product development and operations. Competition for employees
in the computer and electronics industries is intense, and there can be no assurance that we will
be able to attract and retain enough qualified employees. Volatility or lack of positive performance
in our stock price may also adversely affect our ability to retain and continue to attract key employees,
many of whom have been granted stock options. Our inability to retain and attract key employees could
have a material adverse effect on our product development, business, operating results and financial
condition. We do not carry key person life insurance with respect to any of our personnel.
The markets for our products are highly competitive and may become more competitive in the future.
The network enhancement products and computer software markets are highly competitive, and we believe
that competition will intensify in the future. The competition is characterized by rapid change and
improvements in technology along with constant pressure to reduce the prices of products. We currently
compete principally in the market for network fax servers. Both direct and indirect competition could
adversely affect our business and operating results through pricing pressure, loss of market share
and other factors. Any material reduction in the average selling prices of our products would adversely
affect gross margins. There can be no assurance we will be able to maintain the current average selling
prices of our products or the related gross margins.
The principal competitive factors affecting the market for our products include:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

| |       product functionality;                   
| | ------------------------------------------------
| |                                                 
| |       performance;                             
| |                                                 
| |       quality;                                 
| |                                                 
| |       reliability;                             
| |                                                 
| |       ease of use;                             
| |                                                 
| |       quality of customer training and support;
| |                                                 
| |       name recognition;                        
| |                                                 
| |       price; and                               
| |                                                 

| |  | compatibility and conformance with industry standards and changing operating system environments.
| | - | -------------------------------------------------------------------------------------------------

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Several of our existing and potential competitors have substantially greater financial, engineering,
manufacturing and marketing resources than we. We also experience competition from a number of other
software, hardware and service companies. In addition to our current competitors, we may face substantial
competition from new entrants into the network enhancement market, including established and emerging
computer, computer peripheral, communications and software companies. In the fax server market we
compete with companies such as Captaris Inc., Omtool, Ltd. and Esker Software. There can be no assurance
that competitors will not introduce products incorporating technology more advanced than the technology
used by us in our products. In addition, certain competing methods of communications such as the
Internet or electronic mail could adversely affect the market for fax products. There can be no assurance
that we will be able to compete successfully or that competition will not have a material adverse
effect on our business, operating results and financial condition.
We depend on sales in foreign markets, and political or economic changes in these markets could affect
our business, operating results and financial condition.
Sales to customers located outside the United States accounted for approximately 14%, 20% and 18% of
our net sales in 2006, 2005 and 2004, respectively. We sell our products in approximately 40 foreign
countries through approximately 50 international distributors. We expect that international sales
will continue to represent a significant portion of our product revenues and that we will be subject
to the normal risks of international sales, such as export laws, currency fluctuations, longer payment
cycles, greater difficulties in accounts receivable collections and the requirement of complying
with a wide variety of foreign laws. There can be no assurance that we will not experience difficulties
resulting from changes in foreign laws relating to the export of our products in the future. In addition,
because we primarily invoice foreign sales in U.S. dollars, fluctuations in exchange rates could affect

|13
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|demand for our products by causing prices to be out of line with products priced in the local currency.
Additionally, any such difficulties would have a material adverse effect on our international sales
and a resulting material adverse effect on our business, operating results and financial condition.
We may experience fluctuations in European sales on a quarterly basis because European sales may
be weaker during the third quarter than the second quarter due to extended holiday shutdowns in July
and August. There can be no assurance that we will be able to maintain the level of international
sales in the future. Any fluctuations in international sales will significantly affect our operating
results and financial condition.
The introduction of new products may reduce the demand for our existing products and increase returns
of existing products.
From time to time, we may announce new products, product versions, capabilities or technologies that
have the potential to replace or shorten the life cycles of existing products. The release of a new
product or product version may result in the write-down of products in inventory if this inventory
becomes obsolete. We have in the past experienced increased returns of a particular product version
following the announcement of a planned release of a new version of that product. There can be no
assurance that product returns will not exceed our allowance for these returns in the future and
will not have a material adverse effect on our business, operating results and financial condition.
If we fail to obtain components of our products from third-party suppliers and subcontractors, our
business could suffer.
Our products require components procured from third-party suppliers. Some of these components are available
only from a single source or from limited sources. In addition, we subcontract a substantial portion
of our manufacturing to third parties, and there can be no assurance that these subcontractors will
be able to support our manufacturing requirements. We purchase components on a purchase order basis,
and generally have no long-term contracts for these components. If we are unable to obtain a sufficient
supply of high-quality components from our current sources, we could experience delays or reductions
in product shipments. From time to time, component manufacturers announce the end of life of certain
of their products and may or may not have replacement products. If we are unable to secure enough
inventories of the end-of-life components or their replacements, we might not be able to deliver
our products to our customers, which could adversely affect our revenue and net income. On the other
hand, if we have over purchased the end-of-life components, resulting in excessive inventory after
we have developed replacement products, we may be exposed to inventory write-offs. Furthermore, a
significant increase in the price of one or more of these components or our inability to lower component
or sub-assembly prices in response to competitive price reductions could adversely affect our gross margin.
The costs of compliance with recent developments in corporate governance regulation may affect our
business, operating results and financial condition in ways that presently cannot be predicted further.
In the event we are unable to satisfy regulatory requirements relating to internal controls, or if
these internal controls over financial reporting are not effective, our business could suffer.
Beginning with the enactment of the Sarbanes-Oxley Act of 2002, a significant number of new corporate
governance requirements have been adopted or proposed through legislation and regulation by the Securities
and Exchange Commission and Nasdaq National Stock Market. We may not be successful in complying with
these requirements at all times in the future. Additionally, we expect these developments to increase
our legal compliance and accounting costs, and to make some activities more difficult, such as stockholder
approval of new stock option plans. We expect to incur significant costs in connection with compliance
with Section 404 of that law regarding internal controls over financial reporting. We expect these
developments to make it more difficult and more expensive for us to obtain director and officer liability
insurance, and we may be required to accept reduced coverage or incur substantially higher costs
to obtain coverage. These developments could make it more difficult for us to attract and retain
qualified members of our board of directors, or qualified executive officers. We are presently evaluating
and monitoring regulatory developments and cannot estimate the timing or magnitude of additional
costs we may incur as a result, or the effect that these increased costs may have on our operating results.
We have identified and may from time to time identify a number of deficiencies in our disclosure controls
and procedures. In connection with the audit of the consolidated financial statements for the year
ended December
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|14
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|31, 2006, our independent registered public accounting firm, Grant Thornton LLP, determined that we
had internal control deficiencies that constituted significant deficiencies. Furthermore,
we cannot assure you that we will be able to implement enhancements on a timely basis in order to
prevent a failure of our internal controls or enable us to furnish future unqualified certifications.
A significant deficiency in internal control over financial reporting could materially impact our
reported financial results and the market price of our stock could significantly decline. Additionally,
adverse publicity related to the disclosure of a material weakness or significant deficiency in internal
controls over financial reporting could have a negative impact on our reputation, business and stock
price. Any internal control or procedure, no matter how well designed and operated, can provide only
reasonable assurance of achieving desired control objectives.
We depend on proprietary technology, and inability to develop and protect this technology or license
it from third parties could adversely affect our business, operating results and financial condition.
Our success depends to a certain extent upon our technological expertise and proprietary software technology.
We rely upon a combination of contractual rights and copyright, trademark and trade secret laws to
establish and protect our technologies. Despite the precautions taken by us, it may be possible for
unauthorized third parties to copy our products or to reverse engineer or obtain and use information
that we regard as proprietary. In addition, the laws of some foreign countries either do not protect
our proprietary rights or offer only limited protection. Given the rapid evolution of technology
and uncertainties in intellectual property law in the United States and internationally, there can
be no assurance that our current or future products will not be subject to third-party claims of
infringement. Any litigation to determine the validity of any third-party claims could result in
significant expense and divert the efforts of our technical and management personnel, whether or not
any litigation is determined in favor of us. In the event of an adverse result in litigation, we
could be required to expend significant resources to develop non-infringing technology or to obtain
licenses to the technology that is the subject of the litigation. There can be no assurance that
we would be successful in this development or that any such licenses would be available on commercially
reasonable terms. We also rely on technology licensed from third parties. There can be no assurance
that these licenses will continue to be available upon reasonable terms, if at all. Any impairment
or termination of our relationship with third-party licensors could have a material adverse effect
on our business, operating results and financial condition. There can be no assurance that our precautions
will be adequate to deter misappropriation or infringement of our proprietary technologies.
From time to time, we have received, and may receive in the future, communications asserting that our
products infringe the proprietary rights of third parties or seeking indemnification against the
alleged infringement. There can be no assurance that third parties will not assert infringement claims
against us with respect to current or future products or that any assertion will not require us to
enter into royalty arrangements or result in costly litigation. Any claims, with or without merit,
can be time consuming and expensive to defend. There can be no assurance that any intellectual property
litigation will not have a material adverse effect on our business, operating results and financial
condition.
**If a third party asserts that we are infringing proprietary technology rights, whether successful or not, it could subject us to costly and time-consuming litigation or expensive licenses, which could harm our business.**
Our success depends on our ability to operate without infringing the patents and proprietary rights
of third parties. Product development is inherently uncertain in a rapidly evolving technological
environment in which there may be numerous patent applications pending, many of which are confidential
when filed, with regard to similar technologies.
Third parties have in the past sent us letters and other communications regarding their intellectual
property, and in the future, we may receive claims that our products infringe or violate their intellectual
property rights. Any claims or litigation could cause us to incur significant expenses and, if successfully
asserted against us, could require that we pay substantial damages and prevent us from selling our
products. Even if we were to prevail, any litigation regarding our intellectual property could be
costly and time-consuming and divert the attention of our management and key personnel from our business
operations. We may also be obligated to indemnify our customers or business partners in connection
with any such litigation, which could further exhaust our resources. Furthermore, as a result of
an intellectual property challenge, we may be required to enter into royalty, license or other agreements.
We may not be able to obtain these agreements at all or on terms acceptable to us.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|15
|--



|**Our common stock is listed on the Nasdaq SmallCap Market, and we have had difficulty satisfying the listing criteria to avoid the delisting of our common stock**
Our common stock has been listed on the Nasdaq SmallCap Market since April 1999. In order to maintain
our listing on the Nasdaq SmallCap Market, we must maintain total assets, capital and public float
at specified levels, and our common stock generally must maintain a minimum bid price of $1.00 per
share. If we fail to maintain the standards necessary to be quoted on the Nasdaq SmallCap Market,
our common stock could become subject to delisting. There can be no assurance that we will be able
to maintain the $1.00 minimum bid price per share of our common stock and thus maintain our listing
on the Nasdaq SmallCap Market.
If our common stock is delisted, trading in our common stock could be conducted on the OTC Bulletin
Board or in the over-the-counter market in what is commonly referred to as the pink sheets. If
this occurs, a shareholder will find it more difficult to dispose of our common stock or to obtain
accurate quotations as to the price of our common stock. Lack of any active trading market would
have an adverse effect on a shareholders ability to liquidate an investment in our common stock
easily and quickly at a reasonable price. It might also contribute to volatility in the market price
of our common stock and could adversely affect our ability to raise additional equity or debt financing
on acceptable terms or at all. Failure to obtain desired financing on acceptable terms could adversely
affect our business, financial condition and results of operations.
Our stock price has been volatile, and is likely to continue to be volatile in the future.
The price of our common stock has fluctuated widely in the past. Sales of substantial amounts of our
common stock, or the perception that sales could occur, could adversely affect prevailing market
prices for our common stock. Our management believes past fluctuations may have been caused by the
factors identified above, and that these factors may continue to affect the market price of our common
stock. Additionally, stock markets have experienced extreme price volatility in recent years. This
volatility has had a substantial effect on the market price of the common stock of us and other high
technology companies, often for reasons unrelated to operating performance. We anticipate that prices
for our common stock may continue to be volatile. Future stock price volatility may result in the
initiation of securities litigation against us, which may divert substantial management and financial
resources and have an adverse effect on our business, operating results and financial condition.
We may require additional capital in the future, and may be unable to obtain this capital at all or
on commercially reasonable terms.
The development and marketing of products requires significant amounts of capital. If we need additional
capital resources, we may be required to sell additional equity or debt securities, secure additional
lines of credit or obtain other third party financing. The timing and amount of such capital requirements
cannot be determined at this time and will depend on a number of factors, including demand for our
existing and new products and changes in technology in the networking industry. There can be no assurance
that additional financing will be available on satisfactory terms when needed, if at all. Failure
to raise such additional financing, if needed, may result in our inability to achieve our long-term
business objectives. The issuance of equity or convertible debt securities to raise additional capital
would result in additional dilution to our shareholders.
Government regulation could increase our costs of doing business and adversely affect our gross margin.
Certain aspects of the networking industry in which we compete are regulated both in the United States
and in foreign countries. Imposition of public carrier tariffs, taxation of telecommunications services
and the necessity of incurring substantial costs and expenditure of managerial resources to obtain
regulatory approvals, or the inability to obtain regulatory approvals within a reasonable period
of time, could have a material, adverse effect on our business, operating results and financial condition.
This is particularly true in foreign countries where telecommunications standards differ from those
in the United States. Our products must comply with a variety of equipment, interface and installation
standards promulgated by communications regulatory authorities in different countries. Changes in
government policies, regulations and interface standards could require the redesign of products and
result in product shipment delays which could have a material, adverse impact on our business, operating
results and financial condition.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|16
|--



|**Terrorist activity in the United States and the military action to counter terrorism could adversely impact our business.**
Terrorist acts or acts of war (wherever located around the world) could significantly impact our revenue,
costs and expenses, and financial condition. The terrorist attacks that took place in the United
States on September 11, 2001 have created many economic and political uncertainties, some of
which may materially harm our business, operating results and financial condition. The long-term
effects on our business of the September 11, 2001 attacks and the ensuing war on terror are
unknown. The potential for future terrorist attacks, the national and international responses to
terrorist attacks or perceived threats to national security, and other actual or potential conflicts,
acts of war or hostility, including the United States activities in Iraq, have created many
economic and political uncertainties that could adversely affect our business, operating results
and financial condition in ways that cannot presently be predicted.
Voting control by officers, directors and principal shareholders may delay, defer or prevent a change
of control.
At February 28, 2007, our officers, directors and principal shareholders beneficially owned approximately
51% of the outstanding shares of common stock. Accordingly, together they have the ability to significantly
influence the election of our directors and other corporate actions requiring shareholder approval.
Such concentration of ownership may have the effect of delaying, deferring or preventing a change
in control.
**Provisions in our charter documents might deter a company from acquiring us, which could inhibit your ability to receive an acquisition premium for your shares.**
Our Board of Directors has authority to issue shares of preferred stock and to fix the rights, including
voting rights, of these shares without any further vote or action by the shareholders. The rights
of the holders of our common stock will be subject to, and may be adversely affected by, the rights
of the holders of any preferred stock that may be issued in the future. The issuance of preferred
stock, while providing desirable flexibility in connection with possible acquisitions and other corporate
purposes, could have the effect of making it more difficult for a third party to acquire a majority
of our outstanding voting stock, thereby delaying, deferring or preventing a change in control. Furthermore,
such preferred stock may have other rights, including economic rights, senior to the common stock,
and as a result, the issuance thereof could have a material adverse effect on the market.
**Our reported financial results may be adversely affected by changes in accounting principles generally accepted in the United States.**
Generally accepted accounting principles in the United States are subject to interpretation by the
Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants
(AICPA), the Securities Exchange Commission (SEC), and various bodies formed to promulgate and interpret
appropriate accounting principles. A change in these principles or interpretations could have a significant
effect on our reported financial results, and could affect the reporting of transactions completed
before the announcement of a change.
For example, as of January 1, 2006 we were required to adopt the provisions of Statement of Financial
Accounting Standards No. 123 (revised 2004), Share Based Payment, causing us to expense
employee stock options. This change decreased our diluted net income per share by $0.17 for the full
year 2006. This impact may change based upon additional stock option grants, if any, methodology
refinement or other factors.
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes
(as amended)an interpretation of FASB Statement No. 109 (FIN 48). FIN 48
clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial
statements in accordance with SFAS No. 109, Accounting for Income Taxes, and prescribes
a recognition threshold and measurement attribute for the financial statement recognition and measurement
of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim periods, disclosure
and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are in
the process of analyzing the impact of FIN 48, which is required to be adopted by the first quarter
of fiscal 2007. The adoption of FIN 48 may have an adverse impact on our reported financial results.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|17
|--



|ITEM 1B.       UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.          PROPERTIES
Our headquarters, including our executive offices and corporate administration, development, manufacturing,
marketing, sales and technical services/support facilities, are located in Morgan Hill, California
in approximately 16,600 square-feet of leased office space. We occupy this facility under a lease,
the term of which expires on May 31, 2009 with one conditional three-year option, which if exercised,
would extend the lease to May 31, 2012. We believe our existing facilities will be adequate to meet
our requirements for the foreseeable future.
ITEM 3.          LEGAL PROCEEDINGS
From time to time and in the ordinary course of business, we are involved in various legal proceedings
and third party assertions of patent or trademark infringement claims against us in the form of letters
and other forms of communication. We are not currently involved in any litigation which, in our opinion,
would have a material adverse effect on our business, operating results, cash flows or financial
condition; however, there can be no assurance that any such proceeding will not escalate or otherwise
become material to our business in the future.
ITEM 4.          SUBMISSION OF MATTERS TO A VOTE OF SECURITIES
HOLDERS
Not applicable.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|18
|--



|PART II
|-------
|       

|ITEM 5. | MARKET FOR REGISTRANTS COMMON STOCK, RELATED SHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY

SECURITIES
|------- | -------------------------------------------------------------------------------------------------------------

|                                                                                                                                                                                                                                                                                                                                                                                             
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Our common stock (Nasdaq symbol CSTL) began trading on the Nasdaq National Market on December
20, 1995 and was transferred to the Nasdaq SmallCap Market as of April 1999. The following table
shows the closing high and low sale prices per share of our common stock as reported on the Nasdaq
SmallCap Market. Such quotations do not include retail markups, markdowns or commissions.
|                                                                                                                                                                                                                                                                                                                                                                                             

| | 2005           | HIGH  | LOW   | 
| | -------------- | ----- | ----- | 
| | First Quarter  | $3.90 | $2.57 | 
| | Second Quarter | $5.04 | $2.73 | 
| | Third Quarter  | $4.50 | $3.16 | 
| | Fourth Quarter | $3.78 | $2.93 | 
| |                |       |       | 
| | 2006           | HIGH  | LOW   | 
| | First Quarter  | $3.48 | $2.92 | 
| | Second Quarter | $3.65 | $2.70 | 
| | Third Quarter  | $3.15 | $2.26 | 
| | Fourth Quarter | $4.18 | $2.55 | 

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The market price of our common stock has been volatile. See Risk Factors  Our stock price
has been volatile, and is likely to continue to be volatile in the future.
As of March 9, 2007 there were 765 holders of record of our common stock. On March 9, 2007 the last
sale price reported on the Nasdaq SmallCap Market for our common stock was $3.10 per share.
Dividend Policy
We have not paid cash dividends on our common stock. The Board of Directors periodically reviews the
dividend policy and currently intends to retain any and all earnings for use in our business and
we do not anticipate paying cash dividends in the foreseeable future. Our credit line provides that
we shall not pay any dividend without the Banks prior consent.

|19
|--



|Performance Graph
This performance graph shall not be deemed filed for purposes of Section 18 of the
Securities Exchange Act of 1934, as amended (the Exchange Act) or otherwise subject to
the liabilities under that Section and shall not be deemed to be incorporated by reference into any
filing of Castelles under the Securities Act of 1933, as amended or the Exchange Act.
The following graph shows a comparison of cumulative total returns for the Company, the NASDAQ Stock
Market (United States Companies) and the NASDAQ Computer Manufacturers Index for the last five fiscal
years ended on December 31, 2006. The graph assumes that $100 was invested on December 31,
2001 in the common stock of the Company, the Nasdaq Market Index and the NASDAQ Computer Manufacturers
Index and assumes that all dividends have been reinvested. The stock price performance on the following
graph is not necessarily indicative of future stock price performance.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* Among Castelle, The NASDAQ Composite Index And The NASDAQ Computer Manufacturers Index $0 $50 $100 $150 $200 $250 $300 $350 $400 $450 12/01 12/02 12/03 12/04 12/05 12/06 Castelle NASDAQ Composite NASDAQ Computer Manufacturers * $100 invested on 12/31/01 in stock or index-including reinvestment of dividends. Fiscal year ending December 31.


|20
|--



|Equity Compensation Plan Information
The
following table sets forth a summary of our equity compensation plans as of December 31, 2006. Details
of the plans are discussed in Note 6 to the Consolidated Financial Statements.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                              

|Number of securities to
      be issued upon exercise
      of outstanding options   |  | Weighted-average 
      exercise price of 
      outstanding options |  | Number of 
      securities
      remaining 
      available
 for future issuance 
under equity 
      compensation
      plans
|------------------------------------------------------------------------------------ |  | -------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------
|                                                                                     |  |                                                                     
|                                                                                    
|1988 Equity compensation plan approved
      by security holders                     |  | 7,000                                                                |  | $                                                                                                                              
|                                                                                     |  |                                                                      |  |                                                                                                                                
|1998 (1988) Equity compensation plan
      (As Amended) approved by security holders |  | 595,866                                                              |  | $                                                                                                                              
|                                                                                     |  |                                                                      |  |                                                                                                                                
|2002 Equity compensation plan approved
      by security holders                     |  | 436,281                                                              |  | $                                                                                                                              
|                                                                                     |  |                                                                      |  |                                                                                                                                
|Equity compensation plans not approved
      by security holders                     |  | -0-                                                                  |  |                                                                                                                                
|                                                                                    
|                                                                                     |  |                                                                     
|Total                                                                                |  | 1,039,147                                                            |  | $                                                                                                                              

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Stock Buyback Program
In the fourth quarter of 2002, our Board of Directors authorized us, from time to time, to repurchase
at market prices, up to $750,000 of our common stock for cash in open market, negotiated or
block transactions. The timing of such transactions will depend on market conditions, other corporate
strategies and will be at our discretion. No time limit was set for the completion of this program.
The Company has not repurchased any of its common stock since then under this program. This stock
buyback program does not obligate us to acquire any specific number of shares and may be suspended
or discontinued at any time. We made the following repurchases pursuant to this stock buyback program:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

|Period |  | Total 
      Number of
      Shares 
      Purchased |        | Average 
      Price Paid
      per Share |   | Total Number
      of Shares 
      Purchased 
      as Part of 
      Publicly 
      Announced 
      Plans or 
      Programs |  | Approximate
      Dollar Value
      of Shares 
      That May Yet
      Be Purchased
      Under the 
      Plans or 
      Programs
|------ |  | ---------------------------------------------------- | ------ | ----------------------------------------- | - | -------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------
|       |  |                                                      |        |                                           |   |                                                                                                                                  |  |                                                                                                                                      
|      
|2002   |  |                                                      | 19,500 |                                           | $ | 1.03                                                                                                                             |  |                                                                                                                                      
|2003   |  |                                                      | 46,500 |                                           |   | 1.04                                                                                                                             |  |                                                                                                                                      
|       |  |                                                      |       
|Total  |  |                                                      | 66,000 |                                           | $ | 1.04                                                                                                                             |  |                                                                                                                                      

|21
|--



|In the third quarter of 2006, our Board of Directors authorized us, from time to time, to repurchase
at market prices, up to $1 million of our common stock for cash in open market, negotiated or block
transactions. The timing and exact number of shares purchased will be at our discretion and will
depend on market conditions. We do not intend to repurchase any shares from our management team or
other insiders. This stock buyback program does not obligate us to acquire any specific number of
shares and may be suspended or discontinued at any time. During the fourth quarter of 2006, we made
the following repurchases pursuant to this stock buyback program:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

|Period |  | Total 
      Number of
      Shares 
      Purchased |        | Average 
      Price Paid
      per Share |   | Total Number
      of Shares 
      Purchased 
      as Part of 
      Publicly 
      Announced 
      Plans or 
      Programs |  | Approximate 
      Dollar Value 
      of Shares 
      That May Yet 
      Be Purchased 
      Under the 
      Plans or 
      Programs
|------ |  | ---------------------------------------------------- | ------ | ----------------------------------------- | - | -------------------------------------------------------------------------------------------------------------------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------
|      
|      
|2006   |  |                                                      | 22,466 |                                           | $ | 2.81                                                                                                                             |  |                                                                                                                                          
|       |  |                                                      |       
|Total  |  |                                                      | 22,466 |                                           | $ | 2.81                                                                                                                             |  |                                                                                                                                          

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ITEM 6.          SELECTED FINANCIAL DATA
The information set forth below is not necessarily indicative of results of future operations, and
should be read in conjunction with Managements Discussion and Analysis of Financial Condition
and Results of Operations and the Consolidated Financial Statements and related Notes thereto
included elsewhere in this Annual Report on Form 10-K.
The selected consolidated financial data set forth below are derived from our consolidated financial
statements. The consolidated statements of earnings data for the years ended December 31, 2004, 2005
and 2006 and the consolidated balance sheet data as of December 31, 2005 and 2006 are derived from
our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
The consolidated statements of earnings data for the years ended December 31, 2002 and 2003 and the
consolidated balance sheet data as of December 2002, 2003 and 2004 are derived from our audited consolidated
financial statements not included in this Annual Report on Form 10-K.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

|                                         | Years ended December 31,                 |       
|---------------------------------------- | ---------------------------------------- | ------
|                                         |                                          |       
|                                         | 2006                                     |       
|                                         |                                          |       
|                                         | (in thousands, except per share amounts) |       
|CONSOLIDATED STATEMENT OF EARNINGS DATA: |                                         
|Net Sales                                | $                                        | 10,590
|                                         |                                          |       
|Gross Profit                             | $                                        | 6,634 
|Gross Profit as a % of Net Sales         |                                          | 63    
|                                         |                                          |       
|Net income                               | $                                        | 669   
|Net income as a % of Net Sales           |                                          | 6     
|                                         |                                          |       
|Net income per share  diluted           | $                                        | 0.15  

|22
|--



|                                 | Years ended December 31,                 |       
|-------------------------------- | ---------------------------------------- | ------
|                                 |                                          |       
|                                 | 2006                                     |       
|                                 |                                          |       
|                                 | (in thousands, except per share amounts) |       
|CONSOLIDATED BALANCE SHEET DATA: |                                          |       
|Cash and Cash Equivalents        | $                                        | 8,259 
|Working Capital                  | $                                        | 7,746 
|Total Assets                     | $                                        | 11,979
|Long-term Liabilities            | $                                        |      
|Shareholders Equity             | $                                        | 9,095 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1)  In 2006, we recorded a tax provision of $29,000, or $0.01 per diluted share, resulting from
  federal and state provision and a decrease in valuation allowance to reflect managements best
  estimate of deferred tax assets expected to be utilized in future periods. 2006 federal and state
  tax liability was almost entirely offset by the utilization of existing net operating losses, and
  therefore, we do not expect to utilize significant amounts of cash for income tax payments until
  our $11 million of available net operating loss carryforwards as of December 31, 2006 have been utilized.                                                                                                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (1)  In 2005, we recorded a tax provision of $395,000, or $0.09 per diluted share, resulting from
  federal and state provision and an increase in valuation allowance to reflect managements best
  estimate of deferred tax assets expected to be utilized in future periods. 2005 federal and state
  tax liability was almost entirely offset by the utilization of existing net operating losses.                                                                                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (3)  In 2004, we recorded a non-cash tax benefit of $1.1 million, or $0.24 per diluted share. This
  was a result of releasing a portion of our tax valuation allowance due to our continued profitability
  and a determination that it is more likely than not that certain future tax benefits will be realized.                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (4)  In the fourth quarter of 2003, we recorded a non-cash tax benefit of $526,000, or $0.12 per
  diluted share, resulting from the release of a portion of our tax valuation allowance. Prior to the
  fourth quarter of 2003, we had not reported significant income tax expenses because we had utilized
  available Net Operating Loss (NOL) and tax credit carryforwards. These NOLs were fully
  reserved by a valuation allowance due to uncertainly surrounding the likelihood of their realization.
  Due to our continued profitability over the past ten quarters and a determination that it was more
  likely than not that certain future tax benefits will be realized, a portion of the deferred tax
  assets were recognized in the fourth quarter
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (5)  In 2002, cash and cash equivalents and shareholders equity reflect the use of $2 million
  of cash for the repurchase of 1.62 million shares of our common stock and the associated expenses.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Unaudited Quarterly Results of Operations
The following table sets forth certain consolidated quarterly financial data for the eight quarters
ended December 31, 2006. This information is unaudited, but in our opinion, has been prepared on
the same basis as the audited consolidated financial statements appearing elsewhere in this report,
and all necessary adjustments, consisting only of normal recurring adjustments, have been included
in the amounts stated below to present fairly the unaudited interim results. The results of operations
for any quarter are not necessarily indicative of the results of operations for any future period.

|23
|--



|Selected Consolidated Quarterly Data (unaudited)
|------------------------------------------------
|                                                

| |                                      | Year 2006, Quarter Ended              |      
| | ------------------------------------ | ------------------------------------- | -----
| |                                      |                                       |      
| |                                      | Mar 31                                |      
| |                                      |                                       |      
| |                                      | (in thousands, except per share data) |      
| | Net sales                            | $                                     | 2,989
| | Gross profit                         |                                       | 1,922
| | Operating income/(loss)              |                                       | 147  
| | Net income/(loss)                    |                                       | 206  
| | Net income/(loss) per share, basic   |                                       | 0.05 
| | Net income/(loss) per share, diluted |                                       | 0.05 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) In 2006, we recorded a tax provision of $29,000, or $0.01 per diluted share, resulting from federal
  and state provision and a decrease in valuation allowance to reflect managements best estimate
  of deferred tax assets expected to be utilized in future periods. 2006 federal and state tax liability
  was almost entirely offset by the utilization of existing net operating losses, and therefore, we
  do not expect to utilize significant amounts of cash for income tax payments until our $11 million
  of available net operating loss carryforwards as of December 31, 2006 have been utilized.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

| |                               | Year 2005, Quarter Ended              |      
| | ----------------------------- | ------------------------------------- | -----
| |                               |                                       |      
| |                               | Mar 31                                |      
| |                               |                                       |      
| |                               | (in thousands, except per share data) |      
| | Net sales                     | $                                     | 2,594
| | Gross profit                  |                                       | 1,782
| | Operating income              |                                       | 110  
| | Net income                    |                                       | 135  
| | Net income per share, basic   |                                       | 0.04 
| | Net income per share, diluted |                                       | 0.03 

| |                                                                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) Includes a tax provision of $395,000, or $0.09 per diluted share, resulting from the federal and state
  provision and an increase in valuation allowance to reflect managements best estimate of deferred
  tax assets expected to be utilized in future periods..
| |                                                                                                                                                                                                                                                                         

|ITEM 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(All tabular amounts in thousands except per share amounts and as noted)
This Managements Discussion and Analysis of Financial Condition and Results of Operations contains
forward-looking statements that are subject to many risks and uncertainties that could cause actual
results to differ significantly from expectations. For more information on forward-looking statements,
refer to the Special Note on Forward Looking Statements at the front of this Annual Report
on Form 10-K.
Our products have historically centered on fax and print servers and related technologies. Starting
in 1997, our revenues began to decline as competition increased, with respect to print server products,
while at the same time the Internet and other networking technologies advanced. As a result, we experienced
annual operating losses beginning in 1997 through 1999. We redirected our efforts to focus on server
appliances and on development efforts to integrate existing and future products with the Internet
and emerging networking technologies. We introduced our products, the FaxPress 5000 in February 1999,
FaxPress 2500 in November 1999, FaxPress SBE in February 2000, the FaxPress 7500 in September 2000
and the FaxPress Premier Analog and FaxPress Enterprise Digital in September 2003. In July 2006,
we announced our new FaxPress Redundant Fax Server. In addition, in August 2006, we announced that
we will enter into the FoIP market with a new generation of network fax servers that support IP faxing.
We expect to release our new generation of IP fax servers in 2007. Today, our analog fax servers
can provide up to 16 fax channels, the digital servers up to 72 T1 fax channels, the ISDN servers
up to 12 fax channels and the E1 servers up to 90 fax channels. Our current FaxPress and FaxPress
Plus software versions are 9.0 and 4.1, respectively, to support our hardware.

|24
|--



|Improved cash management and operating results resulted in positive operating cash flows in 2006, 2005
and 2004. Cash balances increased to $8.3 million at December 31, 2006 from $6.8 million and $5.6
million at December 31, 2005 and December 31, 2004, respectively.
From time to time, component manufacturers announce the end of life of certain of their products and
at the same time introduce replacement components which are usually more efficient or cost effective.
We were informed by several of our component suppliers that new components are available to replace
certain of their end-of-life components currently used in our FaxPress products. We purchased several
years supply of these end-of-life components in an effort to guarantee a smooth supply of our FaxPress
Products to our customers. We believe this will give us ample time to develop new replacement products.
We believe that most of these end-of-life components will be utilized within approximately the next
two years resulting in insignificant amounts of excessive inventory or none at all. We believe that
Castelles liquidity continues to be strong despite these purchases, as our cash balances increased
during the periods when the parts were purchased. Even though we believe we have secured enough components
for the next two years, there is no assurance that we will be able to secure additional components
in the future, or be able to redesign new products in a timely manner. These end-of-life products
represented $281,000 of the ending inventory balance at December 31, 2006 as compared to $390,000 at December 31, 2005.
Critical Accounting Policies
We have identified the policies below as critical to our business operations and to the understanding
of our results of operations. We have defined a critical accounting policy as one that is both important
to the portrayal of our financial condition and results of operations and requires our management
to make difficult, subjective or complex judgments. For a detailed discussion on the application
of these and other accounting policies, see Note 2 in the Notes to the Consolidated Financial Statements
of this Annual Report on Form 10-K, beginning on page F-7. Note that preparation of this Annual Report
on Form 10-K requires us to make estimates and assumptions that affect the reported amounts of assets
and liabilities, and disclosure of contingent assets and liabilities at the date of our financial
statements, and reported amounts of revenue and expenses during the reporting period. Estimates about
future events and their effects cannot be made with certainty. We base our estimates on historical
experience and on various other assumptions that are believed to be reasonable under the circumstances,
the results of which form the basis for making judgments. These estimates may change as new events
occur, as more experience is acquired, as additional information is obtained and as our operating environment changes.
Revenue recognition
We recognize revenue based on the provisions of Staff Accounting Bulletin No. 104 Revenue Recognition, AICPA Statement of Position No. 97-2 (SOP 97-2) Software Revenue Recognition, as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions, and Statement of Financial Accounting Standards (SFAS) No. 48 Revenue Recognition When Right of Return Exits.
We use the residual method to recognize revenue when an agreement includes one or more elements to
be delivered at a future date. If there is an undelivered element under the arrangement, we defer
revenue based on vendor-specific objective evidence of the fair value of the undelivered element,
as determined by the price charged when the element is sold separately. If vendor-specific objective
evidence of fair value does not exist for all undelivered elements, we defer all revenue until sufficient
evidence exists or all elements have been delivered.
Product revenue is recognized when all of the following criteria are met: persuasive evidence
of an arrangement exists; delivery has occurred; the fee is fixed or determinable; collection is
probable; and returns can be reasonably estimated. If an acceptance period or other contingency exists,
revenue is recognized upon satisfaction of the contingency, customer acceptance or expiration of
the acceptance period. Shipment generally occurs and title and risk of loss is transferred when the
product is delivered to a common carrier.
The Company accrues a liability for any sales taxes and value-added taxes collected on behalf of various
taxing authorities. This liability is relieved when any taxes collected are remitted to the taxing
authority. Revenue excludes sales taxes and any value-added taxes.
We enter into agreements with some of our distributors that permit limited stock rotation rights. These
stock rotation rights allow the distributor to return products for credit but require the purchase
of additional products of equal value. Customers who purchase products directly from us also have
limited return rights, which expire 30 days from product shipment. Revenues subject to stock rotation
or other return rights are reduced by our estimates of anticipated exchanges and returns.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|25
|--



|Pursuant to our agreements with distributors, we also protect our distributors exposure related
to the impact of price reductions. Future price adjustments are estimated and accrued at the time
of sale as a reduction in revenue.
We generally provide our distributors the opportunity to earn volume incentive rebates based on sales
volume achieved during the fiscal quarter. These incentive rebates are accrued in the quarter incurred
and recorded as a reduction in revenue.
We also provide co-op and market development funds to our distributors. These incentives are accrued
at the time revenue is recognized and recorded as a reduction in revenue.
We offer a standard trade-in discount to all of our end-user customers under which the customer, upon
trade-in of any previously purchased product, is entitled to a discount from our published price
list on any product included in our current product offerings. We require our customers to physically
return the previously purchased products to qualify for the trade-in discount. We account for the
trade-in discount as a reduction of revenue at the time the product is traded in and a new product
is purchased.
Payment terms to our distributors and customers are generally 30 days, cash in advance, or by credit
card.
We evaluate product sales through our distribution channels and the related reserve requirement to
establish an estimate for our sales returns reserve by reviewing detailed point-of-sales and on-hand
inventory reports provided to us by our channel partners. Based on a combination of historical return
experience, the sales activities to end-user customers by our channel partners and the level of inventories
on hand at the channel partners, we determine our returns reserve at the end of each financial period,
and increase or reduce the reserve balance accordingly.
We provide standard support to our customers for an initial period of 60 days, which includes advance
swap of the defective hardware and software, bug fixes, software upgrades and technical support.
In addition to standard support, we also offer our customers the option to purchase extended support
at the time of product purchase or anytime thereafter. Extended support covers hardware and software
for a period of one year. We have established vendor-specific objective evidence with respect to
the fair value of the standard support contracts based on standalone sales and renewals of our one-year
extended support contracts. The fair value of our 60 day support contracts included with product
sales is determined by pro-rating the related one-year extended support contracts. We recognize revenue
from extended support contracts ratably over the period of the contract.
We do not sell software, which is incorporated into our hardware, separately, other than for our customers
to purchase as an upgrade to their existing products when we announce a major release of the software.
Product Warranty
Hardware is warranted for one year from the date of sale and is repaired free-of-charge. Provisions
for estimated warranty costs are recorded at the time products are shipped as a charge to cost of
sales. While we engage in extensive product quality programs and processes, our warranty obligation
is affected by product failure rates, material usage and service delivery costs incurred in correcting
a product failure. Should product failure rates, material usage or service delivery cost differ from
our estimates, revision to the estimated warranty liability would be required, which could affect
the amount of gross profit reported.
Distributor Programs and Incentives
We enter into agreements with some of our distributors that permit limited stock rotation rights. These
stock rotation rights allow the distributor to return products for credit but require the purchase
of additional products of equal value. We also protect our distributors exposure related to
the impact of price reductions. We generally provide our distributors the opportunity to earn volume
incentive rebates based upon the amount of sales volume achieved during the fiscal quarter. We also
provide co-op and market development funds to our distributors.
If market conditions were to change, we may take actions to increase distributor incentive offerings
possibly resulting in an incremental reduction of revenues at the time the incentive is offered.
Moreover, if the actual incentive offerings are different from our estimates, or if the actual incentive
claims are significantly higher than our historical experience, then revisions to the estimated incentive
programs may be required resulting in additional reductions to revenue.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|26
|--



|We record estimated reductions to revenues for these distributor programs and incentive offerings including
special pricing agreements, promotions and other volume-based incentives.
Credit, collection and allowance for doubtful accounts
We perform ongoing customer credit evaluations based on a number of factors, including past transaction
history with the customer and the credit-worthiness of the customer. When credit criteria are not
met, we require cash-on-delivery or payment by credit card before products are shipped. On a quarterly
basis, we specifically analyze accounts receivable, historical bad debts, customer concentration,
and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful
accounts. Such losses have generally been within our expectations. If the financial condition of
our customers were to deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required. Two customers accounted for 58% and 59% of accounts
receivable at December 31, 2006 and 2005, respectively.
Inventories and related write-downs for excess and obsolete inventory
Inventories are stated at the lower of standard cost (which approximates cost on a first-in, first-out
basis) or market. We record write downs for excess and obsolete inventory equal to the difference
between the cost of inventory and the estimated fair value based on assumptions about future product
life-cycles, product demand and market conditions. If actual product life cycles, product demand
and market conditions are less favorable than those projected by management, additional inventory
write-downs may be required. At the point of the loss recognition, a new, lower-cost basis for that
inventory is established, and subsequent changes in facts and circumstances do not result in the
restoration or increase in that newly established cost basis.
In light of the approximately two years worth of end-of-life components we had purchased to ensure
a smooth supply of our FaxPress Products to our customers, our management periodically reviews the
usage, supply and inventory levels of these parts to determine whether additional purchases or excessive
inventory provisions are necessary. At December 31, 2006, we have approximately $281,000 worth of
end-of-life components on hand, as compared to $390,000 at December 31, 2005 and we believe that
most of these components will be utilized in the following two years resulting in insignificant
amounts of excessive inventory, or none at all.
Income taxes
We account for income taxes in accordance with the liability method. Under the liability method, deferred
assets and liabilities are recognized based upon anticipated future tax consequences attributable
to differences between financial statement carrying amounts of assets and liabilities and their respective
tax bases. The provision for income taxes is comprised of the current tax liability and the change
in deferred tax assets and liabilities. We assess the likelihood that our deferred tax assets will
be recovered from future taxable income and to the extent we believe that recovery is not likely,
we must establish a valuation allowance against these tax assets. Significant management judgment
is required in determining the amount of any valuation allowance recorded against our deferred tax
assets. The establishment or reversal of any valuation allowance is based in large part on projected
future taxable income.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|27
|--



|Consolidated Results of Operations
|----------------------------------
|                                  

| | Comparison of Years Ended December 31, 2006 and 2005
| | ----------------------------------------------------
| |                                                     

| | Net Sales
| | ---------
| |          

| |                 | Year Ended December 31, |       
| | --------------- | ----------------------- | ------
| |                 |                         |       
| |                 | 2006                    |       
| |                 |                         |       
| | Net Sales:      |                         |       
| | Products        | $                       | 7,253 
| | Services        |                         | 3,337 
| |                 |                         |       
| | Total net sales | $                       | 10,590
| |                 |                         |       

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Net sales decreased 2% to $10.6 million in 2006 from $10.8 million in 2005. The decrease of $242,000
  was primarily from a decrease in product sales of $638,000, offset by an increase in sales derived
  from services of $396,000.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | Products sales of $7.3 million in 2006, which represented 68% of total sales in 2006, declined by 8%
  as compared to $7.9 million in 2005, which represented 73% of total sales in 2005. The lower product
  sales in 2006 were due largely to the continuing phase-out of our legacy products as a result of
  our decision in 2004 to divest our legacy products as part of our overall strategy to transition
  to our new generation of network fax servers, FaxPress Premier and FaxPress Enterprise. This decline
  in sales of our legacy products, which declined primarily to the international channels, was partially
  offset by the continuing increase in sales of our new generation FaxPress Premier and Enterprise
  network fax servers. We anticipate sales of our FaxPress Premier and Enterprise fax servers to continue
  to grow as we continue to expand our fax server product family.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | Service revenues are comprised of extended warranty and support programs as well as 60-days of maintenance
  included with initial product sales. Revenue related to these arrangements is recognized ratably
  over the period of the arrangement. Service revenues, which represented 31% of total sales in 2006,
  increased 13% to $3.3 million in 2006 from $2.9 million in 2005, which represented 27% of total sales
  in 2005. The increase in service revenues was primarily due to increased sales of extended warranty
  contracts mostly due to an increase in our installed customer base and higher average prices of extended
  warranty contracts on FaxPress Premier and Enterprise fax server products relative to our legacy
  products. We anticipate service revenues to increase as more FaxPress Premier fax servers are sold.                                                           
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

| | Sales by geographic area (unaudited)
| | ------------------------------------
| |                                     

| |                                           | Year Ended December 31, |       
| | ----------------------------------------- | ----------------------- | ------
| |                                           |                         |       
| |                                           | 2006                    |       
| |                                           |                         |       
| | Net Sales:                                |                         |       
| | United States                             | $                       | 9,064 
| | Europe                                    |                         | 543   
| | Pacific Rim                               |                         | 659   
| | Rest of Americas, excluding United States |                         | 324   
| |                                           |                         |       
| | Total net sales                           | $                       | 10,590
| |                                           |                         |       

| |                                                                                                                                                                                                                                                                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Sales in the United States were $9.1 million in 2006 as compared to $8.7 million in 2005, representing
  86% and 80%, respectively, of total net sales. The increase in domestic sales was mostly attributable
  to the increase in service revenues referred to above and the continuing shift in our sales mix to
  the FaxPress Premier and Enterprise fax server products, which carry higher selling prices.
| |                                                                                                                                                                                                                                                                                                                                                                                                                  
| | International sales (excluding sales to the rest of the Americas) were $1.2 million in 2006 and $1.6
  million in 2005, representing 11% and 15% of total net sales, respectively. The decrease in international
  sales                                                                                                                                                                                         

|28
|--



| | was largely due to the continuing phase-out of our legacy products as a result of our decision in 2004
  to divest our legacy products as part of our overall strategy to transition to our new generation
  of network fax servers, FaxPress Premier and Enterprise. During 2006, our primary Pacific Rim integrator
  took longer than anticipated lead time to evaluate our FaxPress Premier fax servers, resulting in
  a delay in orders for our fax server products. The evaluation process has now been satisfactorily
  completed and we anticipate orders for these servers to increase in 2007. Most of our international
  sales are denominated in U.S. dollars and thus, could be adversely affected by changes in demand
  resulting from fluctuations in currency exchange rates.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | Sales to the rest of the Americas, excluding the United States, were $324,000 in 2006, as compared
  to $516,000 in 2005, representing 3% and 5% of total net sales in 2006 and 2005, respectively. Sales
  in 2005 included a $203,000 shipment of FaxPress Premier fax server products to a certain customer
  in Latin America.                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | In 2006 and 2005, our top two customers Ingram Micro and Tech Data together accounted for approximately
  47% and 43% of our net sales, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

| | Cost of Sales; Gross profit
| | ---------------------------
| |                            

|         |                            |         
|-------- | -------------------------- | --------
|
|**2006** | **2005**                   | **2004**
|
|         | Cost of sales:             |         
|         | Products                   | $       
|         | Services                   |         
|
|         | Total cost of sales        | $       
|         | Gross profit               | $       
|         | Gross profit as % of sales |         

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Gross profit is equal to net sales less cost of sales. Cost of sales includes cost of materials, including
  components, manuals, diskettes, packaging materials and shipping. Cost of sales also includes compensation
  costs and overhead related to our manufacturing operations and technical services, inventory obsolescence
  and warranty expenses. Gross profit from service revenues in fiscal 2006 increased to $2.3 million,
  as compared to $1.9 million in 2005, due primarily to an increase in the proportion of FaxPress Premier
  and Enterprise fax server products sold in 2006 relative to 2005, which have higher average prices
  on extended support agreements. The higher gross profit from service revenues was offset by lower
  gross profit from product sales of $4.3 million in 2006 as compared to $5.2 million in 2005 due chiefly
  to lower product sales and product mix. FaxPress Premier and Enterprise fax server products yield
  a lower gross profit percentage as compared to FaxPress fax server products. We believe the gross
  margin percentage achieved in 2006 to be more indicative of future periods than the gross margin
  percentage achieved during prior years.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | Periodically, we review obsolete and unmarketable products in our inventory and make appropriate allowances
  for excess and obsolete inventory. Products that are determined to be obsolete and unmarketable are
  physically scrapped when it is determined that such inventories are no longer usable or salable.
  In 2006, we identified $70,000 of unmarketable products, which were scrapped and included in cost
  of sales, as compared to $108,000 worth of unmarketable products scrapped and included in cost of
  sales in 2005.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

|29
|--



| | Research and Development
| | ------------------------
| |                         

|         |                                                 |          |      
|-------- | ----------------------------------------------- | -------- | -----
|
|**2006** | **2005**                                        | **2004**
|
|        
|         | Research and development expenses               | $        | 1,782
|         | Research and development expenses as % of sales |          | 17   

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Research and development expenses represent costs associated with the development of new products and
  consist primarily of employee-related expenses, including beginning in 2006, share-based compensation
  costs, material costs and allocated facility costs. The higher research and development expenses
  in 2006 were mostly due to $122,000 in share-based compensation expense incurred as a result of the
  adoption of SFAS 123R. Research and development spending has supported both existing products and
  the development of new server appliances. We remain committed to the development of highly competitive
  new products and services through the efficient utilization of our engineering resources.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

| | Sales and Marketing
| | -------------------
| |                    

|         |                                            |          |      
|-------- | ------------------------------------------ | -------- | -----
|
|**2006** | **2005**                                   | **2004**
|
|        
|         | Sales and marketing expenses               | $        | 2,502
|         | Sales and marketing expenses as % of sales |          | 24   

| |                                                                                                                                                                                                                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Sales and marketing expenses consist primarily of employee-related expenses, commissions to sales representatives,
  product promotion expenses, and allocated facilities expenses, including expenses associated with
  our regional sales and support offices. Sales and marketing expenses are anticipated to continue
  to remain relatively stable.
| |                                                                                                                                                                                                                                                                                                                                                         

| | General and Administrative
| | --------------------------
| |                           

|         |                                                   |          |      
|-------- | ------------------------------------------------- | -------- | -----
|
|**2006** | **2005**                                          | **2004**
|
|        
|         | General and administrative expenses               | $        | 1,931
|         | General and administrative expenses as % of sales |          | 18   

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | General and administrative expenses consist primarily of employee-related expenses, including beginning
  in 2006, share-based compensation costs, for administration, finance, human resources and general
  management, as well as consulting, outside services, legal and accounting expenses, and allocated
  facilities expenses. Share-based compensation costs charged to general and administrative expense
  were $141,000 during 2006. The decrease in 2006, as compared to 2005, is mainly attributable to accounting
  fees incurred in the first half of fiscal 2005 related to the restatement of our historical financial
  statements included in our December 31, 2004 Annual Report on Form 10-K and our response to a series
  of comment letters issued by the Division of Corporation Finance of the Securities and Exchange Commission
  during the first quarter of fiscal 2005. General and administrative expenses related to the management
  assessment portion of Sarbanes-Oxley related internal control compliance are expected to increase
  in fiscal 2007.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

| | Interest and Other Income (Expenses)
| | ------------------------------------
| |                                     

| | Interest and other income (expense) consists primarily of interest income earned from our invested
  cash balances, interest expense on capital leases, bank service fees, and miscellaneous income and
  expenses. The $174,000 increase in interest and other income (expense) in 2006 as compared to 2005
  is primarily due to the interest earned on higher invested cash balances.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|30
|--



| | Provision for Income Tax
| | ------------------------
| |                         

| | In fiscal 2004, we recorded a tax benefit of $1.1 million as a result of releasing portions of our
  tax valuation allowance. During fiscal 2005, we recorded a tax provision of $395,000 as a result
  of increasing our tax valuation allowance. Consequently, as of December 31, 2005, we had recorded
  a total of $1.1 million of deferred tax assets. During 2006, we again reviewed the need for a valuation
  allowance against our deferred tax assets. As a result of this review, we determined that, based
  on 2006 financial results and projected future taxable income, a slight decrease in the valuation
  allowance was necessary. We recorded a tax provision in 2006 of $29,000 resulting from federal and
  state provision offset by the aforementioned decrease in the valuation allowance. Due to our determination
  that it is more likely than not that certain future tax benefits will be realized, a total of $1.1
  million of our deferred tax assets have been recognized and are included on our consolidated balance
  sheet as of December 31, 2006. As of December 31, 2006, we had approximately $11.4 million of net
  operating loss (NOL) carryforwards available to offset future federal taxable income.
  In addition, at December 31, 2006, we had federal and California credit carryforwards of approximately
  $1.3 million and $855,000, respectively. We do not expect to utilize significant amounts of cash
  for income tax payments until the NOLs have been utilized.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

| | Comparison of Years Ended December 31, 2005 and 2004
| | ----------------------------------------------------
| |                                                     

| | Net Sales
| | ---------
| |          

|         |                 |         
|-------- | --------------- | --------
|
|**2005** | **2004**        | **2003**
|
|        
|         | Net Sales:      |         
|         | Products        | $       
|         | Services        |         
|
|         | Total net sales | $       
|

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Net sales increased 4% to $10.8 million in 2005 from $10.5 million in 2004. The increase of $375,000
  was primarily from increased sales derived from services of $495,000, offset by a reduction in products
  sales of $120,000.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | Products sales of $7.9 million in 2005, which represented 73% of total sales in 2005, declined by 1%
  as compared to $8.0 million in 2004, which represented 77% of total sales in 2004. The lower product
  sales in 2005 were due largely to our decision in 2004 to divest our legacy products as part of our
  overall strategy to transition to our new generation of network fax servers, FaxPress Premier.                                                                                                                                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | Service revenues are comprised of extended warranty and support programs as well as 60-days of maintenance
  included with initial product sales. Revenue related to these arrangements is recognized ratably
  over the period of the arrangement. Service revenues, which represented 27% of total sales in 2005,
  increased 20% to $2.9 million in 2005 from $2.4 million in 2004, which represented 23% of total sales
  in 2004. The increase in service revenues was primarily due to increased sales of extended warranty
  contracts due to an increase in our installed customer base from additional sales of our FaxPress
  fax servers augmented by the introduction of our FaxPress Premier fax server products in the second
  half of 2003.

|31
|--



| | Sales by geographic area (unaudited)
| | ------------------------------------
| |                                     

| |                                           | Year Ended December 31, |       
| | ----------------------------------------- | ----------------------- | ------
|
|
| |                                           |                         |       
| | Net Sales:                                |                         |       
| | United States                             | $                       | 8,722 
| | Europe                                    |                         | 722   
| | Pacific Rim                               |                         | 872   
| | Rest of Americas, excluding United States |                         | 516   
| |                                           |                         |       
| | Total net sales                           | $                       | 10,832
| |                                           |                         |       

| |                                                                                                                                                                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Sales in the United States were $8.7 million in 2005 as compared to $8.6 million in 2004, representing
  80% and 82%, respectively, of total net sales. The increase in sales was mostly attributable to the
  increase in service revenues and the FaxPress Premier fax server products, which carry higher selling
  prices.                  
| |                                                                                                                                                                                                                                                                                                                                                 
| | International sales (excluding sales to the rest of the Americas) were $1.6 million in 2005 and 2004,
  representing 15% of total net sales in each year. Most of our international sales are denominated
  in U.S. dollars and thus, could be adversely affected by changes in demand resulting from fluctuations
  in currency exchange rates.
| |                                                                                                                                                                                                                                                                                                                                                 
| | Sales to the rest of the Americas, excluding the United States, were $516,000 in 2005, as compared
  to $294,000 in 2004, representing 5% and 3% of total net sales in 2005 and 2004, respectively. The
  increase in sales was mostly due to higher sales of the FaxPress Premier fax server products to Latin
  America.                      
| |                                                                                                                                                                                                                                                                                                                                                 
| | In 2005, Ingram Micro and Tech Data, our top two customers together accounted for approximately 43%
  of our net sales. In 2004, the same two distributors accounted for 44% of our net sales.                                                                                                                                                  
| |                                                                                                                                                                                                                                                                                                                                                 

| | Cost of Sales; Gross profit
| | ---------------------------
| |                            

| |                            | Year Ended December 31 |      
| | -------------------------- | ---------------------- | -----
|
|
| |                            |                        |      
| | Cost of sales:             |                        |      
| | Products                   | $                      | 2,694
| | Services                   |                        | 1,035
| |                            |                        |      
| | Total cost of sales        | $                      | 3,729
| | Gross profit               | $                      | 7,103
| | Gross profit as % of sales |                        | 66   

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Gross profit is equal to net sales less cost of sales. Cost of sales includes cost of materials, including
  components, manuals, diskettes, packaging materials and shipping. Cost of sales also includes compensation
  costs and overhead related to our manufacturing operations and technical services, inventory obsolescence
  and warranty expenses. Gross profit from service revenues in fiscal 2005 increased to $1.9 million,
  as compared to $1.6 million in 2004, due primarily to more extended support agreements sold along
  with higher sales of our FaxPress Premier fax servers in fiscal 2005 as compared to 2004. The higher
  gross profit from service revenues was partially offset by lower gross profit from product sales
  of $5.2 million in 2005 as compared to $5.5 million in 2004 due chiefly to product mix. Gross profit
  in 2004 also included a one-time pre-tax benefit of $126,000 from an adjustment of certain accruals
  related to a sales development program.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | Periodically we review obsolete and unmarketable products in our inventory and make appropriate allowances
  for excess and obsolete inventory. Products that are determined to be obsolete and unmarketable are
  physically scrapped when it is determined that such inventories are no longer usable or salable.
  In 2005, we identified $108,000 of unmarketable products, which were scrapped and included in                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

|32
|--



| | cost of sales, as compared to $35,000 worth of unmarketable products scrapped and included in cost
  of sales in 2004.
| | ----------------------------------------------------------------------------------------------------------------------
| |                                                                                                                       

| | Research and Development
| | ------------------------
| |                         

| |                                                            | Year Ended December 31 |       |  
| | ---------------------------------------------------------- | ---------------------- | ----- | -
|
|
| |                                                            |                        |       |  
|
| | Research and development expenses                          | $                      | 1,683 |  
| | Research and development expenses 
      as % of
    sales |                        | 16    | %

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Research and development expenses represent costs associated with the development of new products and
  consist primarily of employee-related expenses, material costs and allocated facility costs. The
  lower research and development expenses in 2005 were mostly due to a reduction in outside consulting
  expenses of $91,000 as a result of the completion of certain projects to enhance our current product
  features, partially offset by $47,000 in higher employee-related expenses.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

| | Sales and Marketing
| | -------------------
| |                    

| |                                                 | Year Ended December 31 |       |  
| | ----------------------------------------------- | ---------------------- | ----- | -
|
|
| |                                                 |                        |       |  
|
| | Sales and marketing expenses                    | $                      | 2,506 |  
| | Sales and marketing expenses as 
    % of sales |                        | 23    | %

| |                                                                                                                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Sales and marketing expenses consist primarily of employee-related expenses, commissions to sales representatives,
  product promotion expenses, and allocated facilities expenses, including expenses associated with
  our regional sales and support offices.
| |                                                                                                                                                                                                                                                                 

| | General and Administrative
| | --------------------------
| |                           

| |                                                        | Year Ended December 31 |       |  
| | ------------------------------------------------------ | ---------------------- | ----- | -
|
|
| |                                                        |                        |       |  
|
| | General and administrative expenses                    | $                      | 2,045 |  
| | General and administrative expenses 
    as % of sales |                        | 19    | %

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | General and administrative expenses consist primarily of employee-related expenses for administration,
  finance, human resources and general management, as well as consulting, outside services, legal and
  accounting expenses, and allocated facilities expenses. The increase of $245,000 in 2005, as compared
  to 2004, is mainly attributable to increases in accounting fees incurred in the first half of fiscal
  2005 related to the restatement of our historical financial statements included in our December 31,
  2004 Annual Report on Form 10-K and our response to a series of comment letters issued by the Division
  of Corporation Finance of the Securities and Exchange Commission during the first quarter of fiscal 2005.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

| | Interest and Other Income (Expenses)
| | ------------------------------------
| |                                     

| | Interest and other income (expense) consists primarily of interest income earned from our invested
  cash balances, interest expense on capital leases, bank service fees, and miscellaneous income and
  expenses. The $119,000 increase in interest and other income (expense) in 2005 as compared to 2004
  is primarily due to the interest earned on higher invested cash balances.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|33
|--



| | Provision for Income Tax
| | ------------------------
| |                         

| | In fiscal 2004 and 2003, we recorded tax benefits of $1.1 million and $526,000, respectively, as a
  result of releasing portions of our tax valuation allowance. Consequently, as of December 31, 2004,
  we had recorded a total of $1.5 million of deferred tax assets. During 2005, we again reviewed the
  need for a valuation allowance against our deferred tax assets. As a result of this review, we determined
  that, based on 2005 financial results and projected future taxable income, an increase in the valuation
  allowance was necessary. We recorded a tax provision in 2005 of $395,000 resulting from federal and
  state provision and an increase in the valuation allowance.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                               
|-------------------------------
|LIQUIDITY AND CAPITAL RESOURCES
|                               

| |                           | December 31, 2006 |       | December 31, 2005 |  
| | ------------------------- | ----------------- | ----- | ----------------- | -
|
|
| | Cash and cash equivalents | $                 | 8,259 |                   | $
| | Working capital           | $                 | 7,746 |                   | $
| | Working capital ratio     |                   | 3.7   |                   |  

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Since our initial public offering of common stock in December 1995, our principal source of funding
has been cash from our operations, with some funding from capital equipment lease lines. As of December
31, 2006, we had $8.3 million of cash and cash equivalents, an increase of $1.5 million from December
31, 2005. The increase in cash and cash equivalents was primarily attributable to cash provided by
operating activities of $1.7 million, partially offset by purchases of $181,000 of computer equipment.
As of December 31, 2006, we had no bank debt.
Our operating activities generated cash of $1.7 million in 2006, primarily due to operating income,
improved cash collections from outstanding accounts receivable of $205,000 and reduction of inventories
of $140,000.
In 2006, our net cash from financing activities, which was primarily from proceeds from issuance of
common stock of $78,000, was totally offset by cash used in the repurchase of common stock of $64,000
and repayment of notes payable of $13,000. We acquired additional equipment and licenses of $181,000,
$593,000 and $35,000 in 2006, 2005 and 2004, respectively. In 2005, net cash provided by financing
activities was $177,000 primarily from proceeds from issuance of common stock.
In the fourth quarter of 2002, our Board of Directors authorized us, from time to time, to repurchase
at market prices, up to $750,000 of our common stock for cash in open market, negotiated or
block transactions. The timing of such transactions will depend on market conditions, other corporate
strategies and will be at our discretion. No time limit was set for the completion of this program.
Under this program, we repurchased from open market and negotiated transactions a total of approximately
66,000 shares for approximately $68,000, at an average per share price of $1.04. The Company
has not repurchased any of its common stock since then under this program.
In the third quarter of 2006, our Board of Directors authorized us, from time to time, to repurchase
at market prices, up to $1 million worth of shares of our common stock for cash in open market, negotiated
or block transactions. The timing of such transactions has depended and will depend on market conditions,
other corporate strategies and has been and will be at the discretion of our management. No time
limit was set for the completion of this program. At the time of approval by our Board of Directors,
we had approximately 4 million shares of common stock outstanding. As of March 21, 2007, we have
repurchased from open market transactions a total of 30,000 shares for $88,000, at an average per
share price of $2.90. We intend to continue to execute our buyback program as our management deems advisable.
We renewed our line of credit with Silicon Valley Bank in July 2006, which now matures on July 30,
2007. The revolving line of credit provides for borrowings of up to $6.0 million. Borrowings under
this line of credit agreement are collateralized by all of our assets and bear interest at the banks
prime rate plus 0.50%. We are required to maintain certain minimum cash and investment balances with
the bank and to meet certain other financial covenants. This credit line provides that we shall not
pay any dividend without the Banks prior consent.

|34
|--



|As of December 31, 2006, we have not drawn down on the line of credit and were in compliance with debt
covenants and all other terms of the agreement.
We lease our headquarters in Morgan Hill, California. We extended our building lease for a term of
five years commencing on June 1, 2004 and expiring on May 31, 2009, with one conditional three-year
renewal option, which if exercised, would extend the lease to May 31, 2012 commencing with rent at
ninety-five percent of fair market value. As of December 31, 2006, future minimum payments under
the lease were $501,000.
The following represents combined aggregate maturities for all our financing and commitments as of
December 31, 2006:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

| |                                    | Payments Due by Period |    
| | ---------------------------------- | ---------------------- | ---
|
|
|
| | Operating Lease Obligations        | $                      | 501
|
|
| | Total contractual cash obligations | $                      | 501
|
|

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|We believe that our existing cash balances, anticipated cash flows from operations and available lines
of credit will be sufficient to meet our anticipated capital requirements for the foreseeable future.
If we have a need for additional capital resources, we may be required to sell additional equity
or debt securities, secure additional lines of credit or obtain other third party financing. The
timing and amount of such capital requirements cannot be determined at this time and will depend
on a number of factors, including demand for our existing and new products, if any, and changes in
technology in the networking industry. There can be no assurance that such additional financing will
be available on satisfactory terms when needed, if at all. Failure to raise such additional financing,
if needed, may result in our inability to achieve our long-term business objectives. To the extent
that additional capital is raised through the sale of additional equity or convertible debt securities,
the issuance of such securities would result in additional dilution to our shareholders.
In addition, because of our dependency on a small number of distributors for a significant portion
of the sales of our products, the loss of any of our major distributors or their inability to satisfy
their payment obligations to us could have a significant adverse effect on our business, operating
results and financial condition.
OFF BALANCE SHEET TRANSACTIONS
As of December 31, 2006, we did not have any off-balance-sheet arrangements, as defined
in Item 303(a)(4)(ii) of Regulation S-K.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes
(as amended)an interpretation of FASB Statement No. 109 (FIN 48). FIN 48
clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial
statements in accordance with SFAS No. 109, Accounting for Income Taxes, and prescribes
a recognition threshold and measurement attribute for the financial statement recognition and measurement
of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim periods, disclosure
and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are in
the process of analyzing the impact of FIN 48, which is required to be adopted by the first quarter
of fiscal 2007.
In June 2005, the Financial Accounting Standards Board (FASB) issued SFAS No. 154, Accounting
Changes and Error Corrections (SFAS No. 154), a replacement of APB Opinion No.
20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim
Financial Statements. SFAS No. 154 changes the requirements for the accounting for and reporting
of a change in accounting principle. Previously, most voluntary changes in accounting principles
required recognition via a cumulative effect adjustment within net income of the

|35
|--



|period of the change. SFAS No. 154 requires retrospective application to prior periods financial
statements, unless it is impracticable to determine either the period-specific effects or the cumulative
effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning
after December 15, 2005; however, the Statement does not change the transition provisions of any
existing accounting pronouncements. The adoption of SFAS No. 154 did not have an effect on the Companys
financial condition, or results of operations.
In September 2006, the FASB issued SFAS No. 157, Accounting for Fair Value Measurements.
SFAS No. 157 defines fair value, and establishes a framework for measuring fair value in generally
accepted accounting principles and expands disclosure about fair value measurements. SFAS No. 157
is effective for the Company for financial statements issued subsequent to November 15, 2007. The
Company does not expect the new standard to have any material impact on the financial position and
results of operations.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and
LiabilitiesIncluding an amendment of FASB Statement No. 115, which permits entities to
measure eligible items at fair value. For items where the fair value election is made, we will be
required to report unrealized gains or losses in earnings. SFAS 159 is effective for fiscal years
beginning after November 15, 2007. At this time, the Company is assessing the impact the adoption
of SFAS 159 will have on our financial statements.
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108,
Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current
Year Financial Statements, (SAB No. 108). SAB No. 108 provides guidance regarding
the consideration of the effects of prior year misstatements in quantifying current year misstatements
for the purpose of materiality assessments. The method established by SAB No. 108 requires each of
the Companys financial statements and the related financial statement disclosures to be considered
when quantifying and assessing the materiality of the misstatement. SAB No. 108 is effective for
fiscal years ending after November 15, 2006 and applies to the Companys financial statements
for the fiscal year ended December 31, 2006. The adoption of SAB No. 108 did not have a material
effect on the Companys financial condition and results of operations.
ITEM 7A.       QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
We had no holdings of derivative financial or commodity instruments at December 31, 2006. However,
we are exposed to financial market risks, including changes in interest rates and foreign currency
exchange rates. While much of our revenue is transacted in U.S. Dollars, certain spending is transacted
in Pounds Sterling. These amounts are not currently material to our financial statements. Therefore
we believe that changes in foreign currency exchange rates currently do not materially affect our
overall financial position, results of operations or cash flows. The fair value of our money market
accounts and related income would not be significantly impacted by increases or decreases in interest
rates due mainly to the highly liquid nature of these investments. However, sharp declines in interest
rates could seriously harm interest earnings.
ITEM 8.          FINANCIAL STATEMENTS AND SUPPLEMENTARY
DATA
The consolidated financial statements and supplementary data required by this Item are set forth at
the pages indicated in Item 15 of this report.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

|ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
|------- | ------------------------------------------------------------------------------------

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Not applicable.
ITEM 9A.       CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Regulations under the Securities Exchange Act of 1934 require public companies, including our company,
to maintain disclosure controls and procedures, which are defined to mean a companys
controls and other procedures that are designed to ensure that information required to be disclosed
in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized, and reported, within the time

|36
|--



|periods specified in the Securities and Exchange Commissions rules and forms. Our Chief Executive
Officer and our Chief Financial Officer, based on their evaluation of our disclosure controls and
procedures as of the end of the period covered by this Annual Report on Form 10-K, concluded that
our disclosure controls and procedures were effective for this purpose.
Changes in Internal Control Over Financial Reporting
Regulations under the Securities Exchange Act of 1934 require public companies, including our company,
to evaluate any change in our internal control over financial reporting, which is defined
as a process to provide reasonable assurance regarding the reliability of financial reporting and
preparation of financial statements for external purposes in accordance with accounting principles
generally accepted in the United States. In connection with their evaluation of our disclosure controls
and procedures as of the end of the period covered by this report, our Chief Executive Officer and
Chief Financial Officer did not identify any change in our internal control over financial reporting
during the period covered by this Annual Report on Form 10-K that materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting.
Limitations on Effectiveness of Controls
In designing and evaluating our disclosure controls and procedures, our management recognized that
any controls and procedures, no matter how well designed and operated, can provide only reasonable
assurance of achieving their objectives, and our management necessarily applied its judgment in evaluating
the cost-benefit relationship of possible controls and procedures.
ITEM 9B.               OTHER INFORMATION
Not applicable.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|37
|--



|PART III
|--------
|        

|ITEM 10. | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
|-------- | ------------------------------------------------------

|                                                                                                                                                                                                                                                                                                                                                                                                            
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The information required by this Item 10 is incorporated herein by reference from our definitive Proxy Statement (the Proxy Statement), related to our 2007 Annual Meeting of Shareholders to be filed by us with the Securities and Exchange Commission (SEC) no later than April 30, 2007 or will be provided in an amendment to this Form 10-K to be filed with the SEC no later than April 30, 2007.
|                                                                                                                                                                                                                                                                                                                                                                                                            

|ITEM 11. | EXECUTIVE COMPENSATION
|-------- | ----------------------

|                                                                                                                                                                                                                  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The information required by this Item 11 is incorporated herein by reference from the Proxy Statement or will be provided in an amendment to this Form 10-K to be filed with the SEC no later than April 30, 2007.
|                                                                                                                                                                                                                  

|ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
|-------- | --------------------------------------------------------------

|                                                                                                                                                                                                                  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The information required by this Item 12 is incorporated herein by reference from the Proxy Statement or will be provided in an amendment to this Form 10-K to be filed with the SEC no later than April 30, 2007.
|                                                                                                                                                                                                                  

|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
|-------- | -------------------------------------------------------------------------

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|In October 2002, we engaged W.R. Hambrecht + Co. (WRH + Co.), an investment bank, to manage our stock buyback program as approved by the Board of Directors. Mr. Robert Hambrecht, a member of our Board of Directors, is also a director of WRH + Co. Through December 31, 2006, WRH + Co. had received an insignificant amount of compensation under this and subsequent arrangements.
    Other information required by this Item 13 is incorporated herein by reference from the Proxy Statement or will be provided in an amendment to this Form 10-K to be filed with the SEC no later than April 30, 2007.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|-------- | --------------------------------------

|                                                                                                                                                                                                                  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The information required by this Item 14 is incorporated herein by reference from the Proxy Statement
or will be provided in an amendment to this Form 10-K to be filed with the SEC no later than April
30, 2007.

|38
|--



|PART IV
ITEM 15.       EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
|-----------------------------------------------------------------
|                                                                 

| | (a) | The following documents are filed as part of this Annual Report on Form 10-K:
| | --- | -----------------------------------------------------------------------------
| |     |                                                                              

| | 1) | Financial Statements
| | -- | --------------------
| |    |                     

| |                                                                                                           | Page in
      Form 10-K | 
| | --------------------------------------------------------------------------------------------------------- | ----------------------- | 
|
|
| | Report of Independent Registered
     Public Accounting Firm                                              | F-1                     | 
| | Consolidated Balance Sheets as of December 31, 2006 and 2005                                              | F-2                     | 
| | Consolidated Statements of Earnings for the years ended
     December 31, 2006, 2005 and 2004             | F-3                     | 
| | Consolidated Statements of Shareholders Equity for the years ended
     December 31, 2006, 2005 and 2004 | F-4                     | 
| | Consolidated Statements of Cash Flows for the years ended
     December 31, 2006, 2005 and 2004           | F-5                     | 
| | Notes to Consolidated Financial Statements                                                                | F-6                     | 

| |    |                              
| | -- | -----------------------------
| | 2) | Financial Statement Schedules
| |    |                              

| | The following financial statement schedule of Castelle for the years ended December 31, 2006, 2005
  and 2004 is filed as part of this Form 10-K and should be read in conjunction with the Companys
  Financial Statements.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                              

| |                                                 | Page in
      Form 10-K | 
| | ----------------------------------------------- | ----------------------- | 
|
|
| | Schedule II  Valuation and Qualifying Accounts | F-23                    | 

| |    |                                                                                                                                                                                               
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    | Schedules not listed above have been omitted because they are not applicable or are not required or because the required information is included in the Financial Statements or Notes thereto.
| |    |                                                                                                                                                                                               
| | 3) | Exhibits                                                                                                                                                                                      
| |    |                                                                                                                                                                                               

| | See Item 15(b) below.
| | ---------------------

|39
|--



| | (b) | Exhibits
| | --- | --------
| |     |         

|Incorporated by Reference
|-------------------------
|                         
|**Exhibit Number**       
|                         
|                         
|3.1                      
|                         
|3.2                      
|                         
|4.1                      
|                         
|10.1*                    
|                         
|10.2                     
|                         
|10.3*                    
|                         
|10.4                     
|                         
|10.5                     
|                         
|10.6                     
|                         
|10.7*                    
|                         
|10.8                     
|                         
|10.9                     
|                         
|10.10*                   
|                         
|10.11                    
|                         
|10.12                    
|                         
|10.13                    
|                         
|10.14                    
|                         
|10.15                    
|                         
|10.16                    
|                         
|23.1                     
|                         
|31.1                     
|                         
|31.2                     
|                         
|32.1**                   
|                         
|32.2**                   

|40
|--



| | *  | Indicates management contracts or compensatory plans or arrangements filed pursuant to Item 601(b)(10)
  of Regulation S-K                                     
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                
| | ** | In accordance with SEC Release No. 33-8212, Exhibits 32.1 and 32.2 are to be treated as accompanying
  this report rather than filed as part of the report.
| |    |                                                                                                                                                                

| | (c) | Financial Statement Schedules
| | --- | -----------------------------
| |     |                              

| | See Item 15(a)(2) above.
| | ------------------------

|41
|--



|SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, as amended, the
Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned,
thereunto duly authorized on the thirtieth day of March 2007.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                     

|By: | /S/ SCOTT C. MCDONALD                
|--- | -------------------------------------
|    |                                      
|    | Scott C. McDonald                    
|    | President and Chief Executive Officer

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|KNOW BY ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Scott C. McDonald, as his
true and lawful attorney-in-fact and agent, with full power of substitution for him, and in his name
in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and
to file the same, with exhibits thereto and other documents in connection therewith, with the Securities
and Exchange Commission, granting unto said attorney-in-fact and agent, full power and authority
to do and perform each and every act and thing requisite and necessary to be done therewith, as fully
to all intents and purposes as he might or could do in person, hereby ratifying and confirming all
that said attorney-in-fact and agent, and any of them, or his substitute or substitutes, may lawfully
do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K
has been signed below by the following persons on behalf of the Registrant and in the capacities
and on the dates indicated:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

|**Name**                                          | **Title**                                                                                                        | **Date**      
|------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------- | --------------
|                                                  |                                                                                                                  |               
|                                                  |                                                                                                                  |               
|/S/ SCOTT  C. MCDONALD
      Scott C. McDonald    | President, Chief Executive Officer (principal executive officer) and Director                                    | March 30, 2007
|                                                  |                                                                                                                  |               
|/S/ PAUL CHENG
        Paul Cheng                 | Vice President, Finance and Administration, Chief Financial Officer (principal accounting officer) and Secretary | March 30, 2007
|                                                  |                                                                                                                  |               
|/S/ DONALD L. RICH
        Donald L. Rich         | Chairman of the Board                                                                                            | March 30, 2007
|                                                  |                                                                                                                  |               
|/S/ ROBERT H. HAMBRECHT
      Robert H. Hambrecht | Director                                                                                                         | March 30, 2007
|                                                  |                                                                                                                  |               
|/S/ ROBERT O. SMITH
      Robert O. Smith         | Director                                                                                                         | March 30, 2007
|                                                  |                                                                                                                  |               
|/S/ PETER R. TIERNEY
        Peter R. Tierney     | Director                                                                                                         | March 30, 2007

|42
|--



|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Report of Independent Registered Public Accounting Firm
Board of Directors and ShareholdersCastelle
We have audited the accompanying consolidated balance sheets of Castelle and its subsidiary (the Company)
as of December 31, 2006 and 2005, and the related consolidated statements of earnings, shareholders
equity, and cash flows for each of the three years in the period ended December 31, 2006. These consolidated
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 the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. The Company is
not required to have, nor were we engaged to perform an audit of its internal control over financial
reporting. Our audit included consideration of internal control over financial reporting as a basis
for designing audit procedures that are appropriate in the circumstances, but not for the purpose
of expressing an opinion on the effectiveness of the Companys internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements, assessing the accounting
principles used and significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material
respects, the financial position of Castelle and its subsidiary as of December 31, 2006 and 2005,
and the results of their operations and their cash flows for each of the three years in the period
ended December 31, 2006 in conformity with accounting principles generally accepted in the United
States of America.
Our audit was conducted for the purpose of forming an opinion on the basic consolidated financial statements
taken as a whole. The Schedule II is presented for purposes of additional analysis and is not a required
part of the basic consolidated financial statements. This schedule, for each of the three years in
the period ended December 31, 2006, has been subjected to the auditing procedures applied in the
audit of the basic consolidated financial statements taken as a whole.
As discussed in Note 2 to the consolidated financial statements, Castelle adopted Financial Accounting
Standards Board Statement No. 123(R), Share-Based Payment on a modified prospective basis as of January 1, 2006.
Grant Thornton LLPSan Francisco, CaliforniaMarch 27, 2007

|F-1
|---



|Castelle
Consolidated Balance Sheets(in thousands)
|--------------------------------------------------
|                                                  
|                                                  

|                                                                                                           | **December 31,** |        
|---------------------------------------------------------------------------------------------------------- | ---------------- | -------
|                                                                                                           |                  |        
|                                                                                                           | **2006**         |        
|                                                                                                           |                  |        
|**Assets**                                                                                                 |                  |        
|Current assets:                                                                                            |                  |        
|Cash and cash equivalents                                                                                  | $                | 8,259  
|Accounts receivable, net                                                                                   |                  | 932    
|Inventories                                                                                                |                  | 1,016  
|Prepaid expenses and other current assets                                                                  |                  | 238    
|Deferred taxes                                                                                             |                  | 185    
|                                                                                                           |                  |        
|Total current assets                                                                                       |                  | 10,630 
|                                                                                                          
|Property and equipment, net                                                                                |                  | 280    
|Other assets                                                                                               |                  | 125    
|Deferred taxes                                                                                             |                  | 944    
|                                                                                                           |                  |        
|                                                                                                          
|Total assets                                                                                               | $                | 11,979 
|                                                                                                           |                  |        
|                                                                                                          
|**Liabilities and Shareholders Equity**                                                                   |                  |        
|Current liabilities:                                                                                       |                  |        
|Current portion of long-term debt                                                                          | $                |       
|Accounts payable                                                                                           |                  | 349    
|Accrued liabilities                                                                                        |                  | 825    
|Deferred revenue                                                                                           |                  | 1,710  
|                                                                                                           |                  |        
|Total current liabilities                                                                                  |                  | 2,884  
|                                                                                                           |                  |        
|Commitments and contingencies(Note 4)                                                                      |                  |        
|                                                                                                           |                  |        
|Shareholders equity:                                                                                      |                  |        
|Preferred stock, no par value:                                                                             |                  |        
|Authorized: 2,000 shares in 2006 and 2005                                                                  |                  |        
|Issued and outstanding: none in 2006 and 2005                                                              |                  |       
|Common stock, no par value:                                                                                |                  |        
|Authorized: 25,000 shares                                                                                  |                  |        
|Issued and outstanding: 4,049 shares at December 31, 2006
           and 3,986 shares at December 31, 2005 |                  | 28,234 
|Accumulated deficit                                                                                        |                  | (19,139
|                                                                                                           |                  |        
|Total shareholders equity                                                                                 |                  | 9,095  
|                                                                                                           |                  |        
|                                                                                                          
|Total liabilities and shareholders equity                                                                 | $                | 11,979 
|                                                                                                           |                  |        

|                                                                          
|--------------------------------------------------------------------------
|The
accompanying notes are an integral part of these financial statements.

|F-2
|---



|CastelleConsolidated Statements of Earnings(in thousands, except per share data)
|--------------------------------------------------------------------------------
|                                                                                
|                                                                                

|                                                            |         
|----------------------------------------------------------- | --------
|
|**2006**                                                    | **2005**
|
|Net sales:                                                  |         
|Products                                                    | $       
|Services                                                    |         
|
|Total net sales                                             |         
|
|
|Cost of sales:                                              |         
|Products                                                    |         
|Services                                                    |         
|
|Total cost of sales                                         |         
|
|Gross profit                                                |         
|
|
|Operating expenses:                                         |         
|Research and development                                    |         
|Sales and marketing                                         |         
|General and administrative                                  |         
|
|                                                            |         
|
|                                                            |         
|Operating income                                            |         
|                                                            |         
|Interest income, net                                        |         
|Other expense, net                                          |         
|
|
|Income before provision for (benefit from)
    income taxes |         
|Provision for (benefit from) income taxes                   |         
|
|
|Net income                                                  | $       
|
|
|Net income per common share  basic                         | $       
|
|
|Net income per common share  diluted                       | $       
|
|
|Shares used in per share calculation  basic                |         
|
|
|Shares used in per share calculation  diluted              |         
|

|                                                                             
|-----------------------------------------------------------------------------
|The



accompanying notes are an integral part of these financial statements.

|F-3
|---



|CastelleConsolidated Statements of Shareholders EquityYears Ended December 31, 2006, 2005 and 2004(in thousands)
|-----------------------------------------------------------------------------------------------------------------
|                                                                                                                 
|                                                                                                                 

|                                                                 |            |                               |           |   |       
|---------------------------------------------------------------- | ---------- | ----------------------------- | --------- | - | ------
|                                                                
|**Shares**                                                       | **Amount** | **Accumulated
      Deficit** | **Total**
|
|Balances, December 31, 2003                                      |            | 3,425                         |           | $ | 27,258
|                                                                 |            |                               |           |   |       
|Issuance of common stock through
      exercise of stock options |            | 374                           |           |   | 410   
|Net income                                                       |            |                              |           |   |      
|                                                                
|
|Balances, December 31, 2004                                      |            | 3,799                         |           |   | 27,668
|
|                                                                
|Issuance of common stock through
      exercise of stock options |            | 187                           |           |   | 192   
|Net income                                                       |            |                              |           |   |      
|                                                                
|
|Balances, December 31, 2005                                      |            | 3,986                         |           |   | 27,860
|
|Issuance of common stock through
      exercise of stock options |            | 85                            |           |   | 78    
|Repurchase and cancellation of common stock                      |            | (22                           | )         |   | (64   
|Share based compensation                                         |            |                              |           |   | 360   
|Net income                                                       |            |                              |           |   |      
|                                                                
|
|Balances, December 31, 2006                                      |            | 4,049                         |           | $ | 28,234
|

|                                                                             
|-----------------------------------------------------------------------------
|The



accompanying notes are an integral part of these financial statements.

|F-4
|---



|CastelleConsolidated Statements of Cash FlowsYears Ended December 31, 2006, 2005 and 2004(in thousands)
|-------------------------------------------------------------------------------------------------------
|                                                                                                       
|                                                                                                       

|                                                                                        |         
|--------------------------------------------------------------------------------------- | --------
|
|**2006**                                                                                | **2005**
|
|**Cash flows from operating activities:**                                               |         
|Net income                                                                              | $       
|Adjustments to reconcile net income to
      net cash provided by operating activities: |         
|Share based compensation                                                                |         
|Depreciation and amortization                                                           |         
|Allowance for sales returns and stock rotation                                          |         
|Deferred taxes                                                                          |         
|Loss on disposal of fixed assets                                                        |         
|Changes in assets and liabilities:                                                      |         
|Accounts receivable, net                                                                |         
|Inventories                                                                             |         
|Prepaid expenses and other current assets                                               |         
|Accounts payable                                                                        |         
|Accrued liabilities                                                                     |         
|Deferred revenue                                                                        |         
|
|Net cash provided by operating activities                                               |         
|
|                                                                                        |         
|**Cash flows from investing activities:**                                               |         
|Acquisition of property and equipment                                                   |         
|Acquisition of licenses                                                                 |         
|
|Net cash used in investing activities                                                   |         
|
|                                                                                        |         
|**Cash flows from financing activities:**                                               |         
|Repayment of notes payable                                                              |         
|Repurchase of common stock                                                              |         
|Proceeds from issuance of common stock                                                  |         
|
|Net cash provided by financing activities                                               |         
|
|                                                                                        |         
|Net increase in cash and cash equivalents                                               |         
|                                                                                        |         
|Cash and cash equivalents, beginning of period                                          |         
|
|                                                                                        |         
|Cash and cash equivalents, end of period                                                | $       
|
|                                                                                        |         
|**Supplemental Information:**                                                           |         
|Cash paid during the period for:                                                        |         
|Interest                                                                                |         

|                                                                             
|-----------------------------------------------------------------------------
|The



accompanying notes are an integral part of these financial statements.

|F-5
|---



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

|  
|--
|1.
|  
|  
|  
|  
|  
|  
|  
|  
|  
|2.
|  

| | Use of estimates in preparation of financial statements                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | 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 reported
  amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date
  of the financial statements, and the reported amounts of revenues and expenses during the reporting
  period. Actual results could differ from those estimates.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | Principles of consolidation                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | The consolidated financial statements include the accounts of Castelle and its wholly owned subsidiary
  in the United Kingdom. All intercompany balances and transactions have been eliminated.                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | Financial instruments                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | Cash equivalents consist of highly liquid investments with original or remaining maturities of three
  months or less when purchased.                                                                                                                                                                                                                                                                                                                                          

|F-6
|---



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | Carrying amounts of financial instruments consisting of cash and cash equivalents, accounts receivable,
  accounts payable and accrued liabilities included in the Companys financial statements approximate
  fair value due to their short-term maturities.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | Concentrations of credit risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | Financial instruments that potentially subject the Company to concentrations of credit risk consist
  principally of trade receivables and cash equivalents. With respect to trade receivables, the Company
  performs ongoing credit evaluations of its customers financial condition. Additionally, the
  Company establishes an allowance for doubtful accounts based upon factors surrounding the credit
  risk of specific customers, historical trends and other available information. The determination
  of past due status is based on contractual terms. Two customers (both distributors) accounted for
  58% and 59% of accounts receivable at December 31, 2006 and 2005, respectively. These same two customers
  also accounted for 47%, 43% and 44% of the Companys total sales in 2006, 2005 and 2004, respectively.
  Although the Company does not require collateral on accounts receivable arising from sales to large,
  well-established companies, it does require prepayments on certain sales to foreign and smaller companies.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | With respect to cash equivalents, the Company has cash investment policies that limit the amount of
  credit exposure to any one issuer and restrict placement of these investments to issuers evaluated
  as creditworthy.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | Inventories and related allowances for excess and obsolete inventory                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | Inventories are stated at the lower of standard cost (which approximates cost on a first-in, first-out
  basis) or market. We record allowances for excess and obsolete inventory equal to the difference
  between the cost of inventory and the estimated fair value based on assumptions about future product
  life-cycles, product demand and market conditions. If actual product life cycles, product demand
  and market conditions are less favorable than those projected by management, additional inventory
  write-downs may be required. At the point of the loss recognition, a new, lower-cost basis for that
  inventory is established, and subsequent changes in facts and circumstances do not result in the
  restoration or increase in that newly established cost basis.                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | We have purchased approximately two years worth of end-of-life components to ensure a smooth supply
  of our FaxPress Products to our customers. Accordingly, our management reviews periodically the usage,
  supply and inventory levels of these parts to determine whether additional purchases or excessive
  inventory provisions are necessary. We had approximately $281,000 and $390,000 worth of end-of-life
  components on hand at December 31, 2006 and 2005, respectively. We believe that most of these components
  will be utilized in the following two years, resulting in insignificant amounts of excessive inventory,
  or none at all.                                                                                                                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | Property and equipment                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation
  is provided using the straight-line method over the estimated useful lives of the respective assets,
  generally three to seven years. Amortization of leasehold improvements is provided on a straight-line
  basis over the life of the related asset or the lease term, if shorter. Gains and losses upon asset
  disposal are recognized in the year of disposition. Expenditures for replacements and betterments
  are capitalized, while expenditures for maintenance and repairs are charged against earnings as incurred.                                                                                                                                                                                                                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | Accounting for long-lived assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate
  that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparison
  of the carrying amount to undiscounted future net cash flows the assets are expected to generate.
  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 asset exceeds its fair market value.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

|F-7
|---



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | Revenue recognition                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | We recognize revenue based on the provisions of Staff Accounting Bulletin No. 104 Revenue Recognition, AICPA Statement of Position No. 97-2 (SOP 97-2) Software Revenue Recognition, as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions, and Statement of Financial Accounting Standards (SFAS) No. 48 Revenue Recognition When Right of Return Exits.                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | The Company uses the residual method to recognize revenue when an agreement includes one or more elements
  to be delivered at a future date. If there is an undelivered element under the arrangement, the Company
  defers revenue based on vendor-specific objective evidence of the fair value of the undelivered element,
  as determined by the price charged when the element is sold separately. If vendor-specific objective
  evidence of fair value does not exist for all undelivered elements, the Company defers all revenue
  until sufficient evidence exists or all elements have been delivered.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | Product revenue is recognized when all of the following criteria are met: persuasive evidence
  of an arrangement exists; delivery has occurred; the fee is fixed or determinable; collection is
  probable; and returns can be reasonably estimated. If an acceptance period or other contingency exists,
  revenue is recognized upon satisfaction of the contingency, customer acceptance or expiration of
  the acceptance period. Shipment generally occurs and title and risk of loss is transferred when the
  product is delivered to a common carrier.                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | The Company accrues a liability for any sales taxes and value-added taxes collected on behalf of various
  taxing authorities. This liability is relieved when any taxes collected are remitted to the taxing
  authority. Revenue excludes sales taxes and any value-added taxes.                                                                                                                                                                                                                                                                                                                                
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | We enter into agreements with some of our distributors that permit limited stock rotation rights. These
  stock rotation rights allow the distributor to return products for credit but require the purchase
  of additional products of equal value. Customers who purchase products directly from us also have
  limited return rights, which expire 30 days from product shipment. Revenues subject to stock rotation
  or other return rights are reduced by our estimates of anticipated exchanges and returns.                                                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | Pursuant to our agreements with distributors, we also protect our distributors exposure related
  to the impact of price reductions. Future price adjustments are estimated and accrued at the time
  of sale as a reduction in revenue.                                                                                                                                                                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | We generally provide our distributors the opportunity to earn volume incentive rebates based on sales
  volume achieved during the fiscal quarter. These incentive rebates are accrued in the quarter incurred
  and recorded as a reduction in revenue.                                                                                                                                                                                                                                                                                                                                                          
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | We also provide co-op and market development funds to our distributors. These incentives are accrued
  at the time revenue is recognized and recorded as a reduction in revenue.                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | We offer a standard trade-in discount to all of our end-user customers under which the customer, upon
  trade-in of any previously purchased product, is entitled to a discount from our published price
  list on any product included in our current product offerings. We require our customers to physically
  return the previously purchased products to qualify for the trade-in discount. We account for the
  trade-in discount as a reduction of revenue at the time the product is traded in and a new product
  is purchased.                                                                         
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | Payment terms to our distributors and customers are generally thirty days, cash in advance, or by credit
  card.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | We evaluate product sales through our distribution channels and the related reserve requirement to
  establish an estimate for our sales returns reserve by reviewing detailed point-of-sales and on-hand                                                                                                                                                                                                                                                                                                                                                                                                         

|F-8
|---



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | inventory reports provided to us by our channel partners. Based on a combination of historical return
  experience, the sales activities to end-user customers by our channel partners and the level of inventories
  on hand at the channel partners, we determine our returns reserve at the end of each financial period,
  and increase or reduce the reserve balance accordingly.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | We provide standard support to our customers for an initial period of sixty days, which includes advance
  swap of the defective hardware and software, bug fixes, software upgrades and technical support.
  In addition to standard support, we also offer our customers the option to purchase extended support
  at the time of product purchase or anytime thereafter. Extended support covers hardware and software
  for a period of one year. We have established vendor-specific objective evidence with respect to
  the fair value of the standard support contracts based on standalone sales and renewals of our one-year
  extended support contracts. The fair value of our sixty day support contracts included with product
  sales is determined by pro-rating the related one-year extended support contracts. We recognize revenue
  from extended support contracts ratably over the period of the contract.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Hardware is warranted for one year from the date of sale and is repaired free-of-charge. Provisions
  for estimated warranty costs are recorded at the time products are shipped as a charge to cost of
  sales. While we engage in extensive product quality programs and processes, our warranty obligation
  is affected by product failure rates, material usage and service delivery costs incurred in correcting
  a product failure.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | We do not sell software, which is incorporated into our hardware, separately, other than for our customers
  to purchase as an upgrade to their existing products when we announce a major release of the software.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Shipping and handling                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Costs related to shipping and handling are included in cost of sales for all periods presented.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Advertising costs                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Advertising costs, included in sales and marketing expenses, are expensed as incurred and were $284,000,
    $250,000 and $219,000 in 2006, 2005 and 2004, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Research and development expenses                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Costs related to the conceptual formulation and design of both hardware and software products are expensed as
    research and development while costs incurred subsequent to establishing technological feasibility
    of software products are capitalized until general release of the product. Generally, technological
    feasibility is established upon completion of a working model. No significant costs subsequent to
    such point have been incurred, and all such costs have been expensed to date.                                                                                                                                                                                                                                                                                                                                                                                                             
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Income taxes                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | The Company accounts for income taxes in accordance with the liability method. Under the liability
  method, deferred assets and liabilities are recognized based upon anticipated future tax consequences
  attributable to differences between financial statement carrying amounts of assets and liabilities
  and their respective tax bases. The provision for income taxes is comprised of the current tax liability
  and the change in deferred tax assets and liabilities. The Company establishes a valuation allowance
  to the extent that all or some portion of the deferred tax assets more likely than not will not be
  recoverable against future taxable income.                                                                                                                                                                                                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Foreign currency translation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | The functional currency of the Companys foreign subsidiary is the U.S. dollar. Accordingly, all
  monetary assets and liabilities are translated into U.S. dollars at the current exchange rates as
  of the applicable balance sheet date while non-monetary items are translated at historical rates.

  Revenues and expenses are translated at the average exchange rates prevailing during the period,
  and gains and losses from such translations have not been material. Cumulative gains and losses from
  the translation of the foreign subsidiaries financial statements have not been material to
  date. Foreign exchange gains and losses resulting from foreign currency transactions were not material
  in any of the periods presented.                                                                                                                                                                    

|F-9
|---



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | Net income per share                                                                                                                                                                                                                                                                                                                                                                            
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                 
| | Basic net income per share is computed by dividing net income by the weighted average number of common
  shares outstanding for that period. Diluted net income per share is computed giving effect to all
  dilutive potential common shares that were outstanding during the period. Dilutive potential shares
  consist of incremental common shares issuable upon exercise of stock options.
| |                                                                                                                                                                                                                                                                                                                                                                                                 
| | Basic and diluted net income per share are calculated as follows (in thousands except per share amounts):                                                                                                                                                                                                                                                                                       
| |                                                                                                                                                                                                                                                                                                                                                                                                 

| |                                             |   |       | 
| | ------------------------------------------- | - | ----- | 
| |                                             |   |       | 
| | Basic:                                      |   |       | 
| | Weighted average shares                     |   | 4,023 | 
| |                                             |   |       | 
| | Net income                                  | $ | 669   | 
| |                                             |   |       | 
| | Net income per share                        | $ | 0.17  | 
| |                                             |   |       | 
| |                                             |   |       | 
| | Diluted:                                    |   |       | 
| | Weighted average shares                     |   | 4,023 | 
| | Common equivalent shares from stock options |   | 452   | 
| |                                             |   |       | 
|
| | Shares used in per share calculation        |   | 4,475 | 
| |                                             |   |       | 
|
| | Net income                                  | $ | 669   | 
| |                                             |   |       | 
|
| | Net income per share                        | $ | 0.15  | 
| |                                             |   |       | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The calculation of diluted shares outstanding excludes 392,000, 132,000, and 123,000 shares of common
  stock issuable upon the exercise of outstanding stock options for the years ended December 31, 2006,
  2005, and 2004 respectively, as their effect was antidilutive in the period.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | Share-Based Compensation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | The Company grants stock options to employees, non-employee directors and consultants under its 2002
  Equity Incentive Plan (the 2002 Plan). Prior to January 1, 2006, the Company accounted
  for these share-based awards under the intrinsic value method of Accounting Principles Board (APB)
  No. 25, Accounting for Stock Issued to Employees (APB No. 25). This method under APB
  No. 25 resulted in no expense being recorded for stock option grants. Effective January 1, 2006,
  the Company adopted Statement of Financial Accounting Standard No. 123 (Revised 2004) Share-Based
  Payment, (SFAS No. 123R), which replaces SFAS No. 123, Accounting for Stock-Based
  Compensation (SFAS No 123) and supersedes APB No. 25. SFAS No. 123R requires that compensation
  cost relating to share-based payment transactions be recognized in the Companys financial statements.
  That cost is measured based upon the fair value of the option issued. SFAS No. 123R applies to all
  of the Companys outstanding unvested share-based payment awards as of January 1, 2006 and all
  prospective awards using the modified prospective transition method without restatement of prior
  periods. Accordingly, the Companys share-based compensation cost is measured at the grant date,
  based on the fair value of the award, and is either recognized as an expense over the requisite service
  period using the graded, or accelerated, attribution method, or capitalized as inventory.

|F-10
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | Share-Based Compensation Expense: Total compensation costs recognized in the Companys financial statements for the year ended
  December 31, 2006 was comprised as follows (in thousands):
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                            

| |                                              |  
| | -------------------------------------------- | -
| |                                              |  
| | Share-based compensation expense by caption: |  
| |                                              |  
| |                                              |  
| | Cost of products                             | $
| |                                              |  
| |                                              |  
| | Cost of services                             |  
| |                                              |  
| |                                              |  
| | Research and development                     |  
| |                                              |  
| |                                              |  
| | Sales and marketing                          |  
| |                                              |  
| |                                              |  
| | General and administrative                   |  
| |                                              |  
|
| | Total share-based compensation:              | $
| |                                              |  

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Share-based compensation expense of $16,000 was capitalized and included in inventory on the Companys
  consolidated balance sheet as of December 31, 2006. No tax benefits were recorded with respect to
  share-based compensation expense recorded during the year ended December 31, 2006.                                                                                                                                                                                                                                                                                                                                                                                                     
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | For the year ended December 31, 2006, the Company recorded $345,000 of expense associated with share-based
  payments which would not have been recorded prior to the adoption of SFAS No. 123R. As a result of
  the adoption of SFAS No. 123R, income from continuing operations was reduced by $345,000 for the
  year ended December 31, 2006. Basic net income per share for the year ended December 31, 2006 was
  $0.08 lower as a result of the adoption of SFAS No. 123R. Diluted net income per share for the year
  ended December 31, 2006 was $0.08 lower as a result of the adoption of SFAS No. 123R.                                                                                
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | FAS 123R requires the cash flows resulting from the tax benefits related to tax deductions in excess
  of the compensation costs recognized (excess tax benefits) to be classified as financing cash flows.
  However, due to the Companys existing net operating loss carryforwards and the valuation allowance
  established to reduce the deferred tax assets there were no excess tax benefits. Therefore, there
  was no impact on cash flows as a result of the adoption of SFAS No. 123R... The Companys share-based
  compensation cost is recognized as an expense over the requisite service period using the graded,
  or accelerated, attribution method, or capitalized as inventory.

|F-11
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | Through 2005, the Company accounted for its stock option plans using the intrinsic value method. Had
  the fair value method prescribed by SFAS 123 been used to account for share-based compensation for
  the years ended December 31, 2005 and December 31, 2004 net income and net income per share would
  have been reduced to the following pro forma amounts (in thousands, except per share amounts):
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                               

|                                             | **Year ended
      December 31, 2005** |      | **Year ended
      December 31, 2004** |  
|-------------------------------------------- | -------------------------------------- | ---- | -------------------------------------- | -
|                                             |                                        |     
|                                            
|Net income  as reported                     | $                                      | 579  |                                        | $
|Fair value of stock-based compensation       |                                        | (310 | )                                      |  
|                                             |                                        |     
|Net income  pro forma                       | $                                      | 269  |                                        | $
|                                             |                                        |     
|                                             |                                        |      |                                        |  
|Net income per share  basic  as reported   | $                                      | 0.15 |                                        | $
|                                             |                                        |     
|Net income per share  diluted  as reported | $                                      | 0.13 |                                        | $
|                                             |                                        |     
|Net income per share  basic  pro forma     | $                                      | 0.07 |                                        | $
|                                             |                                        |     
|Net income per share  diluted  pro forma   | $                                      | 0.06 |                                        | $
|                                             |                                        |     

| | Comprehensive income                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Comprehensive income is the change in equity from transactions and other events and circumstances other
  than those resulting from investments by owners and distributions to owners. There are no significant
  components of comprehensive income excluded from net income, and therefore, no separate statement
  of comprehensive income has been presented.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Segment information                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | The Company uses one measurement of profitability of its business for internal purposes and has determined
  that it operates in one business segment: server appliances. The Companys sales by geographic
  area are included in Note 9.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Recent accounting pronouncements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes
  (as amended)an interpretation of FASB Statement No. 109 (FIN 48). FIN 48
  clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial
  statements in accordance with SFAS No. 109, Accounting for Income Taxes, and prescribes
  a recognition threshold and measurement attribute for the financial statement recognition and measurement
  of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on
  derecognition, classification, interest and penalties, accounting in interim periods, disclosure
  and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are in
  the process of analyzing the impact of FIN 48, which is required to be adopted by the first quarter
  of fiscal 2007.                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | In June 2005, the Financial Accounting Standards Board (FASB) issued SFAS No. 154, Accounting
  Changes and Error Corrections (SFAS No. 154), a replacement of APB Opinion No.
  20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim
  Financial Statements. SFAS No. 154 changes the requirements for the accounting for and reporting
  of a change in accounting principle. Previously, most voluntary changes in accounting principles
  required recognition via a cumulative effect adjustment within net income of the period of the change.
  SFAS No. 154 requires retrospective application to prior periods financial statements, unless
  it is impracticable to determine either the period-specific effects or the cumulative effect of the
  change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December
  15, 2005; however, the Statement does not change the transition provisions of any existing accounting
  pronouncements. The adoption of SFAS No. 154 did not have an effect on the Companys financial
  condition, or results of operations.

|F-12
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

|   | In September 2006, the FASB issued SFAS No. 157, Accounting for Fair Value Measurements.
  SFAS No. 157 defines fair value, and establishes a framework for measuring fair value in generally
  accepted accounting principles and expands disclosure about fair value measurements. SFAS No. 157
  is effective for the Company for financial statements issued subsequent to November 15, 2007. The
  Company does not expect the new standard to have any material impact on the financial position and
  results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   | In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and
  LiabilitiesIncluding an amendment of FASB Statement No. 115, which permits entities to
  measure eligible items at fair value. For items where the fair value election is made, we will be
  required to report unrealized gains or losses in earnings. SFAS 159 is effective for fiscal years
  beginning after November 15, 2007. At this time, the Company is assessing the impact the adoption
  of SFAS 159 will have on our financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   | In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No.
  108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in
  Current Year Financial Statements, (SAB No. 108). SAB No. 108 provides guidance
  regarding the consideration of the effects of prior year misstatements in quantifying current year
  misstatements for the purpose of materiality assessments. The method established by SAB No. 108 requires
  each of the Companys financial statements and the related financial statement disclosures to
  be considered when quantifying and assessing the materiality of the misstatement. SAB No. 108 is
  effective for fiscal years ending after November 15, 2006 and applies to the Companys financial
  statements for the fiscal year ended December 31, 2006. The adoption of SAB No. 108 did not have
  a material effect on the Companys financial condition and results of operations.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|3. | Balance Sheet Detail (in thousands)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   | Accounts Receivable, net:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

|         |                                       | **December 31,** |      
|-------- | ------------------------------------- | ---------------- | -----
|
|**2006** | **2005**                             
|         |                                       |                  |      
|        
|         | Accounts receivable                   | $                | 1,222
|         | Less: allowance for sales returns     |                  | (265 
|         | Less: allowance for doubtful accounts |                  | (25  
|         |                                       |                  |      
|        
|         | Total accounts receivable, net        | $                | 932  
|         |                                       |                  |      

| |             
| | ------------
| | Inventories:
| |             

|         |                   | **December 31,** |      
|-------- | ----------------- | ---------------- | -----
|
|**2006** | **2005**         
|         |                   |                  |      
|        
|         | Raw materials     | $                | 669  
|         | Work in process   |                  | 26   
|         | Finished goods    |                  | 321  
|         |                   |                  |      
|        
|         | Total inventories | $                | 1,016
|         |                   |                  |      

|F-13
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | Property and equipment:
| | -----------------------
| |                        

|         |                                                | **December 31,** |       
|-------- | ---------------------------------------------- | ---------------- | ------
|
|**2006** | **2005**                                      
|         |                                                |                  |       
|        
|         | Production, test and demonstration equipment   | $                | 480   
|         | Computer equipment                             |                  | 1,407 
|         | Office equipment                               |                  | 125   
|         | Leasehold improvements                         |                  | 477   
|         |                                                |                  |       
|         |                                                |                  | 2,489 
|         | Less accumulated depreciation and amortization |                  | (2,209
|         |                                                |                  |       
|        
|         | Total property and equipment                   | $                | 280   
|         |                                                |                  |       
|         |                                                |                  |       

| |                                                                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company recorded depreciation and amortization related to property and equipment of $115,000, $202,000
  and $206,000 in 2006, 2005 and 2004, respectively.                                                  
| |                                                                                                                                                                                                                  
| | As of both December 31, 2006 and 2005, the Company had $75,000 of equipment under capital leases. Accumulated
  amortization associated with these capital leases was $75,000 at both December 31, 2006 and 2005.
| |                                                                                                                                                                                                                  

| | Accrued liabilities:
| | --------------------
| |                     

|         |                             | **December 31,** |    
|-------- | --------------------------- | ---------------- | ---
|
|**2006** | **2005**                   
|         |                             |                  |    
|        
|         | Accrued compensation        | $                | 422
|         | Accrued sales and marketing |                  | 175
|         | Accrued professional fees   |                  | 50 
|         | Advances from customers     |                  | 58 
|         | Other accruals              |                  | 120
|         |                             |                  |    
|        
|         | Total accrued liabilities   | $                | 825
|         |                             |                  |    

|F-14
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

|4. | Commitments and Contingencies                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | Lease Commitments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | The Company has entered into a noncancelable operating lease for its corporate headquarters that expires
  in 2009 and is responsible for certain maintenance costs, taxes and insurance under the lease. The
  lease on the Companys headquarters facility was extended for a term of five years commencing
  on June 1, 2004 and expiring on May 31, 2009, with one conditional three-year renewal option, which
  if exercised, would extend the lease to May 31, 2012 commencing with rent at ninety-five percent
  of fair market value. Future minimum payments under the noncancelable operating lease are as follows
  (in thousands):
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

| | Year Ending December 31, |   |     |  | 
| | ------------------------ | - | --- |  | 
| | 2007                     | $ | 207 |  | 
| | 2008                     |   | 207 |  | 
| | 2009                     |   | 87  |  | 
| |                          |   |     | 
| |                          | $ | 501 |  | 
| |                          |   |     | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Rent expense, including the facility lease and equipment rental, was $222,000, $220,000 and $162,000
  for 2006, 2005 and 2004, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | Product Warranties and Guarantor Arrangements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | We offer warranties on certain products and record a liability for the estimated future costs associated
  with warranty claims, which is based upon historical experience and our estimate of the level of
  future costs. Warranty costs are reflected in the Statement of Earnings as a Cost of Sales. If actual
  warranty costs are different from our estimated costs, or if the warranty claims were to be significantly
  higher than our historical experience, then revisions to the estimated warranty liability may be
  required and the warranty expense could change from current levels. A reconciliation of the changes
  in our warranty liability during the periods presented is as follows (in thousands):
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

|         |                                                |  
|-------- | ---------------------------------------------- | -
|**2006** | **2005**                                      
|
|         | Warranty accrual at the beginning of the year  | $
|         | Accruals for warranties issued during the year |  
|         | Settlements made in kind during the year       |  
|
|         | Warranty accrual at the end of the year        | $
|

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | As permitted under California law, the Company has agreements whereby the Company indemnifies its officers
  and directors for certain events or occurrences while the officer or director is, or was, serving
  at the Companys request in such capacity. The term of the indemnification period is for the
  officers or directors lifetime. The maximum potential amount of future payments the Company
  could be required to make under these indemnification agreements is unlimited; however, the Company
  has a director and officer insurance policy that limits the Companys exposure and enables the
  Company to recover a portion of any future amounts paid. As a result of the Companys insurance
  policy coverage, the Company believes the estimated fair value of these indemnification agreements
  is minimal.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | The Company enters into standard indemnification agreements in the ordinary course of business. Pursuant
  to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified
  party for losses suffered or incurred by the indemnified party, generally the Companys                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

|F-15
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual
  property infringement claim by any third party with respect to the Companys products. The term
  of these indemnification agreements is generally perpetual following execution of the agreement.
  The maximum potential amount of future payments the Company could be required to make under these
  indemnification agreements is unlimited; however, the Company has never incurred costs to defend
  lawsuits or settle claims related to these indemnification agreements.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|5. | Bank Borrowings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | The Company renewed its line of credit with Silicon Valley Bank in July 2006, which now matures on
  July 30, 2007. The revolving line of credit provides for borrowings of up to $6.0 million. Borrowings
  under this line of credit agreement are collateralized by all of the Companys assets and bear
  interest at the banks prime rate plus 0.50%. The Company is required to maintain certain minimum
  cash and investment balances with the bank and to meet certain other financial covenants. As of December
  31, 2006, the Company had not drawn down on the line of credit and was in compliance with debt covenants
  and all other terms of the agreement.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|6. | Common Stock                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Dividend Policy                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | We have not paid cash dividends on our common stock. The Board of Directors periodically reviews the
  dividend policy and currently intends to retain any and all earnings for use in our business and
  we do not anticipate paying cash dividends in the foreseeable future. Our credit line provides that
  we shall not pay any dividend without the Banks prior consent.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | Stock Repurchase Program                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | In the fourth quarter of 2002, our Board of Directors authorized us, from time to time, to repurchase
  at market prices, up to $2.25 million of our common stock for cash in open market, negotiated or
  block transactions. The timing of such transactions will depend on market conditions, other corporate
  strategies and will be at our discretion. No time limit was set for the completion of this program.
  Under this program, we repurchased from open market and negotiated transactions a total of approximately
  1.67 million shares for approximately $1.8 million, at an average per share price of $1.10. The Company
  has not repurchased any of its common stock since then under this program.                                                                                                                                                        
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | In the third quarter of 2006, our Board of Directors authorized management, from time to time, to repurchase
  at market prices, up to $1 million worth of shares of the Companys common stock for cash in
  open market, negotiated or block transactions. The timing of such transactions has depended and will
  depend on market conditions, other corporate strategies and has been and will be at the discretion
  of management. No time limit was set for the completion of this program. At the time of approval
  by our Board of Directors, we had approximately 4 million shares of common stock outstanding. As
  of December 31, 2006, we had repurchased from open market transactions a total of 22,000 shares for
  $64,000, at an average per share price of $2.81. We intend to continue to execute our buyback program
  as our management deems advisable.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | 2002 Equity Incentive Plan                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | In December 2002, the shareholders of the Company approved the adoption of the 2002 Equity Incentive
  Plan (2002 Plan). A total of 850,000 shares of common stock have been reserved for issuance
  under the 2002 Plan. The 2002 Plan provides for awards to employees, directors, consultants and independent
  advisors. The adoption of the 2002 Plan was necessitated by the use or expiration of all but an insignificant
  amount of authorized shares under the prior option plans, (the 1995 Non-employee Directors
  Stock Option Plan (Directors Plan) and the 1988 Incentive Stock Plan (1988 Plan)).
  Under the 2002 Plan, the Board of Directors may grant either the right to purchase shares or options
  to purchase                                                                                                                                  

|F-16
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | shares of the Companys common stock at prices not less than the fair market value at the date
  of grant for incentive stock options and 85% of the fair market value at the date of grant for non-qualified
  options and purchase rights. Options granted under the 2002 Plan as well as those granted under the
  prior option plans generally become exercisable, and the Companys right to repurchase shares
  issued and sold pursuant to stock purchase rights generally lapses, at a rate of one-quarter of the
  shares under option or purchased under stock purchase rights at the end of the first year and thereafter
  ratably over the next three years. Awards under the 2002 Plan and the prior option plans generally
  expire seven years from the date of grant. No additional option grants will be made under any prior
  option plan.                                                                                                                  
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | The fair value of each of the Companys option awards is estimated on the date of grant using
  the Black-Scholes-Merton option-pricing model. Expected stock price volatility is based on historical
  volatility of the Companys common stock over the estimated expected life of the options. The
  expected term of options granted is based on historical experience, expected exercise behavior, and
  the terms and conditions of the options. Separate groups of option awardees that have similar historical
  exercise behavior are considered separately for valuation purposes. The ranges of the assumptions
  given below that were used to value option grants result from certain groups of option awardees exhibiting
  different behavior. As a result, the Company established two different groups of option awardees:
  directors and employees. The risk-free interest rates are based on the U.S. Treasury yield curve
  in effect at the time of grant.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | As of December 31, 2006, the Company had 850,000 shares of common stock reserved for issuance under
  the 2002 Plan, of which 633,000 shares were subject to outstanding options and 215,000 shares were
  available for future grants of stock awards. There were 603,000 shares subject to options outstanding
  under prior plans.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | Options granted under the 2002 Plan as well as those granted under the prior option plans generally
  become exercisable, and the Companys right to repurchase shares issued and sold pursuant to
  stock purchase rights under these plans generally lapses, at a rate of one-quarter of the shares
  subject to the options or purchased under stock purchase rights at the end of the first year and
  thereafter ratably over the next three years. Awards under the 2002 Plan and the prior option plans
  generally expire seven years from the date of grant.                                                                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | The fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton
  model with the following weighted-average assumptions for options granted during the years ended
  December 31:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

| |                         |         
| | ----------------------- | --------
|
| | Risk-free interest rate | 5.0%    
| | Expected term           | 3.0years
| | Expected dividends      |        
| | Volatility              | 49%     

| |                         |         
| | ----------------------- | --------
| | ****Directors****       | **2006**
|
| | Risk-free interest rate | 5.1%    
| | Expected term           | 5.0years
| | Expected dividends      |        
| | Volatility              | 59%     

|F-17
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | A summary of option activity during the year ended December 31, 2006 is presented below:
| | ----------------------------------------------------------------------------------------
| |                                                                                         

|Options                          |  | Shares 
      (in thousands) |       | Weighted
      Average
      Exercise
      Price |  | Weighted 
      Average 
      Remaining 
      Contractual
      Life 
      (in years) |      | Aggregate 
      Intrinsic 
      Value 
      (in thousands) | 
|-------------------------------- |  | ---------------------------- | ----- | ------------------------------------------------- |  | ---------------------------------------------------------------------------------------- | ---- | ------------------------------------------------------------- | 
|
|                                 |  |                              |       |                                                   |  |                                                                                          |      |                                                               | 
|Outstanding at Dec. 31, 2005     |  |                              | 1,301 |                                                   |  | $                                                                                        | 1.94 |                                                               | 
|Granted                          |  |                              | 32    |                                                   |  | $                                                                                        | 3.10 |                                                               | 
|Exercised                        |  |                              | (85   | )                                                 |  | $                                                                                        | 0.92 |                                                               | 
|Forfeited or expired             |  |                              | (12   | )                                                 |  | $                                                                                        | 3.25 |                                                               | 
|                                 |  |                              |       |                                                   |  |                                                                                          |      |                                                               | 
|Outstanding at December 31, 2006 |  |                              | 1,236 |                                                   |  | $                                                                                        | 2.03 |                                                               | 
|                                 |  |                              |      
|Exercisable at December 31, 2006 |  |                              | 1,039 |                                                   |  | $                                                                                        | 1.83 |                                                               | 
|                                 |  |                              |      

|   |                                                                                                                                                                                                                                                                                                                                                                                                    
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   | The weighted-average grant-date fair value of options granted during 2006, 2005, and 2004 was $1.52,
  $2.33 and $3.34 per share, respectively. The total intrinsic value of all options (which is the amount
  by which the stock price exceeded the exercise price of the options at the date of exercise) exercised
  was $171,000, $433,000 and $791,000 in 2006, 2005, and 2004, respectively.
|   |                                                                                                                                                                                                                                                                                                                                                                                                    
|   | As of December 31, 2006, there was $151,000 of total unrecognized compensation cost related to unvested
  stock options that is expected to be recognized over a weighted-average remaining vesting period
  of 0.9 years.                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                    
|7. | Income Taxes                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                    
|   | The provision (benefit) for income taxes is as follows (amounts in thousands).                                                                                                                                                                                                                                                                                                                     

| |                                            | 
| | ------------------------------------------ | 
|
|
|
| |                                            | 
| | Current                                    | 
| | Federal                                    | 
| | State                                      | 
| |                                            | 
| | Total Current                              | 
| | Deferred                                   | 
| | Federal                                    | 
| | State                                      | 
| |                                            | 
| | Total Deferred                             | 
|
| |                                            | 
| | Total provision (benefit) for income taxes | 
| |                                            | 

|F-18
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

| | The Companys tax provision (benefit) differs from the provision computed using statutory income
  tax rates as follows (in thousands):
| | ---------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                        

| | 2006                                             |   | 2005 |   | 2004 |     
| | ------------------------------------------------ | - | ---- | - | ---- | ----
|
| |                                                  |   |      |   |      |     
| | Federal tax provision at statutory rate          | $ | 233  |   | $    | 328 
| | Permanent difference due to                      |   |      |   |      |     
| | non-deductible expenses                          |   | 133  |   |      | 10  
| | State tax provision, net of federal benefit      |   | 5    |   |      | 5   
| | Utilization of net operating loss carryovers     |   |     |   |      |    
| | Change in deferred tax asset/valuation allowance |   | (342 | ) |      | 221 
| | General business credits                         |   |     |   |      | (169
| |                                                  |   |      |   |      |     
| |                                                  | $ | 29   |   | $    | 395 
| |                                                  |   |      |   |      |     

| |                                                                             
| | ----------------------------------------------------------------------------
| | The components of the net deferred tax assets are as follows (in thousands):
| |                                                                             

| | December 31,                         | 
| | ------------------------------------ | 
|
|
|
| |                                      | 
| | Inventory allowances and adjustments | 
| | Accounts receivable allowances       | 
| | Other liabilities and allowances     | 
| | Net operating loss carryforwards     | 
| | Tax credit carryforwards             | 
| | Depreciation and amortization        | 
| | Valuation allowance                  | 
| |                                      | 
| |                                      | 
| | Total net deferred tax assets        | 
| |                                      | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Significant management judgment is required in determining the provision for income taxes, and in particular, any valuation allowance recorded against the Companys deferred tax assets. During 2006, the Company recorded a tax provision of $29,000, while in 2005 it recorded a tax provision of $395,000. The Company annually reviews the future realization of its deferred tax assets based on the current years results and future taxable income. Based on this analysis it determines the appropriate valuation allowance against the deferred tax asset. The tax provision in 2006 reflects a decrease in the valuation allowance because the Company determined that it was more likely than not that certain future tax benefits would be realized as a result of projected future income. At December 31, 2005, as a result of this review, it was determined that an increase in the valuation
allowance was necessary.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | A portion of deferred tax assets relating to net operating losses pertains to net operating loss carryforwards resulting from tax deductions upon the exercise or disposition of employee stock options of approximately $1.3 million. When, and if, recognized, the tax benefit of these loss carryforwards will be accounted for as a credit to additional paid-in capital rather than a reduction to income tax expense.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | At December 31, 2006, the Company had net operating loss carryforwards of approximately $11.4 million and $97,000 available to offset future federal and California taxable income, respectively. These loss carryforwards will expire in varying amounts beginning in 2008. In addition, at December 31, 2006, the Company had federal and California credit carryforwards of approximately $1.3 million and $855,000,                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

|F-19
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

|   | respectively.  The federal credits expire in varying amounts beginning in 2007. The California credits have no expiration.                                                                                                                                
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   |                                                                                                                                                                                                                                                           
|   | For federal and state income tax purposes, the amount of benefit from the Companys net operating loss and credit carryforwards may be limited if the Company incurs a cumulative ownership change of more than 50%, as defined, over a three year period.
|   |                                                                                                                                                                                                                                                           
|   | The Companys profit before provision for income taxes for all periods presented was derived substantially from domestic operations.                                                                                                                      
|   |                                                                                                                                                                                                                                                           
|8. | Retirement Plan                                                                                                                                                                                                                                           

|   |                                                                                                                                                                                                                                               
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   | The Company has a voluntary 401(k) plan covering substantially all employees. The plan provides for employer contributions at the discretion of the Board of Directors. In 2006, 2005 and 2004, the Company made no contributions to the plan.
|   |                                                                                                                                                                                                                                               
|9. | Major Customers and Geographic Information                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                               
|   | Revenues by geographic area are determined by the location of the customer and are summarized as follows (in thousands):                                                                                                                      

| |                                           | 
| | ----------------------------------------- | 
|
|
| |                                           | 
| | United States                             | 
| | Europe                                    | 
| | Pacific Rim                               | 
| | Rest of Americas, excluding United States | 
| |                                           | 
| |                                           | 
| | Total revenues                            | 
| |                                           | 

| |                                                                                                       
| | ------------------------------------------------------------------------------------------------------
| | Customers that individually accounted for greater than 10% of net sales are as follows (in thousands):
| |                                                                                                       

| | Year Ended December 31, | 
| | ----------------------- | 
|
|
|
| |                         | 
|
| | A                       | 
| | B                       | 

| |                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------
| | Customers that individually accounted for greater than 10% of accounts receivable are as follows (in thousands):
| |                                                                                                                 

| | Year Ended December 31, |  |  
| | ----------------------- |  | -
|
|
| |                         |  |  
|
| | A                       |  | $
| | B                       |  | $

|F-20
|----



|CastelleNotes to Consolidated Financial Statements
|--------------------------------------------------
|                                                  
|                                                  

|10. | Litigation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|    | From time to time and in the ordinary course of business, the Company is involved in various legal proceedings and third party assertions of patent or trademark infringement claims against the Company in the form of letters and other forms of communication. The Company is not currently involved in any litigation which, in managements opinion, would have a material adverse effect on its business, operating results, cash flows or financial condition; however, there can be no assurance that any such proceeding will not escalate or otherwise become material to the Companys business in the future.
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|11. | Subsequent Events                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|    | As of March 21, 2007, the Company had repurchased 8,000 shares of common stock in open market transactions subsequent to December 31, 2006. These shares were repurchased for approximately $25,000 or $3.17 per share. The shares are, or will be, retired.                                                                                                                                                                                                                                                                                                                                                             

|F-21
|----



|CastelleSupplemental Financial Information                                                                                                                                                                                                                                                                                                              
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                        
|Supplemental Data (unaudited)                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                        
|The information set forth below is not necessarily indicative of results of future operations, and should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and related Notes thereto included elsewhere in this Annual Report on Form 10-K.
|                                                                                                                                                                                                                                                                                                                                                        

| | Quarterly Results of Operations (unaudited)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | The following table sets forth certain consolidated quarterly financial data for the eight quarters ended December 31, 2006. This information is unaudited, but in our opinion, has been prepared on the same basis as the audited consolidated financial statements appearing elsewhere in this report, and all necessary adjustments, consisting only of normal recurring adjustments, have been included in the amounts stated below to present fairly the unaudited interim results. The results of operations for any quarter are not necessarily indicative of the results of operations for any future period.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

| | Year 2006, Quarter Ended             |  |  
| | ------------------------------------ |  | -
|
|
|
|
|
| | Net sales                            |  | $
| | Gross profit                         |  |  
| | Operating income/(loss)              |  |  
| | Net income/(loss)                    |  |  
| | Net income/(loss) per share, basic   |  |  
| | Net income/(loss) per share, diluted |  |  

| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | In 2006, we recorded a tax provision of $29,000, or $0.01 per diluted share, resulting from federal and state provision and a decrease in valuation allowance to reflect managements best estimate of deferred tax assets expected to be utilized in future periods. 2006 federal and state tax liability was almost entirely offset by the utilization of existing net operating losses, and therefore, we do not expect to utilize significant amounts of cash for income tax payments until our $11 million of available net operating loss carryforwards as of December 31, 2006 have been utilized.
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

| | Year 2005, Quarter Ended             |  |  
| | ------------------------------------ |  | -
|
|
|
|
|
| | Net sales                            |  | $
| | Gross profit                         |  |  
| | Operating income                     |  |  
| | Net income/(loss)                    |  |  
| | Net income/(loss) per share, basic   |  |  
| | Net income/(loss) per share, diluted |  |  

| |     |                                                                                                                                                                                                                                                                        
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | In 2005, we recorded a tax provision of $395,000, or $0.09 per diluted share, resulting from federal and state provision and an increase in valuation allowance to reflect managements best estimate of deferred tax assets expected to be utilized in future periods.

|F-22
|----



|Castelle                          | Schedule II
|--------------------------------- | -----------
|Valuation and Qualifying Accounts
|(in thousands)                   
|                                 
|                                 

|                                               | Balance at
      Beginning 
      of Period |   | Additions 
      Charged to
      Costs and 
      Expenses |  | Deductions |     | Balance at
      End of 
      Period |  
|---------------------------------------------- | ------------------------------------------- | - | ----------------------------------------------------------- |  | ---------- | --- | ------------------------------------- | -
|
|                                               |                                             |   |                                                             |  |            |     |                                       |  
|Year Ended December 31, 2004:                  |                                             |   |                                                             |  |            |     |                                       |  
|Deducted from asset accounts:                  |                                             |   |                                                             |  |            |     |                                       |  
|Allowance for doubtful accounts                |                                             | $ | 39                                                          |  | $          | (1  | )                                     | $
|Allowance for sales returns and stock rotation |                                             | $ | 442                                                         |  | $          | 886 |                                       | $
|Valuation allowance for deferred tax asset     |                                             | $ | 6,688                                                       |  | $          |    |                                       | $
|                                               |                                             |   |                                                             |  |            |     |                                       |  
|Year Ended December 31, 2005:                  |                                             |   |                                                             |  |            |     |                                       |  
|Deducted from asset accounts:                  |                                             |   |                                                             |  |            |     |                                       |  
|Allowance for doubtful accounts                |                                             | $ | 30                                                          |  | $          | 2   |                                       | $
|Allowance for sales returns and stock rotation |                                             | $ | 408                                                         |  | $          | 507 |                                       | $
|Valuation allowance for deferred tax asset     |                                             | $ | 5,579                                                       |  | $          | 383 |                                       | $
|                                               |                                             |   |                                                             |  |            |     |                                       |  
|Year Ended December 31, 2006:                  |                                             |   |                                                             |  |            |     |                                       |  
|Deducted from asset accounts:                  |                                             |   |                                                             |  |            |     |                                       |  
|Allowance for doubtful accounts                |                                             | $ | 30                                                          |  | $          |    |                                       | $
|Allowance for sales returns and stock rotation |                                             | $ | 317                                                         |  | $          |    |                                       | $
|Valuation allowance for deferred tax asset     |                                             | $ | 5,792                                                       |  | $          |    |                                       | $

|F-23
|----



|Castelle and SubsidiariesFinancial Data Schedule | ****
|------------------------------------------------ | ----
|                                                
|                                                

|Exhibit
          Number |  | **Description**                                                                                                                                
|------------------------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------
|                         |  |                                                                                                                                                
|                        
|23.1                     |  | Consent of Independent Registered Public Accounting Firm  Grant Thornton LLP                                                                  
|                         |  |                                                                                                                                                
|31.1                     |  | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  Chief Executive Officer                                              
|                         |  |                                                                                                                                                
|31.2                     |  | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  Chief Financial Officer                                              
|                         |  |                                                                                                                                                
|32.1                     |  | Certification Pursuant to 8 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  Chief Executive Officer
|                         |  |                                                                                                                                                
|32.2                     |  | Certification Pursuant to 8 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  Chief Financial Officer

|F-24
|----